AGGREGATE SUPPLY AND

DEMAND

Course Instructor:
Dr. Abhisek Sur
Assistant Professor
Jindal Global Law School
O P Jindal Global University
 Overview
• What are economic fluctuations? What are their
characteristics?

• How does the model of aggregate demand and aggregate

supply explain economic fluctuations?

• Why does the Aggregate-Demand curve slope downward?

What shifts the AD curve?

• What is the slope of the Aggregate-Supply curve in the short

run? In the long run?
What shifts the AS curve(s)?
 Short-run Economic Fluctuations
• Economic activity fluctuates from year to year
• In most years production of goods and services rises.

• In some years normal growth does not occur, indicating a

recession.
• A recession is a period of declining real incomes, and
rising unemployment.

• A depression is a severe recession.

• Short-run economic fluctuations are often called business

cycles.
Three Key Facts About EconomicFluctuations
1. Economic fluctuations are irregular and unpredictable.
• Fluctuations in the economy are often called the business cycle.
• These fluctuations do not follow regular or easily predictable patterns.

2. Most macroeconomic variables fluctuate together.

• Most macroeconomic variables that measure some type of incomeor
production fluctuate closely together.
• Although many macroeconomic variables fluctuate together,they
fluctuate by different amounts.

3. Asoutput falls, unemployment rises.

• Changes in real GDP are inversely related to changes in the
unemployment rate.
• During times of recession, unemployment risessubstantially.
The Model of Aggregate Demand (AD) and Aggregate
Supply (AS)
• Two variables are used to develop a model to analyze the short-run fluctuations.
• The economy’s output of goods and services measured by real GDP.
• The average level of prices measured by the CPI or the GDP deflator.
• Economist use the model of aggregate demand and aggregate supply to explain
short-run fluctuations in economic activity around its long-run trend.

Economic
activity Business
cycle

Time
 The Model of Aggregate Demand (AD) and
Aggregate Supply (AS)

▪ Explaining these fluctuations is difficult, and the

theory of economic fluctuations is controversial
▪ Most economists use the model of
aggregate demand and aggregate supply
to study fluctuations
▪ This model differs from the classical economic
theories economists use to explain the long run

6
 Classical Economics—A Recap
▪ The Classical Dichotomy, the separation of
variables into two groups:
▪ Real – quantities, relative prices
▪ Nominal – measured in terms of money

▪ The neutrality of money:

Changes in the money supply affect nominal
but not real variables.

AGGREGATE DEMAND AND AGGREGATE SUPPLY 7

 Classical Economics—A Recap
▪ Most economists believe classical theory
describes the world in the long run,
but not the short run.
▪ In the short run, changes in nominal variables
(like the money supply or P ) can affect
real variables (like Y or the u-rate).
▪ To study the short run, we use a new model.

AGGREGATE DEMAND AND AGGREGATE SUPPLY 8

The Model of Aggregate Demand and Aggregate
Supply
• The aggregate-demand curve shows the quantity of goods and
services that households, firms, and the government want to
buy at each price level.
• In other words, the AD curve shows the relationship
between the level of prices and the quantity of real GDP
demanded.

• The aggregate-supply curve shows the quantity of goods and

services that firms choose to produce and sell at each price
level.
 The Aggregate Demand Curve
• The quantity of real GDP demanded, Y, is the total amount of final goods and
services produced in the country that people, businesses, governments, and
foreigners plan to buy.

• The four components of GDP (Y) contribute to the aggregate demand for goods
and services.
Y = C + I + G + NX

• Aggregate demand is the

relationship between the quantity
of real GDP demanded and the
price level.

• The aggregate demand (AD)

curve plots the quantity of real
GDP demanded against the price
level.
 Negative Slope of the AD Curve
• For any given level of money supply M, an increase in P
implies that the real supply of money M/P must go down.

• It becomes harder for people to borrow money, causing the

price of loans, i.e., the interest rate r to go up. When interest
increases, investment demand (and possibly consumption)
decreases. Thus, aggregate demand (Y)goes down.

