Introduction

Aggregate Supply
AS and Price Adjustment
Aggregate Demand Curve
AD policy under alternative supply assumptions
Supply-side Economics
Long-run AD-AS

Aggregate Supply and Demand

Module 1

Rohit M

December 4, 2018

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 Introduction
Aggregate Supply
AS and Price Adjustment Introduction(1/2)
Aggregate Demand Curve Introduction(2/2)
AD policy under alternative supply assumptions Definition
Supply-side Economics
Long-run AD-AS

Introduction(1/2)

I Macroeconomics is concerned with the behavior of the

economy as a whole
I Business cycle swings are big!
I During Great Depression, output fell by nearly 30 percent,
unemployment averaged 18 percent
I During Financial Crisis 2008, output fell by 7 percent in one
quarter, unemployment at 10 percent
I How will inflationary pressure be during a recession?

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 Introduction
Aggregate Supply
AS and Price Adjustment Introduction(1/2)
Aggregate Demand Curve Introduction(2/2)
AD policy under alternative supply assumptions Definition
Supply-side Economics
Long-run AD-AS

Introduction(2/2)
Aggregate supply - aggregate demand model is the basic
macroeconomic tool to study output fluctuations and the
determination of price level and the inflation rate.
Use this to understand
I Why economy deviated from a path of smooth growth
overtime?
I Consequences of government policies intended to reduce
unemployment, smooth output fluctuations and maintain
price stability
I Why do prices go up rapidly at some time and not at
others?
I Why are jobs plentiful in some years and not in others?

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 Introduction
Aggregate Supply
AS and Price Adjustment Introduction(1/2)
Aggregate Demand Curve Introduction(2/2)
AD policy under alternative supply assumptions Definition
Supply-side Economics
Long-run AD-AS

Definition

Aggregate demand and supply curve describes a relation

between the overall price level and output
I Aggregate supply (AS) curve describes for each given
price level, the quantity of output firms are willing to supply.
I Aggregate demand (AD) curve shows the combination of
the price level and level of output at which the goods and
money markets are simultaneously in equilibrium

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 Introduction
Aggregate Supply
AS and Price Adjustment Introduction(1/2)
Aggregate Demand Curve Introduction(2/2)
AD policy under alternative supply assumptions Definition
Supply-side Economics
Long-run AD-AS

Equilibrium

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 Introduction
Aggregate Supply
AS and Price Adjustment Introduction(1/2)
Aggregate Demand Curve Introduction(2/2)
AD policy under alternative supply assumptions Definition
Supply-side Economics
Long-run AD-AS

Central Bank increases money supply(2/2)

Suppose that the Central bank increases money supply.

I What effect will this have on the overall price level and
output of the economy?

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 Introduction
Aggregate Supply
AS and Price Adjustment Introduction(1/2)
Aggregate Demand Curve Introduction(2/2)
AD policy under alternative supply assumptions Definition
Supply-side Economics
Long-run AD-AS

Central Bank increases money supply(2/2)

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 Introduction
Aggregate Supply
AS and Price Adjustment Introduction(1/2)
Aggregate Demand Curve Introduction(2/2)
AD policy under alternative supply assumptions Definition
Supply-side Economics
Long-run AD-AS

Adverse supply shock in the economy

What is the effect of adverse supply shock in the economy?

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 Introduction
Aggregate Supply
AS and Price Adjustment Introduction(1/2)
Aggregate Demand Curve Introduction(2/2)
AD policy under alternative supply assumptions Definition
Supply-side Economics
Long-run AD-AS

Adverse supply shock in the economy

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 Introduction
Aggregate Supply
Definition
AS and Price Adjustment
The Classical Supply Curve
Aggregate Demand Curve
The Keynesian Aggregate Supply Curve
AD policy under alternative supply assumptions
Frictional and Natural Rate of Unemployment
Supply-side Economics
Long-run AD-AS

Definition

Aggregate supply (AS) curve describes, for each price level, the
quantity of output firms are willing to supply.

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 Introduction
Aggregate Supply
Definition
AS and Price Adjustment
The Classical Supply Curve
Aggregate Demand Curve
The Keynesian Aggregate Supply Curve
AD policy under alternative supply assumptions
Frictional and Natural Rate of Unemployment
Supply-side Economics
Long-run AD-AS

The Classical Supply Curve(1/3)

Classical aggregate supply curve is vertical, indicating that the

same amount of goods will be supplied whatever the price level.
I Classicals assumed full employment equilibrium of labour
market
I High demand will lead to increase in price and not an
increase in output as high demand is economywide and all
the factors of production are already at work.
I Will also lead to higher wages

