All Markets Equilibrium:

and
Role of MP and FP

Q: Why Output fluctuates in the short-run?

Q: How MP and FP can control such fluctuations?
 The IS-LM, Lab Mkt and AS-AD Model

Product Market IS
curve
IS-LM Determines
model interest rate
Money Market LM curve and output

Determines
Agg. Price, Interest
demand Rate , Wage Rate
curve and Output
Model of
Agg. Demand
and Agg.
Determines Supply
Labour Market wage Rate Agg. supply
Explanation of
and output curve
short-run
fluctuations
The Fortunes of FedEx Follow the Business Cycle

• Some Wall Street analysts use a “FedEx indicator” to gauge the state of the
economy
• Shows close relationship between fluctuations in FedEx’s business and
fluctuations in GDP.

• Despite FedEx’s tremendous success over the past 40 years, the business
cycle has always affected the company’s business.

• How the business cycle affects FedEx and other firms

• Explained through AS-AD model
• Its impact through Monetary and Fiscal Policy.

• Explore the effects that recessions and expansions have on production,

employment, and prices.
 Facts About Economic Fluctuations
• Economic activity fluctuates from year to year.
1 Economic fluctuations are irregular and unpredictable.
2. Most macroeconomic quantities fluctuate together.
3. As output falls, unemployment rises.
▪ Economist use the model of Aggregate Demand and Aggregate Supply
▪ To explain short-run fluctuations in economic activity around its long-run
trend.

Business
Economic cycle
activity

Time
 Facts About Economic Fluctuations
Real GDP Growth Rate:
GDP at FC (constant price) base year (1999-2000)
12.00
Business Cycle
10.00

8.00

6.00

4.00

2.00

0.00

-2.00

-4.00

-6.00
Trend Line or Potential Growth Rate of output
 Facts About Economic Fluctuations
Business Cycle and Inflation rate

OPEC crisis
Asian Financial crisis
Business Cycles

b. Business Cycle: Inflation rate

 AD-AS Equilibrium
in the Short Run and Long Run

Reference : Ch 7 Putting all market together, in Macroeconomics by Oliver

Blanchard, 4E, Pearson, pg 145 to 155.
 AD and AS Equilibrium:
in the Short Run and Medium Run

 Y 
AS Relation P = P (1 + ) F  1 − , z
e
 L 

▪ Equilibrium depends on the value of Pe.

▪ The value of Pe determines the position of the aggregate supply

curve, and the position of the AS curve affects the equilibrium.
 The Short Run Equilibrium
➢ Point A is equilibrium point,
not B , where labor market,
PM and FM eqm
product market, and
financial market are all in
equilibrium.

• P is the Equilibrium Price Lab mkt eqm

• Y is the Equilibrium
Output

➢ In the short run there is no

reason why Y should be = Yn

➢ The AS Curve is drawn for a given value of Pe. The higher the level of output (Y), the higher the price level (P).
➢ The AD is drawn for given values of C, I, M, G, and T. The higher the price level the lower is the level of output.
 From Short-Run to Medium Run Equilibrium

➢ At point A, Y  Yn  P  P e

➢ So, wage setters will revise their

expectations of the future price level to go
up.

➢ This will cause the AS curve to shift to AS’

where Pe’ > P. and given the AD curve
equilibrium moved to A’. Pe B

➢ If Pe ↑ this leads to ↑ W leads to ↑ P.

Yn

➢ Expectation of a higher price level also leads to

a higher nominal wage, which in turn leads to a
higher price level
 From Short-Run to Medium Run Equilibrium
The Adjustment of Output over Time In Short Run Y≠Yn
In Medium Run Y→Yn
➢ If Y>Yn, then AS curve shifts
up(left) over time until output
has fallen back to the natural
level of output.

Y = Yn and P = P e

➢ The adjustment ends once wage setters

no longer have a reason to change their AD’
expectations.

➢ In the medium run, output returns to the

natural level of output (Y=Yn) and P=Pe

When Y>Yn, P↑, The ↑P=> ↓AD=> ↓Y. then MP and FP plays an important role to shift
demand curve to reduce the price level and restore the equilibrium at a lower price.
 From Short-Run to Long-Run Equilibrium
In the long-run equilibrium, PE = P, & Y = YN ,
and unemployment is at its natural rate.
Price
Level
Long-run
aggregate
Short-run
supply
aggregate
supply

Equilibrium A
price

P=Pe

Aggregate
demand
0 Natural level of Quantity of
of output Y=Yn Output
AD and AS to Depict Long-Run Growth and Inflation

2. . . . and growth in the Long-run

money supply shifts aggregate
aggregate demand . . . supply,
LRAS1980 LRAS1990 LRAS2000
Price
Level

