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22
CHAPTER
AGGREGATE
DEMAND
AND
AGGREGATE
SUPPLY
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Aggregate Demand
The Aggregate Supply Curve
Aggregate supply is the relationship between the quantity
of real GDP supplied and the price level.
The aggregate supply (AS) curve plots the quantity of realGDP
supplied against the price level.
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Aggregate Supply
Aggregate Supply Fundamentals
The aggregate quantity of goods and services supplieddepends on
three factors:
The quantity of labor (L )
The quantity of capital (K )
The state of technology (T )
The aggregate production function shows how quantityof real GDP
supplied, Y, depends on labor, capital, andtechnology.
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Aggregate Supply
Aggregate Supply Fundamentals
The aggregate production function is written as theequation:
Y=F(L, K, T )
In words, the quantity of real GDP supplied depends on (isa
function of) the quantity of labor employed, the quantityof
capital, and the state of technology.
The larger is L, K, orT, the greater is Y.
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Aggregate Supply
Aggregate Supply Fundamentals
Long-run aggregate supplyShort-run aggregate supply
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Aggregate Supply
Long-Run Aggregate Supply
The macroeconomic long run is a time frame that is
sufficiently long for all adjustments to be made so that realGDP
equals potential GDP and there is full employment.
The long-run aggregate supply curve (LAS) is therelationship
between the quantity of real GDP supplied
and the price level when real GDP equals potential GDP.
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Aggregate Supply
Graph shows an LAScurvewith potential GDP of $10trillion.
The LAScurve is verticalbecause potential GDP isindependent of
the pricelevel.
Along the LAScurve allprices and wage rates varyby the same
percentage.
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Aggregate Supply
Short-Run Aggregate Supply
The macroeconomic short run is a period during whichreal GDP has
fallen below or risen above potential GDP.
At the same time, the unemployment rate has risen aboveor fallen
below the natural unemployment rate.
The short-run aggregate supply curve (SAS) is therelationship
between the quantity of real GDP supplied
and the price level in the short-run when the money wagerate,
the prices of other resources, and potential GDPremain
constant.
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Aggregate Supply
Along the SAScurve, risein the price level with nochange in the
money
wage rate and other input prices increases thequantity of real
GDPsuppliedthe SAS curveis upward sloping.
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Aggregate Supply
Along the SAScurve, real
GDP might be abovepotential GDP
or below potential GDP.
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Aggregate Supply
Movement along the
LASand SASCurves
A change in the price level
with an equal percentagechange in the moneywage causes a
movementalong the LAScurve.
A change in the price levelwith no change in themoney wage
causes amovement along the SAScurve.
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Aggregate Supply
Changes in Aggregate Supply
(i) Change in Potential GDP
When potential GDP increases, both the LASand SAS
curves shift rightward.Potential GDP changes, for three
reasons
Change in the full-employment quantity of labor.
Change in the quantity of capital (physical or human). Advance
in technology.
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Aggregate Supply
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Aggregate Supply
(ii) Change in the
money wage rate
A rise in the money
wage rate decreasesshort-run aggregatesupply and shifts
theSAScurve leftward.
But it has no effect onlong-run aggregatesupply.
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Aggregate Demand
The quantity of real GDP demanded, Y, is the total amountof
final goods and services produced in a country thatpeople,
businesses, governments, and foreigners plan tobuy.
This quantity is the sum of consumption expenditures,
C,investment, I, government purchases, G, and net exports,X M. That
is:
Y=C+ I+ G+ X M
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Aggregate Demand
Buying plans depend on many factors and some of themain ones
are:
The price level
Expectations
Fiscal and monetary policy
The world economy
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Aggregate Demand
The Aggregate Demand Curve
Aggregate demand is the relationship between the
quantity of real GDP demanded and the price level.
The aggregate demand (AD) curve plots the quantity ofreal GDP
demanded against the price level.
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Aggregate Demand
The AD curve slopesdownward for tworeasons
A wealth effect
Substitution effects
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Aggregate Demand
(i) Wealth effect
A rise in the price level, other things remaining the
same,decreases the quantity of real wealth.
