Macroeconomics

Aggregate Demand and Aggregate Supply

Tran Nam Quoc∗, PhD.

∗E-mail: [email protected]
Big Questions

► What is the aggregate demand–aggregate supply model?

► What is aggregate demand?

► What is aggregate supply?

► How does the aggregate demand–aggregate supply model help us

understand the economy?

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RECAP

► The original Solow model focused on capital investment as the main

source of economic growth.

► The second Solow model included technology as an additional source of

growth but treated it as exogenous.

► Modern growth theory now recognizes that institutions are also essential
for growth.

► Modern growth theory also treats technological advancements in a

society as endogenous.
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The Aggregate Demand – Aggregate Supply Model

Aggregate Demand Long-Run Short-Run

Aggregate Supply Aggregate Supply
• Consumption
• Investment • Resources • Input prices
• Government • Technology • Menu costs
spending • Institutions • Money illusion
• Net exports
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Macroeconomics

In macroeconomics, there are two paths of study:

1. Long-run growth and development
2. Short-run fluctuations, or business cycles

• Long-run growth and Short-run fluctuations, or

development business cycles
• Focuses on theories • Focuses on time
and policies that affect horizons of five years or
economies over less.
several decades.

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U.S Real GDP Growth, 1990 - 2018

During economic expansions, GDP growth is typically positive while

during recessions it is typically negative.

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U.S Unemployment, 1990 - 2018

In recessions, unemployment rises, while in expansions,

unemployment falls.

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Aggregate Demand and Aggregate Supply Model

► Model used to study business cycles.

► Built on demand and supply model.

► Considers demand and supply for all final goods in an economy.

► Aggregate = total.

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Aggregate Demand (1)
Aggregate demand: The total demand for final goods and services in an
economy.
It is the sum of spending in the economy.

𝐴𝐷 = 𝐶 + 𝐼 + 𝐺 + 𝑁𝑋
where:
• Consumption is C
• Investment is I
• Government spending is G
• Net exports is NX 9 / 58
Aggregate Demand (2)

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Slope of the Aggregate Demand Curve (1)

The three reasons why quantity of aggregate demand and the price level are
negative are:
► The wealth effect.
► The interest rate effect.
► The international trade effect.

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Wealth Effect

► Wealth effect: The change in the quantity of aggregate demand that

results from wealth changes due to price-level changes.

► Wealth: The net value of one’s accumulated assets.

► This effect is related to consumption.

► Example: If real estate prices drop, people who have stored their wealth
in the form of homes will consume less.

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Interest Rate Effect

► Interest rate effect: Occurs when a change in the price level leads to a
change in interest rates and, therefore, in the quantity of aggregate demand.

► This occurs through the loanable funds market.

► Changes in the price level affect saving.
► This directly impacts the supply of loanable funds.

► Example: If price levels rise, people will save less which will increase
interest rates. This will decrease investment.

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International Trade Effect

► International trade effect: Occurs when a change

in the price level leads to a change in the quantity
of net exports demanded.

► Happens due to changes in relative price levels.

► Example: If Japanese goods are cheaper relative

to U.S. goods, more people will demand Japanese
goods.

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Slope of the Aggregate Demand Curve (2)

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Practice What You Know
Q1. The period in which the economy experiences decreased income and
increased unemployment is called:
A. Recession
B. Crisis
C. Recovery
D. business cycle

Q2. The wealth effect is the least important reason in a country that causes the AD
curve to slope downward because:
A. consumer spending does not respond to changes in interest rates.
B. holding money is a small part of household assets.
C. business investment spending does not respond to changes in interest rates.
D. exports and imports only account for a small portion of a country's GDP.
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Shift Factors in Aggregate Demand

When people’s demand for goods and

services at all price levels changes, AD will
shift.

The main categories are:

► Consumption
► Investment
► Government Spending
► Net Exports

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Consumption

Consumption spending accounts for about 70% of all spending in GDP.

Consumption is influenced by:

1. Changes in real wealth
► Stock market rises or falls
► Widespread change in real estate values
2. General expectations about the future
► Changes in expected income
► Change in consumer confidence
3. Changes in taxes
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Investment

Investment shifts when decision-makers at firms decide to increase or

decrease spending on capital goods.
1. Investor confidence
• As investor confidence rises, so does investment.
2. Interest rates
• At lower interest rates, investment increases.
3. Quantity of money in the economy
• More money will lead to lower interest rates, which will
increase investment.
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Government Spending

► Factor influenced most directly by policymakers.

► These changes may be made in response to economic conditions.

► Example: If people become more pessimistic about the future, the

government might decide to spend on roads and highways to offset the
decrease in consumption and investment.

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Net Exports

Net exports shift in response to changes in foreign income and the value of the
U.S. dollar.

As income in other nations rises, their demand for U.S. goods increases.
► As nations become wealthier, net exports increase.

