Chapter 23

Aggregate Demand and

Aggregate Supply
“Is aggregate demand a larger version of the demand curve? How about
aggregate supply?”

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 Learning Objectives

1.Define the aggregate demand curve, explain it’s slope

and why it shifts.
2.Define the aggregate supply curve, explain it’s slope
and why it shifts.
3.Show how the aggregate demand curve and the short-
run aggregate supply curve determine the short-run
equilibrium level of output (Y), and inflation.
4.Show how the aggregate demand curve and the long-
run aggregate supply curve, determine the long-run
equilibrium level of output (Y*) and inflation.

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 Learning Objectives

5. Show how Neo-Keynesian economics

works to help an economy adjust to
expansionary and recessionary gaps.
6. Show why Neo-Classical economics argues
that government or Central Bank intervention
in the economy has no effect on real variables
(output and employment).

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 Generally, because of increases in the labor
force, increases in capital stock, and advances
in technological knowledge, the economy can
produce more and more over time. This grow
allows everyone to enjoy higher standards of
living.

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 In some years, however, this normal growth does not
occur. Firms find themselves unable to sell all of the
goods and services they have to offer, so they cut back
on production.

 As firms cut back on production, workers lose their

jobs, unemployment rises, and factories are left idle.

 With the economy producing fewer goods and services,

real GDP and other measures of income falls.

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 A period of falling output or income, and rising
unemployment is called a recession if it is relatively mild
and a depression if it is more severe. During a recession,
output or current output (Y) is below potential output (Y*).
 A period of extremely rapid output or income growth is
call overheating. When the economy overheats, output or
current output (Y) is above potential output (Y*).
 What causes short-run fluctuations in economic activity?
 What, if anything, can public policy do to prevent a
recession or overheating?

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 The Basic Model
of Economic Fluctuations
 We analyze fluctuations in the economy as a whole
with the model of aggregate demand (AD) and
aggregate supply (AS).
 The aggregate demand curve is a curve that shows the
quantity of goods and services that households, firms,
government, and foreigners want to buy at each price
level.
 The aggregate supply curve is a curve that shows the
quantity of goods and services produced in an
economy at a given price level.

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 Aggregate Demand

 Why does the fall in the price level raise the

quantity of goods and services demanded? That is,
why is AD downward sloping?

 Recall that GDP(Y) is the sum of consumption(C)

Investment (I), government spending (G), and net
exports (NX)

 Y = C + I + G + NX
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 Each of these components contributes to the aggregate
demand for goods and services. For now lets assume that
government spending is fixed by policy.

 The other three components, C, I, and NX depend on

economic conditions, and in particular to the price level.

 To understand why the aggregate demand curve slopes

downward, therefore, we must examine how the price
level affects the quantity of goods and services demanded
for consumption, investment, and net exports.

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 The Price Level and
Consumption: The Wealth Effect
 Consider the money that you hold in your wallet and
bank account. The nominal value of this money is
fixed, but its real value is not. When prices fall,
these dirhams are more valuable because they can be
used to buy more goods and services.

 Thus, a decrease in the price level makes consumers

feel wealthier, which in turn encourages them to
spend more. The increase in consumer spending
means a larger quantity of goods and services
demanded.
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The Price Level and Investment:
The Interest-Rate Effect
 The lower the price level, the lower the demand
for money. As the demand for money falls, it
increases the level of bank deposits driving low
interest rates. Lower interest rates encourage
greater spending on investment goods.

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 The Price Level and Net Exports:
The Exchange-Rate Effect
 As prices fall, the lower demand for money drives down interest
rates. In response, domestic savers will seek higher returns by
saving abroad.

 For example, if interest rates on UAE government bonds falls,

savers might sell the UAE bonds and use the money to buy
German bonds. As assets (dirhams) are moved overseas (to
Germany), it increases the supply of dirhams in the German market
of foreign exchange.

 This increase in supply of dirhams causes the dirham to depreciate

relative, not just to the euro but also to other currencies.

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 As the UAE Dirham depreciates, the level of UAE imports fall (as
foreign goods are now more expensive), while the level of UAE
exports rise (as UAE goods have become cheaper to foreigners).

 Thus, when a fall in the price level in the UAE causes UAE interest
rate to fall, the exchange rate depreciates and its depreciation
stimulates UAE net exports and thereby increases the quantity of
goods and services demanded.