To restore their real wealth, people increase saving anddecrease
spending, so the quantity of real GDP demandeddecreases.
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Aggregate Demand
Changes in Aggregate Demand
A change in any influence on buying plans other than theprice
level changes aggregate demand.
The main influences on aggregate demand are
Expectations
Fiscal and monetary policy
The world economy.
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Changes in Aggregate Demand
(ii) Fiscal policy
A tax cut or an increase in transfer payments
increaseshouseholds disposable income increases consumption
expenditure and increases aggregate demand.
Because government purchases of goods and servicesare one
component of aggregate demand, an increase ingovernment purchases
increases aggregate demand.
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Aggregate Demand
Monetary policy is changes in the interest rate andquantity of
money.
An increase in the quantity of money increases buying
power and increases aggregate demand.
Acut in the interest rate increases expenditure andincreases
aggregate demand.
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Aggregate Demand
(iii) The world economy influences aggregate demand intwo
ways:
A fall in the foreign exchange rate lowers the price of
domestic goods and services relative to foreign goods
andservices, increases exports, decreases imports, andincreases
aggregate demand.
An increase in foreign income increases the demand for
exports and increases aggregate demand.
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Macroeconomic Equilibrium
Short-Run Macroeconomic Equilibrium
Short-run macroeconomic equilibrium occurs when the
quantity of real GDP demanded equals the quantity of realGDP
supplied at the point of intersection of the AD curveand the
SAScurve.
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Macroeconomic Equilibrium
If real GDP is belowequilibrium GDP,firms increaseproduction and
raiseprices.
If real GDP is aboveequilibrium GDP,firms decrease
production and lowerprices.
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Macroeconomic Equilibrium
Long-Run Macroeconomic Equilibrium
Long-run macroeconomic equilibrium occurs when realGDP equals
potential GDPwhen the economy is on itsLAS
curve.
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Macroeconomic Equilibrium
Long-run equilibriumoccurs where the ADand LAS curvesintersect
and resultswhen the moneywage has adjusted toput the SAS
curvethrough the long-run
equilibrium point.
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Macroeconomic Equilibrium
The Business Cycle
The business cycle occurs because aggregate demandand the
short-run aggregate supply fluctuates.
1.Below full employment equilibrium
2.Full employment equilibrium
3.Above full employment equilibrium
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Macroeconomic Equilibrium
Abelow full-employmentequilibrium is anequilibrium in
whichpotential GDP exceeds
real GDP.The amount by whichpotential GDP exceedsreal GDP is
called arecessionary gap.
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Macroeconomic Equilibrium
Along-run equilibrium isan equilibrium in whichpotential GDP
equalsreal GDP.
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Macroeconomic Equilibrium
An above full-employment equilibrium
is an equilibrium inwhich real GDP
exceeds potentialGDP.
The amount by whichreal GDP exceeds
potential GDP iscalled an inflationarygap.
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Macroeconomic Equilibrium
Economic Growth
and Inflation
Economic growth
occurs because thequantity of labor grows, capital
isaccumulated, andtechnology advances,
all of which increasepotential GDP andbring a rightward shiftof
the LAScurve.
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Macroeconomic Equilibrium
Inflation
Inflation occurs becausethe quantity of moneygrows faster
thanpotential GDP, whichincreases AD by morethan long-run
aggregatesupply.
The AD curve shiftsrightward faster than therightward shift of
the LAScurve.
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Macroeconomic Equilibrium
Fluctuations in Aggregate
Demand
Starting at long-run
equilibrium, an increase inaggregate demand shiftsthe AD curve
rightward.
Firms increase productionand rise pricesamovement along the
SAScurve.
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Macroeconomic Equilibrium
Fluctuations in AggregateSupply
A rise in the price of oil
decreases short-runaggregate supply and theSAScurve shifts
leftward.
Real GDP decreases andthe price level rises.
The combination ofrecession combined withinflation is called
stagflation.
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