CHAPTER 33

AGGREGATE
DEMAND AND
AGGREGATE
SUPPLY
 In this chapter

• What are economic fluctuations?

• What are their characteristics?
• How does the model of aggregate demand and aggregate supply
explain economic fluctuations?
• Why does the Aggregate- Demand curve slope downward? What
shifts the AD curve?
• What is the slope of the Aggregate- Supply curve in the short run?
In the long run? What shifts the AS curve?
 Short-Run Economic Fluctuations

Economic activity fluctuates from year to year.

• In most years production of goods and services rises.
• On average over the past 50 years, production in the U.S. economy has
grown by about 3 percent per year.
• In some years normal growth does not occur, causing a recession.
• A recession is a period of declining real income, and rising unemployment.
• A depression is a severe recession.
 THREE KEY FACTS ABOUT ECONOMIC FLUCTUATIONS

• Economic fluctuations are irregular and unpredictable.

• Fluctuations in the economy are often called the business cycle.
• Most macroeconomic variables fluctuate together.
• Most macroeconomic variables that measure some type of income or production fluctuate
closely together.
• Although many macroeconomic variables fluctuate together, they fluctuate by different
amounts.
• As output falls, unemployment rises.
• Changes in real GDP are inversely related to changes in the unemployment rate.
• During times of recession, unemployment rises substantially.
 EXPLAINING SHORT-RUN ECONOMIC FLUCTUATIONS

How the Short Run Differs from the Long Run

• Most economists believe that classical theory describes the world in the
long run but not in the short run.
• Changes in the money supply affect nominal variables but not real
variables in the long run.
• The assumption of monetary neutrality is not appropriate when studying
year-to-year changes in the economy.
 The Basic Model of Economic Fluctuations

Two variables are used to develop a model to analyze the short-run

fluctuations.
•The economy’s output of goods and services measured by real GDP.
•The overall price level measured by the CPI or the GDP deflator.
The Basic Model of Aggregate Demand and Aggregate Supply
•Economist use the model of aggregate demand and aggregate supply to
explain short-run fluctuations in economic activity around its long-run
trend.
•The aggregate-demand curve shows the quantity of goods and services
that households, firms, and the government want to buy at each price level
 Figure 2: Aggregate Demand and Aggregate Supply...

Price
level Aggregate
supply

Equilibrium
price level

Aggregate
demand
0
Equilibrium Quantity of
output Output
 THE AGGREGATE-DEMAND CURVE

• The four components of GDP (Y) contribute to the aggregate

demand for goods and services.
Y = C + I + G + NX
 Figure 3: The Aggregate-Demand Curve...
Price
level

P1

P2
1. A decrease in
the price level Aggregate
demand

0
Y1 Y2 Quantity of
Output
2…increases the quantity of
goods and services demanded.
Why the Aggregate-Demand Curve Is Downward Sloping

• The Price Level and Consumption: The Wealth Effect

• The Price Level and Investment: The Interest Rate Effect
• The Price Level and Net Exports: The Exchange-Rate Effect
Why the Aggregate-Demand Curve Is Downward Sloping

The Price Level and Consumption: The Wealth Effect

• A decrease in the price level makes consumers feel more
wealthy, which in turn encourages them to spend more.
• This increase in consumer spending means larger quantities of
goods and services demanded.
Why the Aggregate-Demand Curve Is Downward Sloping

The Price Level and Investment: The Interest Rate Effect

• A lower price level reduces the interest rate, which encourages
greater spending on investment goods.
• This increase in investment spending means a larger quantity of
goods and services demanded.
Why the Aggregate-Demand Curve Is Downward Sloping

The Price Level and Net Exports: The Exchange-Rate Effect

• When a fall in the U.S. price level causes U.S. interest rates to fall, the real
exchange rate depreciates, which stimulates U.S. net exports.
• The increase in net export spending means a larger quantity of goods and
services demanded.
 Why the Aggregate-Demand Curve Might Shift

