Aggregate Supply and Demand

Session 12
 Introduction
• The AS/AD model is the basic macroeconomic tool for studying output
fluctuations and the determination of the price level and the inflation
rate.

• The model can be used to

– explain how the economy deviates from a path of smooth growth over time,
– explore the consequences of government policies intended to reduce
unemployment and output fluctuations, and maintain stable prices
 LM1 at M/P1
Deriving the AD Curve i P2< P1

LM2 at M/ P2
E1

Interest rate
• At IS-LM equilibrium both i1
goods and money market are
in equilibrium i2 E2
• AD curve plots the points
when both goods and money
market are in equilibrium at IS
different price levels
• Suppose prices decreases from Y1 Y2 Y
P1 to P2 Income, output (b)
– M/P increses from M/P1 to
M/P2  LM shifts from LM1 P
to LM2
– Interest rates decreases from i1
P1 E1
to i2, and output increases
from Y1 to Y2
• The AD schedule maps out the IS-
LM equilibrium holding E2
P2
autonomous spending and the
nominal money supply constant AD
and allowing prices to vary
Y1 Y2Y
DERIVATION OF THE AD CURVE
 LM1 at M1/P
Shifts in AD i M2> <M1

LM2 at M2/ P
E1

Interest rate
• At IS-LM equilibrium both i1
goods and money market are
in equilibrium i2 E2
• AD curve plots the points
when both goods and money
market are in equilibrium at IS
different price levels
• Suppose M increases from M1 Y1 Y2 Y
to M2 Income, output (b)
– M/P increases from M1/P to
M2 /P LM shifts from LM1 P
to LM2
– At interest rates decreases E2
from i1, and output increases P1
E1
from Y1 to Y2

• How will you plot the IS curve

shift AD
• All changes in the IS-LM curve
(except price change) leads to Y1 Y2 Y
shift of the AD SHIFT OF THE AD CURVE
 Keynesian Supply Curve
• The Keynesian supply curve
is horizontal, indicating
firms will supply whatever
amount of goods is
demanded at the existing
price level
– Since unemployment
exists, firms can obtain
any amount of labor at
the going wage rate
– Since average cost of
production does not
change as output
changes, firms willing to
supply as much as is
demanded at the
existing price level
 Keynesian Supply Curve
• Intellectual genesis of the Keynesian AS curve is found in the Great
Depression, when it seemed firms could increase production without
increasing P by putting idle K and N to work
• Additionally, prices are viewed as “sticky” in the short run  firms
reluctant to change prices and wages when demand shifts
– Instead firms increase/decrease output in response to demand shift  flat AS
curve in the short run
 The Production Function and
Potential Output
• Y depends upon inputs (labor = N, capital = K) and technology (A)
𝑌 =𝐹 (𝐾 , 𝑁 , 𝐴)
• Potential output (Y*) can be defined as the output when all the
available capital stock and labor force is in full employment
 Classical Supply Curve
• The classical supply
curve is vertical,
indicating that the same
amount of goods will be
supplied, regardless of
price
– Based upon the
assumption that the
labor market is in
equilibrium with full
employment of the
labor force
– The level of output
corresponding to full
employment of the
labor force =
potential GDP, Y*
 Micro vs Macro: (Aggregate) Supply Curve
• In microeconomics, short run supply curve is inelastic, while the long-run
supply curve is elastic

• In macro, it is reverse when compare supply curve from micro with aggregate
supply curve from macro

• In micro, the price rise was essentially a rise in price of one commodity while
keeping the price for all other goods constant
– Thus, the good experiencing relative rise in prices could be produced more by
diverting labour and capital from goods that have become ‘relatively cheaper’

• In macro, “price” refers to nominal price level of all the goods, and price rise
(inflation) is the general rise in prices for all goods.
– Thus, diverting labour from one sector to another only raise prices, not the overall
output in the longrun
Flexibility and Rigidity in Different Markets
• Asset market: Most flexible. Reduction in interest rate can translate
into quick changes in the bond prices/exchange rates.

• Goods market: Prices respond to the changed demand/market

conditions in relatively longer time.

• Labour market: Most inflexible. It can take year to revise the

contracts, though conditions in goods and asset markets may alter
in between.

• Mismatch in the rigidity/flexibility in different markets creates the

need for macroeconomic management
 Classical Supply Curve Over Time
• Y* grows over time as the economy accumulates resources and
technology improves  AS curve moves to the right
• Y* is “exogenous with respect to the price level”
 illustrated as a vertical line, since graphed in terms of the
price level
 Labor-force, WFPR, and Unemployment

• The size of the labor force is determined from surveys

• Labor force = unemployed (U) + employed (E)

• Unemployed is one who is out of work and looking

for a job or expecting a recall from a layoff

• The unemployment rate measures the unemployed/workforce

• WFPR (Workforce participation rate): Labor-force/population in

16-64 age group
 Frictional Unemployment and the Natural
Rate of Unemployment
• Taken literally, the classical model implies that there is no involuntary
unemployment  everyone who wants to work is employed
– In reality there is some unemployment due to frictions in the labor market (Ex.
Someone is always moving and looking for a new job, there are some new
entrants and retirees, some firms are expanding while others are losing business)
• The unemployment rate associated with the full employment level of output
is the natural rate of unemployment
– Natural rate of unemployment is the rate of unemployment arising from normal
labor market frictions that exist when the labor market is in equilibrium

• What will happen to natural rate of unemployment if unemployment

benefits are made more generous
 Types of Unemployment
• Frictional Unemployment: Result of Matching
Behavior between Firms and Workers.

