AGGREGATE

DEMAND
and
AGGREGATE
SUPPLY
REVIEW: BUSINESS CYCLE

aggregate  demand  and

 aggregate  supply (AS/AD
model)
Explain short‐run   fluctuations
 in  economic  activity around
 its  long‐run  trend.
AS/AD MODEL
AGGREGATE DEMAND (AD) CURVE

The aggregate-demand curve shows the quantity of

goods and services that households, firms, and the
government want to buy at each price level.

Components:
AD = C + I + G + (X – M)
• C= Consumption Spending
• I = Investment Spending
• G = Government Spending
• (X-M) = difference between spending on imports
and receipts from exports (Balance of Payments)
WHY THE AD CURVE IS DOWNWARD
SLOPING?

1. The Wealth Effect (The Real Balance Effect)

- The Price Level and Consumption
2. The Interest Rate Effect
- The Price Level and Investment
3. The Exchange Rate Effect (The Foreign Purchases Effect)
- The Price Level and Net Exports
 WHY THE AD CURVE IS DOWNWARD
SLOPING?
1. The Wealth Effect (The Real Balance Effect)
- The Price Level and Consumption

as the price level falls, the real value of money increases and people find that they are
wealthier. This concept is associated with the reality principle.
“What matters to people is the real value or purchasing power of money or income, not its
face value.”

PRICE REAL CONSUMPTION

VALUE OF AGGREGATE
LEVEL SPENDING
MONEY DEMAND
 WHY THE AD CURVE IS DOWNWARD
SLOPING?

2. The Interest Rate Effect - The Price Level and Investment

A lower price level reduces the real interest rate and makes borrowing less
expensive, which encourages greater spending on investment goods.
This increase in investment spending means a larger quantity of goods and
services demanded.

CURRENCY INTEREST DEMAND FOR AGGREGATE

PRICE
IN THE RATE INVESTMENT DEMAND
LEVEL
BANKS S
 WHY THE AD CURVE IS DOWNWARD
SLOPING?

3. The Exchange Rate Effect (The Foreign Purchases Effect)

- The Price Level and Net Exports
a lower price level makes domestic goods cheaper relative to foreign goods
Ex. a lower PH interest rate leads to a lower PH exchange rate which also makes
domestic goods relatively cheaper than foreign goods.

DOMESTIC REAL NET EXPORTS AGGREGATE

PRICE
INTEREST EXCHANGE INCREASES DEMAND
LEVEL
RATE RATE
SHIFTS ON THE AD CURVE

AD curve will SHIFT whenever there is a change in any of the following:

• CHANGES IN CONSUMPTION
• CHANGES IN INVESTMENT
• CHANGES IN GOVT PURCHASES
• CHANGES IN NET EXPORTS
**CHANGES IN MONEY SUPPLY CAN ALSO SHIFT AD CURVE

REMEMBER: When there’s a change in price level, we move along AD

curve.
AGGREGATE SUPPLY (AS) CURVE

The aggregate supply curve describes the relationship between the level of prices
and real GDP.

We will consider two aggregate supply curves, one corresponding to the long run
(the long run aggregate supply curve), and one to the short run (the short run
aggregate supply curve).
SHORT-RUN AGGREGATE SUPPLY
(SRAS) CURVE

• In the short run, the aggregate supply

curve has a positive slope. At low levels
of aggregate output, the curve is fairly
flat. As the economy approaches
capacity, the curve becomes nearly
vertical. At capacity, Y*, the curve is
vertical.
WHY AS UPWARD SLOPING IN SHORT-
RUN?

Reasons for an upward sloping short run AS curve:

1. The sticky wage theory
„2. The sticky price theory
„3. The misperceptions theory
 WHY AS UPWARD SLOPING IN SHORT-
RUN?

1. The sticky wage theory

- sticky wage theory assume that wages are slow to adjust to changing economic
conditions, either because workers and firms sign long-­term contracts or because
wage-­setting conventions make it difficult for firms to rapidly adjust the wages
they pay.

REAL FIRMS
PRICE LABOR HIRE AGGREGATE
WAGES CHEAPER OUTPUT
LEVEL (MORE
FALL (WAGE) LABOR)
 WHY AS UPWARD SLOPING IN SHORT-
RUN?

„2. The sticky price theory

-Sticky price theory emphasizes that the prices of certain goods and services are
slow to adjust to changing economic conditions.
- based on the idea that firms do not adjust their price instantly to changes in the
economy.
OTHER
FIRMS WILL
EXPEC FOLLOW
TED FIRM PRICE ACTUAL AGGREGATE
PRICE SET SETTING PRICE OUTPUT
LEVEL PRICE
 WHY AS UPWARD SLOPING IN SHORT-
RUN?

„3. The misperceptions theory

- Based on the labor market. individual firms may mistakenly believe that it is
really just the price of their particular good that is rising.

WORKER’S
PRODUCTIV
ITY (DUE FIRMS
PRICE NOMINAL TO HIRE AGGREGATE
LEVEL WAGES MISPERCEP (MORE OUTPUT
TION) LABOR)
SHIFTS ON SRAS CURVE

Shifts might arise from changes in

• Labor.
• Capital.
• Natural Resources.
• Technology.
THE EQUILIBRIUM PRICE LEVEL

The price level at

which the
aggregate demand
and aggregate
supply curves
intersect.
LONG-RUN AGGREGATE SUPPLY (LRAS)
CURVE

In the long run, an economy’s production of goods

and services depends on its supplies of resources
along with the available production technology.
(capital, labor, natural resources and technology)

Because the price level does not affect these

determinants of output in the long run, the long-run
aggregate-supply curve is vertical.
MONETARY AND FISCAL POLICY
EFFECTS

RECALL: RECALL:
FISCAL POLICY VARIABLES EXPANSIONARY
- GOVT SPENDING (G) - STIMULATE THE ECONOMY
- TAX (T)
CONTRACTIONARY
MONETARY VARIABLE - SLOWING DOWN THE
- MONEY SUPPLY ECONOMY
MONETARY AND FISCAL POLICY
EFFECTS

EFFECT OF
EXPANSIONARY FISCAL
POLICY ON IF THE
ECONOMY IS INITIALLY
ON THE FLAT PORTION OF
AS CURVE.
MONETARY AND FISCAL POLICY
EFFECTS

EFFECT OF
EXPANSIONARY FISCAL
POLICY ON IF THE
ECONOMY IS INITIALLY
ON THE STEEP PORTION
OF AS CURVE.