AGGREGATE DEMAND AGGREGATE SUPPLY CHAPTER AND 8asadpriyo.weebly.com/uploads/4/5/1/4/45143247/ch08.pdf · Short-Run Aggregate Supply Aggregate demand is one side of the economy; aggregate

AGGREGATE DEMAND

AND

AGGREGATE SUPPLY 8CHAPTER

A Way to View the Economy

We can think of an economy as consisting of two

major activities: buying and producing.

When economists speak about aggregate

demand, they are speaking about the buying

side of the economy.

When economists speak about aggregate

supply, they are speaking about the producing

side of the economy.


The framework of analysis we use is called aggregate

demand–aggregate supply (AD–AS).

That framework of analysis has three parts:

1. Aggregate demand (AD)

2. Short-run aggregate supply (SRAS)

3. Long-run aggregate supply (LRAS)


Aggregate Demand

Recall from the last chapter that households, firms, governments and

the rest of the world buy domestic goods and services.

Aggregate demand is the quantity demanded of these goods and

services, or the quantity demanded of Real GDP, at various price

levels, ceteris paribus.

For example, the following whole set of data represents aggregate

demand:

Aggregate Demand

An aggregate demand

(AD) curve is the

graphical representation

of aggregate demand.

AD is downward sloping

As the price level falls,

the quantity demanded

of Real GDP rises.

As the price level rises,

the quantity demanded

of Real GDP falls

Why Does the Aggregate Demand Curve Slope Downward?

This inverse relationship and the resulting downward slope of

the AD curve are explained by:

(1) The real balance effect

(2) The interest rate effect

(3) The international trade effect

Aggregate Demand

Real Balance Effect

When price level goes up, the real value of monetary wealth or

the value of a person’s monetary assets goes down.

This means that purchasing power of monetary assets go down,

that is, the quantity of goods and services that can be purchased

with a unit of money decreases.

As a result, ceteris paribus, people demand less.

In summary, a rise in the price level causes purchasing power to

fall, which decreases a person’s monetary wealth. As people

become less wealthy, the quantity demanded of Real GDP falls.

Aggregate Demand

Interest Rate Effect

The inverse relationship between the price level and the

quantity demanded of Real GDP is established through changes

in the part of household and business spending that is sensitive

to changes in interest rates.

As the price level rises, the purchasing power of the person’s

money decreases.

With less purchasing power (per unit of money), she cannot

purchase her fixed bundle of goods with the same amount of

money.

Aggregate Demand

Interest Rate Effect

If she wants to continue to buy the goods, she needs to

acquire more money.

To do that, she goes to a bank and requests a loan. In terms

of simple supply-and demand analysis, the demand for credit

increases. Consequently, the interest rate rises.

As the interest rate rises, households borrow less to finance,

say, automobile purchases, and firms borrow less to finance

new capital goods spending. Thus, the quantity demanded of

Real GDP falls.

Aggregate Demand

International Trade Effect

The international trade effect takes place through changes in

foreign sector spending due to changes in price level.

As the price level in Bangladesh rises, Bangladeshi goods

become relatively more expensive than foreign goods.

As a result, both Bangladeshis and foreigners buy fewer

Bangladeshi goods and more foreign goods, i.e. exports fall

and imports rise implying a fall in net exports.

The quantity demanded of Real GDP falls.

Aggregate Demand

An Important Word on the Three Effects

Keep in mind that what caused these three effects is a

change in the price level.

When discussing, say, the interest rate effect, we are talking

about the interest rate effect of a change in the price level.

Why is this point important?

The interest rate can change due to things other than the

price level changing. Other things that change the interest

rate lead to a shift in the AD curve instead of a movement

along the AD curve.

Aggregate Demand

A Change in Quantity Demanded of Real GDP vs. a Change

in Aggregate Demand

A change in the price level brings about a change in the quantity

demanded of Real GDP.

As the price level falls, the quantity demanded of Real GDP rises,

ceteris paribus.

When the aggregate demand curve shifts, the quantity demanded

of Real GDP changes even though the price level remains

constant.

