Chapter 6 Aggregate Demand and Aggregate Supply

BÙI DUY HƯNG
MACROECONOMICS
CHAPTER
6
AGGREGATE DEMAND AND AGGREGATE SUPPLY
Interactive PowerPoint Slides by:
V. Andreea Chiritescu
Eastern Illinois University
1
IN THIS CHAPTER
• What are economic fluctuations? What are their characteristics?

• How does the model of aggregate demand and aggregate supply
explain economic fluctuations?
• Why does the Aggregate-Demand curve slope downward? What shifts
the AD curve?
• What is the slope of the Aggregate-Supply curve in the short run? In
the long run? What shifts the AS curve(s)?
2
IN THIS CHAPTER
1. Three key facts about economic fluctuations
2. The aggregate-demand curve
3. The aggregate-supply curve
4. Explaining short-run economic fluctuations
3
Introduction
• Real GDP over the long run, Vietnam.

– Grows about 6.78% per year on average since 1992
• GDP in the short run
– Fluctuates around its trend
• Recessions
– Periods of falling real incomes and rising unemployment
• Depressions
– Severe recessions (very rare)
4
Chapter 6: Aggregate Demand and Aggregate Supply
I THREE KEY FACTS ABOUT ECONOMIC FLUCTUATIONS
10
9.3
FACT 1: 9
8.4 8.23 8.48 GDP growth rate since 1992
8.2
Economic 8 7.8
fluctuations are 6.8 6.9

7.1
7.3
6.78 6.81
7.08 7.02
7 6.68
irregular and 6.18
5.89 5.98
6.2
5.8
unpredictable 6
5.32 5.42
5.03
5 4.8
2.91
3 2.6
5
FACT 2: Most Real Gross Private Domestic Investment 1969-2019

macroeconomic
quantities fluctuate
together.
6
9
FACT 3: As output
falls, unemployment 8
rises. 7
7
The Assumptions of Classical Economics
• The Classical Dichotomy

– Separation of variables into two groups:
• Real – quantities, relative prices
• Nominal – measured in terms of money
• The neutrality of money:
– Changes in the money supply affect nominal but not real variables
8
The Reality of Short-Run Fluctuations
• Classical theory
– Describes the world in the long run, but not the short run
• In the short run
– Changes in nominal variables (like the money supply or P ) can
affect real variables (like Y or the u-rate).
– We use a new model…
9
Model of aggregate demand and aggregate supply
The price level P “Short-Run
The model Aggregate Supply”
determines the SRAS
equilibrium
price level P1
AD
“Aggregate
Demand”
and equilibrium Y
Y1
output (real GDP).
Real GDP, the
quantity of output
10
I THE AGGREGATE-DEMAND (AD) CURVE
The AD curve shows the quantity of all g&s demanded in the economy at any
given price level.
P
Why the AD curve slopes downward?
Y = C + I + G + NX P2
Assume G is fixed by government policy.
To understand the slope of AD,
must determine how a change in P affects P1
C, I, and NX.
AD
Y2 Y1 Y
11
Why the AD curve slopes downward

The Wealth Effect (P and C )
• Suppose the price level, P, declines
– Increase in the real value of money
– Consumers are wealthier
– Increase in consumer spending, C
– Increase in quantity demanded of goods and services (AD increases)
12

The Interest-Rate Effect (P and I)
– Buying goods and services requires fewer dollars: people buy bonds and
other assets
– Decrease in the interest rate
– Increase spending on investment goods, I
13

The Exchange-Rate Effect (P and NX )
– Decrease in interest rate
– Domestic currency depreciates (decline in the real value of domestic currency
in foreign-exchange markets)
– Stimulates net exports, NX
14
WHY THE AD CURVE SLOPES DOWNWARD

P
An increase in P reduces the quantity
of goods and services demanded
P2
because:
• the wealth effect (C falls)
• the interest-rate effect (I falls)
P1
• the exchange-rate effect (NX falls)
AD
Y
Y2 Y1
15
A shift in the AD curve

