Aggregate demand and supply

Aggregate Supply
Quantity of real GDP supplied is the total amount of final goods and services that domestic
firms plan to produce (not only one good but all in all together).
- Depends on
o Labour employed
o Capital, human capital and state of technology
o Land and natural resources
o Entrepreneurial talent
- At full employment
o Real wage rate makes quantity of labour demanded = quantity of labour
supplied
o Real GDP = potential GDP
- Over the business cycle
o Quantity of labour employed fluctuates around its full employment level
o Real GDP fluctuates around potential GDP
Aggregate supply curve
Relationship between quantity of real GDP supplied and price level ceteris paribus
o When price level. Rises, quantity of real GDP supplied increases
o When price level falls, quantity of real GDP supplied decreases
- Along the curve the only influence on production plans that changes are price level
o Money wage rate
o Money prices of other resources
Along potential GDP line, when price level changes the money wage rate changes. To
keep the real wage rate at full employment level
- Upward slopes
o When price level rises and the money wage rate is constant, real wage rate
falls and employment increases (quantity of real GDP supplied increases)
o When price level falls and money wage rate is constant, real wage rate rises
and employment decreases (real GDP supplied decreases)
- Changes in supply
o Potential GDP changes
o Money wage rate changes
o Money prices of other resources change
Changes in money wage rate
- It changes firms’ costs
the higher the money wage rate, the higher are firms’ costs and the smaller is the
quantity that firms are willing to supply at each price level
à increase in money wage rate decreases aggregate supply but don’t change
potential GDP
- Money prices of other resources
o Changes aggregate supply because it changes firms’ costs
The higher the money prices of other resources, the higher are firm’s costs and
the smaller is the quantity that firms are willing to supply at each price level
à increase in money prices decrease AS
Aggregate Demand
Quantity of real GDP demanded is the total amount of final goods and services produced
that people, businesses, governments, and foreigners plan to buy
1. Real consumption expenditure
2. Investment
3. Government expenditure on goods and services
4. Export – imports
à Real GDP = Y= C+I+G+X-M
Aggregate demand
Relationship between the quantity of real GDP demanded and the price level when all
other influences on expenditure plans remain the same
o When PL rises the quantity of real GDP demanded decreases
o When PL falls, the quantity of real GDP demanded increases
- Price level brings changes in
o Buying power of money
 Lowers buying power of money and decreases real GDP demanded
 Given quantity of money will buy less goods (cut spending)
o Real interest rate
 Price level rises, real interest rate rises
 Increase in price level increase amount of money people want to hold
 Businesses and people delay plans to buy new capital goods and
durable goods and cut back on spending
o Real prices of exports and imports
 Prices in other countries do not changes if price level of domestic
country rises
 Domestic goods are therefore more expensive relative to foreign
goods
 Changes in real prices encourages people to spend less on domestic
goods
 Exports decrease and import increases
- Changes
When aggregate demand increases, the AD curve shifts rightward
When AD decreases, the AD curve shifts leftward
o Expectations about the future
 Increase in expected future income
 Increase amount of consumption goods that people plan to
buy today and increases AD
 Increase in expected future inflation
 Increases AD today because people decide to buy more goods
now before price rises
 Increase in expected future profits
 Increases investment that firms plan to undertake today and
increase AD
o Fiscal policy and monetary policy
 Changing taxes, transfer payments and government expenditure on
goods
 Tax cut (e.g.) or increase in other two methods, increase AD
  Changing quantity of money and interest rate (cut in interest rate
increase AD)
o State of the world economy
 Foreign exchange rate (FX) and foreign income
 FX is amount of foreign currency you can buy (indirect notation)
 Ceteris paribus, a rise in foreign exchange rate ($ appreciation)
decrease AD
 Increase in foreign income increases exports and increases AD

Increase AD Decrease AD
+Expected future income, inflation or profit -expected future income, inflation or profit
+ planned investment through fiscal policy -planned investment through fiscal policy
-exchange rate (falls) + exchange rate (rises)
+ foreign income -foreign income

