BEE (2019-20) Handout 04

Macroeconomic equilibrium - Aggregate Demand & Aggregate Supply analysis (variable Price Level)

When demand for a product increases, firms will usually respond by increasing production, but they are also likely to increase
prices. Similarly, when demand falls, production will fall, but often prices will also fall. We would expect then, that an increase or
decrease in aggregate expenditure would affect not just aggregate output but also the price level. So far, we have not taken into
account the effect of changes in the price level on the components of aggregate expenditure. In fact, as we will see, increases in
the price level will cause aggregate expenditure to fall and decrease in the price level will cause aggregate expenditure to rise. In
this handout, we use aggregate demand and aggregate supply model (AD-AS model) to explain fluctuations in the aggregate
output and the price level.

AGGREGATE DEMAND:
The aggregate demand curve (AD) shows the relationship between the price level and the quantity of output demanded by
households, firms, the government and ROW. AD curve is downward sloping which indicates an inverse relation between price
level and aggregate expenditure. Remember that we measure the price level as an index number with a value of 100 in the base
year. If price level rises from, say, 100 to 110, it implies that price level has increased by 10 percent over the base year prices.

Why is the aggregate demand curve downward sloping?

The aggregate demand curve is downward sloping because a fall in the price level increases the quantity of output demanded. To
understand why this is true, we need to look at how changes in the price level affect each of the components of aggregate demand
(expenditure). We begin with the assumption that government purchases are determined by the policy decisions of lawmakers and
are not affected by changes in the price level. We then can consider the effect of changes in the price level on each of the other
three components: consumption, investment, and net exports.
(i) Wealth Effect - How a change in the price level affects Consumption : Current income is the most important variable
determining the consumption of households. But consumption also depends on household wealth. A household's wealth
is the difference between the value of its assets and the value of its liabilities. As total household wealth rises,
consumption will rise. Some household wealth is held in cash or other nominal assets that lose value as the price level
rises and gain value as the price level falls. When the price level falls, the real value of household wealth rises, and so
will consumption. This impact of the price level on consumption is called the wealth affect.
(ii) Interest rate effect – How a change in the price level affects Investment : When prices rise, households and firms need
more money to finance buying and selling. Therefore, when the price level rises, households and firms try to increase the
amount of money they hold by withdrawing funds from banks, borrowing from banks, or selling financial assets, such as
bonds. These actions tend to drive up the interest rate charged on bank loans and interest rate on bonds. A higher interest
rate raises the cost of borrowing for firms and households. As a result, firms will borrow less to build new factories or to
install new machinery and equipment, and households will borrow less to buy new houses. To a smaller extent,
households will also borrow less to finance spending on automobiles, furniture, and other durable goods. Consumption
will therefore be reduced. A lower price level will have the reverse effect, leading to an increase in investment and – to a
lesser extent – consumption. This impact of the price level on investment is known as the interest-rate effect.
(iii) International Trade Effect – How a change in the price level affects net exports : If the price level in India rises relative to
the price levels in other countries, Indian exports will become relatively more expensive and foreign imports will
become relatively less expensive. Indian exports will fall and Indian imports will rise, causing net exports to fall. A
lower price level in India has the reverse effect, causing net exports to rise. This impact of the price level on net exports
is known as the international-trade effect.

Shifts of the AD curve versus movement along it:

If the price level changes, but other variables that affect the willingness of households, firms, and the government to spend are
unchanged, the economy will move up or down a stationary AD curve. If any variable changes other than the price level, the AD
curve will shift. The variables that cause the AD curve to shift fall into three categories:
(i) Change in Government policies: Monetary policy and fiscal policy changes cause the shift in AD curve. Monetary policy
involves changes in interest rates, and fiscal policy involves changes in government purchases and taxes.
a. Lower interest rates lower the cost to firms and households of borrowing. Lower borrowing costs increase
consumption and investment spending, which shifts the AD curve to the right. Higher interest rates shift the AD
curve to the left.
b. Because government purchases are one component of aggregate demand, an increase in government purchases
shifts the AD curve to the right, and a decrease in government purchases shifts the AD curve to the left.
c. An increase in personal income taxes reduces the disposable income available to households. Higher personal
income taxes reduce consumption spending and shift the AD curve to the left. Lower personal taxes shift the
AD curve to the right.
d. Increases in business taxes reduce the profitability of investment spending and shift the AD curve to the left.
Decreases in business taxes shift the AD curve to the right.
(ii) Changes in the expectations of households and firms:
a. If households become more optimistic about their future incomes, they are likely to increase their current
consumption. This increased consumption will shift the AD curve to the right. If households become more
pessimistic about their future incomes, the AD curve will shift to the left.
b. If firms become more optimistic about the future profitability of investment spending, the AD curve will shift to
the right. If firms become more pessimistic, the AD curve will shift to the left.
 (iii) Changes in Foreign variables: An increase in net exports at every price level will shift the AD curve to the right.
Similarly, a decrease in net exports at every price level will shift the AD curve to the left.
a. Net exports from India will increase if real GDP grows more slowly in India than in other countries.
b. If the value of the INR falls against other currencies, net exports from India will increase.

