Macroeconomics and Business

Forecasting (Eco 502) - 5

- Dr. Mirza Azizul Islam

Aggregate supply and demand (Ch – 5)
 Aggregate supply (AS) – Aggregate demand (AD) model is the basic

macroeconomic tool for studying fluctuations in output (GDP) and the

determination of the price level and the inflation rate – hence can be used

to understand the consequence of policies for growth, that is, variations

of output as well as stability of prices.

 We will undertake more detailed analysis of the factors underlying

aggregate demand and aggregate supply (if time permits), for the moment

recall the concepts of aggregate supply and aggregate demand we

introduced earlier.
Aggregate supply and demand
 AS curve describes for each given price level, the output that
the firms in the economy are willing to supply – Generally
upward because firms are willing to supply more output at
higher prices.

A slight variation in the definition of AD curve to say that it

shows the combinations of the price level and output at
which the goods and money markets are simultaneously in
equilibrium – to be discussed in details later.
 Aggregate supply and demand
 AD curve slopes downward because higher prices reduce
the value of money supply and therefore, reduce the
demand for goods (to be elaborated later)

 Intersection – shifts – impact of a shift in aggregate

demand/supply on output and price level will depend on
the extent of shifts and slopes of both curves. – use
Figures
This brings us to the question of the slopes of
supply curves – two extreme cases: (sec:5.1)

 Classical – full employment of all factors of production – no

scope for increasing the supply of output and hence only price
increases with increase in aggregate demand – Vertical AS

 Different from the case of a single product where a demand

increase leads to price increase and induces firms to buy more
materials, employ more labour and so forth and thus increases
supply
This brings us to the question of the slopes of
supply curves – two extreme cases:

 Keynesian aggregate supply – firms will supply whatever output is

demanded at existing prices, unemployment prevailing, can hire as
much labour as needed at the existing wage rate – therefore costs do not
change as output increases – Horizontal AS

 Even under the classical scenario, GDP does not remain fixed over time
as the economy accumulates more resources and technology improves,
Y shifts – Draw figures with different levels of Y but each vertical AS
and then output growth with ‘t’ on X – axis and Y on Y – axis.
This brings us to the question of the slopes of
supply curves – two extreme cases:

 Vertical or Horizontal – it is all a matter of timing (Box 5-2) – the

same AS curve may be partly flat, partly steep – flatter below full

employment output, i.e. a situation of recession implying a

positive role of demand management policies – needs to be wary

if output at or close to full employment.

 Role of factors other than capital and labor e.g. infrastructure

constraints in BD and other indicators discussed previously.