• An increase in P can also create the so-called “real balance

effect.” The resulting decline in M/P may lead people to
believe that they are less wealthy. This further implies that
they will reduce consumption. Thus, aggregate demand goes
down.
 The Model of Aggregate Demand
and Aggregate Supply
P
The price
level
SRAS
“Short-Run
The model P1 Aggregate
determines the Supply”
eq’m price level “Aggregate
Demand” AD

and eq’m output Y

Y1
(real GDP).
Real GDP, the
quantity of output
12
The Aggregate-Demand (AD) Curve
P
The AD curve
shows the P2
quantity of
all goods &
services
demanded P1
in the economy AD
at any given
Y
price level. Y2 Y1

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 Why the AD Curve Slopes Downward

Y = C + I + G + NX P

Assume G fixed
P2
by govt policy.
To understand
the slope of AD,
P1
must determine
how a change in P AD
affects C, I, and NX.
Y
Y2 Y1

AGGREGATE DEMAND AND AGGREGATE SUPPLY 14

 The Wealth Effect (P and C )
Suppose P rises.
▪ The dollars people hold buy fewer goods &
services, so real wealth is lower.
▪ People feel poorer.

Result: C falls.

AGGREGATE DEMAND AND AGGREGATE SUPPLY 15

Why the Aggregate-Demand CurveIs
Downward Sloping

• The Price Level and Consumption:

• The Wealth Effect

• A lower/higher price level raises/lowers the real value

of money and makes consumers wealthier/poorer,
which encourages them to spend more/less.

• This increase/decrease in consumer spending

means larger/smaller quantities of goods and
services demanded.
 The Interest-Rate Effect (P and I )

Suppose P rises.
▪ Buying goods & services requires more dollars.
▪ To get these dollars, people sell bonds or other assets.
▪ This drives up interest rates.
Result: Investment (I) falls
(Recall, I depends negatively on interest rates (r))

17
Why the Aggregate-Demand Curve Is
Downward Sloping

• The Price Level and Investment:

• The Interest Rate Effect/Intertemporal Substitution Effect

• With a given supply of money in the economy, a lower price level

will lead to lower interest rates.

• With lower interest rates, both consumers and firms will find it
cheaper to borrow money to make purchases.

• As a consequence, the demand for goods in the economy

(consumer durables purchased by households and investment
goods purchased by firms) will increase.
The Exchange-Rate Effect (P and NX )
Suppose P rises.
▪ Interest rates in India rise (the interest-rate effect).
▪ Foreign investors desire more domestic (Indian) bonds.
▪ Higher demand for Rupee in foreign exchange market.
▪ Indian exchange rate appreciates.
▪ India exports more expensive to people abroad, imports
cheaper to Indian residents.
Result: NX falls.

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Why the Aggregate-Demand CurveIs
Downward Sloping

• The Price Level and Net Exports:

• The Exchange-Rate Effect/International Substitution Effect

• In an open economy, a lower price level will mean that domestic

goods (goods produced in the home country) become cheaper
relative to foreign goods, so the demand for domestic goods will
increase.
Also,
• Alower price level in India causes India’s interest rates to fall and
the real exchange rate to depreciate, which stimulates India’s net
exports.
• The increase in net export spending means a larger quantity of
goods and services demanded.
The Slope of the AD Curve: Summary
An increase in P P
reduces the quantity
of g&s demanded P2
because:
▪ the wealth effect
(C falls)
P1
▪ the interest-rate
AD
effect (I falls)
▪ the exchange-rate Y
Y2 Y1
effect (NX falls)

AGGREGATE DEMAND AND AGGREGATE SUPPLY 21

Why the Aggregate-Demand Curve Is Downward
Sloping

• The Price Level and Consumption:

• The Wealth Effect/The Real Balances Effect
• The Price Level and Investment:
• The Interest Rate Effect
• The Price Level and Net Exports:
• The Exchange-Rate Effect/The International Trade Effect
Summary: Aggregate Demand Rises as Price Falls

Suppose aggregate prices in the economy fell

• This would cause the demand for money to shift in, causing interest rates to
decline
• Alternatively, the real money supply (M/P) rises, causing interest rates to fall.

