Aggregate Supply and Demand

Aggregate Supply and Aggregate Demand

• The aggregate supply–aggregate demand

(AS–AD) model is the basic tool for
studying output fluctuations and the
determination of price levels
• The model describes the relationship
between overall prices (GDP deflator) and
output (real GDP)
 The Aggregate Supply Curve
The AS curve describes, for each given price
level, the quantity of output firms are willing
to supply
The AS curve is upward sloping since firms
are willing to supply more at higher prices
In the short run the AS curve is horizontal
(the Keynesian AS curve)
In the long run the AS curve is vertical (the
classical AS curve)
The Aggregate Supply
 The Classical AS Curve
The classical AS curve
◦ Is vertical, indicating that the same amount of
goods will be supplied whatever the price level
Assumption
◦ The labour market is in equilibrium at full
employment and all factors of production are
fully utilised
Implication
◦ Increases in AD do not increase output but
merely raises prices
 The Classical AS Curve

• The level of output corresponding to full

employment is called potential GDP
• Potential GDP grows over time as the
economy accumulates resources and new
technologies
• This shifts the AS curve to the right over
time
 The Keynesian AS Curve
The Keynesian AS curve
◦ Is horizontal, indicating firms will supply
whatever amount of goods is demanded at the
existing price
Assumption
◦ There is unemployment, so firms may obtain as
much labour as they want at the current wage
Implication
◦ AD determines the level of output, with prices
‘sticky’ in the short run
Vertical or Horizontal?
 Vertical or Horizontal?
• At levels of output below potential, the
AS is quite flat, as there is little tendency
for prices of goods and factors to fall
• At levels of output above potential, the
AS curve is steep, and prices tend to rise
continuously
• Hence, the effect of changes in AD on
output and prices depends on the level of
actual output relative to potential output
 The Aggregate Demand Curve
• The AD curve
– Shows the combinations of the price and
output level at which the goods and money
markets are in equilibrium
– Is downward sloping because for a given
level of nominal money, higher prices reduce
the value of the real money supply, which
reduces the demand for output
– Increases in autonomous AD shifts the AD
curve to the right
 The Aggregate Demand Curve
• The AD relationship between price and
output
– Is dependent upon the real money supply
– Real money supply is nominal money supply
(Ms) deflated by the price level (P)
– That is: Ms/P
– When P falls, the real money supply rises,
interest rates fall and investment rises, causing
AD to increase
 The Aggregate Demand Curve

• The quantity theory of money provides a

simple analysis of the AD curve
MV=PY
Where M is the nominal money supply
and V is the velocity of money
• If we assume that V and M are constant
then an increase in output Y must be
offset by a decrease in prices P
 The Keynesian Case
– Initial equilibrium is at E where AD and AS
intersect (goods and money market
equilibrium)
– Assume an increase in AD, which shifts AD to
AD’
– The new equilibrium point is E’ where output
has increased
– Firms are willing to supply any amount of
output at that level of price
AD Under Alternative Supply
Assumption
 The Classical Case
– Assume an increase in AD
– At the initial level of prices, spending has
increased and the economy would tend to move
towards point E’
– However, firms cannot obtain more labour as
the economy is at full employment
– Wages are bid up which increases the costs of
production
– The increase in costs is passed on as higher
prices
The Classical Case
 The Classical Case

– The increase in prices reduces real money

stock and decreases spending
– The economy moves up along AD’ until
spending has decreased to the level
consistent with full employment output at E”
– Increases in AD only lead to higher prices,
not increases in output
 Supply-side Economics
• Shifting the AS to the right is preferred as it
increases potential GDP
• There is debate about how best to achieve
this increase in AS
– Cutting taxes will significantly increase AS
– This increase will be so large that total tax
revenue will rise
Supply-side Economics
 Supply-side Economics

• The initial tax cut shifts AD to the right

• The AS also shifts to the right over time
because lower tax rates increase the
incentive to work
• However, the AD curve shifts by more
than the AS curve, since consumer
spending increases by more than the
increase in potential GDP
 Supply-side Economics
• In the short run
– GDP has increased substantially (from E to E’)
– This is primarily due to the AD effect
• In the long run
– The economy moves to E”
– GDP has only increased by a small amount, total
tax collection falls, the government’s budget
deficit rises, and prices are permanently higher