P
What is the effect of a stock market boom on
the AD curve?
A stock market boom makes households feel
wealthier, C rises, the AD curve shifts right. P1
Any event that changes C, I, G, or NX (EXCEPT
A CHANGE IN P) will shift the AD curve.
AD2
AD1
Y
Y1 Y2
16
Why the AD Curve Might Shift – 1

• Changes in C
– Stock market boom/crash
– Preferences re: consumption/saving tradeoff
– Tax hikes/cuts
• Changes in I
– Firms buy new computers, equipment, factories
– Expectations, optimism/pessimism
– Interest rates,
– Monetary policy,
– Investment Tax Credit or other tax incentives
17
Why the AD Curve Might Shift – 2

• Changes in G
– Government spending, e.g., defense
– Local province spending, e.g., roads, schools
• Changes in NX
– Booms/recessions in countries that buy our exports
– Appreciation/depreciation resulting from international
speculation in foreign exchange market
18
Active Learning 1: The aggregate-demand curve
What happens to the AD curve in each of the following scenarios?

A. An investment stimulus policy expires.
B. The Vietnamese exchange rate falls.
C. A fall in prices increases the real value of consumers’ wealth.
19
Active Learning 1: Answers
A. An investment policy expires.

– I falls, AD curve shifts left.
B. The Vietnamese exchange rate falls.
– NX rises, AD curve shifts right.
C. A fall in prices increases the real value of consumers’ wealth.
– Move down along AD curve (wealth-effect).
20
II THE AGGREGATE-SUPPLY (AS) CURVE
The AS curve shows the total quantity

of goods and services firms produce P LRAS
and sell at any given price level.
SRAS
AS is:
 upward-sloping in short run
 vertical in long run
21
II THE AGGREGATE-SUPPLY (AS) CURVE – LONG RUN (LRAS)
The natural rate of output (YN) is the amount of P LRAS

output the economy produces when unemployment
is at its natural rate.
Also called
potential output
or
full-employment output.
YN Y
22
Why LRAS is vertical

P LRAS
YN determined by the economy’s stocks of
labor, capital, and natural resources, and on
the level of technology.
P2
An increase in P does not affect any of these,
so it does not affect YN. P1
(Classical dichotomy)
YN Y
23
A shift in the LRAS curve

P LRAS1 LRAS2
What is the effect of an increase in

immigration on the LRAS curve?
Immigration increases the
economy’s stock of labor, L,
causing YN to rise.
Any event that changes any of the
determinants of YN will shift LRAS.
YN Y’
N Y
24
Why the LRAS Curve Might Shift – 1

• Changes in L or natural rate of unemployment
– Immigration
– Baby-boomers retire
– Government policies reduce natural u-rate
• Changes in K or H
– Investment in factories, equipment
– More people get college degrees
– Factories destroyed by a hurricane
25
Why the LRAS Curve Might Shift – 2

• Changes in natural resources
– Discovery of new mineral deposits
– Reduction in supply of imported oil
– Changing weather patterns that affect agricultural production
• Changes in technology
– Productivity improvements from technological progress
26
Using AD & AS to depict long-run growth & inflation
LRAS2020
Over the long run, tech. progress shifts P LRAS2010
LRAS2000
LRAS to the right
• and growth in the money supply shifts
AD to the right. P2020
• Result: ongoing inflation and growth
in output. P2010
AD2020
P2000
AD2010
AD2000
Y
Y2000 Y2010 Y2020
27
II THE AGGREGATE-SUPPLY (AS) CURVE – SHORT RUN (SRAS)
P
The SRAS curve is upward sloping:
SRAS
Over the period of 1–2 years, an increase in P
P2
• causes an increase in the quantity of goods

and services supplied. P1
Y
Y1 Y2
28
Why the Slope of SRAS Matters

P LRAS
If AS is vertical, fluctuations in AD
do not cause fluctuations in output or Phi
SRAS
employment.
Phi
If AS slopes up, then shifts in AD

do affect output and employment. ADhi
Plo
AD1
Plo
ADlo
Ylo Y1 Yhi Y
29
The Sticky-Wage Theory – 1
• Imperfection:
– Nominal wages are sticky in the short run, they adjust sluggishly.
• Due to labor contracts, social norms
• Firms and workers set the nominal wage in advance based on PE, the
price level they expect to prevail.
30
The Sticky-Wage Theory – 2