• With lower interest rates, the opportunity cost of consumption is lower:

• P↓ → Md↓ → i↓ → C↑ (Real Wealth/BalanceEffect)

• With lower interest rates, the direct cost of investment falls:

• P↓ → Md↓ → i↓ → I↑

• With lower interest rates a country’s currency will depreciate. Aweaker

currency makes exports cheaper and imports more expensive
• P↓ → Md↓ → i↓ → Exchange Rate↓ → NX↑
 Deriving the Aggregate Demand Curve
The Impact of an Increase in the Price Level on the Economy – Assuming
No Changes in G, T, and M s

 P → M d  → r  → I  → AE → Y 
 Shift of Aggregate Demand

Shifts of the Aggregate

Demand Curve

AD curve describes the

relationship between price
level and the output.
So, changes in monetary or
fiscal policy - or more generally
in any variable, other than the
price level, - shift the
aggregate demand curve.

•An increase in government

spending increases output at
a given price level, shifting the
aggregate demand curve to

the right. A decrease in

nominal money decreases
M 
output at a given price level, Y =Y ,G,T
shifting the aggregate demand  P 
curve to the left.
(+ , +, −)
 Factors that Shift the AD Curve
• Anything (other than price!) that causes C, I, G, or NX to increase will shift the AD curve to the right.

• C increases when…
• There is an increase in consumer confidence, leading to more current consumption and less current
savings
• Taxes are cut leaving consumers with more income to spend (assuming Ricardian Equivalence doesn’t
hold!)
• Ricardian equivalence: when a government tries to stimulate demand by increasing debt-financed
government spending, demand remains unchanged. This is because the public will save its excess
money in order to pay for future tax increases that will be initiated to pay off the debt.

• I increases when…
• Business confidence rises, prompting firms to invest more for the future.

• G increases when…
• Government spending increases

• NX increases when…
• There is increased preference for domestically produced goods.

• An increase in the money supply will cause AD to shift right

• Interest rates are lower, so Cand I rise.
• The currency weakens, so NX increases.
 Factors that Shift the AD Curve

• Expectations about future income, future inflation, and

future profits change aggregate demand.

• Increases in expected future income increase people’s consumption

today, and increases aggregate demand.

• A rise in the expected inflation rate makes buying goods cheaper

today and increases aggregate demand.

• An increase in expected future profits boosts firms’ investment, which

increases aggregate demand.
 Factors that Shift the AD Curve

• The world economy influences aggregate demand in two

ways:

• A fall in the foreign exchange rate lowers the price of

domestic goods and services relative to foreign goods and
services, increases exports, decreases imports, and
increases aggregate demand.

• An increase in foreign income increases the demand for a

country’s exports and increases aggregate demand.
 Shifts in the Aggregate Demand Curve

ALL OTHER CHANGES IN DEMAND

Shifting Aggregate Demand

Decreases in taxes, increases in
government spending, and an increase in
the supply of money all shift the aggregate
demand curve to the right.
Higher taxes, lower government spending,
and a lower supply of money shift the curve
to the left.
ACTIVE LEARNING 1
The Aggregate-Demand curve
What happens to the AD curve in each of the
following scenarios?
A. A ten-year-old investment tax credit expires.
B. The U.S. exchange rate falls.
C. A fall in prices increases the real value of
consumers’ wealth.
D. State governments replace their sales taxes
with new taxes on interest, dividends, and
capital gains.

30
ACTIVE LEARNING 1
Answers
A. A ten-year-old investment tax credit expires.
I falls, AD curve shifts left.
B. The U.S. exchange rate falls.
NX rises, AD curve shifts right.
C. A fall in prices increases the real value of
consumers’ wealth.
Move down along AD curve (wealth-effect).
D. State governments replace sales taxes with new
taxes on interest, dividends, and capital gains.
C rises, AD shifts right.
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 How the Multiplier Makes the ShiftBigger

The Multiplier

Initially, an increase in
desired spending will shift
the aggregate demand
curve horizontally to the
right from a to b.

The total shift from a to c

will be larger. The ratio of
the total shift to the initial
shift is known as the
multiplier.

● multiplier
The ratio of the total shift in aggregate
demand to the initial shift in aggregate
demand.
Total increase in GDP from $50 billion rise in G
 The Multiplier

The multiplier is the ratio of the eventual change in GDP caused by an

autonomous change in aggregate spending to the size of that
autonomous change.
 Aggregate Supply Fundamentals
• The aggregate quantity of goods and services supplied depends on three
factors:
• The quantity of labor (L )
• The quantity of capital (K )
• The state of technology (T)

• The aggregate production function shows how quantity of real GDP

supplied, Y, depends on labor, capital, and technology.