When the value of the dollar increases, people in the U.S. can buy more foreign
goods but people outside of the U.S. can buy less U.S. goods. So, net exports
decrease.
► A stronger dollar leads to a decline in net exports.
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Shift Factors in Aggregate Demand Summary

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Practice What You Know
Q1. Which of the following does NOT shift the aggregate demand curve?
A. Decrease in money supply.
B. Decrease in private investment.
C. Increase in the general price level.
D. Decrease in taxes.

Q2. The aggregate demand curve shifts due to changes in which of the following
factors?
A. National production capacity.
B. General price level.
C. Interest rates.
D. Potential output.
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Movements along vs. shirts in the AD Curve

Movement along the AD Curve Shifts in the AD Curve

• Causes: Start with a change • Causes: Occur when
in the price level. something other than the
• Results: Affect the quantity price level changes.
of aggregate demand
through the three effects. • Examples: Changes in real
wealth, businesses
• Examples: Wealth effect, confidence, value of the
interest rate effect, dollar.
international trade effect.

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Function of a Firm

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Aggregate Supply

► How do changes in the price level affect the

supply decisions of the firm?
► It depends.

► Economists use two different time horizons:

► Long-run
► Short-run

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Long-Run Aggregate Supply

Long run: A period of time sufficient for all prices to adjust.

► The level of output produced when an economy is at the natural rate of
unemployment (u*).
► It depends on an economy’s resources, technology, and institutions.

Vertical line:
► Not affected by changes in price.
► An economy’s ability to produce is the same regardless of how much
paper money is present.

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Long-Run Aggregate Supply Curve

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Shifts in Long-run Aggregate Supply (1)

► LRAS changes when a nation’s ability to

produce output changes.

► This occurs with changes in:

► Resources
► Technology
► Institutions

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Shifts in Long-run Aggregate Supply (2)

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Practice What You Know
Q1. In the AS-AD model, the long-run aggregate supply curve shifts when:
A. The general price level in the economy changes.
B. The government changes its investments.
C. National income changes.
D. Natural disasters occur.

Q2. In the AS-AD model, the long-run aggregate supply curve will shift to the
right if:
A. Immigration from abroad increases.
B. Capital increases.
C. There is technological progress.
D. All of the above are correct.
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Short-run Aggregate Supply

► Short run: The period of time in which some prices have not yet been
adjusted.

► There are three reasons why there is a positive relationship between the
price level and the quantity of aggregate supply:
► Sticky input prices
► Menu costs
► Money illusion

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Short-run AS Curve

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Sticky Input Prices

Resource prices tend to be sticky because they are often set by written contracts.
► Example: Workers might sign a two-year contract for a fixed wage.

Output prices are more flexible since they are generally easy to change by the
company.
► Example: Prices in a coffee shop can be written on a blackboard that can
change day-to-day.

Since input prices are sticky but output prices are not, when the price level
increases companies can increase their profits by producing more.
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Menu Costs

Menu costs: The costs of changing prices.

Because of this expense, firms do not adjust their output price when the price
level changes.
► This will impact the amount customers will want.
► The quantity of aggregate supply will adjust to meet this change in the
quantity of aggregate demand.

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Money Illusion

Money illusion: Occurs when people interpret nominal changes in wages or

prices as real changes.

Workers are very reluctant to accept pay decreases, even if the pay decrease is
nominal.
► Firms will reduce output in response to decreases in the price level rather than
cut wages.

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Shifts in Short-run Aggregate

Whenever the long-run AS curve shifts, it takes the short-run AS curve with it.

Factors that shift only the short-run AS curve:

► Changes in resource prices
► Changes in expectations of prices
► Supply shocks: surprise events that change a firm’s production costs

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Factors that Shift the SRAS

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Using the AD and AS Model
To determine how the economy moves from one long-run equilibrium
to another:

1. Begin with the model in long-run equilibrium.

2. Determine which curve(s) are affected by the change(s) and

the direction(s) of the change(s).

3. Shift the curve(s) in the appropriate direction(s).

4. Determine the new short-run and/or long-run equilibrium

points.

5. Compare the new equilibrium(s) with the starting point.

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Long-run Equilibrium in the Economy (1)

Long-run equilibrium: Reached when the quantity of aggregate demand is

equal to the quantity of aggregate supply in the short run and long run.

• LRAS=SRAS=AD.

• Delimited as “A.”

At this point:

• The economy is at full employment.

• The unemployment rate is equal to the natural rate.

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Long-run Equilibrium in the Economy (2)

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Practice What You Know
Q1. The short-run aggregate supply curve is built on the assumption of:
A. Fixed price level.
B. Fixed output.
C. Fixed prices of factors of production.
D. Fixed profit.

Q2. The slope of the short-run aggregate supply curve tends to:
A. Decrease as output increases.
B. Remain unchanged as output increases.
C. Increase as output increases.
D. Can increase, decrease, or remain unchanged as output increases.

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Example: Adjustment in Long-run AS (1)
Suppose that there is a technology shock.
Which curves shift?
• Both LRAS and SRAS.