Aggregate Demand

Aggregate Demand

Changes in Aggregate Demand: Shifts in the AD Curve

What can change aggregate demand? What can cause

aggregate demand to rise, and what can cause it to fall?

The simple answer is, if:

Spending increases at a given price level AD rises

Spending decreases at a given price level AD falls

Aggregate Demand

How Spending Components Affect Aggregate Demand

At a given price level if:

Aggregate Demand

Why Is There More Total Spending?

True or false?

“The price level falls and total spending rises. As a result of

total spending rising, aggregate demand in the economy

rises, and the AD curve shifts rightward.”

Aggregate Demand

Aggregate Demand

Why Is There More Total Spending?

The answers is: FALSE

Aggregate demand curve shifts to the right only if total spending

rises at a given price level.

Total spending can rise for one of two reasons.

The first deals with a decline in prices and leads to a movement

along a given AD curve.

The second deals with a change in some factor other than prices

and leads to a shift in the AD curve.

Aggregate Demand

Factors That Can Change C, I, G, and NX and Therefore

Can Shift the AD Curve

Consumption: C

Four factors can affect consumption:

1.Wealth

2.Expectations about future prices and income

3.Interest rate

4.Income taxes

Factors That Can Change C and Therefore Can Shift

the AD Curve

1. Wealth

Individuals consume not only on the basis of their present

income but also on the basis of their wealth.

Greater wealth makes individuals feel financially more secure

and thus more willing to spend.

Wealth C AD

Wealth C AD

Aggregate Demand


the AD Curve

2. Expectations About Future Prices and Income

Individuals’ expectations of future prices can increase or

decrease aggregate demand:

Expect higher future prices C AD

Expect lower future prices C AD

Similarly, expectations regarding income can affect aggregate

demand:

Expect higher future income C AD

Expect lower future income C AD

Aggregate Demand

Factors That Can Change C and Therefore Can Shift the

AD Curve

3. Interest Rate

Current empirical work shows that spending on consumer durables is

sensitive to the interest rate.

Buyers often pay for these items by borrowing; so an increase in the

interest rate increases the monthly payment amounts linked to the

purchase of durables and thereby reduces their consumption.

The reduction in consumption leads to a decline in aggregate demand.

Interest rate C AD

Interest rate C AD

Aggregate Demand


the AD Curve

4. Income Taxes

As income taxes rise, disposable income decreases. When people

have less take-home pay to spend, consumption falls.

Consequently, aggregate demand decreases.

A decrease in income taxes has the opposite effect; it raises

disposable income. When people have more take-home pay to

spend, consumption rises and aggregate demand increases.

Income taxes C AD

Income taxes C AD

Aggregate Demand

Factors That Can Change I and Therefore Can Shift the

AD Curve

Investments: I

Three factors can change investment:

1. The interest rate

2. Expectations about future sales

3. Business taxes

Aggregate Demand


AD Curve

1. Interest Rate

As the interest rate rises, the cost of an investment project rises and

businesses invest less. As investment decreases, aggregate demand

decreases.

As the interest rate falls, the cost of an investment project falls and

businesses invest more. Consequently, aggregate demand increases.

Interest rate I AD

Interest rate I AD

Aggregate Demand


AD Curve

2. Expectations About Future Sales

If businesses become optimistic about future sales, investment

spending grows and aggregate demand increases.

If businesses become pessimistic about future sales, investment

spending contracts and aggregate demand decreases.

Businesses become optimistic about future sales I AD

Businesses become pessimistic about future sales I AD

Aggregate Demand


AD Curve

3. Business taxes

An increase in business taxes lowers expected profitability. With less

profit expected, businesses invest less. As investment spending

declines, so does aggregate demand.

A decrease in business taxes, on the other hand, raises expected

profitability and investment spending. This increases aggregate

demand.

Business taxes I AD

Business taxes I AD

Aggregate Demand

Factors That Can Change G and Therefore Can Shift

the AD Curve

Government Expenditure: G

Government expenditure usually rises due to expansionary Fiscal

policy – designed to reduce unemployment.