• The downward slope of the aggregate demand curve shows that a

fall in the price level raises the overall quantity of goods and
services demanded.
• Many other factors, however, affect the quantity of goods and
services demanded at any given price level.
• When one of these other factors changes, the aggregate demand
curve shifts.
 Why the Aggregate-Demand Curve Might Shift

Shifts arising from Price

level
• Consumption
• Investment
• Government Purchases
• Net Exports P1

𝐷2
Aggregate
demand, 𝐷1

0
Y1 Y2 Quantity
of
Output
 Why the Aggregate-Demand Curve Might Shift

• Changes in C
• Stock market boom/crash
• Preferences re: consumption/saving tradeoff
• Taxes
• Changes in I
• Firms buy new computers, equipment, factories, etc
• Expectations, optimism
• Interest rates, monetary policy
• Investment tax credit or other tax incentives
 Why the Aggregate-Demand Curve Might Shift

• Changes in G
• Federal spending
• State and local spending
• Taxes
• Changes in NX
• Booms/recessions in countries that buy our exports
• Appreciation/depreciation resulting from international speculation in foreign exchange
market
 THE AGGREGATE-SUPPLY CURVE

• In the long run, the aggregate-supply curve is vertical.

• In the short run, the aggregate-supply curve is upward sloping.
 THE AGGREGATE-SUPPLY CURVE

The Long-Run Aggregate-Supply Curve

• In the long run, an economy’s production of goods and services
depends on its supplies of labor, capital, and natural resources
and on the available technology used to turn these factors of
production into goods and services.
• The price level does not affect these variables in the long run.
 Figure 4: The Long-Run Aggregate-Supply Curve

Price
level Long-run
aggregate
supply

P1

2…does not affect the

P2 quantity of goods and
1. A change in services supplied in the
the price level.. long run.

0
Natural rate Quantity of
of output Output
 THE AGGREGATE-SUPPLY CURVE

The Long-Run Aggregate-Supply Curve

• The long-run aggregate-supply curve is vertical at the natural rate of
output.
• This level of production is also referred to as potential output or full-
employment output.
Why the Long-Run Aggregate-Supply Curve Might Shift

• Any change in the economy that alters the natural rate of output
shifts the long-run aggregate-supply curve.
• The shifts may be categorized according to the various factors in
the classical model that affect output.
• Shifts arising
• Labor
• Capital
• Natural Resources
• Technological Knowledge
 Figure 5: Long-Run Growth and Inflation

Long-run
Price aggregat 𝐿𝑅𝐴𝑆1990 𝐿𝑅𝐴𝑆2000 1. In the long run,
level e supply, technological progress
𝐿𝑅𝐴𝑆1980 shifts long-run
aggregate supply…

P2000 2…and growth in the

4…and
money supply shifts
ongoing P1990 aggregate demand…
inflation

P1980
Aggregate
Demand, 𝐴𝐷 2000
𝐴𝐷1990
𝐴𝐷1980
0
𝑌1890 𝑌1990 𝑌2000 Quantity of
3…leading to Output
growth in output…
 Why the Long-Run Aggregate-Supply Curve Might Shift

• Changes in L or natural rate of unemployment

• Immigration
• Baby-boomers retire
• Government policies reduce natural u-rate
• Changes in K or H
• Investment in factories, equipment
• More people get college degrees
• Factories destroyed by a hurricane
 Why the Long-Run Aggregate-Supply Curve Might Shift

• Changes in natural resources

• Discovery or new mineral deposits
• Reduction in supply of imported oil
• Changing weather patterns that affect agricultural production
• Changes in technology
• Productivity improvements from technological progress
 A New Way to Depict Long-Run Growth and Inflation