• If P > PE,
– Revenue is higher, but labor cost is not.
– Production is more profitable, so firms increase output and employment.
Hence, higher P causes higher Y, so the SRAS curve slopes upward.
31
The Sticky-Price Theory – 1

• Imperfection:
– Many prices are sticky in the short run.
• Due to menu costs, the costs of adjusting prices.
• Examples: cost of printing new menus, the time required to change price
tags
– Firms set sticky prices in advance based on PE
32
The Sticky-Price Theory – 2

• Suppose the Fed increases the money supply unexpectedly
– In the long run, P will rise
– In the short run:
• Firms without menu costs can raise their prices immediately
• Firms with menu costs wait to raise prices. With relatively low prices:
increase demand for their products: increase output and employment
Hence, higher P is associated with higher Y.
33
The Misperceptions Theory

• Imperfection:
– Firms may confuse changes in P with changes in the relative price of the
products they sell.
• If P rises above PE
– A firm sees its price rise before realizing all prices are rising.
• The firm may believe its relative price is rising, and may increase output
and employment.
So, an increase in P can cause an increase in Y, making the SRAS curve upward-sloping.
34
What the 3 theories have in common – 1
• In all 3 theories, Y deviates from YN when

P deviates from PE.
Y = YN + a (P – PE)
Expected
Quantity of
price level
output
supplied a > 0, measures how
much Y responds to Actual
Natural rate unexpected changes price level
of output in P
(long-run)
35
What the 3 theories have in common – 2
Y = YN + a(P – PE)
P
SRAS
When P > PE
the expected
PE
price level
When P < PE
Y
YN
Y < YN Y > YN
36
SRAS and LRAS
• The imperfections in these theories are temporary. Over time,

– Sticky wages and prices become flexible
– Misperceptions are corrected
• In the LR,
– PE = P
– AS curve is vertical
37
SRAS and LRAS
Y = YN + a(P – PE) P LRAS
SRAS
In the long run,
PE = P PE
and
Y = YN.
Y
YN
38
Why the SRAS curve might shift

P LRAS
Everything that shifts LRAS shifts SRAS2
SRAS, too. SRAS1
Also, PE shifts SRAS:
PE
If PE rises, workers & firms set higher
wages.
At each P, production is less PE
profitable, Y falls, SRAS shifts left.
Y
YN
39
The long-run equilibrium
In the long-run
P LRAS
equilibrium:
• PE = P, SRAS
• Y = YN ,
• and PE
unemployment is
at its natural rate.
AD
Y
YN
40
III EXPLAINING SHORT-RUN ECONOMIC FLUCTUATIONS
• Four steps to analyzing economic fluctuations:

