aggregate demand and aggregate supply for 2nd semester for BBA

Aggregate Demand
and Aggregate Supply
Chapter 4

Aggregate Demand
 Aggregate demand for national output is
underpinned by the purchases of four groups
of ultimate buyers: (a) Consumers, (b)
Investors, (c) Government, and (d)
Foreigners.
 Their spending plans are interdependent, and
are combined in an aggregate demand curve.
The amount of national output each group
buys depends, in part, on the price level.

Aggregate Demand
 An aggregate demand curve depicts a
negative relationship between the price level
and purchases of national output
 If the price level rises, purchases of our
national output fall, and vice versa.
 The AD curve is negatively sloped because
of (a) the wealth effect, (b) the foreign-sector
substitution effect, and (c) interest rate effect

Aggregate Demand
Responses to a higher price level:
 The wealth effect reduces the purchasing power of
financial assets.
 The foreign-sector substitution effect reduces (a)
sales of domestic consumer goods as households
shifts to imports, (b) domestic investment because
more new plants will be relocated abroad
 The interest rate effect-higher interest rates
discourage major purchases that require loans-
expensive consumer durables, business
investments, and spending by government usually
through bond issue.

Aggregate Demand
Responses to a lower price level:
 The wealth effect boosts the purchasing power of
financial assets.
 The foreign-sector substitution effect increases (a)
sales of domestic consumer goods as households
shifts from imports, (b) domestic investment
because more new plants will be relocated to home
country.
 The interest rate effect-lower interest rates
encourage major purchases that require loans-
expensive consumer durables, business
investments, and spending by government.

Shifts in Aggregate Demand
Decreases in Aggregate Demand
1. Consumption (C) declines:
 Reduced disposable income or wealth
 Smaller or older households
 More durables owned
 More Indebtedness
 Less money available or slower spending
 Pessimism about income
 Expectations of price deflation

2. Investment (I) declines:
 Higher interest rates
 Investment pessimism
3. Government
 Spending declines
 Tax increases
 Money supply decreases
4. Net foreign sector (X-M) declines:
 Exports decline and Imports grow

Q
Real Output
Aggregatepricelevel
P
AD0
AD1

Increases in Aggregate Demand
1. Consumption (C) increases:
 Increased disposable income or wealth
 Larger or younger households
 Pent-up demands for durables
 Less Indebtedness
 Bigger money supply or faster spending
 Optimism about income (security about jobs and
income)
 Expectations of inflation/shortages

2. Investment (I) increases:
 Lower interest rates
 Investor optimism
3. Government
 Spending increases
 Tax decreases
 Money supply increases
4. Net foreign sector (X-M) grows:
 Exports increase and Imports decline

Q
Real Output
Aggregatepricelevel
P
AD1
AD0

Aggregate supply
 The aggregate supply curve reflects a positive
relationship between the price level and the
real quantity of national output.
 This means aggregate supply is an increasing
function of domestic price level.
 AS is positively sloped because of the (a)
capacity and price-cost dynamics, (b) national
output and the work force

Aggregate supply
 Capacity and price-cost dynamics: The positive slope
of the AS curve reflects that prices adjust more rapidly
than production costs, costs are relatively more sticky.
When the price level rises, delayed hikes in costs yield
profit incentives to expand production.
 Idle resources become less available when higher
employment presses against a society’s productive
capacity. In a growing economy, prices rise faster than
the resource costs, profits rise and firms respond by
producing and selling more goods.

Aggregate supply
Capacity and price-cost dynamics:
 But prices tend to fall faster than costs when business
activity slows down, and profits per unit of output may
even become negative. Firms facing declining profit
margins may heavily cut down production and lay off
staff to reduce costs.
 Production costs per unit are much slower to adjust to
changes in AD than are the prices of output. This is the
major reason why a society’s AS is positively sloped in
the short run.

Aggregate supply
National output and the workforce:
 Labor markets are also based on supply and demand,
much like the goods market. Higher wages also attract
more people to the job market and supply rises. In
general, supply curves for labor have a positive slope.
 The upshot is that when AD increases, prices go up,
firms expand output and hire more labors. And
because of this also, AS is positively sloped.
 But also remember, why firms are hiring more labors. It
is because given the current nominal wage and
increased price of the output, real wage for labors has
gone down. That’s why firms would like to hire more
labors. However, this may not remain in the long run
since firms can not make labors fool for a long time.

Shifts in aggregate supply
 In addition to price rise, the major determinants
of AS are: (a) resource costs, (b) production
technology (c) expectations (d) taxes or
subsidies or regulations on producers (e) the
price of other producible goods (f) the number
of producers in the market.