• Short-run fluctuations in output and price level should be viewed

as deviations from the continuing long-run trends.
Why the Aggregate-Supply Curve Slopes Upward in the 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.
• A decrease in the level of prices tends to reduce the quantity of
goods and services supplied.
 Figure 6: The Short-Run Aggregate-Supply Curve

Price
level Short-run
aggregate
supply

P1

P2
1. A decrease 2…reduces the quantity of
in the price goods and services supplied in
level the short run.
0
Y2 Y1 Quantity of
Output
Why the Aggregate-Supply Curve Slopes Upward in the Short Run

• The Misperceptions Theory

• The Sticky-Wage Theory
• The Sticky-Price Theory
 The Sticky-Wage Theory

• Imperfection:
Nominal wages are sticky in the short run, they adjust sluggishly
Due to labor contracts, social norms
• Firms and workers set the nominal wage in advanced based on PE, the price
level they expect to prevail
• If P> PE, : revenue is higher, but labor cost is not
Production is more profitable, so firms increase output and employment
• Hence, higher P causes higher Y, so the SRAS curve slopes upward
 The Sticky-Price Theory

• Imperfection
Many prices are sticky in the short run
Due to menu costs, the costs of adjusting prices
Examples: cost of printing new menu, the time required to change price tags
• Firms set sticky prices in advanced based on PE
 The Sticky-Price Theory

• Suppose the Fed increases the money supply unexpectedly . In the long run, P
will rise
• In the short run, firms without menu costs can raise their prices immediately
• Firms with menu costs wait to raise prices. Meantime, their prices are
relatively low, which increases demand for their products, so they increase
output and employment
• Hence, higher P is associated with higher Y, so the SRAS curve slopes
upward
 The Misperceptions Theory

• Imperfection
Firms may confuse changes in P with changes in the relative price of the
products they sell
• If P rises above PE, a firm sees its price rise before realizing all prices are
rising
The firm may believe its relative price is rising, and may increase output and
employment
• So, an increase in P can cause an increase in Y, making the SRAS curve
upward- sloping
 What the 3 theories have in common

• In all 3 theories, Y deviates from YN when P deviates from PE

Y = YN + α (P – PE)
Where
Y: output
YN: natural rate of output (long-run)
α > 0: measures how much Y responds to unexpected changes in P
P: actual price level
PE: expected price level
 What the 3 theories have in common

Y = YN + α (P – PE) SRAS
P

P > PE

PE

P < PE

Y
Y < YN YN Y > YN
 Short run AS and Long run AS

• The imperfection in these theories are temporary. Over time,

• Sticky wages and prices become flexible
• Misperceptions are corrected
• In the long run
• PE = P
• AS curve is vertical
 Short run AS and Long run AS

Y = YN + α (P – PE) P LRAS SRAS

In the long run

PE
PE = P
And Y = YN

YN Y
 Why the Aggregate Supply Curve Might Shift

• An increase in the expected price level reduces the quantity of

goods and services supplied and shifts the short-run aggregate
supply curve to the left.
• A decrease in the expected price level raises the quantity of goods
and services supplied and shifts the short-run aggregate supply
curve to the right.
 Why the Aggregate Supply Curve Might Shift

P SRAS1
Everything that shifts LRAS also SRAS0
shifts SRAS too
Also, PE shifts SRAS
PE
If PE rises, workers and firms set
higher wages
PE
At each P, production is less
profitable, Y falls, SRAS shifts left

YN Y
 Figure 7: The Long-Run Equilibrium

Long-run
Price aggregate
level supply Short-run
aggregate
supply
Equilibrium A
price

Aggregate
demand
0
Natural rate Quantity
of out put of Output
 Economic Fluctuations

• Caused by events that shift the AD and/or AS curve

• Four steps to analyzing economic fluctuations:
1. Determine whether the event shifts AD or AS
2. Determine whether curve shifts left or right
3. Use AD-AS diagram to see how the shift changes Y and P in the
short run
4. Use the AD- AS diagram to see how the economy moves from
new SR equilibrium to new LR equilibrium
 TWO CAUSES OF ECONOMIC FLUCTUATIONS