• The aggregate production function is written as the equation:

Y = F(L, K, T )
• In words: the quantity of real GDP supplied depends on (is a function of) the
quantity of labor employed, the quantity of capital, and the state of
technology.

• The larger is L, K, or T, the greater is Y.

 Aggregate Supply
• The aggregate supply (AS) curve is a graph that shows the
relationship between the aggregate quantity of output supplied
by all firms in an economy and the overall price level.

• Note: The aggregate supply curve is not a market supply curve or

the sum of all the individual supply curves in the economy.

• Firms do not simply respond to market-determined prices, but

they actually set prices. Price-setting firms do not have individual
supply curves because these firms are choosing both output and
price at the same time.
 Aggregate Supply
• At any given time, the quantity of capital and the state of
technology are fixed but the quantity of labor can vary.

• The higher the real wage rate, the smaller is the quantity of
labor demanded and the greater is the quantity of labor
supplied.

• The wage rate that makes the quantity of labor demanded

equal to the quantity supplied is the equilibrium wage rate
and at that wage the level of employment is the natural rate
of unemployment.
 Aggregate Supply

We distinguish two time frames associated with

different states of the labor market:

➢ Long-run aggregate supply

➢ Short-run aggregate supply

 The Aggregate-Supply (AS) Curves
The AS curve shows P LRAS
the total quantity of
goods & services firms SRAS
produce and sell at any
given price level.

AS is:
▪ upward-sloping
in short run
Y
▪ vertical in
long run

39
Long-Run Aggregate Supply Curve

• The macroeconomic long run is a time frame that

is sufficiently long for all adjustments to be
made so that real GDP equals potential GDP and
there is full employment.

• The long-run aggregate supply curve (LRAS or

LAS) is the relationship between the quantity of
real GDP supplied and the price level when real
GDPequals potential GDP.
 The Long-Run Aggregate-Supply Curve (LRAS)

The potential output (YN) P LRAS

is the amount of output
the economy produces
when unemployment
is at its natural rate.

YN is also called natural

rate of output
Y
or YN
full-employment output.

41
 Long-Run Aggregate Supply

• The classical model

postulates that the AS curve
is vertical, i.e., aggregate
quantity produced in the
economy Y is independent of
the price level P.

• A vertical aggregate supply

curve that represents the idea
that in the long run, output
is determined solely by the
factors of production.
 Long-Run Aggregate Supply
• Quantity supplied in an economy depends on
labor employed, amount of capital used,
technological level, human capital (health,
knowledge) of its workers, efficiency in
production, institutional support (such as
good government or well defined property
rights) and so on.

• Imagine that the government suddenly

announces that from now on, a one rupee bill
should be regarded as 10 rupees, and ten
rupees should be taken as 100 rupees and so
on. The general price level P will go up by 10
times. Nothing would happen to the output.

• Workers know that prices are 10 times higher,

but their wage rates are also exactly 10 times
higher. So they will supply the same amount of
labor, and therefore output won’t change.
 Monetary neutrality in the AD-AS model
• Suppose the economy begins in general
equilibrium, but then the money supply is
increased by 10%

• This shifts the AD curve upward by 10% because to

maintain the aggregate quantity demanded at a
given level, the price level would have to rise by
10% so that real money supply wouldn’t change
and would remain equal to real money demand

• In the short run, with the price level fixed,

equilibrium occurs where AD2 intersects SRAS 1 ,
with a higher level of output

• Since output exceeds full-employment output, over

time firms raise prices and the short-run aggregate
supply curve shifts up to SRAS 2 , restoring long-run
equilibrium

• The result is a higher price level—higher by 10%

The key question is: How long does it take to get from the
short run to the longrun?
• Money is neutral in the long run, as output is
unchanged
The answer to this question is what separates classicals
from Keynesians
 Long Run AggregateSupply
• In the long run, money is neutral
• Any changes in the money supply will be met by a proportionate change
in prices
• Increasing the money supply will not affect the economy’s output in the
long run.