1. Determine whether the event shifts AD or AS.
2. Determine whether curve shifts left or right.
3. Use AD–AS diagram to see how the shift changes Y and P in the short run.
4. Use AD–AS diagram to see how economy moves from new SR equilibrium
to new LR equilibrium .
41
EXAMPLE 3: The effects of a shift in AD
Use the AD–AS diagram to show the effect of a
stock market crash. P LRAS
1. Affects C, AD curve SRAS1
2. C falls, so AD shifts left
3. SR equilibrium at B. P1 A SRAS
2
P and Y lower, P2 B
unemployment higher AD1
P3 C
4. Over time, PE falls,
AD2
SRAS shifts right,
until LR equilibrium at C. Y 2 YN Y
Y and unemployment back at initial levels.
42
Two big AD shifts: 1.The Great Depression
U.S. Real GDP,
From 1929–1933, money supply billions of 2000 dollars
900
fell 28% due to problems in 850
banking system 800
• stock prices fell 90%, 750
reducing C and I 700
650
• Y fell 26%
600
• P fell 22% 550
• Unemployment rate rose from
1929
1930
1931
1932
1933
1934
3% to 25%
43
Two big AD shifts: 2.The World War II boom
From 1939–1944, U.S. Real GDP,
billions of 2000 dollars
• government outlays 2,000
rose from $9.1 billion 1,800
to $91.3 billion 1,600
• Y rose 90% 1,400

1,200
• P rose 20%
1,000
• unemployment fell
800
from 17% to 1%
1939
1940
1941
1942
1943
1944
44
Active Learning 2: Working with the model
Draw the AD–AS diagram for the V.N. economy starting in a
long-run equilibrium (point A).
• A boom occurs in China. Use your diagram to determine the
SR and LR effects on V.N. GDP, the price level, and
unemployment.
45
Active Learning 2: Answers
Event: Boom in China P LRAS
SRAS2
1. Affects NX, AD curve
2. Shifts AD right
P3 C SRAS1
3. SR equilibrium at point
B. P and Y higher, P2 B
unemployment lower P1 A AD2
4. Over time, PE rises,
SRAS shifts left, until AD1
LR equilibrium at C. Y
YN Y2
Y and unemployment
back at initial levels.
46
The Great Recession of 2008–2009
• Large contractionary shift in AD
– Real GDP fell sharply
• By 4.2% between the forth quarter of 2007 and the second
quarter of 2009
– Employment fell sharply
• Unemployment rate rose from 4.4% in May 2007 to 10.0% in
October 2009
• The housing market played a central role in this
recession.
47
• Rising house prices during 2002–2006 due to:
– Low interest rates
– Easier credit for subprime borrowers
– Government policies to increase homeownership
– Securitization of mortgages: investment banks purchased
mortgages from lenders,
• Created securities backed by these mortgages,
• Sold the securities to banks, insurance companies, and other
investors.
– Mortgage-backed securities perceived as safe, since house prices
“never fall”
48
• Consequences of 2006–2009 housing market crash:
– Millions of homeowners “underwater”—owed more than
house was worth.
– Millions of mortgage defaults and foreclosures.
– Banks selling foreclosed houses increased surplus and
downward price pressures.
– Housing crash badly damaged construction industry: 2010
unemployment rate was 20.6% in construction vs. 9.6%
overall.
49
• Consequences of 2006–2009 housing market crash:
– Mortgage-backed securities became “toxic,”
• Heavy losses for institutions that purchased them,
• Widespread failures of banks and other financial institutions.
– Sharply rising unemployment and falling GDP.
50
• The policy response:
– Federal Reserve reduced Fed Funds rate target to near zero.
– Federal Reserve purchased mortgage-backed securities and
other private loans.
– U.S. Treasury injected capital into the banking system to
increase banks’ liquidity and solvency in hopes of staving off
a “credit crunch.”
– Fiscal policymakers increased government spending and
reduced taxes by $800 billion.
51
EXAMPLE 4: The effects of a shift in SRAS
Use the AD–AS diagram to show the effect of an
increase in oil prices (assume the LRAS is constant)
1. Increases costs, shifts P LRAS
SRAS
SRAS2
2. SRAS shifts left
SRAS1
3. SR equilibrium at point B. B
P higher, Y lower, P2
unemployment higher P1 A
From A to B, stagflation, a
period of falling output AD1
and rising prices. Y
Y2 YN
52
EXAMPLE 4: What happens in the long run?
If policymakers do nothing,
4. Low employment P LRAS
causes wages to fall, SRAS2
SRAS shifts right, until
P3 C SRAS1
LR equilibrium at A. B
Or, policymakers could use P2
fiscal or monetary policy to P1 A
increase AD and AD2
accommodate the AS shift: AD1
• Y back to YN, but
Y2 YN Y
P permanently higher.
53
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
54
John Maynard Keynes, 1883–1946
The General Theory of Employment, Interest, and Money, 1936
• Argued recessions and depressions
can result from inadequate demand;
policymakers should shift AD.
• Famous critique of classical theory:
The long run is a misleading guide to
current affairs. In the long run, we are all dead. Economists set themselves
too easy, too useless a task if in tempestuous seasons they can only tell us
when the storm is long past, the ocean will be flat.
55
CHAPTER IN A NUTSHELL
• Short-run economic fluctuations around long-run trends are
irregular and largely unpredictable.
• When recessions occur, real GDP and other measures of income,
spending, and production fall, while unemployment rises.
• Classical economic theory assumption: nominal variables such as
the money supply and the price level do not influence real
variables such as output and employment.
• Accurate in the long run but not in the short run
56
• Model of aggregate demand and aggregate supply” the output of
goods and services and the overall level of prices adjust to balance
aggregate demand and aggregate supply.
• The aggregate-demand curve slopes downward due to: the wealth
effect, the interest-rate effect, and the exchange-rate effect.
• Any event or policy that raises consumption, investment,
government purchases, or net exports at a given price level
increases aggregate demand.
57
• Any event or policy that reduces consumption, investment,
government purchases, or net exports at a given price level
decreases aggregate demand.
• The long-run aggregate-supply curve is vertical. The quantity of
goods and services supplied depends on the economy’s labor,
capital, natural resources, and technology but not on the overall level
of prices.
• Three theories explain the upward slope of the short-run aggregate-
supply curve: Sticky-wage theory, Sticky-price theory, Misperceptions
theory
58
• All three theories imply that output deviates from its natural level
when the actual price level deviates from the price level that
people expected.
• Shifts of short-run aggregate supply curve: events that alter the
economy’s ability to produce output
• Causes of economic fluctuations: shifts in aggregate demand and
aggregate supply.
59