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 Introduction
Aggregate Supply
Definition
AS and Price Adjustment
The Classical Supply Curve
Aggregate Demand Curve
The Keynesian Aggregate Supply Curve
AD policy under alternative supply assumptions
Frictional and Natural Rate of Unemployment
Supply-side Economics
Long-run AD-AS

The Classical Supply Curve(2/3)

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 Introduction
Aggregate Supply
Definition
AS and Price Adjustment
The Classical Supply Curve
Aggregate Demand Curve
The Keynesian Aggregate Supply Curve
AD policy under alternative supply assumptions
Frictional and Natural Rate of Unemployment
Supply-side Economics
Long-run AD-AS

The Classical Supply Curve(3/3)

I Potential or full employment GDP grows overtime as

economy accumulates resources and as technology
improves
I AS curve moves to the right overtime
I Potential GDP changes, but,
do not depend on the price level in the economy
Potential GDP is exogenous with respect to the price level

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 Introduction
Aggregate Supply
Definition
AS and Price Adjustment
The Classical Supply Curve
Aggregate Demand Curve
The Keynesian Aggregate Supply Curve
AD policy under alternative supply assumptions
Frictional and Natural Rate of Unemployment
Supply-side Economics
Long-run AD-AS

Keynesian AS Curve
Keynesian aggregate supply curve is horizontal, indicating that
firms will supply whatever amount of goods demanded at the
existing price level.
I Keynesians assumed less that full employment equilibrium.
I Firms can obtain as much labour as they want at the
current wage rate.
I Average cost remains constant as their output level
changes and hence price remains constant.
Short-run price stickiness is a real world phenomenon.
Aggregate Supply curve is quite flat in the short-run.
Short-run price level is unaffected by current level of GDP
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 Introduction
Aggregate Supply
Definition
AS and Price Adjustment
The Classical Supply Curve
Aggregate Demand Curve
The Keynesian Aggregate Supply Curve
AD policy under alternative supply assumptions
Frictional and Natural Rate of Unemployment
Supply-side Economics
Long-run AD-AS

Frictional Unemployment

Frictional unemployment occurs as people search for the right

job.

People are moving and changing job, some firms have lost
business and have to reduce employment by firing workers etc.

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 Introduction
Aggregate Supply
Definition
AS and Price Adjustment
The Classical Supply Curve
Aggregate Demand Curve
The Keynesian Aggregate Supply Curve
AD policy under alternative supply assumptions
Frictional and Natural Rate of Unemployment
Supply-side Economics
Long-run AD-AS

Natural Rate of Unemployment

Unemployment associated with full-employment level of

employment or potential level of output.

Definition: The natural rate of unemployment is the rate of

unemployment arising from normal labour market frictions that
exist when the labour market is in equilibrium.

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 Introduction
Aggregate Supply
Definition
AS and Price Adjustment
The Classical Supply Curve
Aggregate Demand Curve
The Keynesian Aggregate Supply Curve
AD policy under alternative supply assumptions
Frictional and Natural Rate of Unemployment
Supply-side Economics
Long-run AD-AS

How flat is flat?

I It is a simplification assumption, although the supply curve

is slightly upward sloping even in the short-run.
I Solution becomes easier rather than a simultaneous
equation
I The researcher/policy maker should be aware of the
position of economy in making the simplification.

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 Introduction
Aggregate Supply
AS and Price Adjustment
AS and Price Adjustment
Aggregate Demand Curve
Vertical or Horizontal
AD policy under alternative supply assumptions
Supply-side Economics
Long-run AD-AS

AS and Price Adjustment Mechanism

AS curve describes the price adjustment mechanism in the

economy.

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 Introduction
Aggregate Supply
AS and Price Adjustment
AS and Price Adjustment
Aggregate Demand Curve
Vertical or Horizontal
AD policy under alternative supply assumptions
Supply-side Economics
Long-run AD-AS

AS and Price Adjustment Mechanism

Figure: Dynamic Process (AS)

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 Introduction
Aggregate Supply
AS and Price Adjustment
AS and Price Adjustment
Aggregate Demand Curve
Vertical or Horizontal
AD policy under alternative supply assumptions
Supply-side Economics
Long-run AD-AS

AS and Price Adjustment Mechanism

I Indicates that after an years time price would have risen

enough to partially, but not completely, push GDP back to
the potential level.
Pt+1 = Pt [1 + λ(Y − Y ∗ )]
Next period price level is a functional increment of output gap.

