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Aggregate Demand and Aggregate Supply

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Modeling the Aggregate Economy Aggregate Demand Aggregate demand is a schedule relating the total demand for all goods and services in an economy to the general price level in that economy. Aggregate Supply Aggregate supply is a schedule relating the total supply of all goods and services in an economy to the general price level.

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Aggregate Demand Determinants Consumption Investment Government Net Exports Money Financial Assets Nonfinancial Markets Financial Markets Aggregate Demand

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Aggregate Demand Y P AD 0 Aggregate demand is a schedule relating the total demand for all goods and services in an economy to the general price level in that economy.

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Aggregate Demand The aggregate demand curve slopes down because as the general price level rises, the amount of goods and services that can be purchased with the given stock of money and other financial assets declines. In addition, the aggregate demand curve slopes down because as the price level rises, a nations goods and services become less competitive in the international markets.

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Shifting Aggregate Demand Y P 0 AD 1 Anything that causes aggregate spending to change (holding the price level constant) shifts the aggregate demand curve. Increases in AD shift the curve to the right. Decreases in AD shift the curve to the left. AD 2 AD 3

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Aggregate Supply Aggregate supply is a schedule relating the total supply of all goods and services in an economy to the general price level.

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Aggregate Supply: Determinants Labor Costs Capital Costs Materials Cost Productivity Capacity Expectations Profit Margins Production Costs Aggregate Supply

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Aggregate Supply AS YYY PPP 0 00

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Aggregate Supply The aggregate supply curve may be flat, upward sloping or vertical. Horizontal aggregate supply implies that increasing aggregate output puts no pressure on prices. Aggregate supply curves are horizontal when resources are in ample supply.

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Aggregate Supply Vertical aggregate supply implies that in attempts to increase aggregate output result in an increase in the price level only. Aggregate supply curves are vertical in the long run where full employment of all resources exists. Aggregate supply in the long run does not depend on the price level.

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Aggregate Supply Upward sloping aggregate supply implies that attempts to increase aggregate output result in an increase in both output and the price level. When the demand for goods and services rises, firms increase their demand for inputs. When all firms demand more inputs and the market supply of inputs is upward sloping, firms costs rise. Firms respond by raising prices.

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Shifting Aggregate Supply Y P 0 AS 2 Anything that causes aggregate supply to change (holding the price level constant) shifts the aggregate supply curve. Increases in AS shift the curve to the right. Decreases in AS shift the curve to the left. AS 3 AS 1

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Aggregate Demand and Supply: Determinants Consumption Investment Government Net Exports Money Financial Assets Labor Costs Capital Costs Materials Cost Productivity Capacity Expectations Nonfinancial Markets Financial Markets Profit Margins Production Costs Aggregate Demand Aggregate Supply Price Level Real Output

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Aggregate Demand and Supply: Long Run Y P 0 AS The intersection of AD and AS determines the price level. In the long run, changes in AD do not change Y. Increases in AD cause P to rise while decreases in AD cause P to fall. AD 2 AD 1 AD 3

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Aggregate Demand and Supply: Short Run Y P 0 AS AD 2 The intersection of AD and AS determines the price level. In the short run, changes in AD change P and Y. Increases in AD cause Y and P to rise while decreases in AD cause Y and P to fall. Y 1 Y 2 Y 3 AD 1 AD 3

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Aggregate Demand and Supply: Short Run Y P 0 AS 3 The intersection of AD and AS determines the price level. In the short run, changes in AS change P and Y. Increases in AS cause Y to rise and P to fall while decreases in AS cause Y to fall and P to rise. Y 1 Y 2 Y 3 AD 1 AS 2 AS 1

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Aggregate Demand and Supply: Short Run Y P 0 AS sr Y AD AS lr Long run equilibrium occurs at the intersection of aggregate demand and the long run aggregate supply curve where P = P and Y = Y. Since in the long run all prices have adjusted, short run equilibrium occurs at the same P-Y combination. P

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Reduction in Aggregate Demand Y P 0 AS sr Y* AD 1 AS lr P AD 2 12 3 A decrease in aggregate demand from AD 1 to AD 2 moves the economy from point 1 to point 2. At point 2, the economy is below Y*, the natural rate of full employment. AS > AD, causing the price level to fall. Decreases in P increase real money balances, causing Y to rise from Y 1 to Y*. Y1Y1

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Increase in Aggregate Demand Y P 0 AS sr Y* Y 1 AD 1 AS lr P1P1 AD 2 P2P2 12 3 An increase in aggregate demand moves the economy from point 1 to point 2. At point 2, the economy is above Y*, the natural rate of full employment. AD > AS causes the price level to rise. Increases in P decrease real money balances, causing Y to fall from Y 1 to Y*.

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Y P 0 AS 1 Y 1 Y* AD AS lr P1P1 Adverse Aggregate Supply Shock AS 2 P2P2 1 2 Adverse supply shocks push up costs and prices. If aggregate demand is fixed, the economy moves from point 1 to point 2 as Y falls and P rises. At point 2, AD < AS and Y 1 < Y*. Eventually, prices fall and the economy moves back to Y*.

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Conclusions: Long Run The crucial difference between the long and short run is that output is inflexible in the long run but not the short run. The long run aggregate supply curve is vertical. Therefore, shifts in aggregate demand cannot change output in the long run.

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Conclusions: Short Run The short run aggregate supply curve is upward sloping because of mark-up pricing. Therefore, shifts in aggregate demand can change levels of output and price levels. Shocks to aggregate demand and short run aggregate supply can cause fluctuations in economic activity.