ECN 60204 Macroeconomics

Aggregate Supply and Aggregate

Demand

Chapters 24( Hubbard, R. Glen & O’Brien, Anthony Patrick. (2013))

Chap 15, 17 & 21 (Sloman J., Wride A. and Garratt D. (2012))
 Learning Outcome
• Introduce the concepts of aggregate demand
(AD) and aggregate supply (AS)
• Describe the determinants of AD and AS
• Distinguish between short-run and long-run
aggregate supply
• Explain how equilibrium real GDP and the
price level are determined using AD-AS model

2
 Aggregate Demand
– The quantity of real GDP demanded is the total amount of final
goods and services produced in the economy that people
(consumers), businesses, governments, and foreigners plan to buy.

– This quantity is the sum of :

C+I+G+X–M
AD =
Reflects Aggregate Expenditure
 Aggregate Demand
– Buying plans depend on many factors
and some of the main ones are:
1) The price level Change in quantity of
real GDP demanded
2) Expectations
Change in real GDP
3) Fiscal policy and monetary policy demanded

4) The world economy

The Price level & Aggregate Demand
Aggregate demand is the relationship between the
quantity of real GDP demanded and the price level.

• Figure 27.4 shows an AD curve.

– The aggregate demand curve
(AD) plots the quantity of real
GDP demanded against the
price level.
– A change in prices creates a
movement along the AD curve
– Inverse (negative) relationship
The Aggregate Demand Curve

The AD curve slopes As price ,

real wealth
downward for two reasons: , C 
 Wealth effect

 Substitution effects
 Intertemporal effects
 International effects

Will explain the

substitution effects as
we go along Quantity demanded for
Consumption goods 
 Wealth Effect
• When the price level rises but other things
remain the same, real wealth decreases.
• Real Wealth is the amount of money in bank,
bonds, stocks and other assets that people
own.
• People will restore real wealth by increasing
saving equivalently decrease consumption
which leads to a decrease in AD.

7
 Substitution Effect
• Intertemporal substituition effect is decision to delay the
consumption plan. When price rises and other things
remain the same, interest rates rise due to decrease in
the real value of money. Quantity of AD falls.

• International effect. When price rises in Malaysia,

Malaysian goods are comparatively more expensive than
other foreign goods. Quantity of AD falls because
Malaysians will replace home made goods with foreign
goods.

8
Changes in Aggregate Demand
– A change in any influence on buying plans
(other than the price level) changes aggregate
demand.
– The main influences on aggregate demand are:
2) Expectations – confidence, optimism, etc
3) Fiscal policy and monetary policy
– The world economy
– The above shifts the aggregate demand curve
 Changes in Aggregate Demand
– Figure 27.5 illustrates changes
in aggregate demand.
– When aggregate demand  —
the AD curve shifts rightward
– When aggregate demand  —
the AD curve shifts leftward.
 Expectations
Expectations about future income, future inflation,
and future profits results in a change in aggregate
demand:-
 Consumer confidence e.g. an  in expected future
income —  people’s consumption today —  aggregate
demand (AD)
 Investment confidence e.g. an  in expected future profits
—  boosts firms’ investment (I) —  AD.
 An  in the expected inflation rate — makes buying goods
cheaper today —  AD
 Fiscal Policy
Fiscal policy is the government’s attempt to influence the
economy by:
 setting and changing taxes - personal income taxes t,
autonomous taxes on consumption (e.g. GST) T or tax on firms
 spending and investing on infrastructural projects, G
 Purchases of goods and services, G
 transfer payments (e.g. unemployment benefits), TR
– An  in G — AD
– A personal income tax  or an  in transfer payments — 
households’ disposable income, Yd — consumption
expenditure — AD
– A  in corporate tax on profits —  retained earnings — 
investment —AD (alternatively, may also create incentives for
production to increase – SAS)
 Monetary Policy
Monetary policy involves changing interest rates by
changing the quantity of money in the economy.

