Principles of

Macroeconomics:
Lecture 6
Aggregate Demand and Aggregate Supply Model P1
What are Economic Fluctuations?
• https://youtu.be/vnUo82ZCo5s
What are Economic Fluctuations?
• Expansion: A period of growing
real incomes and declining
unemployment defined by positive
GDP growth for two consecutive
quarters.
• Recession: A period of declining
real incomes and rising
unemployment defined by negative
growth for two consecutive quarters.

• Depression: Severe Recession

Three Facts about Economic
Fluctuations
1. Economic Fluctuations are
irregular and unpredictable
2. Most Macroeconomic quantities
fluctuate together
3. As output fall, unemployment
rises
Fact 1: Economic Fluctuations are Irregular and
Unpredictable
• Economic fluctuations are referred to as the
business cycle because they correspond to
changes in business conditions

Real GDP is Business is

Expansion growing good

Real GDP is Businesses

Recession falling have trouble

• Economic fluctuations are very irregular and

difficult to predict with any level of accuracy
Fact 2: Most Macroeconomic Quantities
Fluctuate Together
• Because economic fluctuations are economy-wide
phenomena, they are reflected in different
measures of economic activity
• Most measures of income, spending or production
fluctuate closely together (e.g. personal income,
corporate profits, consumer spending, industrial
production, etc.)
• However, macroeconomic quantities fluctuate by
different amounts
Investment spending varies greatly over the business
cycle When economic conditions deteriorate,
much of the decline is due to reductions
in investment (i.e. spending on new
factories, housing and inventories).
Fact 3: As Output Falls, Unemployment Rises
• Real GDP and the unemployment rate are
negatively related
• This is because the changes in the economy’s
output of goods and services will be strongly
correlated with changes in the economy’s
utilization of labour

Firms produce
Real GDP falls less goods and
services

When economic conditions deteriorate, the

Unemployment Firms lay off unemployment rate rises.
rate rises workers
Explaining Short-run economic
Fluctuations
The Assumptions of Classical Economics The Reality of Short-Run Fluctuations
• Classical economic thinking on the • Classical theory describes the world in the
macroeconomy is based on two related long-run, but not in the short-term
ideas:
• In the short-term, we observe that:
1. Classical dichotomy
 The separation of real variables 1. Real and nominal variables are highly
(measured in quantities or relative prices) inter-connected
vs. nominal variables (measured in terms
2. Changes in the money supply can
of money)
temporarily affect real variables
2. Monetary Neutrality
Therefore, classical economic assumptions
 Changes in the supply of money only affect
do not hold in the short-term
nominal variables, but not real variables
The Aggregate Demand and Aggregate Supply
Model
• Main model used to understand short-term economic
fluctuations around its long-run trend
• The model focuses on two variables:
1. Economy’s output of goods and services as measured by real
GDP
Real variable
2. Average price level as measured by the CPI or GDP deflator
Nominal variable

 The variables are represented on an x-y plane as

follows:
Vertical axis: Overall price level in the economy
Horizontal axis: Overall quantity of goods and services
 The Aggregate Demand and Aggregate Supply
Model
• Output and the level adjust to the point at which the aggregate supply and aggregate
demand curves intersect
 
Price
 𝑨𝑺
Level

   𝑷 𝑬

 𝑨 𝑫 

 𝑸 𝑬 𝑸𝒖𝒂𝒏𝒕𝒊𝒕𝒚
  𝒐𝒇 𝑶𝒖𝒕𝒑𝒖𝒕
The Aggregate Demand and Aggregate
Supply Model
Aggregate Demand Aggregate Supply
• The quantity of goods and services that • The quantity of goods and services that
household, firms, government and firms firms choose to produce at each price level
abroad want to buy at each price level

Macroeconomic theories are needed to explain the total quantity of goods and
services demanded and supplied at a given price level.
Why Does the Aggregate Demand Curve
Slope Downwards?
Price
Level

 𝑷𝟏

 𝑷𝟐

  𝑨𝑫

 𝒀 𝟏  𝒀 𝟐 𝑸𝒖𝒂𝒏𝒕𝒊𝒕𝒚
  𝒐𝒇 𝑶𝒖𝒕𝒑𝒖𝒕

Other things equal, a decrease in the economy’s overall level of prices (P1-P2),
raises the quantity to goods demanded (Y1-Y2).
Why Does the Aggregate Demand Curve
Slope Downwards?
We must examine the effect of a fall in prices on each component contributing to
aggregate demand for goods and services:

Y = C + I + G + NX Assume that govt.

spending is fixed

Three effects stimulate demand when prices fall:

1. Consumers are wealthier, which stimulates the demand for consumption
goods.
2. Interest rates fall, which stimulates the demand for investment goods.
3. The currency depreciates, which stimulates the demand for net exports.
The Price Level and Consumption:
The Wealth Effect
• A decrease in the price level increases real wealth, which stimulates spending
on consumption.

