Lecture 9

Aggregate Demand & Aggregate Supply

(Part 1)
(Ch:20; P.O.M.E)

ECO 104
Faculty: Asif Chowdhury

 An economy experiences fluctuations in its

level of activities during different periods.
In some years production level are high &
eventually standard of living is also high.
However in other years output level falls,
unemployment rises & income level falls
( Real GDP falls).
Recession: Periods of falling income &
rising unemployment.
Depression: A severe form of Recession.

 In order to understand such fluctuations,

variables like GDP, Unemployment, Interest
Rates & Price Levels are analyzed. We have
already looked into these variables previously,
however the previous analysis were based on a
long run time frame. Current analysis will
consider short run fluctuations in these
variables. These short run fluctuations occurs
around their long run trends. The model of
Aggregate Demand & Aggregate Supply is used
to understand such short run fluctuations.

 Such fluctuations in an economy is called

Business Cycle, since these fluctuations
changes the business conditions in the
economy. When output ( Real GDP) is
growing, firms make more sales & makes
higher profit. However when Real GDP falls
firms makes lesser sales & profit also goes
down. Business Cycles are not regular &
predictable as the name suggest, they are
irregular & difficult to predict accurately.

As mentioned previously, variables like GDP,

unemployment, interest rate & price level are
considered
while
analyzing
short
run
fluctuations. The previous analysis of these
variables were based on the platforms of the
two Classical Economics concepts: Classical
Dichotomy & Monetary Neutrality. We have
seen that real variables like Real GDP,
Unemployment, Real Interest Rates were
determined without the influence of nominal
variables like money supply & price level.

 However other economist believe that

these two classical economics concepts
only apply in the long run. To understand
short run fluctuations the analysis has to
depart from Monetary Neutrality &
Classical Dichotomy since in the short
run money supply can influence real
variables & both nominal & real variables
interact together in the short run.

Model Of Aggregate
Demand & Aggregate
Supply:

This model combines output of goods

& services as represented by Real
GDP ( real variable) & average price
level as represented by GDP Deflator
or CPI ( nominal variable).This model
looks at short run fluctuations in
economic activities around its long
run trend.

Components of the AD-AS

model:
Aggregate Demand Curve: A curve showing
the quantity demanded of goods & services by
households, firms, government & foreign
buyers ( export) wanting to buy at each price
level.
Aggregate Supply Curve: the curve that shows
the quantity of goods & services that firms
choose to produce & sell at each price level.
In this model quantity of output & price level
adjust to bring AD & AS into equilibrium.

Aggregate Demand (AD):

Aggregate Demand (AD) curve is downward
sloping.
Why the AD Curve slopes downward: by
breaking down the AD into its components parts
& then analyzing each component, we can get a
macroeconomic perspective of why AD curve is
downward sloping:

Y = C + I + G + NX
C represents Households, I represents firms, G
represents Government Expenditure, NX
represents Net Exports.

o The Price Level & Consumption: The

Wealth Effect
o The Price Level & Interest: The
Interest-Rate Effect.
o The Price Level & Net Export: The
Exchange Rate Effect.

Why the Aggregate Demand

(AD) curve might shift:
o Shifts Arising From Change in
Consumption
o Shifts Arising From Change in
Investment
o Shifts Arising From Change in
Government Purchase
o Shifts Arising From Change in Net
Exports.

The Aggregate Supply (AS)

Curve:
The relationship between AS & price
level depends on the time horizon we
are talking about. In the short run AS is
related to price & is upward sloping, in
the long run AS curve is unresponsive to
price & is vertical. In order to
understand
short
run
economic
fluctuations, we have to look at both the
short run & long run Aggregate Supply.

Why is the long run AS

curve vertical:
o In the long run an economys output (Real GDP) is
defined by the following function:

Y = fA (K, L, N)
Y = output
A= Technology
K= Physical Capital + Human capital
L= Labor
N= Natural Resource
Hence in the long run AS doesnt respond to price & is
vertical. The long run AS actually supports both the
Classical Dichotomy & Monetary Neutrality theories.

Why the long run AS might

shift:
Natural Rate of Output: the production of
goods & services in an economy in the
long run, which is achieved at a natural
rate of unemployment. The economy will
eventually move towards this long run
natural rate of output level.
Any changes in the factors which
determines long run output/long run AS,
can shift the long run AS curve:

 Shifts Arising From Change in Labor: Inflow into the

workforce, outflow out of the workforce & also changes in
the natural rate of unemployment.
Shifts Arising from Change in Capital: Increase or decrease
in the capital stock, including both physical capital & human
capital.
Shifts Arising from Changes in Natural Resource : increase in
the level of natural resource, adverse effect of natural
resource like weather.
Shifts Arising from Changes in Technological Knowledge:
helps to produce more output with same level of other input
resources. International trading based on specialization &
comparative advantage also has similar effect like
technological progress.

AD & AS depicting long run

Growth & Inflation:
AD shift factor like monetary policy involving
raising money supply & AS shift factor like
technological progress are considered to be the
most important shift factors, among many. Over
time raising money supply & continuous
technological progress will keep on shifting the
AD & AS curve thus changing & raising the
economy's level of natural rate of output and also
general price level ( Growth & Inflation.) The short
run economic fluctuations takes place around
these long run trends of output growth & inflation.