4.

AGGREGATE DEMAND AND SUPPLY

4.1. Aggregate demand

Aggregate expenditures change depending on their components: 1) private consumption;

2) investments; 3) public expenditures; 4) net export.

What happens if prices change?

Private consumption: depends on revenues and wealth

- if prices increase they determine the decrease of real wealth ⇒ the decrease of
the purchasing power of all nominal assets ⇒ the decrease of the consumption (the effect
of wealth = the effect of the real wealth change on the consumption underthe effect of the
price change);

Investments: the price change has an effect on investments through the interest rate (the
interest rate is the opportunity cost of capital change);
- if prices increase ⇒ the increase of money demand ⇒ the interest rate increases
⇒ investments decrease (when money supply is constant);
- interest rate influences the aggregate expenditures through the consumption of
durable goods bought by credit as well.

Net export: it depends on the modification of internal prices: an increase of national

prices makes external products cheaper comparing to the national ones ⇒ the increase of
imports and the decrease of exports ⇒ the decrease of net export.educerea exportului net.

Conclusion: There is a negative relationship between prices and aggregate

expenditures; prices have an impact on wealth, interest rate and external
tranzactions.
 Aggregate
expenditures (C + I + G + X – M)0
CG
(C + I + G + X – M)1

(C + I + G + X – M)2

C0
45º
0 Y2 Y1 Y0 Income (Y)

P2

P1
P0
Aggregate demand
0 Y2 Y1 Y0 Income(Y)

Fig. 4.1.: Aggregate expenditures and aggregate demand

AGGREGATE DEMAND: the total amount of good and services which consumers,
firms, government and foreigners want and can buy taking into account the average price
in economy.
- The aggregate demand means combinations of prices and incomes for which the
economy is in equilibrium; (Y = CG);
- Any point in the left of aggregate demand: the expenditures are higher than
production;
- Any point in the right of aggregate demand: the expenditures are lower than
production;
The change of aggregate demand is determined by:
- Consumption;
 - investments;
- public expenditures, without tax change;
- net export.

AD1
AD0
AD2

Y
Fig. 4.2.: The change of aggregate demand
4.2. Aggregate supply

AGGREGATE SUPPLY: the total production of goods and services which firms want
and can make taking into account the average price in economy.
- time is very important for analysing the aggregate supply:
- on the short run, we consider the factors’ prices relatively rigid and the
production has a direct relationship with price of goods or services;
- on the long run, economy works at its potential level and the supply is perfectly
inelastic at the highest possible level of GDP.

4.2.1. The aggregate supply on the short run (Fig. 4.3.):

- zone I, resources are underused and the supply is perfectly elastic (it is the zone
of economies of scale and producers accept to produce more without changing the
prices); ATC = TC/Q decreases, ascending average productivity
- zone II, resources are intensively used and the supply is ascending (it is the zone
of diseconomies of scale and the producers accept to produce and sell more only
if they sell more expensive and supply is ascending taking into account the price);
 - zone III, resources are completely used and the supply is perfectly inelastic (the
economy reaches its maximum capacity).

P
Zona III:
Zona II: perfectly
ascending inelastic
Zone I: supply supply
perfectly
elastic
supply

Y
Fig. 4.3.: The aggregate supply on the short
run
The change of AS is determined by:
- The modification of the prices of inputs;
- The modification of the anticipated inflation rate;
- The modification of inputs’ productivity;
- Information and new technologies;
- the modification of laws and fiscality;
- External shocks.

P AS1 AS0
AS2

Y
Fig. 4.4.: Increase and decrease of aggregate supply on the short run
4.2.2. Aggregate supply on the long term
- on the long run, the supply is at the potential level of GDP (the prices of goods increase
⇒ the aggregate supply shifts to the right ⇒ the demand for inputs increases ⇒ the prices
of inputs increase ⇒ the gains of producers (their surpluses) decrease ⇒ there are no
incentives to increase production).
- the increase of AS takes a very long time in which the whole national way of production
would be improved.