1. In the long run,

technological
progress shifts
P2000 long-run aggregate
supply . . .
4. . . . and
ongoing inflation.
P1990
Aggregate
Demand, AD2000
P1980
AD1990

AD1980

0 Y1980 Y1990 Y2000 Quantity of

Output
3. . . . leading to growth
in output . . .
 Two Causes Of Economic Fluctuations

1. Shift in AD
Two 2.
Causes:
Shift in AS
1. Shifts in Aggregate Demand
Reference: 2. Shifts in Aggregate Supply
1. Ch 33 Aggregate Demand and Supply in Principles of Economics by N
G Mankiw, 7E Cengage Learning.
 1. Shifts in Aggregate Demand
• In the short run, shifts in aggregate demand cause
fluctuations in the economy’s output of goods and
services.

• In the long run, shifts in aggregate demand affect the

overall price level but do not affect output.

• Policymakers who influence aggregate demand can

potentially mitigate the severity of economic
fluctuations.
 1. Shifts in Aggregate Demand
Event: Stock market
2. . . . causes output to fall in the short run . . .leading to recession
crash
Price Affects C, AD curve
Level
Long-run Short-run aggregate
aggregate supply, AS
supply
AS2

3. . . . but over
time, the short-run
P A aggregate-supply
curve shifts . . .
P2 B
1. A decrease in
aggregate demand . . .
P3 C
Aggregate
demand, AD
AD2
0 Y2 Y Quantity of
4. . . . and output returns Output
to its natural rate.
 Two Big AD Shifts:
1. The Great Depression

From 1929–1933,
U.S. Real GDP,
• money supply fell 28% due to
problems in banking system billions of 2000 dollars
900
• stock prices fell 90%, reducing
850
C and I
800
• Y fell 27%
750
• P fell 22%
700
• u-rate rose
from 3% to 25% 650
600
550
1929

1930

1931

1932

1933

1934
 Two Big AD Shifts:
2. The World War II Boom

From 1939–1944, U.S. Real GDP,

• govt outlays rose from $9.1
billions of 2000 dollars
billion to $91.3 billion 2,000
• Y rose 90%
1,800
• P rose 20%
• unemp fell from 17% to 1% 1,600

1,400

1,200

1,000

800
1939

1940

1941

1942

1943

1944
 2. Shifts in Aggregate Supply
Consider an adverse shift in aggregate supply:

• Might arise due to natural calamities like earthquake,

Tsunami, Cyclone, drought, etc.
OR
• A decrease in one of the determinants of aggregate
supply shifts the curve to the left.

• Output falls below the natural rate of employment.

• Unemployment rises.

• The price level rises.

 2. Shifts in Aggregate Supply
Event :natural calamities like earthquake,
Tsunami, Cyclone, drought, Covid-19, WAR
1. An adverse shift in the short-
SRASC Shift downward run aggregate-supply curve . . .
Price
Level

Long-run Short-run
aggregate AS2 aggregate
supply supply, AS

B
P2
A
P
3. . . . and
the price
level to rise.
Aggregate demand

0 Y2 Y Quantity of
2. . . . causes output to fall . . . Output
 2. Shifts in Aggregate Supply: The Effects

▪ Adverse shifts in AS cause stagflation (i.e. a period of recession

and inflation).
• Output falls and prices rise.

▪ Policymakers who can influence AD cannot offset both of these

adverse effects simultaneously.

▪ Policy Responses to Recession either of these

- Do nothing and wait for prices and wages to adjust.
- Take action to increase aggregate demand by using
monetary and fiscal policy
Accommodating an Adverse Shift in Aggregate Supply

1. When short-run aggregate

supply falls . . .
Price
Level
Long-run Short-run
aggregate AS2 aggregate
supply supply, AS

P3 C 2. . . . policymakers can
P2 accommodate the shift
A by expanding aggregate
3. . . . which P demand . . .
causes the
price level
to rise 4. . . . but keeps output AD2
further . . . at its natural rate.
Aggregate demand, AD

0 Natural rate Quantity of

of output Output
 The Effects of a Shift in SRAS
Event: Oil prices rise
1. Increases costs,
shifts SRAS P LRAS
(assume LRAS constant)
SRAS2
2. SRAS shifts left
3. SR eq’m at point B. SRAS1
P higher, Y lower, B
unemp higher P2
From A to B, stagflation, A
P1
a period of
falling output
and rising prices.
AD1
Y
Y2 YN
 Accommodating an Adverse Shift in SRAS
If policymakers do nothing,
4. Low employment
causes wages to fall, SRAS shifts P LRAS
right,
SRAS2
until LR eq’m at A.
P3 C SRAS1
B
Or, P2
policymakers could use fiscal or
monetary policy to shift AD P1 A
AD2
towards right and accommodate
the AS shift:
Y back to YN, but AD1
P permanently higher. Y
Y2 YN
The 1970s Oil Shocks and Their Effects

1973–75 1978–80

Real oil prices + 138% + 99%

CPI + 21% + 26%

Real GDP – 0.7% + 2.9%

# of unemployed + 3.5 + 1.4

persons million million
 Monetary and Fiscal Policy
on
Aggregate Demand
▪ Monetary and fiscal policy are sometimes used to offset those
shifts and stabilize the economy.