Shifts in Aggregate Demand

• In the short run, shifts in aggregate demand cause fluctuations
in the economy’s output of goods and services.
• In the long run, shifts in aggregate demand affect the overall
price level but do not affect output.
 Figure 8: A Contraction in Aggregate
Demand
2…causes Long-run
output to fall in aggregate Short-run
Price aggregate
the short run… supply
level supply,𝐴𝑆1
𝐴𝑆2
3…but over time, the
short-run aggregate-
𝑃1 A supply curve shitfts
𝑃2 B
C 1. A decrease in
𝑃3
aggregate
demand…
Aggregate
𝐴𝐷2 demand, 𝐴𝐷1
0
𝑌2 𝑌1 4…and output returns to Quantity of
its natural rate Output
 TWO CAUSES OF ECONOMIC FLUCTUATIONS

An Adverse Shift in Aggregate Supply

•A decrease in one of the determinants of aggregate supply shifts
the curve to the left:
• Output falls below the natural rate of employment.
• Unemployment rises.
• The price level rises.
 Figure 10: An Adverse Shift in Aggregate Supply

Long-run
Price aggregate Short-run
level supply 𝐴𝑆2 aggregate
supply, 𝐴𝑆1

B 1. An adverse shift in the

𝑃2 short-run aggregate-
supply curve
𝑃1 A

3…and the
price level
to raise. Aggregate
demand
0
Y2 Y1 Quantity of
2…causes Output
output to fall
 The Effects of a Shift in Aggregate Supply

Stagflation
• Adverse shifts in aggregate supply cause
stagflation - a period of recession and inflation.
• Output falls and prices rise.
• Policymakers who can influence aggregate demand cannot offset both
of these adverse effects simultaneously.
 The Effects of a Shift in Aggregate Supply

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 aggregate demand by using monetary and
fiscal policy.
 Figure 10: An Adverse Shift in Aggregate Supply

Long-run
Price aggregate Short-run
level supply 𝐴𝑆2 aggregate
supply, 𝐴𝑆1

1. When short-run
aggregate supply falls…
𝑃3 C
𝑃2 2…policymakers can
B
A accommodate the shift by
3…which 𝑃1
expanding aggregate demand…
causes the
price level to 𝐴𝐷2
rise further… Aggregate demand, 𝐴𝐷1
0
Natural rate Quantity of
4…but keeps output
of output Output
at its natural rate.
 Summary

• All societies experience short-run economic fluctuations around

long-run trends.
• These fluctuations are irregular and largely unpredictable.
• When recessions occur, real GDP and other measures of income,
spending, and production fall, and unemployment rises.
 Summary

• Economists analyze short-run economic fluctuations using the

aggregate demand and aggregate supply model.
• According to the model of aggregate demand and aggregate
supply, the output of goods and services and the overall level of
prices adjust to balance aggregate demand and aggregate supply.
 Summary

• The aggregate-demand curve slopes downward for three reasons:

a wealth effect, an interest rate effect, and an exchange rate effect.
• Any event or policy that changes consumption, investment,
government purchases, or net exports at a given price level will
shift the aggregate-demand curve.
 Summary

• In the long run, the aggregate supply curve is vertical.

• The short-run, the aggregate supply curve is upward sloping.
• The are three theories explaining the upward slope of short-run
aggregate supply: the misperceptions theory, the sticky-wage
theory, and the sticky-price theory.
 Summary

• Events that alter the economy’s ability to produce output will

shift the short-run aggregate-supply curve.
• Also, the position of the short-run aggregate- supply curve
depends on the expected price level.
• One possible cause of economic fluctuations is a shift in
aggregate demand.
 Summary

• A second possible cause of economic fluctuations is a shift in

aggregate supply.
• Stagflation is a period of falling output and rising prices.