Government expenditure usually falls due to contractionary Fiscal

policy – designed to reduce inflation.

Expansionary Fiscal Policy G AD

Contractionary Fiscal Policy G AD

Aggregate Demand

Factors That Can Change NX and Therefore Can Shift

the AD Curve

Net Exports: NX

Two factors can change net exports:

1. Foreign real national income

2. The exchange rate

Aggregate Demand

Factors That Can Change NX and Therefore Can Shift the

AD Curve

1. Foreign real national income

As foreign real national income rises, foreigners buy more Bangladeshi

goods and services. Thus, exports rise. As exports rise, net exports rise,

ceteris paribus. As net exports rise, aggregate demand increases.

This process works in reverse. As foreign real national income falls,

foreigners buy fewer Bangladeshi goods and exports fall. This lowers

net exports, reducing aggregate demand.

Foreign real national income BD exports BD net exports AD

Foreign real national income BD exports BD net exports AD

Aggregate Demand

Aggregate Demand

Factors That Can Change NX and Therefore Can Shift the AD

Curve

2. Exchange Rate

As the Taka depreciates, Bangladeshi goods become cheaper and foreign goods

become more expensive. Bangladeshis cut back on imported goods, and foreigners

increase their purchases of Bangladeshi exported goods. If exports rise and imports

fall, net exports increase and aggregate demand increases.

As Taka appreciates, Bangladeshi goods become more expensive and foreign goods

become cheaper, Bangladeshis increase their purchases of imported goods, and

foreigners cut back on their purchases of Bangladeshi exported goods. If exports fall

and imports rise, net exports decrease, thus lowering aggregate demand.

Taka depreciates BD exports and BD imports BD net exports AD

Taka appreciates BD exports and BD imports BD net exports AD

Can a Change in the Money Supply Change Aggregate

Demand?

Most economists would say that it does, but they differ on

how.

Most economists agree that an increase in money supply

increases aggregate demand and shifts aggregate demand

curve to the right.

Aggregate Demand

Short-Run Aggregate Supply

Aggregate demand is one side of the economy;

aggregate supply is the other.

Aggregate supply is the quantity supplied of all goods

and services (Real GDP) at various price levels, ceteris

paribus. Aggregate supply includes both short-run

aggregate supply (SRAS) and long-run aggregate supply

(LRAS).


Curve: What It Is

A short-run aggregate supply

(SRAS) curve shows the quantity

supplied of all goods and services

(Real GDP or output) at different

price levels, ceteris paribus.

the SRAS curve is upward sloping:

As the price level rises, firms

increase the quantity supplied of

goods and services; as the price

level drops, firms decrease the

quantity supplied of goods and

services.


Short-Run Aggregate Supply Curve: Why It Is Upward

Sloping (The sticky cost argument)

Think about an individual firm: firm A. It’s fair to assume that in the

short run the money wage rate and the prices of nonlabor inputs

remain unchanged (sticky). Now, if price of the good that firm A

produces rises with no change in these costs, then firm A can

increase profit by increasing production. Since any firm usually is

in business to maximize its profit, firm A will increase production.

Similarly, if price of the good produced by firm A falls while the

money wage rate and the prices of nonlabor inputs remain

unchanged, then firm A can reduce its losses (or profit reductions)

by decreasing production.



What’s true for firm A is true for the producers of all

goods and services. When all prices rise, the price level

rises. If the price level rises and the money wage rate

and other factor prices remain constant, all firms

increase production and the quantity of real GDP

supplied increases.

A fall in the price level has the opposite effect and

decreases the quantity of real GDP supplied.

What Puts the “Short Run” in the SRAS Curve?

The SRAS curve slopes upward because of the reason

explained in the previous slide.

Things are likely to change over time.

Wages will not be sticky forever (labor contracts will expire),

Factor costs will also not remain constant.

Only for a period of time—identified as the short run—are

these issues likely to be relevant.


Changes in Short-Run Aggregate Supply: Shifts in the

SRAS Curve

The factors that can shift the SRAS curve are:

1. Wage rates

2. Prices of nonlabor inputs

3. Productivity

4. Supply shocks

5. Expected price level



SRAS Curve

1. Wage rates

Changes in wage rates have a major impact on the position of

the SRAS curve because wage costs are usually a firm’s major

cost item.