1. Ch 34 The Influence of Monetary and Fiscal Policy on Aggregate

Demand in Principles of Economics by N G Mankiw, 7E Cengage
Learning.
How Monetary Policy Influences Aggregate Demand
 How Monetary Policy Influences Aggregate Demand
The Downward Slope of the Aggregate-Demand Curve

(a) The Money Market (b) The Aggregate-Demand Curve

Interest Money Price

Rate supply Level
2. . . . increases the
demand for money . . .

r2 P2
Money demand at
price level P2 , MD2
r 1. An P
3. . . .
which increase
Money demand at in the Aggregate
increases
price level P , MD price demand
the
equilibrium 0 level . . . 0
Quantity fixed Quantity Y2 Y Quantity
interest
by the RBI of Money of Output
rate . . .
4. . . . which in turn reduces the quantity
of goods and services demanded.
 How Monetary Policy Influences Aggregate Demand
Changes in the Money Supply

▪ The RBI can shift the aggregate demand curve when it changes monetary
policy.
• An increase in the money supply shifts the money supply curve to the
right.
• Without a change in the money demand curve, the interest rate falls.
• Falling interest rates increase the quantity of goods and services
demanded.
▪ When the RBI increases the money supply, it lowers the interest rate and
increases the quantity of goods and services demanded at any given price
level, shifting aggregate-demand to the right.

▪ When the RBI decreases the money supply, it raises the interest rate and
reduces the quantity of goods and services demanded at any given price level,
shifting aggregate-demand to the left.
 How Monetary Policy Influences Aggregate Demand
Changes in the Money Supply

(a) The Money Market (b) The Aggregate-Demand Curve

Interest Price
Rate Money MS2 Level
supply,
MS

r 1. When the RBI P

increases the
money supply . . .
2. . . . the r2
AD2
equilibrium
interest rate Money demand Aggregate
falls . . . at price level P demand, AD
0 Quantity 0 Y Y Quantity
of Money of Output
3. . . . which increases the quantity of goods
and services demanded at a given price level.
Monetary policy

For each of the events below,

- determine the short-run effects on output
- determine how the RBI should adjust the money
supply and interest rates to stabilize output
A. BJP Govt tries to balance the budget by cutting govt
spending.

B. A stock market boom increases household wealth

C. War breaks out in the Russian- Ukraine, causing oil prices

to soar.
Answers
A. BJP Govt tries to balance the budget by cutting govt spending.
This event would reduce Agg Demand and Output.
To stabilize output, the RBI should increase MS and reduce r to increase
AD.

B. A stock market boom increases household wealth.

This event would increase AD, raising output above its natural rate.
To stabilize output, the RBI should reduce MS and increase r to reduce AD.

C. War breaks out in the Russia Ukriane, causing oil prices to soar.
This event would reduce AS, causing output to fall.

To stabilize output, the RBI should increase MS and reduce r to increase

AD.
How Fiscal Policy Influences Aggregate Demand
 How Fiscal Policy Influences Aggregate Demand
• an increase in G
and/or decrease in T
• shifts AD right
• Fiscal policy
– (a) Government Expenditure
– (b) Taxes(T)
– (c) Transfer Payments ( Tr).

• Fiscal policy influences saving, investment,

and growth in the long run.

• In the short run, fiscal policy primarily affects the

aggregate demand.
 A. Changes in Government Purchases (G0)

▪ When policymakers change the money supply or taxes, the

effect on aggregate demand is indirect—through the spending
decisions of firms or households.

▪ When the government alters its own purchases of goods or

services, it shifts the aggregate-demand curve directly.

▪ There are two macroeconomic effects from the change in

government purchases:
▪
• The multiplier effect
• The crowding-out effect
 1. The Multiplier Effect

▪ Q. If suppose the Central Govt spends Rs 20 million to buy

helicopter from HAL this year , how it affects the AD or economy?

Ans: HAL’s revenue increases by Rs 20 million.

This money is distributed to HAL’s workers (as wages) and owners
(as profits or stock dividends). Since these people are also
consumers , they will spend a portion of the extra income which
further causes increases in AD via multiplier.

