MACROECONOMICS

Le Phuong Thao Quynh

FACULTY OF INTERNATIONAL ECONOMICS
Email:quynhlpt@ftu.edu.vn
 Chapter 5: AGGREGATE DEMAND
AND AGGREGATE SUPPLY
• CONTENT:
- The AD – AS model
- Analyze short run economic fluctuations by using AD – AS
model
- Focus on two factors: Yield (Y or GDPr) and price (P)
SHORT-RUN ECONOMIC FLUCTUATIONS

• Economic activity fluctuates from year to year:

• In most years, productions of goods and services rises
• In recent years, Vietnam production rises about 5-6% per year
• In some years, this normal growth does not occur => recession
• Recession is the period with falling income and increasing
unemployment. If it is more severe, it is called depression.
 THREE KEY FACTS ABOUT
ECONOMIC FLUCTUATIONS
• Economic fluctuations are irregular and unpredictable

• Most macroeconomic quantities fluctuate together: real

GDP, investment, unemployment rate etc.

• As output falls, unemployment rises

 THE BASIC MODEL OF ECONOMIC
FLUCTUATIONS
• Economists use the model of aggregate demand and
aggregate supply to explain short-run fluctuations in
economic activity around its long-run trend.
• Price level as measured by the CPI
• Aggregate Output as measured by real GDP.
 THE BASIC MODEL OF ECONOMIC
FLUCTUATIONS
• The aggregate demand (AD) curve shows the quantity of
goods and services that households, firms, the
government and the foreign sector want to buy at each
price level.

• The aggregate supply (AS) curve shows the quantity of

goods and services that firms produce and sell at each
price level.
THE AD – AS MODEL
THE AD CURVE
 WHY THE AD CURVE IS DOWNWARD SLOPING?

AD = C + I + G+ NX = C + I + G + X – M

C: consumption
I: investment
G: government purchases
X: export
M: import
WHY THE AD CURVE IS DOWNWARD SLOPING?

AD slopes downward due to 3 effects:

P & C : The Wealth effect

• A decrease in the price level raises the real value of money and
makes consumers wealthier, which in turn encourages them to
spend more. C => AD
 WHY THE AD CURVE IS DOWNWARD SLOPING?

AD slopes downward due to 3 effects:

P & I : The interest rate effect

• A lower price level reduces MD, then lower the interest rate,
encourages greater spending on investment goods, and thereby
increasing AD

P & NX : The exchange – rate effect

A lower price level in an economy reduces the prices of its goods and
services relative to foreign-produced goods and services, and this
encourages net export => Increase AD
 MOVEMENT ALONG AD CURVE
• Changes in the price level (P) cause a movement along
the AD Curve.
WHY AD CURVE MIGHT SHIFT?
• Changes of factors other than P → shift of AD curve.
• Expectations
• Wealth
• Size of the capital stock
• Government economic policy
- Fiscal policy: ∆G & ∆T
- Monetary policy: ∆money supply & ∆i
 WHY AD CURVE MIGHT SHIFT?
AD = C + I + G + NET EXPORTS

• Shifts arising from Consumption. Eg: government cuts

taxes, it encourages people to spend more (C increases => AD
increases and shifts to the right

• Shifts arising from Investment. Eg: firms become optimistic

about future business conditions => invest more => AD
increases and shifts to the right
 WHY AD CURVE MIGHT SHIFT?
AD = C + I + G + NET EXPORTS

• Shifts arising from Government Purchases. Eg: state

governments start building more highways, the result is a
greater AD, so AD shifts to the right.

• Shifts arising from Net Exports. Eg: When Europe recovers

from its recession, it starts buying VN. goods again, and AD
curve shifts to the right.

• Conversely, a decrease in C, I, G and NX will result in a

reducing AD and the AD curve shifts to the left
WHY AD CURVE MIGHT SHIFT?
 THE AS CURVE
• The aggregate supply curve shows the level of production
at each price level.
• In the long run, the aggregate-supply curve is vertical.
• In the short run, the aggregate-supply curve is upward
sloping.
 THE LONG RUN AS CURVE (LRAS)

LRAS (or real GDP in long run) only depends on labor, capital, and natural
resources and on the available technology.
Because the price level does not affect the long-run determinants of real
GDP, the long-run aggregate-supply curve is vertical,
 THE LONG RUN AS CURVE (LRAS)
• The long-run level of production is sometimes called
potential output or full-employment output. we call it the
natural rate of output because it shows what the
economy produces when unemployment is at its natural,
or normal, rate.
 THE LRAS MIGHT SHIFT
• Shifts arising from:
- Labor (L)
- Capital (K)
- Natural Resources (N)
- Technological Knowledge (Tech)

• Any change in the economy that alters the natural rate of

output shifts the LRAS curve.
THE SHORT RUN AGGREGATE SUPPLY
CURVE (SRAS)
 WHY SRAS SLOPES UPWARD IN 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.
 WHY SRAS SLOPES UPWARD IN SHORT
RUN?