– An  in the quantity of money (MS) —  interest rates —

 investment (I) and consumption expenditure (C) — AD

– A  in MS —  interest rates —  I and C — AD

 The World Economy

The world economy influences aggregate demand in two ways:

Depreciation
Exchange rate fluctuations
– An  in the exchange rate —  the price of domestic goods
and services relative to foreign goods and services which —
exports,  imports — and  AD

Foreign income
– An  in foreign income — the demand for exports — and
 AD
 Aggregate Supply
– The quantity of real GDP supplied is the total
quantity (output) that firms plan to produce
during a given period.
– Relationship between the quantity of real GDP
supplied and the price level.
– We distinguish two time frames :
 Long-run aggregate supply
 Short-run aggregate supply
 Long-Run Aggregate Supply
– Long-run aggregate supply is the
relationship between the quantity of real
GDP supplied and the price level when
real GDP equals to potential GDP.
– Potential GDP where factors of
production are fully employed
– Potential GDP is independent of the
price level
– So the long-run aggregate supply curve
(LAS) is vertical at potential GDP.

As the price level rises, in the long-run

money wage rate will change by the
same percentage, the quantity of real
GDP supplied remains at potential GDP Labour market at full
employment
 Short-Run Aggregate Supply
In the short run, money wage rate is sticky

• Short-run aggregate supply is the

relationship between the quantity of
Price Level (GDP Deflator, 2000=100)

SAS0 real GDP supplied and the price level

110  Money wage rate, the prices of

other resources, and potential
In the
short-run GDP remain constant (fixed)
100
 – A rise in the price level (with no
change in the money wage rate
and other factor prices) will
200 210 real GDP $billions
increase the quantity of real GDP
supplied.
 Changes in Aggregate Supply
– Changes in production plans caused by factors
other than price level changes (non-price factors).
– These influences include a change in:
 Potential GDP
 Factor prices
Land, labour, capital

Money wages
Fuel / Oil (other material costs)
Subsidies
 Changes in Aggregate Supply
• When potential GDP
increases, both the LAS and
SAS curves shift rightward.
– Potential GDP changes, for three
reasons:
 The physical quantity of capital
changes
 The quality of human capital
changes
 Technology advances
Long-run changes

Change in full
employment output
 Changes in Short-run Aggregate Supply:
Factor Prices
Rise in factor prices cause a rise in
cost of production:
Figure 27.3 shows the effect of a rise
in the money wage rate on aggregate
supply.
Decreases short-run aggregate
supply and shifts the SAS curve
leftward.
Has no effect on long-run
aggregate supply (but prices rise)

likewise: indirect taxes on firms, rise in oil prices, etc

subsidies given to firms (petrol, diesel, flour, rice) - SAS shifts right
If subsidies removed – SAS shifts left
Malaysia cuts subsidies on fuel
http://www.bbc.com/news/business-23926411

Malaysia implements mininum wages

http://www.thestar.com.my/News/Nation/2014/01/09/
Malaysia-implements-mininum-wages/

Malaysian Goods and Services Tax (GST): How GST Affects You?

http://www.nbc.com.my/gst/faqs-malaysia-goods-and-services-tax-gst/
Short-run Aggregate Supply: Application
Fuel Subsidies in Malaysia
The formula used to calculate the price of fuel
is called the Automatic Pricing Mechanism (in
place since 1983) and its function is to stabilize
the price of petrol and diesel in the country

http://paultan.org/2009/02/15/how-fuel-prices-are-calculated-in-malaysia/
http://etp.pemandu.gov.my/Transformation_Unplugged-@-
The_truth_about_subsidies.asp
 Macroeconomic Equilibrium:
How to explain the movement to an equilibrium
using wealth and substitution effects?
Point C is AD=SAS at price=115 = Equilibrium

– At P=125, SAS > AD — inventory

surplus
– prices  - & resolve surplus by:
– firms  production – quantity of SAS 
– wealth & substitution effects will 
quantity of GDP demanded

At P=105, AD >SAS — inventory shortage

—  prices - & resolve shortage by:
— firms  production - quantity of SAS 
— wealth & substitution effects will  More about wealth &
quantity of GDP demanded substitution effects later
 Long-Run Macroeconomic
Equilibrium
– Long-run macroeconomic
equilibrium occurs when actual real
GDP equals potential GDP—when
the economy is on its LAS curve
– Long-run equilibrium occurs at the
intersection at point a — a
AD=SAS=LAS