• Long run output is determined entirely by an economy’s productive

capacity
• Production Function: YP= A*F(K,L,H,N)

• Only changes in real variables can affect potential output.

• Price does not have any effect on YP

• In the long run, all resources are being efficiently utilized such that
unemployment equals the natural rate
 Long-Run Growth and Inflation
2. . . . and growth in the Long-run
money supply shifts aggregate
aggregate demand . . . supply,
LRAS 1980 LRAS 1990 LRAS 2000
Price
Level

1. In the long run,

technological
progress shifts
P 2000 long-run aggregate
supply . . .
4. . . . and
ongoing inflation.
P 1990
Aggregate
Demand, AD 2000
P 1980
AD 1990

AD 1980

0 Y1980 Y 1990 Y 2000 Quantityof

Output
3. . . . leading to growth
in output . . .
Using Aggregate Demand and Aggregate Supply to Depict
Long-Run Growth and Inflation

• The most important forces that govern the economy in

the long run are technology and monetary policy.

• Short-run fluctuations in output and the price level

should be viewed as deviations from the continuing long-
run trends of output growth and inflation.
Why the Long-Run Aggregate-Supply Curve MightShift

• Any change in the economy that alters the natural rate of

output shifts the long-run aggregate-supply curve.

• Shifts might arise from changes in:

• Labor
• Capital
• Natural Resources
• Technological Knowledge
 Short-Run Aggregate Supply
• The macroeconomic short run is a period during which real
GDPhas fallen below or risen above potential GDP.

• At the same time, the unemployment rate has risen above

or fallen below the natural unemployment rate.

• The short-run aggregate supply curve (SRAS) is the

relationship between the quantity of real GDP supplied and
the price level in the short run when the nominal wage rate,
the prices of other resources, and potential GDP remain
constant.
 Short Run Aggregate Supply (SRAS)
The SRAS curve P
is upward sloping:
SRAS
Over the period
of 1-2 years, P2
an increase in P
causes an increase P1
in the quantity of
goods & services
supplied. Y
Y1 Y2

50
 The Short-Run Aggregate Supply Curve
Aggregate Demand and Short-
Run Aggregate Supply

With a short-run aggregate supply

curve, shifts in aggregate demand
lead to large changes in output but
small or no changes in price.

The short-run aggregate supply curve

is horizontal; prices are fixed in the
short run
Aggregate Supply in the ShortRun
• At low levels of aggregate output, the
curve is fairly flat. As the economy
approaches capacity, the curve becomes
nearly vertical. At capacity, the curve is
vertical.
• As the economy approaches maximum
capacity, firms respond further
increases in demand only
to by raising prices.

• When the economy is operating at low

levels of output, an increase in aggregate
demand is likely to result in an increase in
output with little or no increase in the
overall price level.
 Why the Aggregate-Supply Curve SlopesUpward in the Short Run

Price-Output
• In the short run, an increase in the overall level of prices in the economy tends to raise
the quantity of goods and services supplied.
• A decrease in the level of prices tends to reduce the quantity of goods and services
supplied.
• As a result, the short-run aggregate-supply curve is upward sloping.

Output-Price
• An increase in output leads to increase in employment.
• An increase in employment leads to a decrease in unemployment and, therefore, to
a decrease in unemployment rate.
• The lower unemployment rate leads to an increase in nominal wage.
• The increase in the nominal wage leads to an increase in the prices set by firms,
and, therefore, to an increase in the price level.
 The Short-Run Aggregate SupplyCurve

The Great Depression, from 1929 to 1933: when deflation occurred and the aggregate
price level fell from 11.9 (in 1929) to 8.9 (in 1933), firms responded by reducing the
quantity
44 of aggregate output supplied from $865 billion to $636 billion in 2000 dollars.
Theories of Short-Run AggregateSupply

The aggregate supply curve is upward sloping.

Theories which attempt to explain these include:

• Sticky-Wage Theory

• Imperfect Information / Worker Misperception Theory

• Sticky-Price Theory
 Three Theories of SRAS
In each,
▪ some type of market imperfection
▪ Result:
Output deviates from its natural rate
when the actual price level deviates
from the price level people expected

57
 1. The Sticky-Wage Theory
▪ Imperfection:
Nominal wages are sticky in the short run,
they adjust sluggishly.
▪ Due to labor contracts, social norms

▪ Firms and workers set the nominal wage in

advance based on PE, the price level they
expect to prevail.