• The Sticky Wage Theory:

Nominal wages are slow to adjust to changing economic
conditions (wages are “sticky” in the short run due to long-term
contracts between workers and firms) => P goes down, real
wage increases => Firms’ profit decrease => Cut employment
and reduce AS
 WHY SRAS SLOPES UPWARD IN SHORT
RUN?
- The Sticky-Price Theory: An unexpectedly low price
level leaves some firms with higher- than-desired prices, which
depresses their sales and leads them to cut back production.

- The Misperceptions Theory: An unexpectedly low price

level leads some suppliers to think their relative prices have
fallen, which induces a fall in production.
 MOVEMENT ALONG AS CURVE
• Changes in price level lead to movement along AS curve
 WHY THE SRAS CURVE MIGHT SHIFT?
• Changes of factors other than Price level → shift of SRAS
curve:
1) commodity prices (cost of inputs)
2) nominal wages
3) productivity: L, K, N and tech (same
to LRAS)
THE LONG RUN EQUILIBRIUM
 ECONOMIC FLUCTUATIONS

4 steps for analyzing economic fluctuations:

1. Decide whether the event shifts the AD or AS curve (or
perhaps both).
2. Decide in which direction the curve shifts.
3. Use the diagram of AD and AS to see how the shift
changes output and the price level in the short run.
4. Use the diagram of AD and AS to analyze how the
economy moves from its new short-run equilibrium to its
long-run equilibrium.
TWO CAUSES OF ECONOMIC FLUCTUATIONS

• The Effects of a Shift in Aggregate Demand

- A contraction in AD:

Eg: war oversea, a scandal in government, a crash in stock

market => consumers and firms become pessimistic about
future => reduce consumption and investment => reduce
AD
A CONTRACTION IN AD
 A CONTRACTION IN AD
• A fall in AD is represented with a leftward shift in the AD
curve from AD1 to AD2.
• In the short run, the economy moves from point A to point
B. Output falls from Y1 to Y2, and the price level falls from
P1 to P2.
• If the policymakers do nothing, over time: Y2 < Y1 => =>
higher unemployment => decrease nominal wage
=>SRAS curve shifts to the right from AS1 to AS2, and
the economy reaches point C. In the long run, the price
level falls to P3, and output returns to its natural rate, Y1.
 A CONTRACTION IN AD
• Policymakers could take action to increase AD and let AD
shift back by using expansionary Fiscal and Monetary
Policy:

Expansionary Fiscal Policy: Increase G and reduce T

=> Increase AD

Expansionary Monetary Policy: Increase MS (money

supply) and reduce i (interest rate) => Increase AD.
 A CONTRACTION IN AD
To sum up:
• In the short run, shifts in AD cause fluctuations in the
economy’s output of goods and services.
• In the long run, shifts in AD affect the overall price level
but do not affect output.
• Policymakers who influence AD can potentially mitigate
the severity of economic fluctuations.
AN INCREASE IN AD?
 THE EFFECT OF A SHIFT IN AS
• A decrease in one of the determinants of AS shifts the
curve to the left:
- Output falls below the potential yield.
- Unemployment rises.
- The price level rises.
- Stagflation results! (a period of recession and inflation.)
AN ADVERSE SHIFT IN AS
 AN ADVERSE SHIFT IN AS
• Stagflation
• Output falls and prices rise.
• Policymakers who can influence AD cannot offset
both of these adverse effects simultaneously.
 POLICY RESPONSES TO RECESSION

• Policymakers may respond to a recession in one of the

following ways:
- Do nothing and wait for prices and wages to adjust.
- Take action to increase AD by using monetary and fiscal
policy.
POLICY RESPONSES TO RECESSION
POLICY RESPONSES TO INFLATION?
 Questions
• Explain whether each of following events will have impact
on SRAS and/or AD. Show the changes in Y and P
1. Household decides to save more because of pessimism
about future.
2. US grows faster and import more goods from Vietnam.
3. Oil prices sharply increase.
4. The government decides to reduce tax on imported raw
materials.
5. The government decides to increase tax on imported
goods.
 SUMMARY
1 The effects of a shift in aggregate demand:
expansionary demand shock and contractionary demand
shock
Summary
AD curve Output Price level Policy of
shift to (inflation) government
Contracti Left Decline (short Fall Shift AD to the
on run) (short run) right
Unchanged Fall further
(long run) (long run)
Expansio Right Rise (short Increase Shift AD to the
n run) (short run) left
Unchanged Increase
(long run) further (long
run)
 SUMMARY
2 The effects of a shift in aggregate supply: adverse
supply shock and beneficial supply shock

SRAS Output Price level Policy of government

curve (inflation)
shift to
Adverse left Decline Rise (1) Increase AD so that Y unchanged
(short run) (short run) but P increases further
Unchange Unchange (2) Decrease AD so that P
d (long d (long unchanged but Y decreases
run) run) further
Benefici right Rise Decline (1) Increase AD so that P unchanged
al (short run) (short run) but Y increases further
(tempora Unchange Unchange (2) Decrease AD so that Y
ry d (long d unchanged but P decreases
effects) run) (long run) further