The multiplier is: Multiplier = 1/(1 – MPC)

Let the MPC = 3/4, then the multiplier will be
Multiplier = 1/(1 – 3/4) = 4

In this case, a Rs 20 milion increase in government spending for

buying Aircraft from HAL generates Rs 80 milion of increased
demand for goods and services.
 1. The Multiplier Effect

Price
Level

2. . . . but the multiplier

effect can amplify the
shift in aggregate
demand.

Rs. 20 milion

AD3
AD2
Aggregate demand, AD1
0 Quantity of
1. An increase in government purchases Output
of Rs. 20 milion initially increases aggregate
demand by Rs. 20 milion . . .
 2. The Crowding-Out Effect
• Q. If suppose the Central Govt spends Rs 20 million for buying
helicopter from HAL this year and money is financed through
borrowing from market , what will happen to AD and economy?
▪ An ↑Govt Exp.=> ↑ i=>↓I=>↓AD.
▪ This reduction in demand that results when a fiscal expansion
raises the interest rate is called the crowding-out effect.

▪ The crowding-out effect tends to dampen the effects of fiscal

policy on aggregate demand.

▪ When the government increases its purchases by Rs. 20 milion,

the aggregate demand for goods and services could rise by more
or less than Rs. 20 milion, depending on whether the multiplier
effect or the crowding-out effect is larger.
 2.The Crowding-Out Effect

(a) The Money Market (b) The Shift in Aggregate Demand

Interest Price
Money 4. . . . which in turn
Rate Level
supply partly offsets the
2. . . . the increase in Rs.20 milion initial increase in
spending increases aggregate demand.
money demand . . .
r2

3. . . . which
increases AD2
the r
AD3
equilibrium M D2
interest
rate . . . Aggregate demand, AD1
Money demand, MD
0 Quantity fixed Quantity 0 Quantity
by the Fed of Money 1. When an increase in government of Output
purchases increases aggregate
demand . . .
 B. Changes in Taxes(T)
• Q. If suppose the Central Govt spends Rs 20 million for buying
helicopter from HAL this year and money is financed through
raising Taxes (T) , what will happen to AD and economy?

▪ When Govt. ↑ Income T=> take home income of household

↓ => ↓ Pvt S ↓ also Pvt C => ↓ C leads to ↓ AD.

▪ The size of the shift in aggregate demand resulting from a

tax change is affected by the multiplier and crowding-out
effects.

▪ It is also determined by the households’ perceptions about

the permanency of the tax change.
Q.Fiscal policy effects

Suppose the economy is in recession and needs policy

intervention. Let Shifting the AD curve rightward by Rs.200
billion would end the recession.

A. If MPC = 0.8 and there is no crowding out, how

much should Govt increase G to end the recession?

B. If there is crowding out, will Govt need to increase

G more or less than this amount?
Answers
Suppose the economy is in recession and needs policy intervention.
Let Shifting the AD curve rightward by Rs.200b would end the
recession.
A. If MPC = 0.8 and there is no crowding out, how much should
Govt increase G to end the recession?
Multiplier = 1/(1 – .8) = 5
Increase G by Rs.40b
to shift agg demand by 5 x Rs.40b = Rs.200b.

B. If there is crowding out, will Govt need to increase G more or less

than this amount?
Crowding out reduces the impact of G on AD.
To offset this, Govt should increase G by a larger amount.
Fiscal Policy Influences on Aggregate Supply
 Fiscal Policy and Aggregate Supply

▪ Most economists believe the short-run effects of fiscal policy mainly

work through AD.

▪ But fiscal policy might also affect AS.

How Fiscal Policy Affects Aggregate Supply?

1. Taxation :
A cut in the tax rate gives workers incentive to work more, so it might
increase the quantity of Goods & Services supplied and shift AS to the
right.

People who believe this effect is large are called “Supply-Siders.”

• Ex. The then US President Ronald Ragan and his economic advisor
Arthur Laffer.
 Fiscal Policy and Aggregate Supply

2. Govt Spending.
▪ Govt purchases might affect AS.
Example:
• Govt increases spending on roads.
• Better roads may increase business productivity,
which increases the quantity of Goods &Services
supplied, shifts AS to the right.
▪ This effect is probably more relevant in the long run:
it takes time to build the new roads and put them
into use.
 References.
▪ Ch 7 Putting all market together, in Macroeconomics by Oliver
Blanchard, 4E, Pearson, pg 145 to 155.
▪ Ch 33 Aggregate Demand and Supply in Principles of Economics
by N G Mankiw, 7E Cengage Learning.
▪ Ch 34 The Influence of Monetary and Fiscal Policy on Aggregate
Demand in Principles of Economics by N G Mankiw, 7E Cengage
Learning.
Thank You All