58
 1. The Sticky-Wage Theory

▪ If P > PE,
revenue is higher, but labor cost is not.
Production is more profitable,
so firms increase output and employment.

▪ Hence, higher P causes higher Y,

so the SRAS curve slopes upward.

59
 2. The Sticky-Price Theory
▪ Imperfection:

Many prices are sticky in the short run.

▪ Due to menu costs, the costs of adjusting prices.
▪ Examples: cost of printing new menus,
the time required to change price tags

▪ Firms set sticky prices in advance based

on PE.

60
 2. The Sticky-Price Theory
▪ Suppose the Fed increases the money supply
unexpectedly. In the long run, P will rise.
▪ In the short run, firms without menu costs can raise
their prices immediately.
▪ Firms with menu costs wait to raise prices.
Meantime, their prices are relatively low,
which increases demand for their products,
so they increase output and employment.
▪ Hence, higher P is associated with higher Y,
so the SRAS curve slopes upward.

61
 3. The Misperceptions Theory
▪ Imperfection:
Firms may confuse changes in P with changes
in the relative price of the products they sell.
▪ If P rises above PE, a firm sees its price rise before
realizing all prices are rising.
The firm may believe its relative price is rising,
and may increase output and employment.
▪ So, an increase in P can cause an increase in Y,
making the SRAS curve upward-sloping.

62
 What the 3 Theories Have in Common:
In all 3 theories,
Y deviates from YN when P deviates from PE.

Y = YN + a(P – PE)
Output Expected
price level
Natural rate
of output a > 0, measures Actual
(long-run) how much Y price level
responds to
unexpected
changes in P

63
 What the 3 Theories Have in Common:
Y = YN + a(P – PE)
P

SRAS
When P > PE

the expected
PE
price level

When P < PE

Y
YN
Y < YN Y > YN
64
The Short-Run Aggregate Supply Curve:Summary
Aggregate Supply

• Along the SRAS curve,

real GDP might be above
potential GDP…

…or below potential GDP.

Short-Run Macroeconomic Equilibrium

Short-run macroeconomic equilibrium occurs when the quantity of

real GDP demanded equals the quantity of real GDP supplied at
the point of intersection of the AD curve and the SRAS curve.
Macroeconomic Equilibrium
• Figure illustrates a short-run
equilibrium.

• If real GDP is below

equilibrium GDP, firms
increase production and
raise prices…
• …and if real GDP is above
equilibrium GDP, firms
decrease production and
lower prices.
Macroeconomic Equilibrium

• These changes bring a

movement along the SAS
curve toward equilibrium.

• In short-run equilibrium,
real GDP can be greater
than or less than potential
GDP.
Long-Run Macroeconomic Equilibrium
• Long-run macroeconomic
equilibrium occurs when real
GDP equals potential GDP—
when the economy is on its
LAS curve.

• Long-run equilibrium occurs

where the AD and LAS curves
intersect and results when the
nominal wage has adjusted to
put the SAS curve through the
long-run equilibrium point.
Economic Growth and Inflation

• Figure illustrates economic

growth and inflation.
Macroeconomic Equilibrium

• Economic growth occurs

because the quantity of labor
grows, capital is
accumulated, and technology
advances, all of which
increase potential GDP and
bring a rightward shift of the
LRAS curve.
Macroeconomic Equilibrium
• Inflation occurs because the
quantity of money grows
faster than potential GDP,
which increases aggregate
demand by more than long-
run aggregate supply.

• The AD curve shifts

rightward faster than the
rightward shift of the LAS
curve.
 The Business Cycle

The business cycle occurs because aggregate demand and

the short-run aggregate supply fluctuate but the
nominal wage rate does not change rapidly enough to
keep real GDPat potential GDP.
 Macroeconomic
Equilibrium
• A below full-employment
equilibrium is an equilibrium
in which potential GDP
exceeds real GDP.

• Figures (a) and (d) illustrate

below full-employment
equilibrium.