Larger quantity
Consumers are Increase in
A decrease in the Raises the real of goods and
wealthier in real consumer
price level value of money services
terms spending
demanded
The Price Level and Investment:
The Interest Rate Effect
• A decrease in the price level reduces interest rates, which stimulates spending
on investment.

Encourages firms
Increase in Larger quantity of
A decrease in the Reduces the interest and households to
investment goods and services
price level rate invest as borrowing
spending demanded
is less expensive

Households hold less money and convert it to interest-bearing assets,

driving down the interest rate
Real and Nominal Exchange Rates
There are two important prices used in international transactions:

Nominal Exchange Rate Real Exchange Rate

• The rate at which a person can trade the • The rate at which a person can trade the
currency of one country for the currency of goods and services of one country for the
another. goods and services of another.

The real exchange depends on the nominal exchange rate and the
relative price of domestic and foreign goods
Real and Nominal Exchange Rates
Exchange rates can either appreciate or depreciate:
Appreciation
• An increase in the value of a currency as
measured by the amount of foreign
currency it can buy.
• E.g. If the exchange rate rises from 5.18 to
5.60 pounds per Saudi Riyal, the SR has
appreciated
Depreciation
• A decrease in the value of a currency as
measured by the amount of foreign
currency it can buy.
• E.g. If the exchange rate rises falls 5.18 to
4.90 pounds per Saudi Riyal, the SR has
depreciated
The Price Level and Net Exports:
The Exchange Rate Effect
• A decrease in the price level causes the real exchange rate to depreciate,
which stimulates spending on net exports.

Reduces the real

Larger quantity of
A decrease in the Drives down the value of the Increase in next
goods and services
price level interest rate currency in foreign exports
demanded
exchange markets

A depreciation in the exchange rate

Thought Experiment
• Imagine that you woke up tomorrow and for some mysterious
reason the price of all goods and services have fallen by half. In
real terms, you now have twice as much money you had when you
went to bed the night before.
• What would you do with the extra money? What would be the
effect on consumption, investment and net exports?
Why Causes Shifts in the Aggregate
Demand Curve?
Price
Level
An increase in the quantity
demanded at any given prices
shifts the AD to the right

An decrease in the quantity

 𝑨𝑫𝟐
demanded at any given prices
shifts the AD to the left
 𝑨𝑫𝟏
 𝑨𝑫𝟑
𝑸𝒖𝒂𝒏𝒕𝒊𝒕𝒚
  𝒐𝒇 𝑶𝒖𝒕𝒑𝒖𝒕

Shifts in Aggregate Demand occur when the quantity of goods and services
demanded at every price level changes.
What Causes Shifts in the Aggregate
Demand Curve?
Shifts in the
demand curve

Changes in Changes in Changes in Govt. Changes in net

Consumption Investment Purchases exports

The causes of shifts in Aggregate Demand can be categorized according to which

component of spending is most directly affected.
What Causes Shifts in the Aggregate Demand
Curve?
Changes in Consumption
• Any event that changes how much
consumers spend at a given price level

Shifts to the left Shifts to the right

(e.g. stock-market (e.g. stock-market
decline, tax hikes) boom, tax cuts) Changes in Investment
• Any event that changes how much firms
invest at a given price level

Shifts to the left Shifts to the right

(e.g. pessimism about (e.g. optimism about the
the future, a rise in the future, a fall in the
interest rate) interest rate)
What Causes Shifts in the Aggregate Demand
Curve?
Changes in Govt. Purchases
• Any event that changes government
purchases

Shifts to the left Shifts to the right Changes in Net Exports

(e.g. cut back in income (e.g. greater spending on
transfers, infrastructure infrastructure and
• Any event that changes net exports at a
spending) income transfers) given price level

Shifts to the left Shifts to the right

(e.g. recession overseas, (e.g. boom overseas,
speculation that causes speculation that causes
ER appreciation) ER depreciation)
Reading
• Textbook:
Mankiw, N. (2009). Principles of
economics (5th ed.). Mason, OH:
Thomson South-Western
• Reading:
Chapter 34