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BÙI DUY HƯNG

• What are economic fluctuations? What are their characteristics?

1. Three key facts about economic fluctuations

2. The aggregate-demand curve

3. The aggregate-supply curve

4. Explaining short-run economic fluctuations

• Real GDP over the long run, Vietnam.

fluctuations are 6.8 6.9

FACT 2: Most Real Gross Private Domestic Investment 1969-2019

• The Classical Dichotomy

Why the AD curve slopes downward

Why the AD curve slopes downward

Why the AD curve slopes downward

WHY THE AD CURVE SLOPES DOWNWARD

A shift in the AD curve

Why the AD Curve Might Shift – 1

Why the AD Curve Might Shift – 2

What happens to the AD curve in each of the following scenarios?

A. An investment policy expires.

The AS curve shows the total quantity

The natural rate of output (YN) is the amount of P LRAS

Why LRAS is vertical

A shift in the LRAS curve

What is the effect of an increase in

Why the LRAS Curve Might Shift – 1

Why the LRAS Curve Might Shift – 2

• causes an increase in the quantity of goods

Why the Slope of SRAS Matters

If AS slopes up, then shifts in AD

The Sticky-Wage Theory – 1

The Sticky-Wage Theory – 2

The Sticky-Price Theory – 1

The Sticky-Price Theory – 2

The Misperceptions Theory

• In all 3 theories, Y deviates from YN when

SRAS and LRAS

• The imperfections in these theories are temporary. Over time,

SRAS and LRAS

Y = YN + a(P – PE) P LRAS

Why the SRAS curve might shift

• Four steps to analyzing economic fluctuations:

• Y rose 90% 1,400

Real oil prices + 138% + 99%

CPI + 21% + 26%

Real GDP – 0.7% + 2.9%

# of unemployed + 3.5 + 1.4

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