• Structural Unemployment: Result of Mismatch of

Skills and Employer Needs + Industry/Product
structural change

• Cyclical Unemployment:Result of Output being

below full-employment
 We will (mostly) focus on the slope of
the aggregate supply curve, and causes
that shifts the aggregate demand curve
 AS and the Price Adjustment Mechanism:
The Transition from Short to Long-Run
• Start with a short run AS and the Y* (which also gives you long run AS)
• Shift the AD curve (fiscal/monetary policy)
• The current output is higher than the full employment level
• Workers would ask for higher wages; costs and prices go up
• Supply curve for can be defined as:
where : Pt-1 is the price level next period, Pt is the price level today, Y* is potential output
The upward shifting horizontal lines correspond to successive snapshots of equation
Process continues until Y=Y*

Long-run AS t = ∞
P t3
t2 P
t1 t1
t2
t1
Price

Short-run AS Price t0
t0

Y
AD
Y* Y
 AS and the Price Adjustment Mechanism

• If output is above potential (Y>Y*), prices increase, higher next period

• If output is below potential (Y<Y*), prices fall, lower next period
• Prices continue to rise/fall over time until Y=Y*
– Today’s price equals tomorrow’s if output equals potential (ignoring price expectations)
The difference between GDP and potential GDP, Y-Y*, is called the output gap
 AS and the Price Adjustment Mechanism

• Speed of the price adjustment mechanism determined by the parameter 

– If  is large, AS moves quickly (the counter clock-wise rotations in Figure a)
– If  is small, prices adjust slowly
•  is of importance to policy makers:
– If  is large, the AS mechanism will return the economy to Y * relatively quickly
– If  is small, might want to use AD policy to speed up the adjustment process
 AS and the Price Adjustment Mechanism:
The Transition from Short to Long-Run
• Start with a short run AS and the Y* (which also gives you long run AS)
• Shift the AD curve
• The current output is below the full employment level
• Workers would not like, but finally will accept wage cuts; leading to cost and price reductions
• Supply curve for can be defined as:
where : Pt-1 is the price level next period, Pt is the price level today, Y* is potential output
Process continues until Y=Y*
Would the policy maker like to wait for this process

Long-run AS t = ∞
P t3
t2 P
t1
Price

Short-run AS Price t0
t0 t1
t2
t1
Y
AD
Y Firms are stuck with prices that are too high
Y*
 AD Curve
• AD shows the combination of
the price level and level of
output at which the goods and
money markets are
simultaneously in equilibrium

Shifts in AD due to:

1. Policy measures (changes in G,
T, and MS)
2. Consumer and investor
confidence
 AD Relationship Between
Output and Prices
• Key to the AD relationship between output and prices is the dependency of AD on
real money supply
– Real money supply = value of money provided by the central bank and the banking
system
– Real money supply is written as , where is the nominal money supply, and P is the
price level

• For a given level of , high prices result in low OR high prices mean that the
real value of the number of available dollars is low and thus a high P = low level of
real AD
• Lower prices for a given money stock can also translate into wealth effect (to the
extent money is part of portfolio)
 AD and the Money Market
• For the moment, ignore the goods market and focus on the money market
and the determination of AD
• The quantity theory of money offers a simple explanation of the link
between the money market and AD
– The total number of dollars spent in a year, NGDP, is P*Y
– The total number of times the average dollar changes hands in a year is the
velocity of money, V
– The central bank provides M dollars

 The fundamental equation underlying the quantity theory of money is

the quantity equation:
 AD and the Money Market

• If the velocity of money is assumed constant, above equation

becomes

• This is an equation for the AD curve

• For a given level of M, an increase in Y must be offset by a decrease in
P, and vice versa
– Inverse relationship between Y and P as illustrated by downward sloping AD
curve
• An increase in M shifts the AD curve upward for any value of Y
 Changes in the Money Stock and AD
• An increase in the nominal
money stock shifts the AD
schedule up in proportion
to the increase in nominal
money
– Suppose corresponds to
AD and the economy is
operating at P0 and Y0
– If money stock increases by
10% to , AD
shifts to AD’  the value of
P corresponding to Y0 must
be P’ = 1.1P0
– Therefore

 real money balances and

Y are unchanged

In short run you look at the rightward shift, in the long run you look at the upward shift
• To begin with,
economy is at the
AD Policy & the
full employment Keynesian Supply Curve
• An adverse
demand shock
Long-run AS
shifts the AD
t=∞