• The amount by which

potential GDP exceeds real
GDP is called a recessionary
gap.
 Macroeconomic Equilibrium

• Along-run equilibrium is an
equilibrium in which potential
GDP equals real GDP.

• Figures (b) and (d)

illustrate long-run
equilibrium.
 Macroeconomic Equilibrium

• An above full-employment
equilibrium is an equilibrium in
which real GDP exceeds
potential GDP.

• Figures (c) and (d)

illustrate above full-
employment equilibrium.

• The amount by which real

GDP exceeds potential
GDP is called an
inflationary gap.
 Macroeconomic Equilibrium

• Figure (d) shows how, as the

economy moves from one type
of short-run equilibrium to
another, real GDP fluctuates
around potential GDP in a
business cycle.
 Four steps in the process ofanalyzing
economic fluctuations
• Determine whether the event affects aggregate supply or
aggregate demand.

• Decide which direction the curve shifts.

• Use a diagram to compare the initial and the new equilibrium.

• Keep track of the short and long run equilibrium, and the
transition between them.
 TWO CAUSES OF ECONOMIC FLUCTUATIONS

• Shifts in Aggregate Demand

• In the short run, shifts in aggregate demand cause fluctuations in the

economy’s output of goods and services.

• In the long run, shifts in aggregate demand affect the overall pricelevel
but do not affect output.

• Policymakers who influence aggregate demand can potentially mitigate

the severity of economic fluctuations.
Fluctuations in Aggregate Demand

• Figure shows the effects of an

increase in aggregate demand.

• Part (a) shows the short-run

effects.

• Starting at long-run equilibrium, an

increase in aggregate demand
shifts the AD curve rightward.
Macroeconomic Equilibrium

• Firms increase production

and raise prices - a
movement along the SAS
curve.
Macroeconomic Equilibrium

• Figure (b) shows the long-run

effects.

• Real GDP increases, the price

level rises, and in the new
short-run equilibrium, there is
an inflationary gap.
Macroeconomic Equilibrium

• The nominal wage rate begins to

rise and short-run aggregate supply
begins to decrease.

• The SAS curve shifts leftward.

• The price level rises and real GDP

decreases until it has returned to
potential GDP.
 A Contraction in AggregateDemand
2. . . . causes output to fall in the short run . ..
Price
Level
Long-run Short-run aggregate
aggregate supply, AS
supply
AS2

3. . . . but over
time, the short-run
P A aggregate-supply
curve shifts . . .
P2 B
1. Adecreasein
aggregate demand . . .
P3 C
Aggregate
demand, AD
AD2
0 Y2 Y Quantityof
4. . . . and output returns Output
to its natural rate.
TWO CAUSES OF ECONOMIC FLUCTUATIONS

• Shifts in Aggregate Supply

• Consider an adverse shift in aggregate supply:
• A decrease in one of the determinants of aggregate supply shifts the curve
to the left.
• Output falls below the natural rate of employment.
• Unemployment rises.
• The price level rises.
 Short Run Supply Shocks
• Tightness in the labor market.
• Suppose that because of a big economic expansion, the economy is producing at an
output level Ythat is greater than YP.
• This suggests that the economy is using more labor than it normally does.
• To get people to work longer hours, you have to pay them more.
• This increase in labor costs will shift the SRAS curve left, as profit per output falls when
labor costs rise.

• Expectations about inflation

• If workers expect inflation to be higher in the future, they will demand higher wages in
anticipation of this increase in the cost of living.
• Higher wages reduce firm profit and shift SRASleft

• Supply shocks to critical raw materials

• Suppose a war broke out between the US and Iran. Oil prices would rise dramatically
• Since oil is such a pervasive part of nearly everything we produce, production costs would
rise significantly.
• The SRAS curve would shift left as the return on production fell.
An Adverse Shift in AggregateSupply
1. An adverse shift in the short-
run aggregate-supply curve . . .
Price
Level

Long-run Short-run
aggregate AS2 aggregate
supply supply, AS

B
P2
A
P
3. . . . and
the price
level to rise.
Aggregate demand

0 Y2 Y Quantityof
2. . . . causes output to fall . . . Output
The Effects of aShift in Aggregate Supply
• Adverse shifts in aggregate supply cause stagflation - a period
of recession and inflation.

• Output falls and prices rise.