Long-run equilibrium occurs when

the money wage has adjusted to
place the SAS curve at the long-run
equilibrium point (will explain how Full employment at
later) potential GDP
The Business Cycles in the AS-AD Model
The business cycle occurs due to fluctuations in aggregate
demand and the short-run aggregate supply,
And the money wage does not change fast enough to keep
real GDP at potential GDP (in the short-run)
So the outcome (at least in the short-run) are 2 more types
of equilibrium:-
• Above full-employment equilibrium is an equilibrium
in which real GDP > potential GDP — Inflation gap
• Below full-employment equilibrium is an equilibrium
in which real GDP < potential GDP — Recession gap
Below Full-employment Equilibrium:

GDP Deflator
LAS
SAS0

b
100 e
Recession gap

AD0
Y1 Yf Real GDP ($ billions)

Associated problems with recession gap:

•high unemployment
•Unutilised capacity
Above Full-employment Equilibrium:

GDP Deflator
LAS
SAS0

100 e
Inflation gap
AD0
Yf Y1 Real GDP ($ billions)

Associated problems with inflation gap:

•Insufficient capacity resulting in labour shortages, etc
•Likely lead to inflation as money wages rise long-run if
problem is left unchecked (will explain how later)
 Below Full-employment Equilibrium:
As price ,
interest rates,
Short run effects
C - Qty of AD  Suppose future expectations of down-turn – I 
AD   AD curve shifts left to AD01
GDP Deflator

LAS
SAS0 SAS > AD (stock surplus) at P = 110
b
110  aa P 110 to 100:-
 Qty of Agg supply  - given money wage
b
100 c fixed in short run, with a price , firms 
output as profits 
AD0   Qty of Agg Dd – explain wealth
AD1 effect, intertemporal & international
sub effects
111 12f Real GDP ($
trill)
The stock surplus is eventually resolved
Short-run as Y from $12 trill to $11 trill
•Recession gap Economy moves to pt c
•unemployment
 Below Full-employment Equilibrium: Long-run Effects
Assume that markets are efficient
If there is a recession, the economy will self-adjust back to full
employment in the long-run as wages become flexible
As price, local
goods cheaper At pt a, unemployment forces workers
C - Qty of AD to accept  money wage, W
LAS
Price Level

SAS0  wage costs

SAS1 encourage firms to  output
a SAS curve shifts right
a b At P=100 SAS>AD (surplus)
100   As money wage
is fixed short  P to 90 – adjustment along AD/AS
90 c run - as price ,
output as
 Surplus removed as Y from
profits 
AD1 $11 to $12 trill
Economy settles back at full
111 12Real
f
GDP ($ trill)
employment at point c
 Above Full-employment Equilibrium
Short run effects
Economy is at long run equilibrium point a – suppose foreign income rises
LAS X   AD   AD curve shifts right to AD1
Price Level GDP
Deflator at P0, AD >SAS stock shortage (-)
SAS0
P to P1:-
As price ,
c real wealth   qty of Agg supply. As money wages
P1
 , C  fixed in short run, P will  profits,
a b
P0 firms  output.
 Qty of Agg Dd – explain wealth effect,
AD1 intertemporal & international sub effects
AD0
400f 4201 Real GDP ($  shortage is resolved as Y  from
billions)
$400b to $420b
Short-run at point C
•economy faces inflation gap  economy moves to pt c
•inflation
•Insufficient capacity – resource shortages
 Above Full-employment Equilibrium: Long –run
adjustment. Assume markets are efficient.
If there is an inflation gap, the economy will self-adjust back to full
employment in the long-run as wages become flexible
As money wage is fixed At pt c, labour shortages will force workers to
short run - as price, demand  in money wages
profits  - output 
  production costs
LAS
SAS1  force firms to  output
Price Level

SAS0  SAS curve shifts left

P2 e As price ,
At P1 SAS<AD (stock shortage)
P to P2
P1 d c interest rates,
C - Qty of AD  Qty of AS output (see
movement along SAS curve)
 Qty of AD  along AD curve
AD1  Shortages are resolved Y  from $420b to
400f 420
Real GDP ($ $400b
billions) Economy settles back to full
employment at point e
 Next Week’s Lecture
• The Keynesian Income and Expenditure
Model: The simple economy
• Consumption & savings, simple multiplier,
investment, equilibrium: planned expenditure
& role of inventory levels

Bring along a calculator