In what direction?
• To the right.

What happens to output, employment, price level?

• Output increases.
• Employment stays the same.
• Price level goes down. 43 / 58
Example: Adjustment in Long-run AS (2)

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Example: Adjustment in Short-run AS (1)
Suppose that there is an important oil pipeline leak.
Which curves shift?
• Just SRAS.
In what direction?
• To the left.
What happens to output, employment, and price level in the short run?
• Output falls.
• Unemployment increases.
• Price level goes up. 45 / 58
Example: Adjustment in Short-run AS (2)

How do we get back to long-run equilibrium?

• Because SRAS shock is temporary, SRAS will shift back to the

right.

What happens to output, employment, and price level in the long run?

• Output stays the same.

• Unemployment stays the same.

• Price level stays the same.

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Example: Adjustment in Short-run AS (3)

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Example: Adjustment in Aggregate Demand (1)
Suppose that consumer confidence rises.
Which curves shift?
• AD.
What direction?
• To the right.
What happens to output, employment, and price level in the short run?
• Output increases.
• Unemployment goes down.
• Price level rises. 48 / 58
Example: Adjustment in Aggregate Demand (2)

How do we get back to long-run equilibrium?

• SRAS shifts left.

What happens to output, employment, and price level in the long run?

• Output stays the same.

• Employment stays the same.

• Price level goes up.

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Unexpected Increase in Aggregate Demand

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Practice What You Know
Q1. If the economy is at long-run equilibrium, and people become more optimistic
about the future, then:
A. The aggregate demand curve will shift to the right.
B. The aggregate demand curve will shift to the left.
C. The aggregate supply curve will shift to the right.
D. The aggregate supply curve will shift to the left.

Q2. Suppose the economy is at long-run equilibrium. If there is an increase in government

spending at the same time as a rise in oil prices, in the short run:
A. Real GDP will increase, the general price level may increase, decrease, or remain unchanged.
B. Real GDP will decrease, the general price level may increase, decrease, or remain unchanged.
C. The general price level will increase, real GDP may increase, decrease, or remain unchanged.
D. The general price level will decrease, real GDP may increase, decrease, or remain unchanged.

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Case study: The COVID-19 pandemic

Negative Aggregate Supply Shock: The COVID-19 pandemic caused production to be

disrupted.

Negative Aggregate Demand Shock: The COVID-19 pandemic caused a serious decrease
in demand.

Some other examples: (1) Food price crisis, (2) Russia-Ukraine conflict, (3) China's zero-
COVID policy... => Change in aggregate supply/aggregate demand?

Analyze economic fluctuations through the aggregate supply – aggregate demand

model (AS-AD model). Draw a diagram illustrating the shift in AS-AD:
1. Aggregate supply shock.
2. Aggregate demand shock.
3. Aggregate supply and aggregate demand shock.
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RECAP: Equilibrium
The diagram illustrates the intersection of
the aggregate demand (AD), long-run
aggregate supply (LRAS), and short-run
aggregate supply (SRAS) curves at point E.

This is the long-run equilibrium point of

the economy.

At point E:
• Output reaches potential output Yp.
• The equilibrium price level reaches the
expected price level Pe: inflation is
stable at a controlled level.
• The unemployment rate is at the natural
rate Un.
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Negative Aggregate Supply Shock

SRAS shifts to the left.

Short-run equilibrium shifts: Lower

output (Y) and Higher price level (P).

(1) When the economy reopens, the

equilibrium will return to its original
state because the COVID closure is
temporary.
(2) LRAS shifts to the left due to Yp
decreasing and Un increasing.
(3) The government stimulates demand
to fight recession but causes inflation.

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Negative Aggregate Demand Shock

AD shifts to the left.

Short-run equilibrium shifts: Lower output

(Y) and Lower price level (P).

(1) No government intervention: SRAS

shifts to the right => price decreases
and Y increases.
(2) The government stimulates demand to
fight the recession.

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Aggregate Supply and Demand Shocks
Quarter 1/2020: the government-mandated
closures of businesses and restrictions on
activities, leading to a significant drop in
demand (AD shifts to the left).

Factories and business activities had to

temporarily cease => SRAS shifts to the left.

Equilibrium shifts from E2019 -> E2020.

=> The economy experiences a recession, with

output falling below its potential (Yp) and
higher unemployment (u).

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Ideal Scenario

(1) Stimulate the economy through policies

such as: reducing VAT, reducing interest
rates, supporting businesses to return to
production.
=> Fiscal and monetary policy.

(2) Control inflation: stabilize real wages and

energy prices.

External factors beyond control: the Russia-

Ukraine war, China's zero-COVID policy
continues, global financial crisis, liquidity
crisis...

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Conclusions

► Recessions are unpredictable and can be caused by a variety of factors.

► The AD–AS model helps us understand the macroeconomic impacts of real-

world changes.

► We can use the AD–AS model to evaluate past recessions or analyze policy
remedies to these events.

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