I Price levels will be constant iff. Y = Y ∗

I (Y − Y ∗ ) is called output gap

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 Introduction
Aggregate Supply
AS and Price Adjustment
AS and Price Adjustment
Aggregate Demand Curve
Vertical or Horizontal
AD policy under alternative supply assumptions
Supply-side Economics
Long-run AD-AS

AS and Price Adjustment Mechanism

I Prices move up until the output is no longer above potential

I λ is called the speed of adjustment
I If λ is large, AS mechanism would return the economy to
potential output relatively quickly.
I If λ is small, we might want to use AD policy to speed up
the process

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 Introduction
Aggregate Supply
AS and Price Adjustment
AS and Price Adjustment
Aggregate Demand Curve
Vertical or Horizontal
AD policy under alternative supply assumptions
Supply-side Economics
Long-run AD-AS

Figure: Aggregate Demand and Nonlinear Aggregate Supply

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 Introduction
Aggregate Supply
AS and Price Adjustment
AS and Price Adjustment
Aggregate Demand Curve
Vertical or Horizontal
AD policy under alternative supply assumptions
Supply-side Economics
Long-run AD-AS

Is it all a matter of timing?

I At low level of output; below Y ∗ , the aggregate supply

curve is quite flat.
Hence, during recession demand management policies
can be effective at boosting the economy without affecting
the price levels.
I As economy approaches full employment, too much
stimulus could run the AD curve up the vertical portion of
AS curve causing inflation.

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 Introduction
Aggregate Supply
AS and Price Adjustment
Definition
Aggregate Demand Curve
Mechanism
AD policy under alternative supply assumptions
Supply-side Economics
Long-run AD-AS

Definition

Aggregate Demand curve shows the combinations of the price

level and level of output at which the goods and money market
are simultaneously in equilibrium.

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 Introduction
Aggregate Supply
AS and Price Adjustment
Definition
Aggregate Demand Curve
Mechanism
AD policy under alternative supply assumptions
Supply-side Economics
Long-run AD-AS

Mechanism(1/4)

I Expansionary policies - increase in government spending,

tax cuts, increase in the money supply - move AD curve to
the right.
I Consumer and investor confidence also affects AD
I AD depends upon real money supply

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 Introduction
Aggregate Supply
AS and Price Adjustment
Definition
Aggregate Demand Curve
Mechanism
AD policy under alternative supply assumptions
Supply-side Economics
Long-run AD-AS

Mechanism(2/4)

If M is the money supply and P is the price level;

Real money supply = MP
M
I When P rises; interest rate falls and investment rises - AD
rises.
I At a given level of money supply M̄; higher price level
means low real money supply and hence low demand and
vice-versa.
As AD curve shows equilibrium in both goods and money
market, both these markets can move AD curve.

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 Introduction
Aggregate Supply
AS and Price Adjustment
Definition
Aggregate Demand Curve
Mechanism
AD policy under alternative supply assumptions
Supply-side Economics
Long-run AD-AS

Mechanism(3/4)

We can use quantity theory of money to explain the AD curve.

MV = PY
If we assume that V is constant - then this becomes the
equation of AD curve.
With a constant money supply, any increase in Y must be offset
by a decrease in P, and vice-versa.
Downward sloping AD curve explained.

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 Introduction
Aggregate Supply
AS and Price Adjustment
Definition
Aggregate Demand Curve
Mechanism
AD policy under alternative supply assumptions
Supply-side Economics
Long-run AD-AS

Mechanism(4/4)

An increase in the nominal money stock shifts the AD schedule

up exactly in the same proportion to the increase in nominal
money.

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 Introduction
Aggregate Supply
AS and Price Adjustment
Definition
Aggregate Demand Curve
Mechanism
AD policy under alternative supply assumptions
Supply-side Economics
Long-run AD-AS

Figure: Effect of Money Supply on AD

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 Introduction
Aggregate Supply
AS and Price Adjustment
Definition
Aggregate Demand Curve
Mechanism
AD policy under alternative supply assumptions
Supply-side Economics
Long-run AD-AS

M 0 leads to P0 price and Y0 output in AD.

Suppose M increases by 10 percent to M 0 = 1.1 × M
AD curve shifts to the right.
At output Y0 , the price moves up to P 0 = 1.1 × P0 .
New money supply equals old money supply

M0 1.1 × M 0 M0
= =
P0 1.1 × P0 P0

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 Introduction
Aggregate Supply
AS and Price Adjustment
The Keynesian Case
Aggregate Demand Curve
The Classical Case
AD policy under alternative supply assumptions
Supply-side Economics
Long-run AD-AS

Aggregate Demand Policy

An AD-AS framework is used to study the effect of aggregate

demand policy in the two extreme supply cases - Keynesian
and Classical.

