Aggregate Demand and Aggregate Supply

Modeling the Aggregate Economy

• Aggregate Demand– Aggregate demand is a schedule relating the total

demand for all goods and services in an economy to the general price level in that economy.

• Aggregate Supply– Aggregate supply is a schedule relating the total

supply of all goods and services in an economy to the general price level.

Aggregate Demand Determinants

ConsumptionInvestmentGovernmentNet Exports

MoneyFinancial Assets

NonfinancialMarkets

FinancialMarkets

Aggregate Demand

Aggregate Demand

Y

P

AD

0

Aggregate demand is a schedule relating the total demand for all goods and services in an economy to the general price level in that economy.

Aggregate Demand

• The aggregate demand curve slopes down because as the general price level rises, the amount of goods and services that can be purchased with the given stock of money and other financial assets declines.

• In addition, the aggregate demand curve slopes down because as the price level rises, a nation’s goods and services become less competitive in the international markets.

Shifting Aggregate Demand

Y

P

0AD1

Anything that causes aggregate spending tochange (holding the price level constant)shifts the aggregate demand curve.

Increases in AD shift the curve to the right.

Decreases in AD shift the curve to the left.

AD2

AD3

Aggregate Supply

• Aggregate supply is a schedule relating the total supply of all goods and services in an economy to the general price level.

Aggregate Supply: Determinants

Labor CostsCapital CostsMaterials CostProductivityCapacityExpectations

Profit Margins

Production Costs

Aggregate Supply

Aggregate Supply

AS

AS

Y Y Y

PPP

0 0 0

AS

Aggregate Supply

• The aggregate supply curve may be flat, upward sloping or vertical.

• Horizontal aggregate supply implies that increasing aggregate output puts no pressure on prices.

• Aggregate supply curves are horizontal when resources are in ample supply.

Aggregate Supply

• Vertical aggregate supply implies that in attempts to increase aggregate output result in an increase in the price level only.

• Aggregate supply curves are vertical in the long run where full employment of all resources exists.

• Aggregate supply in the long run does not depend on the price level.

Aggregate Supply

• Upward sloping aggregate supply implies that attempts to increase aggregate output result in an increase in both output and the price level.– When the demand for goods and services rises,

firms increase their demand for inputs.• When all firms demand more inputs and the market

supply of inputs is upward sloping, firms’ costs rise.

• Firms respond by raising prices.

Shifting Aggregate Supply

Y

P

0

AS2

Anything that causes aggregate supply tochange (holding the price level constant)shifts the aggregate supply curve.

Increases in AS shift the curve to the right.

Decreases in AS shift the curve to the left.

AS3

AS1

Aggregate Demand and Supply: Determinants

ConsumptionInvestmentGovernmentNet Exports

MoneyFinancial Assets

Labor CostsCapital CostsMaterials CostProductivityCapacityExpectations

NonfinancialMarkets

FinancialMarkets

Profit Margins

Production Costs

Aggregate Demand

Aggregate Supply

Price Level

Real Output

Aggregate Demand and Supply: Long Run

Y

P

0

ASThe intersection of AD and AS determinesthe price level.

In the long run, changes in AD do not change Y.

Increases in AD cause P to rise while decreasesin AD cause P to fall.

AD2AD1

AD3

Aggregate Demand and Supply: Short Run

Y

P

0

AS

AD2

The intersection of AD and AS determinesthe price level.

In the short run, changes in AD change P and Y.

Increases in AD cause Y and P to rise while decreases in AD cause Y and P to fall.

Y1 Y2 Y3

AD1

AD3

Aggregate Demand and Supply: Short Run

Y

P

0

AS3 The intersection of AD and AS determinesthe price level.

In the short run, changes in AS change P and Y.

Increases in AS cause Y to rise and P to fall while decreases in AS cause Y to fall and P to rise.

Y1 Y2 Y3

AD1

AS2

AS1

Aggregate Demand and Supply: Short Run

Y

P

0

ASsr

Y

AD

ASlr

Long run equilibrium occurs at the intersection of aggregate demand and thelong run aggregate supply curve whereP = P and Y = Y.

Since in the long run all prices have adjusted, short run equilibrium occursat the same P-Y combination.

P

Reduction in Aggregate Demand

Y

P

0

ASsr

Y*

AD1

ASlr

P

AD2

12

3

A decrease in aggregate demand fromAD1 to AD2 moves the economy frompoint 1 to point 2.

At point 2, the economy is below Y*, thenatural rate of full employment.

AS > AD, causing the price level to fall.

Decreases in P increase real money balances, causing Y to rise from Y1 to Y*.

Y1

Increase in Aggregate Demand

Y

P

0

ASsr

Y* Y1

AD1

ASlr

P1

AD2

P2

1 2

3

An increase in aggregate demand movesthe economy from point 1 to point 2.

At point 2, the economy is above Y*, thenatural rate of full employment.

AD > AS causes the price level to rise.

Increases in P decrease real moneybalances, causing Y to fall from Y1 toY*.

Y

P

0

AS1

Y1 Y*

AD

ASlr

P1

Adverse Aggregate Supply Shock

AS2P2

1

2

Adverse supply shocks push up costs andprices. If aggregate demand is fixed,the economy moves from point 1 topoint 2 as Y falls and P rises.

At point 2, AD < AS and Y1 < Y*.

Eventually, prices fall and the economymoves back to Y*.

Conclusions: Long Run

• The crucial difference between the long and short run is that output is inflexible in the long run but not the short run.

• The long run aggregate supply curve is vertical. Therefore, shifts in aggregate demand cannot change output in the long run.

Conclusions: Short Run

• The short run aggregate supply curve is upward sloping because of mark-up pricing.

• Therefore, shifts in aggregate demand can change levels of output and price levels.

• Shocks to aggregate demand and short run aggregate supply can cause fluctuations in economic activity.