Decreases in aggregate
supply
1. Resource costs rise:
 Workers prefer more leisure
 Less education and training
 Shrinking workforce
 Inflationary expectations shrink labor supplies.
Unions become more powerful.
 Decreased savings and investment
 Investor pessimism
 Shrinking supplies of raw materials
 Competition reduced

supply
2. Technology declines
3. Government policies worsen
 Inefficient new regulations
 Higher taxes
 Welfare programs discouraging productivity
4. The foreign sector
 Increases in exports
 New barriers to imports

supply
Decrease in AS :
Q
Real output
Aggregatepricelevel
P AS0
AS1

Increases in aggregate supply
1. Resource costs fall:
 Workers desire more income
 More education and training
 Increased labor supplies
 Decreasing inflationary expectations. Union power
declines.
 Increased savings and investment
 Investor Optimism
 Discoveries of new raw materials
 Competition increases

2. Technology advances
3. Government policies improve
 More efficient new regulations
 Reduced taxes on productivity
 Efficient welfare reform programs
4. The foreign sector
 Increases in imports
 Lower trade barriers

Increase in AS :
Q
Real output
Aggregatepricelevel
P AS1
AS0

Macroeconomic equilibrium
 Macroeconomic equilibrium occurs where
Aggregate Demand meets Aggregate Supply.
 Only at the combination of GDP and price
level given by the intersection the AD and AS
curves are spending (demand) behavior and
production (supply) activity consistent.
 A shift in either the AD or the AS curve leads
to changes in the equilibrium values of the
price level and real GDP.

AD
AS
Y0
P0
Real output
Price
e

 If the price level deviates from this equilibrium (P0),
pressures on business and consumers will move the
economy back toward point e.
 Two conditions should be satisfied to attain
macroeconomic equilibrium: (1) at the prevailing
price level, desired expenditure must be equal to
national output. The idea is agents are willing to buy
all that is produced. The AD curve is constructed in
such a way that this condition holds everywhere on
it. (2) at the prevailing price level, firms must wish to
produce the prevailing level of national output, no
more and no less. This is introduced by the
consideration of AS.

The Keynesian SRAS curve
Short run aggregate supply curve
SRAS
AD
Real output
Price

The Keynesian SRAS
 The Keynesian short run aggregate supply curve is
horizontal over some range of GDP. The idea is
when real GDP is below potential GDP, individual
firms are operating at less than normal capacity
output, and they hold their prices constant at the
level that would maximize profits if production were
at normal capacity. They then respond to demand
variations below that capacity by altering output.
 In other words, firms will supply whatever they can
sell at their existing prices as long as they are
producing below their normal capacity. This means
that the firms have horizontal supply curves and that
their output is demand determined.

Determining GDP in the long
run

In the long run, output is determined by
the fixed factor supplies and the fixed
state of technology.
 The Cobb-Douglas production function
is usually used to show the long run GDP.

The Cobb-Douglas Production
Function
 The Cobb-Douglas production function has
constant factor shares:
α = capital’s share of total income:
capital income = MPK x K = α Y
labor income = MPL x L = (1 – α )Y
 The Cobb-Douglas production function is:
where A represents the level of technology.
1
Y AK L−
= α α

The classical AS curve
 The idea of the long run AS curve is that in the
long run, the real productive capacity of an
economy does not vary (i.e., is perfectly inelastic)
with respect to changes of the price level, a
nominal quantity, but it may vary with changes of
real phenomena, i.e., real matters such as
resource availability, productivity, and
technological changes.
 The long run changes of these real phenomena
may be depicted in the short-run analysis as shifts
or drifts of LRAS to the right with on-going growth,
or as leftward shifts consequent upon supply-
shocks that may have lasting adverse effects on
the economy's output capacity.

The long run AS curve
AS
Real output
Price
AD
SRAS
e

 When nominal wages are flexible, as usually
assumed in the long run, the AS curve is
perfectly vertical.
 Another reason is that the total amount of
goods that the economy produces when all
factors are efficiently used at their normal
rate of utilization does not vary with the price
level. In the long run, price does not affect the
AS, rather AS depends in the availability of
the factors of production.

Conclusion
 The AD is determined by C+I+G+X.
 AS in the short run is determined by the labor supply.
When MPL>W/P, firms hire more labors and vice
versa.
 The long run AS is determined by the availability of
resources: capital, labor and technology. This is the
full employment level in the economy.
 Macroeconomic equilibrium occurs where AS and
AD intersect. The SRAS curve denotes the real
output below the potential level in the economy.

aggregate demand and aggregate supply for 2nd semester for BBA

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