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 Introduction
Aggregate Supply
AS and Price Adjustment
The Keynesian Case
Aggregate Demand Curve
The Classical Case
AD policy under alternative supply assumptions
Supply-side Economics
Long-run AD-AS

The Keynesian Case(1/2)

Figure: AD Expansion - Keynesian Framework

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 Introduction
Aggregate Supply
AS and Price Adjustment
The Keynesian Case
Aggregate Demand Curve
The Classical Case
AD policy under alternative supply assumptions
Supply-side Economics
Long-run AD-AS

The Keynesian Case(2/2)

AD curve shifts - increased government spending, a cut in

taxes or an increase in money supply - from AD to AD’.
I Equilibrium shifts from E to E’.
I Output increased without any effect on price.
Only effect of increased demand in the Keynesian framework is
to have an increase in output and employment.

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 Introduction
Aggregate Supply
AS and Price Adjustment
The Keynesian Case
Aggregate Demand Curve
The Classical Case
AD policy under alternative supply assumptions
Supply-side Economics
Long-run AD-AS

The Classical Case(1/3)

The aggregate supply curve is vertical at full-employment level

of output.
I Under classical assumption, producers would supply
potential level of output Y ∗ , at all price levels.

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 Introduction
Aggregate Supply
AS and Price Adjustment
The Keynesian Case
Aggregate Demand Curve
The Classical Case
AD policy under alternative supply assumptions
Supply-side Economics
Long-run AD-AS

Figure: AD Expansion - The Classical Case

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 Introduction
Aggregate Supply
AS and Price Adjustment
The Keynesian Case
Aggregate Demand Curve
The Classical Case
AD policy under alternative supply assumptions
Supply-side Economics
Long-run AD-AS

The Classical Case(3/3)

I Firms are unable to increase output by hiring more workers

to respond to increased demand.
I As firms try to hire more workers, they bid up wages and
leads to increase in cost of production.
Increase in the demand for goods therefore leads only
to higher prices, and not to higher output
I Increase in price reduces the real money stock; to reduce
spending to a level consistent with full-employment output.

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 Introduction
Aggregate Supply
AS and Price Adjustment Definition
Aggregate Demand Curve Dynamic Scoring
AD policy under alternative supply assumptions Dynamics
Supply-side Economics
Long-run AD-AS

Definition and Concepts

All economists are in favour of policies that increase potential
GDP (move AS curve to the right).

Supply-side policies are

I removing unnecessary regulation
I maintaining an efficient legal system
I encouraging technological progress Supply-side
economists, encourage tax cuts, which will increase the
aggregate supply enormously - so much that tax
collections will rise, rather than fall.

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 Introduction
Aggregate Supply
AS and Price Adjustment Definition
Aggregate Demand Curve Dynamic Scoring
AD policy under alternative supply assumptions Dynamics
Supply-side Economics
Long-run AD-AS

Dynamic Scoring

Tax cuts leads to a budget deficit. Supply-side economists

argue that the analysis of deficit should include dynamicscoring

Dynamic Scoring: A cut in tax rates will increase economic

growth through a supply-side stimulus. In the long-run this
would increase the tax base and the extra tax collections will in
part offset the increase in the deficit due to the tax cut in the tax
rate. Accounting of this offset over a number of years following
the policy change is called dynamicscoring.

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 Introduction
Aggregate Supply
AS and Price Adjustment Definition
Aggregate Demand Curve Dynamic Scoring
AD policy under alternative supply assumptions Dynamics
Supply-side Economics
Long-run AD-AS

Criticisms:
I Tax base increase are very small
I Hard to do objectively, as there are lots of uncertainties
about future governments and policies.

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 Introduction
Aggregate Supply
AS and Price Adjustment Definition
Aggregate Demand Curve Dynamic Scoring
AD policy under alternative supply assumptions Dynamics
Supply-side Economics
Long-run AD-AS

Dynamics(1/2)

Figure: Effect of Tax Cut on AD-AS

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 Introduction
Aggregate Supply
AS and Price Adjustment Definition
Aggregate Demand Curve Dynamic Scoring
AD policy under alternative supply assumptions Dynamics
Supply-side Economics
Long-run AD-AS

Dynamics(2/2)

I Effects on both aggregate supply and aggregate demand.

I GDP is higher, but only by a very small amount.
I Only supply-side policies can permanently increase output.
I Supply-side economists argue for cutting government
expenditure at the same time.
I Deficit would be nearly neutral.

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 Introduction
Aggregate Supply
AS and Price Adjustment
Aggregate Demand Curve
AD policy under alternative supply assumptions
Supply-side Economics
Long-run AD-AS

Long-run shifts in AD-AS

I AS curve shifts to the right at a steady rate.

I AD movements can be large or small, depending mostly on
movements in money supply.
Over long periods, output is essentially determined by
aggregate supply and prices are determined by aggregate
demand relative to movement of aggregate supply.

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 Introduction
Aggregate Supply
AS and Price Adjustment
Aggregate Demand Curve
AD policy under alternative supply assumptions
Supply-side Economics
Long-run AD-AS

Long-run shifts in AD-AS

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