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 The Aggregate-Demand Curve
Price Level

P1

P2

1. A decrease
in the price
level... Aggregate demand

0 Y1 Y2 Quantity of Output

2. ...increaes the quantity of

goods and services demanded.
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 Why the Aggregate-Demand
Curve Might Shift
 Shifts AD occurs when any of the component of
AD changes for a reason other than a change in
the price level. For example, other things equal,
an increase in C (maybe due to higher income),
shifts the AD to the right.

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 The Aggregate Supply Curve

 Unlike the aggregate demand curve, which is

always downward sloping, the aggregate supply
curve shows a relationship that depends on the
time horizon being examined.

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 In the short-run, the AS curve is upward sloping (Neo-
Keynesian AS). The underlying assumptions in the Neo-
Keynesian model is that prices are sticky (they adjust
slowly), the economy is suffering from high unemployment,
and all other factors of production are not fully utilized.
 In the long-run, the AS curve is vertical (Neo-Classical AS)
and changes only due to changes in productivity. The
underlying assumptions in the Neo-Classical model is that
prices adjust instantaneously to changes in the value of
money (money does not change real variables like output and
employment). This can only happen if the economy is at full
employment and all other factors of production are fully
utilized. The economy is at full production capacity.
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 Why The Aggregate-Supply Curve Slopes
Upward in the Short-Run
(The Keynesian AS Curve)
 If in the short-run resources are not fully utilized and
we have unemployment, that is, if the economy is not
operating at full production capacity, will money
make a difference?
 In the short-run, that is, over a period of 2 years,
changes in the money supply (monetary policy),
causes changes in the price level but also causes
changes in output and employment. In other words,
money matters, it is not neutral in the short-run as it
affects real variables.

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 Short-Run AS Curve
(Keynesian AS)

AS
P2

P1

Y1 Y2 Y

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 Why Aggregate Supply Curve is Vertical in
the Long-Run – The Neo-Classical Argument

 According to the neo-classical argument, the quantity of output supplied

depends on the economy’s factors of production such as human capital,
physical capital, natural resources, and on the technology for turning these
inputs into output.
 Since money is not listed as a determinant of output, money does not
matter in a neo-classical world, hence, money is neutral (does not affect
real variables such as output and employment). If the quantity of money in
the economy were to double, everything will cost twice as much and we
will make twice as much, but are we better off?
 Most economists believe that the neo-classical theory describes the world
in the long run but not in the short run.
 For money to be neutral, the economy must be operating at full production
capacity, a long-run scenario.

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 The Long-Run AS
(Neo-Classical AS)
Price Level

Long-run
aggragate
supply

P1

P2
2. ...does not affect the
1. A change in quantity of goods and
the price level... services supplied in the
long run.

0 Natural rate Quantity of Output

of output

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 Why the Long-Run AS Might
Shift?
 Due to changes in the economy’s factor of
production such as human capital, physical capital,
natural resources and technology.

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 A New Way to Depict Long-Run
Economic Growth and Inflation
 The economy’s long-run trend can be described with shifts both in the
aggregate demand and aggregate supply curves.

 The most important determinant of the aggregate supply curve is

technology, while monetary policy is the most important determinant of
the aggregate demand curve.

 Since technology makes labor more productive, as productivity

increases, so do real wages. As real wages increase, consumption
increases, thus demand for money goes up. The Central Bank uses
monetary policy to increase money supply in order to meet this increase
in the demand for money.
 The Central Bank always target some positive level of inflation in
order to stimulate aggregate demand.
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 2…. And growth in the
Money supply shifts
Aggregate demand…
LRAS 1990 LRAS 2000 LRAS 2010
Price
level

1…. In the long run

technological progress
P 1990 shifts long-run aggregate
4. ..and supply……
ongoing
inflation P 2000
AD 2010
P 2010
AD 2000

AD 1990
Y 1990 Y 2000 Y 2010 Quantity of
3….leading to growth Output
in output….
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 Why the Short-Run Aggregate
Supply Curve May Shift
 The short-run aggregate supply curve tells us the
quantity of goods and services supplied in the short-run
for a given level of prices.
 Any determinant of long-run AS is also a determinant of
short-run AS, but not vice-versa.
 In this course will concentrate on negative and positive
supply shocks that affect the short-run aggregate supply
curve as well. So, for simplicity, we will use negative
and positive supply shocks as determinants of the short-
run AS.

