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W10 C2 (6th Jan, 2009)

3.Aggregate Demand & Aggregate Supply (AD &

AS)

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Aggregate demand is thetotal demand for goods andservices in the economy.

Deriving the AD curve: toderive the aggregate demandcurve, we examine whathappens to aggregate output(income) (Y) when the pricelevel (P) changes, assuming no

changes in governmentspending (G), net taxes (T), orthe monetary policy variable(Ms).

The aggregate demand

(AD) curve is a curve thatshows the negative

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P M r I A E d Y

The Impact of an Increase in the Price Level on theEconomy Assuming No Changes in G, T, and Ms

Discuss

Later

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A higher price level causesthe demand for money torise, which causes theinterest rate to rise. Then,the higher interest ratecauses aggregate output tofall.

The decrease inconsumption brought aboutby an increase in theinterest rate contributes tothe overall decrease in

output.

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At every point along the aggregate demand curve, theaggregate quantity of output demanded is exactly equal toplanned aggregate expenditure.

Y = C + I + G

equilibrium condition

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An increase in the quantityof money supplied at agiven price level shifts theaggregate demand curve to

the right.

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An increase in governmentpurchases or a decrease innet taxes shifts theaggregate demand curve to

the right.

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Factors That Shift the Aggregate Demand Curve

Expansionary monetary policy

Ms ADcurve shifts to the rightContractionary monetary policy

Ms ADcurve shifts to the leftExpansionary fiscal policy

G ADcurve shifts to the rightContractionary fiscal policy

G ADcurve shifts to the leftT ADcurve shifts to the right T ADcurve shifts to the left

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Aggregate supply is the total supply of all goods andservices in the economy.

The aggregate supply(AS) curve is a graph that shows therelationship between the aggregate quantity of output

supplied by all firms in an economy and the overall pricelevel.

Firms do not simply respond to market-determined prices, butthey actually set prices. Price-setting firms do not have

individual supply curves because these firms are choosingboth output and price at the same time.

When we draw a firms supply curve, we assume that inputprices are constant. In macroeconomics, an increase in theoverall price level means that at least some input prices will

be rising as well. The outputs of some firms are the inputs of

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In the short run, theaggregate supply curve(the price/output responsecurve) has a positive slope.

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At low levels of aggregateoutput, the curve is fairlyflat. As the economyapproaches capacity, the

curve becomes nearlyvertical. At capacity, thecurve is vertical.

Macroeconomists focus on

whether or not theeconomy as a whole isoperating at full capacity.

As the economy

approaches maximumca acit , firms res ond to

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When the economy is operating at low levels of output, anincrease in aggregate demand is likely to result in anincrease in output with little or no increase in the overallprice level.

There must be a lag between changes in input prices andchanges in output prices, otherwise the aggregate supply(price/output response) curve would be vertical.

Wage rates may increase at exactly the same rate as theoverall price level if the price-level increase is fullyanticipated. Most input prices, however, tend to lagincreases in output prices.

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A cost shock, or supply shock, is a changein costs that shifts the aggregate supply (AS)curve.

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Bad weather, natural

disasters, destruction

from wars

Good weather

Public policywaste and inefficiency

over-regulation

Public policy supply-side policies

tax cuts

deregulation

Stagnation

capital deterioration

Economic growth

more capital

more labor

technological change

Higher costs

higher input priceshigher wage rates

Lower costs

lower input priceslower wage rates

Shifts to the LeftDecreases in Aggregate Supply

Shifts to the RightIncreases in Aggregate Supply

Factors That Shift the Aggregate Supply Curve

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The equilibrium pricelevel is the point at whichthe aggregate demand andaggregate supply curves

intersect.

P0 and Y0 correspond to

equilibrium in the goodsmarket and the money

market and a set ofprice/output decisions on thepart of all the firms in theeconomy.

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Costs lag behind price-levelchanges in the short run,resulting in an upward-slopingAS curve.

Costs and the price levelmove in tandem in the longrun, and the AS curve isvertical.

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Output can be pushed abovepotential GDP by higheraggregate demand. Theaggregate price level also

rises.

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When output is pushedabove potential, there isupward pressure on costs,and this causes the short-

runAS curve to the left.

Costs ultimately increase bythe same percentage as theprice level, and the quantity

supplied ends up back at Y0.

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Y0 represents the level of

output that can be sustainedin the long run withoutinflation. It is also calledpotential output orpotential GDP.

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AD can shift to the right for anumber of reasons, includingan increase in the moneysupply, a tax cut, or an

increase in governmentspending.

Expansionary policy works

well when the economy is onthe flat portion of the AScurve, causing little changein P relative to the outputincrease.

Discuss

Later

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On the steep portion of the AScurve, expansionary policydoes not work well. Themultiplier is close to zero.

When the economy isoperating near full capacity,an increase in AD will result in

an increase in the price levelwith little increase in output.

Discuss

Later

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If theAS curve is vertical inthe long run, neithermonetary policy nor fiscalpolicy has any effect on

aggregate output.