The impact of a rise or fall in equilibrium wage rates can be

understood in terms of the following equation:

Profit per unit = Price per unit - Cost per unit


Changes in Short-Run

Aggregate Supply: Shifts in

the SRAS Curve

Higher wage rates mean higher

costs and, at constant prices,

translate into lower profits and a

reduction in the number of units

(of a given good) that firms will

want to produce.

Lower wage rates mean lower

costs and, at constant prices,

translate into higher profits and

an increase in the number of

units (of a given good) firms will

decide to produce.



SRAS Curve

2. Prices of nonlabor inputs

There are other inputs to the production process besides

labor.

Changes in the prices of nonlabor inputs affect the SRAS curve

in the same way as changes in wage rates do.

An increase in the price of a nonlabor input (e.g., oil) shifts the

SRAS curve leftward; a decrease in their price shifts the SRAS

curve rightward.



SRAS Curve

3. Productivity

Productivity is the output produced per unit of input employed

over some period of time.

Let’s consider the labor input. An increase in labor productivity

means businesses will produce more output with the same

amount of labor, causing the SRAS curve to shift rightward.

A decrease in labor productivity means businesses will produce

less output with the same amount of labor, causing the SRAS

curve to shift leftward.



SRAS Curve

Many factors lead to increased labor productivity. Some

examples:

A more educated labor force

A larger stock of capital goods

Technological advancements



SRAS Curve

4. Supply shocks

Major natural or institutional changes that affect aggregate supply

are referred to as supply shocks.

Supply shocks are of two varieties. Adverse supply shocks shift the

SRAS curve leftward.

A long drought can have severe impact on the production of

paddy in Bangladesh.

A major cutback in the supply of oil coming to the United

States from the Middle East.



SRAS Curve

Beneficial supply shocks shift the SRAS curve rightward.

A major oil discovery or unusually good weather

leading to increased production of a food staple

These supply shocks can be reflected in resource or

input prices.



SRAS Curve

5. Expected price level

A change in expected price level can lead to a shift in the SRAS

curve. When prices of most goods and services are expected to rise,

the price level is expected to rise, and vice versa.

Suppose producers expect the price level to decline. If the price

level is expected to fall in the future, current supply increases and

the supply curve shifts rightward.

Suppose individuals expect the price level to rise. If the price level is

expected to rise in the future, current supply decreases and the

supply curve shifts leftward.



SRAS Curve


Putting AD and SRAS Together: Short-

Run Equilibrium

How Short-Run

Equilibrium in the

Economy is Achieved

At 𝑃1, the quantity supplied of Real

GDP is greater than the quantity

demanded. As a result, the price level

falls and firms decrease output.

At 𝑃2, the quantity demanded of Real

GDP is greater than the quantity

supplied. As a result, the price level

rises and firms increase output.

Short-run equilibrium occurs at point E,

where the quantity demanded of Real

GDP equals the (short-run) quantity

supplied. This is at the intersection of

the AD curve and the SRAS curve.

Changes in Short-Run Equilibrium in the Economy


Run Equilibrium


Run Equilibrium

In Dollars and in Oil

In November 2007 the barrel price of oil was rising. On

November 1, 2007, it had risen to $96 a barrel.

In the same month the value of the dollar was falling in foreign

exchange markets. In fact, the value of the dollar had been

falling for some time. Although the value of $1 was €0.83 in

January 2006, it had fallen to €0.69 by November 1, 2007.

How would Real GDP and Price change?


Run Equilibrium


We know that the falling value of the dollar would lead to

greater U.S. exports, and this is exactly what was

happening at the time. As a result, U.S. net exports were

rising, pushing the AD curve in the economy to the right.

But because oil prices were rising, the SRAS curve in

the economy was shifting to the left.

How would these two changes affect Real GDP?


Run Equilibrium


The answer depends on the relative shifts of the AD and SRAS curves.

