Aggregate Supply and Aggregate

Demand
The aggregate supply (AS) curve: is the relationship between the quantity of real GDP
(at constant prices) supplied and the price level, or the average price for goods and
services in the economy. In other words, the overall supply in the economy is tied to
the general price level.
We distinguish two time frames associated with different states of the labor market:
 Long-run aggregate supply.
 Short-run aggregate supply.
The macroeconomic long run is the period of time required for all macro-economic
variables—especially the price level—to be completely flexible.
The macroeconomic short run is the period of time during which at least some prices
are inflexible (i.e., rigid or "sticky"), causing a relatively inflexible or con-stant price
level in the economy.
Long-Run Aggregate Supply
Long-run aggregate supply is the relationship between the quantity of real GDP
supplied and the price level when real GDP equals potential GDP.
Potential GDP is independent of the price level.
So the long-run aggregate supply curve (LAS) is vertical at potential GDP.
Short-Run Aggregate Supply
Short-run aggregate supply is the relationship between the quantity of real GDP
supplied and the price level when the money wage rate, the prices of other resources,
and potential GDP remain constant.
A rise in the price level with no change in the money wage rate and other factor prices
increases the quantity of real GDP supplied.
The short-run aggregate supply curve (SAS) is upward sloping.

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Changes in Aggregate Supply
Aggregate supply changes if an influence on production plans other than the price
level changes.
These influences include
- Changes in potential GDP
- Changes in money wage rate (and other factor prices)
Changes in Potential GDP
- When potential GDP increases, both the LAS and SAS curves shift rightward.
- Potential GDP changes for three reasons:
o An increase in the full-employment quantity of labor
o An increase in the quantity of capital (physical or human)
o An advance in technology

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Figure shows the effect of an increase in potential GDP.

 The LAS curve shifts rightward and the SAS curve shifts along with the LAS curve.

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Changes in the Money Wage Rate
Figure shows the effect of a rise in the money wage rate.

 Short-run aggregate supply decreases and the SAS curve shifts leftward.
 Long-run aggregate supply does not change.

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Aggregate Demand
The quantity of real GDP demanded, Y, is the total amount of final goods and services
produced in the United States that people, businesses, governments, and foreigners
plan to buy.
This quantity is the sum of consumption expenditures, C, investment, I, government
expenditure, G, and net exports, X – M.
That is, Y = C + I + G + X – M.
Buying plans depend on many factors and some of the main ones are
 The price level
 Expectations
 Fiscal policy and monetary policy
 The world economy
The aggregate demand (AD) curve is the relationship between the quantity of real
GDP demanded and the price level.
It slopes downward because higher average price levels will decrease consumers'
buying power and therefore decrease the quantity demanded.
In addition, higher price levels will decrease exports because domestic products are
more expensive for the foreign sector ,and lower exports mean lower aggregate
demand. A linear aggregate demand curve.
The aggregate demand curve may shift as a result of changed expectations
(anticipated income, inflation, and so on) or changes in foreign exchange rates. Also,
the government may cause a shift by increasing expenditures or lowering taxes (fiscal
policy), while the Federal Reserve can cause shifts by making changes in the monetary
policy (e.g., the discount rate).
Figure shows an AD curve.
The AD curve slopes downward for two reasons:
 Wealth effect
 Substitution effects

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Wealth Effect
A rise in the price level, other things remaining the same, decreases the quantity of
real wealth (money, stocks, etc.).
To restore their real wealth, people increase saving and decrease spending.
The quantity of real GDP demanded decreases.

Substitution Effects
Intertemporal substitution effect:
- A rise in the price level, other things remaining the same, decreases the real value
of money and raises the interest rate.
- When the interest rate rises, people borrow and spend less, so the quantity of real
GDP demanded decreases.
International substitution effect:
- A rise in the price level, other things remaining the same, increases the price of
domestic goods relative to foreign goods.
- So imports increase and exports decrease, which decreases the quantity of real
GDP demanded.
- Similarly, a fall in the price level, other things remaining the same, increases the
quantity of real GDP demanded.