ASLT

Y` Y
Fig.4.5.: The aggregate supply on the long term

4.3. The macroeconomic equilibrium

4.3.1. The equilibrium on the short run

P AS

P*
AD

Y* Y
Fig. 4.6.: The macroeconmic equilibrium on the short run
- the analysis of the impact of the AD and AS on GDP and prices both on the short and
long run.
- on the short run, when the AD increases, the impact on prices and GDP depends on the
specific shape of the AS (Fig. 4.7.)
AS
P
P5

P4

P3
P2
P0=P1

Y0 Y1 Y2 Y3 Y4=Y5 Y
Fig. 4.7.: The modification of the equilibrium when the AD changes
Fig. 4.7.:
- If the AD increases in the perfectly elastic zone of the AS, the effect will be an
increase of GDP, letting the price constant;
- An increase of the AD in the ascending zone of the AS will determine an increase
of both GDP and prices;
- an increase of the AD in the perfectly inelastic zone of the AS will determine only
inflation.

P AS1 AS0
AS2

P1
P0
P2
AD

Y1 Y0 Y2
Fig. 4.8.: The change in equilibrium depending on AS
- the equilibrium on the short run can change due to the modification of the AS as well.
Fig. 4.8.: :
- The increase of the AS determines the increase of GDP and the decrease of the
prices;
- The decrease of the AS determines the reduction of GDP and the increase of the
prices.
4.3.2. The equilibrium on the long run
- on the long run, the economy goes to its potential level (Y*), for which there is a certain
level of prices (P*).

ASLT
P

P*
ADAD
ADAD
ADAD
AD

Y* Y
Fig. 4.9.: The macroeconomic equilibrium on the long run
- it is possible that economy to be in an equilibrium only on the short run, but on the long
run to be some gaps
4.3.3. Gaps on the long run
4.3.3.1. The recession gap
- the equilibrium on the short run is under the potential level of GDP ⇒ unused resources
(imagine an economy in the left of the production possibility curve) ⇒ certain reserves of
production which have to be exploited.

ASTL AS
P

P* AD

Y*Y` Y
Fig. 4.10.: The recession gap

- The recession gap can be the result of either a sudden decrease of the aggregate
demand or a sudden decrease of the aggregate supply.
- The recession would solve without intervention: there is a surplus on the inputs
market ⇒ inputs’prices decrease ⇒ the decrease of the costs in economy ⇒ the
increase of supply to its potential level (there is a problem we can identify here:
the rigidity of the labour price which means the rigidity of the salaries (wages) to
decrease; this problem can make the recession longer).

4.3.3.2. The inflationist gap

- the equilibrium on the short run goes to a level which exceeds the potential GDP;
- the cause can be a shock of the aggregate demand;

ASTL AS
P

P* AD

Y` Y* Y
Fig. 4.10.: The inflationist gap

- this kind of gap can be solved: the aggregate supply which exceeds the potential GDP
makes the inputs’ prices to go up ⇒ the increase of the salaries exceeds labour
productivity ⇒ the increase of costs ⇒ the decrease of the AS on the short run.

Solving the gaps by the government through the budgetary policy (public
expenditures and taxes)
- The recession gap:
⇒ the increase of the public expenditures ⇒ the increase of the AD and the
establish of the equilibrium to its potential level;
⇒ the increase of transfers in economy (social helps) and the decrease of
taxes on the revenues;
- The inflationist gap:
⇒ the reduction of the public expenditures;
⇒ the increase of taxes and the reduction of transfers.
4.3.4. Automatic stabilizers
Automatic stabilizers are economic policies and programs designed to offset fluctuations
in a nation's economic activity without intervention by the government or policymakers
on an individual basis. The best-known automatic stabilizers are corporate and personal
taxes, and transfer systems such as unemployment insurance and welfare. Automatic
stabilizers are so called because they act to stabilize economic cycles and are
automatically triggered without explicit government action.
- even if the government does not modify the public expenditures and taxes, its simple
implication through the state budget is meant to attenuate the shocks of AD and AS.
- taxes on revenues and transfers act like automatic stabilizers:
- when the available revenue increases, the consumption increases as well but not
in the same proportion; if we have higher taxes, these will affect the consumption
increase;
- transfers attenuate the AD fluctuations because during recession, for example,
they increase the revenues of poor people and they allow them not to modify their
consumption suddenly.