There are the three possibilities:

1. If the AD curve shifted rightward more than the SRAS curve shifted

leftward, then Real GDP will rise.

2. If the AD curve shifted rightward by less than the SRAS curve shifted

leftward, then Real GDP would fall.

3. If the AD curve shifted rightward by the same amount as the SRAS

curve shifted leftward, then Real GDP would remain unchanged.

In all three cases, though, the price level would increase. Rising

aggregate demand, combined with falling short-run aggregate supply,

always results in a rising price level.

An Important Exhibit

Expected Price Level

1. Expansionary Fiscal Policy

2. Contractionary Fiscal Policy

Long-Run Aggregate Supply

Going from the Short Run to the Long Run

Remember that an upward-sloping SRAS curve is explained by sticky

wages and constant factor costs. When these conditions hold, short-

run equilibrium identifies the Real GDP that the economy produces.

In time, though, wages become unstuck and costs of other factors

change in the direction of the price change. In that event, the economy

is said to be in the long run. In other words, these conditions do not

hold in the long run.

Most economists argue that, in the long run, the economy produces the

full-employment Real GDP, Potential Real GDP or the Natural Real

GDP (𝑄𝑁). The aggregate supply curve that identifies the output the

economy produces in the long run is the long-run aggregate supply

(LRAS) curve.


Going from the Short Run

to the Long Run

Long-run equilibrium identifies the

level of Real GDP the economy

produces when wages, other factor

costs and prices have adjusted to

their final equilibrium levels and

when workers have no relevant

misperceptions.

Graphically, this occurs at the

intersection of the AD and LRAS

curves. Further, the level of Real

GDP that the economy produces in

long-run equilibrium is the Natural

Real GDP (𝑄𝑁).


Short-Run Equilibrium, Long-

Run Equilibrium, and

Disequilibrium

In this Exhibit, the economy is at

point 1, producing 𝑄1 amount of

Real GDP. At point 1, the quantity

supplied of Real GDP (in the short

run) is equal to the quantity

demanded of Real GDP, and both

are 𝑄1. The economy is in short-

run equilibrium.


Short-Run Equilibrium,

Long-Run Equilibrium, and

Disequilibrium

In this Exhibit, the economy is

at point 1, producing 𝑄𝑁. In

other words, it is producing

Natural Real GDP. The

economy is in long-run

equilibrium when it produces

𝑄𝑁.

In both short-run and long-

run equilibrium, the quantity

supplied of Real GDP

equals

the quantity demanded.

So what is the difference

between short-run

equilibrium and

Short-Run Equilibrium, Long-Run Equilibrium, and

Disequilibrium

In both short-run and long-run equilibrium, the quantity supplied of

Real GDP equals the quantity demanded.

So what is the difference between short-run equilibrium and long-run

equilibrium?

In long-run equilibrium, the quantities supplied and demanded of Real

GDP equal Natural Real GDP. But in short-run equilibrium, the

quantities supplied and demanded of Real GDP are either more or

less than Natural Real GDP.




Disequilibrium

Let’s illustrate that difference with numbers. Suppose

𝑄𝑁 = $9.0 trillion. In long-run equilibrium, the quantity

supplied of Real GDP equals the quantity demanded:

$9.0 trillion.

In short-run equilibrium, the quantity supplied of Real

GDP equals the quantity demanded, but neither

equals $9.0 trillion. For example, the quantity supplied

of Real GDP could equal the quantity demanded of

Real GDP at $8.5 trillion.


Disequilibrium

When the economy is in neither short-run nor long-run

equilibrium, it is said to be in disequilibrium.

Essentially, disequilibrium is the state of the economy as

it moves from one short-run equilibrium to another or

from short-run equilibrium to long-run equilibrium.

In disequilibrium, the quantity supplied and the quantity

demanded of Real GDP are not equal.


Documents

AGGREGATE DEMAND AGGREGATE SUPPLY CHAPTER AND 8asadpriyo.weebly.com/uploads/4/5/1/4/45143247/ch08.pdf · Short-Run Aggregate Supply Aggregate demand is one side of the economy; aggregate