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Changes in Aggregate Demand
A change in any influence on buying plans other than the price level changes
aggregate demand.
The main influences on aggregate demand are
 Expectations
 Fiscal policy and monetary policy
 The world economy
Expectations
- 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.
Fiscal Policy and Monetary Policy
- Fiscal policy is the government’s attempt to influence the economy by setting and
changing taxes, making transfer payments, and purchasing goods and services.
- A tax cut or an increase in transfer payments increases households’ disposable
income—aggregate income minus taxes plus transfer payments.
- An increase in disposable income increases consumption expenditure and increases
aggregate demand.
- Because government expenditure on goods and services is one component of
aggregate demand, an increase in government expenditure increases aggregate
demand.
- The Fed’s attempt to influence the economy by changing the interest rate and
adjusting the quantity of money is called monetary policy.
- An increase in the quantity of money increases buying power and increases
aggregate demand.
- A cut in interest rates increases expenditure and increases aggregate demand.

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The World Economy
- The world economy influences aggregate demand in two ways:
o A fall in the foreign exchange rate lowers the price of domestic goods and
services relative to foreign goods and services, which increases exports,
decreases imports, and increases aggregate demand.
o An increase in foreign income increases the demand for U.S. exports and
increases aggregate demand.
Figure illustrates changes in aggregate demand.
When aggregate demand increases, the AD curve shifts rightward…
… and when aggregate demand decreases, the AD curve shifts leftward.

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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 SAS curve.
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.
- These changes bring a movement along the SAS curve towards equilibrium.
- In short-run equilibrium, real GDP can be greater than or less than potential GDP.

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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 at the intersection of the AD and LAS curves.
Figure 27.7 illustrates the adjustment to long-run equilibrium.

- Initially, the economy is at below-full employment equilibrium.

- In the long run, the money wage falls until the SAS curve passes through the long-
run equilibrium point.

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- Initially, the economy is at an above-full employment equilibrium.
- In the long run, the money wage rate rises until the SAS curve passes through the
long-run equilibrium point
Note that:
- Long-run macroeconomic equilibrium occurs when aggregate demand and long-run
aggregate supply are equal. By definition, in the long run prices will adjust so that
real GDP equals potential GDP. Economic growth takes place when the potential
GDP increases. Inflation will occur when aggregate demand increases more than
long-run aggregate supply.
- Short-run macroeconomic equilibrium occurs when aggregate demand and short-
run aggregate supply are equal. If the short-run real GDP is below potential GDP,
the amount of the difference is called a recessionary gap .An above-full-
employment equilibrium occurs when real GDP exceeds potential GDP. The
inflationary gap is the amount by which real GDP exceeds potential GDP. According
to Keynesian theory, instability and business cycles result when aggregate demand
and short-run aggregate supply are not growing at the same rate
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The AS/AD Model
 The AS/AD model is the macroeconomic supply and demand model that explains
how macroeconomic equilibrium is achieved and how shifts of the aggregate supply
curves and aggregate demand curves change the macroeconomic equilibrium.
 For example, an increase in aggregate demand means that, in the short run, the
aggregate demand curve shifts to the right. Consequently, the equilibrium moves
along the SAS curve. This means that real GDP increases and the price level rises.
The money wage rate rises as a result of the higher prices. Then the SAS curve
shifts left, and real GDP decreases while price levels are raised further. In the long
run, the SAS curve will shift to the left just enough for real GDP to equal potential
GDP. At that point, adjustments cease, and real GDP equals potential GDP. The
price level is permanently higher than before the increase in aggregate demand.
 As another example, a decrease in short-run aggregate supply means that the SAS
curve will shift to the left, and as a consequence real GDP will decrease, and the
price level rises. This condition (recession and inflation combined) is known as
stagflation.
 The AS/AD model is helpful in understanding the expected (or predicted) impact of
real-world events on the economy.
 Increase in government expenditures. Aggregate demand goes up, and the AD
curve shifts to the right. This leads to an increase in GDP and an increase in the
price level.
 Decline in household consumption. Aggregate demand goes down, and the AD
curve shifts to the left. This causes GDP, as well as the price level, to go down
(similar to the 1930s Depression).
 Wage rate declines. Aggregate supply shifts to the right (higher profitability), and
GDP goes up while the price level goes down.
 Oil supply goes down. Aggregate supply shifts to the left (lower profitability), and
GDP goes down while the price level goes up (similar to 1970s stagflation).
 The AS/AD model also demonstrates the likely effects of fiscal or monetary policy
and can be used to analyze major economic models

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