• Policymakers who can influence aggregate demand cannot

offset both of these adverse effects simultaneously.
The Effects of aShift in Aggregate Supply

• Policy Responses to Recession

• Policymakers may respond to a recession in one of the following ways:

• Do nothing and wait for prices and wages to adjust!

• Take action to increase aggregate demand by using monetary and fiscal

policy.
 Accommodating an Adverse Shift in Aggregate Supply

1. When short-run aggregate

supply falls . . .
Price
Level
Long-run Short-run
aggregate AS2 aggregate
supply supply, AS

P3 C 2. . . . policymakers can
P2 accommodate the shift
A by expanding aggregate
3. . . . which P demand . . .
causes the
price level
to rise 4. . . . but keeps output AD2
further . . . at its natural rate.
Aggregate demand, AD

0 Natural rate Quantityof

of output Output
 Debates Over Aggregate Supply
Classical Theory
1. Achange in AD will not change output even in the short run because prices
of resources (wages) are very flexible.
2. AS is vertical so AD can’t increase without causing inflation.

Price AS
level

AD

Qf
Real domestic output, GDP
 Debates Over Aggregate Supply
Classical Theory
1. Achange in AD will not change output even in the short run because prices
of resources (wages) are very flexible.
2. AS is vertical so AD can’t increase without causing inflation.

AS Recessions caused by a fall in AD

Price are temporary.
level
Price level will fall and economy will
fix itself.
No Government Involvement
Required

A
D
AD1
Qf
 Debates Over Aggregate Supply
Keynesian Theory
1. A decrease in AD will lead to a persistent recession because prices of
resources (wages) are NOT flexible.
2. Increase in AD during a recession doesn’t cause inflation

Price AS
level

AD

Qf
Real domestic output, GDP
 Debates Over Aggregate Supply
Keynesian Theory
1. A decrease in AD will lead to a persistent recession because
prices of resources (wages) are NOT flexible.
2. Increase in AD during a recession puts no pressure on prices

Price AS
“Sticky Wages” prevents
level wages to fall.
The government should
increase spending to
close the gap

AD1 AD
Q1 Qf
Real domestic output, GDP
 Debates Over Aggregate Supply
Keynesian Theory
1. A decrease in AD will lead to a persistent recession because
prices of resources (wages) are NOT flexible.
2. Increase in AD during a recession puts no pressure on prices

Price AS When there is high

unemployment, an
level increase in AD doesn’t
lead to higher prices
until you get close to full
employment

AD3
AD1 AD2
Q1 Qf
Real domestic output, GDP
 The Ratchet Effect
A ratchet (socket wrench)
permits one to crank a
tool forward but not backward.

Like a ratchet, prices can easilymove

up but not down!
 Does deflation (falling prices) oftenoccur?

Not as often as inflation. Why?

• If prices were to fall, the cost of resources mustfall or firms
would go out of business.

• The cost of resources (especially labor) rarely fallbecause:

• Labor Contracts (Unions)
• Wage decrease results in poorworker morale.
• Firms mustpay to change prices (ex: re-pricing items in
inventory, advertising new prices to consumers, etc.)
The AS curve
Classical range;
No multiplier effect
Price level price response only

Intermediate range;
Multiplier reduces as economy
approaches full employment
P2
P1

Keynesian range;
full multiplier effect

Real domestic product

Aggregate Demand, Aggregate
Supply, and Monetary and FiscalPolicy

• AD can shift to the right for a

number of reasons, including an
increase in the money supply, a tax
cut, or an increase in government
spending.

• Expansionary policy works well

when the economy is on the flat
portion of the AS curve, causing
little change in P relative to the
output increase.
Aggregate Demand, Aggregate
Supply, and Monetary and FiscalPolicy

• On the steep portion of the

AS curve, expansionary
policy does not work well.
The multiplier is close to
zero.
• When the economy is
operating near full capacity,
an increase in AD will result
in an increase in the price
level with little increase in
output.
Long-Run Aggregate
Supply and Policy Effects

• If the AS curve is vertical in

the long run, neither
monetary policy nor fiscal
policy has any effect on
aggregate output.
• In the long run, the
multiplier effect of a change
in government spending or
taxes on aggregate output
is zero.