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Aggregate Demand and Aggregate Supply

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The Aggregate Demand Curve

• When price level rises, money demand curve shifts rightward• Consequently, interest rate is higher, given money supply is fixed• Then, aggregate expenditure decreases (AE line shifts downward)• As a result, the equilibrium GDP becomes lower

So, a rise in price level causes a decrease in equilibrium GDP.

The aggregate demand curve shows the negative relationship between price levels and equilibrium real GDP

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Figure 1: Deriving the Aggregate Demand Curve

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Understanding the AD Curve

• Each point on the AD curve represents a short-run equilibrium in economy

• The AD curve is different from a demand curve for one particular product

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Movements of the AD Curve

• Moving along the AD curve whenever price level changes

• When anything other than price level cause equilibrium GDP to change, the AD curve shifts– Government purchasing– Taxes– Autonomous consumption spending– Investment spending– Net exports– Money supply– Expectations

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Figure 2: A Spending Shock Shifts the AD Curve

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Costs and Prices

• To understand how macroeconomic events affect the price level, we assume– A firm sets price of its products as a markup over cost per unit– So, in the short-run, price level rises when there is an economy-

wide increase in unit costs• Labor costs• Costs of natural resources

• How an increase in output level raises the price level?– As output increases, demand for inputs rises– As unit cost increases, price level ( assumed as a markup over unit cost)

rises

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Figure 3: The Aggregate Supply Curve

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Movements of the AS Curve

• When price level changes due to a change in real GDP, the change happens along the AS curve

• When the change of price level is caused by any factor other than real GDP, the AS curve shifts– Oil prices– Weather– Technological change– Nominal wage

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Figure 4: Shifts of the Aggregate Supply Curve

Price Level

Real GDP ($ Trillions)

100

AS1

10

A

AS2

140 L

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Figure 5: Short-Run Macroeconomic Equilibrium

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Figure 6: The Effect of a Demand Shock

Price Level

Real GDP ($ Trillions)

AS

10

E

AD1

H

12

130

13.5

100 J

AD2

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An Increase in Government Purchases

– When G , AD curve shifts rightward. As a result, real GDP , given price level is fixed

– However, when real GDP , unit cost , so price level– Furthermore, as price level , Md and interest rate ,

which causes aggregate expenditure to decrease– In the end, real GDP increases by less than horizontal

shift in AD curve

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An Increase in the Money Supply

• Can you demonstrate how an increase in the money supply affects the real equilibrium GDP?

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Demand Shocks

• A positive demand shock—shifts AD curve rightward– Increases both real GDP and price level in

short-run

• A negative demand shock—shifts AD curve leftward– Reduces both real GDP and price level in short-

run

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Examples

• The Great Depression 1929 – 1933– Negative demand shocks

• Oil Crisis 1973 (began on October 17)– Negative supply shocks

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Demand Shocks: Adjusting to the Long-Run

• In short-run, wage rate is treated as given

• But in long-run, wage rate can change– When output is above full employment, wage

rate will rise, shifting AS curve upward– When output is below full employment, wage

rate will fall, shifting AS curve downward

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Figure 7: The Long-Run Adjustment Process After A Positive Demand Shock

Price Level

Long-Run AS Curve

Real GDP

P1

YFE

E

AS1

AD1

2

2AD

Y2

P H

AS2

P4 K

Y3

P3J

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Figure 8: Long-Run Adjustment After A Negative Demand Shock

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Figure 9: The Effect of a Supply Shock

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More examples

• 1990-91 recession – Oil supplies and price of oil

• 2001 recession– Money supply and interest rate

Inflation and Unemployment

• Low inflation and unemployment

–Fed’s major goals

–Compatible or conflicting?

• Short-run tradeoff

• Supply shocks cause both rates to rise

• No long-run tradeoff

The Phillips Curve

Real Domestic Output

0

P0

P1

P2

P3

Q0 Q1 Q2 Q3

AD0

AD1

AD2

AD3

AS

Pri

ce L

evel

The Phillips Curve

• Demonstrates short-run tradeoff between inflation and unemployment

0

1

2

3

4

5

6

7

0 1 2 3 4 5 6 7

Unemployment Rate (Percent)

An

nu

al

Ra

te o

f In

fla

tio

n (

Pe

rce

nt)

0

1

2

3

4

5

6

7

0 1 2 3 4 5 6 7An

nu

al

Ra

te o

f In

fla

tio

n (

Pe

rce

nt)

Unemployment Rate (Percent)

69

68

6766

65

64

6362

61

Concept Empirical DataData for the 1960s

The Phillips Curve

• No long-run tradeoff between inflation and unemployment

• Short-run Phillips curve

–Role of expected inflation

• Long-run vertical Phillips curve

• Disinflation vs. Reflation

The Long Run Phillips Curve

3 4 5 60

3

6

9

12

15A

nn

ual

Rat

e o

f In

flat

ion

(P

erce

nt)

Unemployment Rate (Percent)

PCLR

PC3

PC2

PC1

a1

b1

a2

a3

b2

b3

c3

c2