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 Shifts in the Short-run AS Curve

 Two changes can shift the AS

curve in the Short-run
 Negative supply shock, AS
Negative Supply Shock
 Positive supply shock, AS
AS2
P
AS1
P2
P1

Y* Output (Y)
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 Two Causes of
Economic Fluctuations
 Now we can use the aggregate demand, aggregate supply model to examine two basic
causes of short-run fluctuations.
 Long-run equilibrium is determined by the intersection of the aggregate demand and
the long-run aggregate supply curve.
 At the point of intersection, output is at its potential (Y*). Y* is also called the natural
rate of output because in the long-run, the level of unemployment (U*), is called the
natural rate of unemployment. For this same reason, Y* is sometimes also call full
employment output. The level of prices (P*) is called the target price or inflation level.
At Y* the economy is at full production capacity.
 The intersection of the short-run AS with AD determines the level of output in the short
run (Y). Y is also called actual output (Y). The level of unemployment (U) associated
with Y is cyclical unemployment (or actual unemployment) and the price level (P) is
the actual price level.
 If the short-run AS supply curve passes through the point where the long-run AS and
AD intersects, the economy is said to be in long-run and short-run equilibrium, where
Y*=Y, U*=U and P*=P. In other words, the economy is operating at full production
capacity in the short run, an ideal situation.
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 The Long-Run Equilibrium
Price Long-run
Level Aggregate
supply

Short-run
Aggregate
Supply

Equilibrium
Price A

0 Natural rate Quantity of Output

of output
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 The Effects of a Shift in
Aggregate Demand (Recession)
 Suppose that a wave of pessimism (due to Trump’s
election in the US) overtakes the US economy. As a result,
household cuts back on spending and firms put off buying
new equipment.
 What is the impact of such an event in the economy?
 Other things equal, such an event reduces (contracts) AD.
As a result, Y < Y*, P < P*, and U > U*, thus we have a
recession.
 Expansionary monetary policy tools: Lower reserve
requirement ratio and open market purchases (OMP).
 Expansionary fiscal policy tools: Higher investment tax
credit and higher investment subsidy.
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The Effects of a Shift in Aggregate
Demand (Overheating)
 Suppose that a wave of optimism (due to low
unemployment) leads to higher household spending and
firms’ investment.
 What is the impact of such an event in the economy?
 Other things equal, such an event increases (expands) AD.
As a result, Y > Y*, P > P*, and U = U*, thus we have an
overheated economy.
 Contractionary monetary policy tools: Higher reserve
requirement ratio and open market sales (OMS).
 Contractionary fiscal policy tools: A decrease in the
investment tax credit and a decrease in the investment
subsidy.
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 Output Gap and Inflation

Relationship of Output
to Potential Output due to Behavior of Inflation
Changes in AD
Expansionary gap
Inflation increases
Y > Y*

No output gap
Inflation is stable
Y = Y*

Recessionary gap
Y < Y* Inflation decreases

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 The Effects of a Shift in Short-
Run Aggregate Supply
 Imagine once again an economy in its long-run equilibrium. Now
suppose that suddenly firms experience an increase in the cost of
production (maybe oil prices in the world market went up).
 The macroeconomic impact of such an increase in production costs
causes the short run AS curve to decrease (shift to the left).
 A situation where output falls and prices go up is called stagflation.
 What should policymakers do when faced with stagflation?
 One possibility is to do nothing and led the economy in stagflation
for a while. Eventually, stagflation will remedy itself as
perceptions, wages, and prices adjust to a higher production costs.
 Another possibility is to use monetary or fiscal policy, but there are
consequences.

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 If policy makers who control monetary and fiscal
policy attempt to offset some of the effects of the
decrease in the short-run aggregate supply curve
by shifting the aggregate demand curve, they will
face even higher levels of inflation.
 In this case, Neo-Keynesian economics fails as the
trade-offs between inflation and unemployment no
longer holds.

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 A shift in the short-run aggregate supply has two
important implications:

1.- A decreases in short-run aggregate supply causes

stagflation (falling output, higher unemployment,
and rising prices).

2.- An increase in short-run aggregate supply leads

to higher output and lower prices, however,
employment is not affected.
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