AGGREGATE DEMAND AND SUPPLY

Macroeconomics Based on Demand and Supply
-1970s: Dependence on demand-based economics, supply side was glossed over

Aggregate Demand Curve
- Why is it downward sloping?
- The aggregate demand curve is not the sum of all the market demand curves in the economy.
When the price of a good goes down, we assume that prices of all other goods remain the same,
otherwise, we would have substitution effect. This good now becomes cheaper in relation to
other goods. In the case of the AD curve, overall prices drop, i.e, many prices are falling
together.
- Keynes Interest Rate Effect. The investors will be affected in the increase in prices and their
money will now be insufficient for existing production level.
- Increase in Prices = Insufficient production
- Decrease in Money supply and demand = Higher interest rates
- Higher Interest rates = Less Investments = Decrease in GDP
- Pigou Wealth Effect.
- Increase in overall price levels = Less goods consumed = Decrease in wealth
- Decrease in wealth = Downward consumption function
- Higher overall prices = Lower level of income
- Mundell - Fleming Exchange Rate Effect.
- Open economy - with the increase of overall prices in the world, it affects the country’s
external accounts
- Domestic prices suddenly higher than foreign goods = Local goods become less attractive to
foreign buyers = Slowing down of exports and to local buyers
- Lower demand of domestic good = Net outflow from the economy to the rest of the world =
Aggregate demand and income will fall
- Conclusion: Higher price levels = Lower level income or output and vice versa
- Conclusion: AD Curve depends on factors like consumption function and interest elasticity of
inverstment

Aggregate Supply Curve
- Generally upward sloping like the industry supply curve
- Ranges of the Curve:
• Classical Range
- Vertical range - the economy has reached full employment, increase in AD can lead to
inflation since you can no longer increase output
- Labor is deemed the scarcest resource and therefore it normally implies to full employment of
labor
- Prices are flexible
- Vertical AS curve = potential output (maximum output that an economy can produce without
putting pressure on inflation to accelerate) = The long run AS curve

the quality of labor fixed.As more and more labor is employed.Upward sloping: range increases/decreases in demand would lead to increases/decreases in both output and prices . • Output and employment were going down.Output will increase only with some increases in prices . overall prices will have to adjust to aggregate demand-supply imbalances Special Cases 1. and Increased productivity .More money and less regulation = Productive business firms = Improved energy sourcing - Movement of AS to the right • Increasing productivity by promoting energy-saving methods. and amount of capital is also constant .Short run AS curve: prices may not be fully flexible and product capacity not expandable in so short a period. technological applications. Lower real wage. • Keynesian Range .More money will be left in the hands of the consumers and investors . • The economy experiences overheating • Traditional approach: reduce AD through monetary and fiscal policies = Shift curve to the left • Lower output and higher prices • Asian Financial Crisis in 1997-1998: Philippine economy contracted and inflation jumped • Governments decide to “reflate” or push up demand 2.There is difficulty because of shortage in foreign exchange .Reduction in the budget = Deregulation: removal of many government regulations that tied the hands of businesses producing efficiently . when prices were shooting up. and more efficient equipment • Results to accelerated depreciation. Removal of constraints.Adequate supply side management = Less taxes on goods. Stagflation • A combination of stagnation (or recession) and inflation. lower production.Operates with the Law of Diminish Returns (Production Function is constant with technology unchanged.Government will be forced to reduce its budget in order no to contribute to further inflation . Tackling Stagflation • Basic solution to stagflation: Supply side economics: Adjustment of the economy is focused in the AS curve —Ronald Reagan • Reaganomics: Whole package of economic measures designed to halt inflation and normalize US economy .Large Tax Cuts . zero capital gains tax = Less revenues for the gonverment • Government must decide on acceptable rates of price increases and unemployment rates • How can LDC tackle stagflation? .AS curve is flat: Changes in AD = output increases without price ranges . the increment to the total output of each additional unit become smaller .Substantial unemployment or underemployment of resources or excess capacity in the economy • Intermediate or More normal range .

Removal of constraints and increased productivity 3.More foreign exchange must be generated which means promotion of exports .Low tax collections? Results to poor infrastructure.Exchange rate should be slightly higher than normal or undervalued so that exports exceed imports and foreign exchange reserves are built up rapidly . foreign exchange will be generated rapidly 4. decline in wage is either politically or humanly unacceptable . . Increasing productivity • A long term solution . Removal of constraints • Find indigenous substitutes and energy savings • Successes in the PH: Geothermal energy and coal for electricity .Reducing real wage? Not acceptable since wages in LDCs are already very low.Once foreign demand for local goods come in and rise. 2 World Producer in Geothermal Energy • Removal of foreign exchange constraint .A higher exchange rate = More attractive to foreign buyers of domestic products . LDS already have budget defeats = Not a promising avenue .No.