- Multiplier
o Effect that magnifies changes in expenditure plans and brings potentially large
fluctuation in AD
 Change in expenditure changes income
 Changes in income influence change in consumption
Business cycle
AS and AD determine real GDP and price level
- Equilibrium
Quantity of real GDP supplied at the point of intersection and the AD curve and AS
curve
o Adjustment à cut production and lower price when demand < supply
1. Below full employment equilibrium
Potential GDP >equilibrium real GDP
2. Full employment equilibrium
Equilibrium real GDP = potential GDP
3. Above full employment equilibrium
Equilibrium real GDP > potential GDP
à Adjustment to full employment
o Inflationary gap
 Shortage of labour à higher wage rate
 Shifts leftward to AS à PL increases
o Recessionary gap
 Surplus labour à lower wage rate
 Shifts rightward to AS à PL decreases
Fluctuations in AD
o Fluctuation in AD bring fluctuations in actual real GDP around potential GDP
Real GDP, Growth, Inflation and BC.
- Economic growth, Inflation and business cycle changes AD and AS
- Increase in potential GDP brings growth
- Greater increase in AD than in potential GDP brings inflation
Inflation cycles
Any factor that increases AD or AS can start an inflation, but growth can in quantity of
money sustains it
- Demand-pull inflation (demand)
o Inflation that starts because AD increases
o Quantity of money increases à AD shifts rightward
o Real GDP > potential GDP à inflationary gap AS shifts leftward
 Shortage of labour
o Results with real GDP fluctuating
- Cost-push inflation (supply)
o Inflation starts because AS increases
o Cost increase à AS shifts leftward
o Real GDP < potential GDP à recessionary gap AD shifts rightward
 Unemployment thigh
 CB increase quantity of money to restore full employment
 Price level rises
o Results with real GDP fluctuating

Fluctuation in AS
Stagflation à combination of recession (falling real GDP) and inflation (rising price level)
- Potential GDP grows at uneven pace
- Money price of major resource might change
(PL up and GDP leftshift)

Causes the business cycle

- Business cycle theory
o Mainstream business cycle theory à potential GDP grows at a steady rate
while AD grows at a fluctuating rate
o AD grows more quickly than potential GDP, real GDP > potential GDP resulting
in inflationary gap
 Money wage rate is slow to change
 Inflation rate rises and real GDP is pulled back toward potential GDP
o If AD grows more slowly than potential GDP, real GDP < potential GDP
resulting in recessionary gap
 Inflation rate slows but money wage rate responds slowly to
recessionary gap
 Real GDP does not return to potential GDP until another increase in
AD occurs
 Fluctuations in investment are the main sources of AD fluctuations
Recession
- occur if AS decreases to bring stagflation
- because both AD and AS decrease
Deflation and great depression
Great depression
- during the great depression the price level fell by 22% and real GDP decreased by
31%
- during great depression, banks failed, and the quantity of money fell by 25%
- Fed stood by and took no action to counteract the fall of buying power (AD collapsed)
 - Money wage rate didn’t fall immediately, decrease in AD brought a large fall in real
GDP
- Money wage rate and price level fell eventually but not until employment and real
GDP had shrunk to 75% of their 1929 levels
2008
- Real GDP fell by less than 4% and price level continued to rise (more slowly)
- Fed bailed out troubled financial institution sand doubled the monetary base
- Quantity of money kept growing
- Government increased its own expenditures (added to AD)
- Combined effects of continued growth in the quantity of money and increased
government expenditure limited the fall in AD and prevented a large decrease in. real
GDP
Challenge now
- Unwind the monetary and fiscal stimulus as the components of private expenditure
begin to increase
- As these components return to more normal levels, AD will increase
- Too much monetary and fiscal stimulus will bring an inflationary gab and faster
inflation
- Too little monetary and fiscal stimulus will bring recessionary gap