ECON6098

Business Economics
Week 7

Aggregate Demand and Aggregate Supply as a

Model to describe the Economy
 Outline

 economic fluctuations
 The aggregate demand curve
 The aggregate supply curve
ECONOMIC FLUCTUATIONS
 Three Key Facts About
Economic Fluctuations

 Fact 1: Economic Fluctuations are Irregular and

Unpredictable
 Fact 2: Most Macroeconomic Quantities Fluctuate
Together
 Fact 3: As Output Falls, Unemployment Rises
THE AGGREGATE DEMAND CURVE
 Aggregate Demand

 The aggregate demand relation captures the effect of

the price level on output. It is derived from the
equilibrium conditions in the goods and financial markets.
 The Aggregate-demand
Curve

 The four components of GDP (Y) contribute to the

aggregate demand for goods and services.
 Y = C + I + G + NX
 The Aggregate-demand
Curve
A fall in the price level from P1 to P2 increases the
quantity of goods and services demanded from Y1
to Y2. There are three reasons for this negative
relationship. As the price level falls, real wealth
rises, interest rates fall and the exchange rate
depreciates. These effects stimulate spending on
consumption, investment and net exports.
Increased spending on these
components of output means a
larger quantity of goods and
services demanded.
 Why the Aggregate Demand
Curve Slopes Downward

 The Price Level and Consumption: The Wealth Effect

 The Price Level and Investment: The Interest Rate Effect
 The Price Level and Net Exports: The Exchange-Rate
Effect
 Why the Aggregate-Demand
Curve Might Shift

 The downward slope of the aggregate demand curve

shows that a fall in the price level raises the overall
quantity of goods and services demanded.
 Many other factors, however, affect the quantity of goods
and services demanded at any given price level.
 When one of these other factors changes, the aggregate
demand curve shifts.
 Why the Aggregate-Demand
Curve Might Shift

 Shifts arising from

– Consumption
– Investment
– Government Purchases
– Net Exports
 Shifts in the Aggregate
Demand Curve
Price
Level

P1

D2
Aggregate
demand, D1

0 Y1 Y2 Quantity of
Output
AGGREGATE SUPPLY (AS)
 Aggregate Supply

 The aggregate supply relation captures the effects of

output on the price level. It is derived from the behavior
of wages and prices.
 The Aggregate-supply Curve

 In the long run, the aggregate-supply curve is vertical.

 In the short run, the aggregate-supply curve is upward
sloping.
 The Long-run Aggregate-
supply Curve

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

services depends on its supplies of labor, capital, and
natural resources and on the available technology used to
turn these factors of production into goods and services.
– The price level does not affect these variables in the long
run.
The Aggregate-supply Curve

In the long run, the quantity of output

supplied depends on the economy’s
quantities of labour, capital and natural
resources and on the technology for
turning these inputs into output.
The quantity supplied does
not depend on the overall
price level. As a result, the
long-run aggregate supply
curve is vertical at the
natural rate of output.
 The Aggregate-supply Curve

 The Long-Run Aggregate-Supply Curve

– The long-run aggregate-supply curve is vertical at the
natural rate of output.
– This level of production is also referred to as potential
output or full-employment output.
 Why the Long-Run Aggregate-
Supply Curve Might Shift

 Shifts arising
– Labor
– Capital
– Natural Resources
– Technological Knowledge
Long-Run Growth and
Inflation
Long-Run Growth and Inflation
in the Model of Aggregate
Demand and Aggregate Supply
 The Aggregate-Supply Curve in
the Short Run

 In the short run, an increase in the overall level of prices

in the economy tends to raise the quantity of goods and
services supplied.
 A decrease in the level of prices tends to reduce the
quantity of goods and services supplied.
The Short-Run Aggregate
Supply Curve

In the short run, a fall in the price level

from P1 to P2 reduces the quantity of
output supplied from Y1 to Y2. This
positive relationship could be due to
sticky wages, sticky prices or
misperceptions.
Over time, wages, prices
and perceptions adjust, so
this positive relationship is
only temporary.
 Why the Short-Run Aggregate-
Supply Curve Might Shift

 Shifts arising
– Labour
– Capital
– Natural Resources.
– Technology.
– Expected Price Level.
 Why the Aggregate Supply Curve
Might Shift

 An increase in the expected price level reduces the

quantity of goods and services supplied and shifts the
short-run aggregate supply curve to the left.
 A decrease in the expected price level raises the quantity
of goods and services supplied and shifts the short-run
aggregate supply curve to the right.
AD-AS EQUILIBRIUM
The Long-Run Equilibrium

The long-run equilibrium of the

economy is found where the
aggregate demand curve
crosses the long-run aggregate
supply curve (point A).
When the economy
reaches this long-run
equilibrium, wages,
prices and perceptions
will have adjusted so
that the short-run
aggregate supply curve
crosses this point as well.
The Effects of a Shift in
Aggregate Demand
Figure 7.7. A
Contraction in
Aggregate Demand
 References

 N. Gregory Mankiw, (2018), Principles Of Economics,

Eighth Edition, Cengage Learning, ISBN 13: 978-1-305-
58512-6, chapter 33
 N. Gregory Mankiw, Mark P. Taylor, Andrew Ashwin,
(2013). Business Economics, 1 Edition, Cengage Learning.
United Kingdom, ISBN: 978-1-4080-6981-3, Chapter 17
Thank You