Price
leftward
• The firms respond
by cutting
production, output P SRAS
declines
• The government
may wait for AD
market to correct
on its own, by firm Pt
cutting the wages
and costs in the AD’
long-run
Y’ Y* Y
 • To begin with,
economy is at the AD Policy & the
full employment
• An adverse
Keynesian Supply Curve
demand shock
Long-run AS
shifts the AD
t=∞

Price
leftward
• The firms respond
by cutting
production, output P SRAS
declines
• The government
respond by raising AD
(↑ 𝐺the AD,↓ 𝑇 ,↑ 𝑀 𝑆 )
AD’’
AD’

Y’ Y* Y
• In the classical case, AS
schedule is vertical at FE
AD Policy & the Long-Run
level of output
– Unlike the Keynesian case,
Supply Curve
the price level is not given,
but depends upon the
interaction between AS
and AD
P
t =∞
Long-run AS

• Suppose AD increases to
AD’
– Spending increases to E’
BUT firms can not obtain
the N required to meet the E’’
increased demand in the
long-run
Price
– Firms hire more workers
& wages and costs of Short-run AS
production rise  firms E’ t0
must charge higher price
– The increase in price from
the increase in AD
reduces the real money
stock, , and leads
to a reduction in spending
AD AD’
– Move up AS and AD
curves to E’’ where AS =
AD’
Y* Y
 Adjustment
Paths of Price
Level and
Output

How will the

intertemporal
path of output
and prices look
like if you are to
start with a
recession?
• To begin with,
economy is at the full
AD Policy & the
employment Keynesian Supply Curve
• An adverse demand
shock shifts the AD
Long-run AS
leftward
t=∞

Price
• The firms respond by
cutting production,
output declines
R
• From the initial P SRAS
point of recession
(R), prices will
decrease overtime, AD
while the output
Pt
will increase
towards potential AD’
output level
Y’ Y* Y
 Supply Side Economics
• Supply side economics focuses on AS as the driver in the economy
• Potential GDP changes every year, but the changes do not depend on the price
level
• Thus, the potential output is exogenous to price level
• Changes in the potential output over a short-period are relatively small, a few
percent a year
 Supply Side Economics
• Supply side policies are those that encourage growth in
potential output  shift AS to right.
– Such policy measures include:
– Removing unnecessary regulation, Maintaining efficient legal
system, Encouraging technological progress
– These measures will improve resource allocation and
marginal product of labor and capital

• Politicians use the term supply side economics in reference to

the idea that cutting taxes will increase AS
• They claim that this rise in AS due to tax-cut could be to the
extent that tax collections will actually increase, rather than fall
 Supply Side Economics
• Cutting tax rates has an
impact on both AS and AD
– AD shifts to AD’ due to
increase in disposable
income
• Shift is relatively large
compared to that of the
AS (Why ?)
– AS shifts to AS’ as the
incentive to work increases
• In short run, move to E’: GDP
increases, tax revenues fall
proportionately less than tax
cut (AD effect)
• In the LR, moves to E’’: GDP
is higher, but by a small
amount, tax collections fall as
the deficit rises, and prices
rise (AS effect)
 Supply Side Economics
• Supply side policies are useful, despite previous example
– Only supply-side policies can permanently increase output
– Demand side policies are useful for short run results

• Many economists support cutting taxes for the incentive effect, but
with a simultaneous reduction in government spending
– Tax collections fall, but the reduction in government spending minimizes
the impact on the deficit
 AS and AD in the Long Run
• In the LR, AS curve moves to the
right at a slow, but steady pace
• Movements in AD over long
periods can be large or small,
depending largely on
movements in money supply
– Movements in AS slightly
higher after 1990
– Big shifts in AD between 1970
and 1980
– Prices increase when AD moves
out more than AS
– Output determined by AS, while
prices determined by the
relative shifts in AS and AD
 AS and AD in the medium-run
• Aggregate supply curve describes, for each given price level, the quantity of
output firms are willing to supply
– Upward sloping since firms are willing to supply more output at higher prices
(while the AS is flat in the short-run, the counterclockwise curves represent the
medium-run)

• Aggregate demand curve shows the combinations of the price level and the
level of output at which the goods and money markets are simultaneously in
equilibrium
– Downward sloping since higher prices reduce the value of the money supply, which
reduces the demand for output

• Intersection of AS and AD curves determines the equilibrium level of output

and price level
• In a recession we are on the
flat part of the aggregate Aggregate Demand and Nonlinear
supply curve
Aggregate Supply
• Demand
management policies can be
effective at boosting the
economy without having
much
effect on the price level.

• However, as the economy

approaches full
employment,
policymakers must be wary
of too much stimulus to
avoid running the
aggregate
demand curve up the
vertical portion of the

aggregate supply curve

 AS, AD, and Equilibrium
• Shifts in either the AS or AD
schedule result in a change
in the equilibrium level of
prices and output
– Increase in AD  increase
in P and Y
– Decrease in AD  decrease
in P and Y
– Increase in AS  decrease
in P and increase in Y
– Decrease in AS  increase
in P and decrease in Y