AGGREGATE SUPPLY
Aggregate Supply (AS) curve shows the relationship between the price level and quantity of goods and services that firms are
willing and able to supply. AS curve is upward sloping indicating that firms are willing to supply larger quantities of goods and
services as the price level rises.

Why is the aggregate supply curve upward sloping?

The main reason firms are willing to supply more goods and services as the price level rises is that, as prices of final goods and
services rise, prices of inputs – such as the wages of workers or the price of natural resources – rise more slowly. Profits rise when
the prices of the goods and services firms sell rise more rapidly than the prices they pay for inputs. Therefore, a higher price level
leads to higher profits and increases the willingness of firms to supply more goods and services.

Shift of AS curve versus movements along it:

If the price level changes but other variables are unchanged, the economy will move up or down a stationary AS curve. If any
variable other than the price level changes, the AS curve will shift. Four most important variables that cause AS curve to shift are
discussed below:
(i) Increases in the labour force and in the capital stock : As the labour force and capital stock grow, firms will supply more
output at every price level, and AS curve will shift to the right. Similarly, decrease in labour force and capital stock will
shift AS curve to the left.
(ii) Technological change: As technological change takes place, the productivity of workers and machinery increases, which
means firms can produce more goods and services with the same amount of labour and machinery. This improvement
reduced the firm's costs of production and, therefore, allows them to produce more output at every price level. As a
result, AS curve shifts to right.
(iii) Expected changes in the future price level : If workers and firms believe that the price level is going to increase by
certain percentage (say 5 percent) during the next year, they will try to adjust their wages and prices accordingly. Such
adjustments by workers and firms will result in costs increasing throughout the economy by the same percentage (5
percent). As a result, AS curve will shift to the left so that any level of output is now associated with a price level that is
5 percent higher.
(iv) Unexpected changes in the price of an important natural resource : An unexpected increase or decrease in the price of an
important natural resource can cause firm's costs to be different from what they had expected. Oil prices can be
particularly volatile. Oil is a common input used by many firms, directly or indirectly. Sudden increase in oil prices will
lead to increased cost of production. Because firms face rising costs, they will only supply the same level of output at
higher prices, and the AS curve shift to left.

EQUILIBRIUM AND DISEQUILIBRIUM

There will be equilibrium in the commodity market when Price Level

aggregate demand becomes equal to aggregate supply.
Graphically, the equilibrium is depicted by interaction of AS
downward-sloping aggregate demand curve and upward-
sloping aggregate supply curve. Thus, equilibrium price level
and equilibrium aggregate output (or aggregate income) is
determined in the economy. Disequilibrium may be caused by P*
either of following two sets of factors:
(i) Change in Price level: Decrease in price level will AD
cause downward movement along the AD curve and
AS curve leading to situation of AD > AS. Increase in
price level will cause upward movement along the AD
curve and AS curve creating a situation of AS > AD. 0 Y* Aggregate output (Y)

(ii) Change in non-price level factors : As disturbed earlier, any change in non-price level factors will lead to shift of AD
curve or AS curve.
a. Rightward shift of AD curve (i.e., increase in AD at all price levels)
b. Leftward shift of AD curve (i.e., decrease in AD at all price levels)
c. Rightward shift of AS curve (i.e., increase in AS at all price levels)
d. Leftward shift of AS curve (i.e., decrease in AS at all price levels)

Any of the above changes will disturb the equilibrium leading to either of two situations: AD > AS or AS > AD. These changes
will drive the economy to new equilibrium price level and/or aggregate output/income in the economy.