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Fundamentals Of Aggregate Demand And Aggregate Supply

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Fundamentals Of Aggregate Demand And Aggregate Supply

  1. 1. Fundamentals of Aggregate Demand and Aggregate Supply
  2. 2. Session Outline <ul><li>Aggregate demand curve and its properties </li></ul><ul><li>Determinants of aggregate demand </li></ul><ul><li>Aggregate supply curve and its properties </li></ul><ul><li>Determinants of aggregate supply </li></ul>06/07/09
  3. 3. <ul><ul><li>The aggregate demand and supply model is the basic macroeconomic model that studies output and price level determination. </li></ul></ul><ul><ul><li>The aggregate demand curve shows the combinations price and output levels at which the goods and the money markets are simultaneously in equilibrium. </li></ul></ul>06/07/09
  4. 4. Deriving aggregate demand curve <ul><li>This curve is derived from the IS-LM framework. </li></ul><ul><li>If the given price level is P 0 and the nominal stock of money is M, then the real stock of money is (M/P 0 ). </li></ul><ul><li>The IS curve is denoted by IS. </li></ul><ul><li>The economy is in equilibrium at point E, and the output and interest rates are denoted by Y 0 and i 0 respectively. The initial price level is represented by P 0 . </li></ul><ul><li>When P is at P 0 the goods and the money market are in equilibrium at an income level of Y 0 . </li></ul>06/07/09 P 0 LM 1 (M/P 1 ) E 1 i 1 i 0 Interest Rate Y 0 E Income and Output LM (M/P 0 ) IS Y 1 AD E E 1 P 1 Price Level Y 0 Output and Spending Y 1
  5. 5. <ul><li>In the next figure, point E shows the income and price </li></ul><ul><li>combination (Y 0 , P 0 ). If the price falls from P 0 to P 1 , the </li></ul><ul><li>real stock of money in the economy Increases to M/P 1 </li></ul><ul><li>(for the same level of nominal stock of money M). This </li></ul><ul><li>increase in the real stock of money will lead to a shift of </li></ul><ul><li>LM curve downwards to LM 1 (M/P 1 ). The new </li></ul><ul><li>equilibrium is at point E 1 . Thus when the price level is </li></ul><ul><li>P 1 , the goods market and the money market are in </li></ul><ul><li>equilibrium at an income level of Y 1 . When the price </li></ul><ul><li>level falls form P 0 to P 1 , the income level rises from Y 0 to </li></ul><ul><li>Y 1 and vice versa. Therefore the aggregate demand </li></ul><ul><li>curve will be downward sloping. </li></ul>06/07/09 P 0 LM 1 (M/P 1 ) E 1 i 1 i 0 Interest Rate Y 0 E Income and Output LM (M/P 0 ) IS Y 1 AD E E 1 P 1 Price Level Y 0 Output and Spending Y 1
  6. 6. Aggregate Demand Policies <ul><li>Both the fiscal and monetary policy changes influence and cause shift in the AD curve. </li></ul><ul><ul><li>Fiscal Policy </li></ul></ul><ul><ul><li>Monetary Policy </li></ul></ul>06/07/09
  7. 7. Effect of Fiscal policy on AD curve <ul><li>In the upper panel of figure 1, the initial LM and IS </li></ul><ul><li>curves correspond to a given nominal quantity of money </li></ul><ul><li>and the price level P 0 . The economy is at equilibrium at </li></ul><ul><li>point E. The AD curve shifts to the right in case of fiscal </li></ul><ul><li>expansion and to the left in case of fiscal contraction. At </li></ul><ul><li>the initial price level there is a new equilibrium at point E 1 </li></ul><ul><li>with higher interest rates and higher level of income and </li></ul><ul><li>spending. Thus at initial level of prices P 0 , equilibrium </li></ul><ul><li>income and spending are higher. This is shown point E 1 </li></ul><ul><li>in the lower panel. E 1 is the new equilibrium point on the </li></ul><ul><li>new AD curve. A similar exercise at other points on the </li></ul><ul><li>original demand curve would lead to a new aggregate </li></ul><ul><li>demand curve AD 1 . </li></ul>06/07/09 IS 1 E 1 i 1 i 0 Interest Rate Y 0 E Income and Output LM IS Y 1 AD E E 1 P 0 Price Level Y 0 Output and Spending AD’ Y 1
  8. 8. Effect of monetary policy on AD curve <ul><li>An increase in the nominal stock </li></ul><ul><li>of money results in higher real </li></ul><ul><li>money stock at each level of </li></ul><ul><li>prices and thus shifts the LM </li></ul><ul><li>curve to LM 1 . The equilibrium </li></ul><ul><li>level of income rises from Y 0 to Y 1 </li></ul><ul><li>at the initial price level P 0 and the </li></ul><ul><li>AD curve moves to the right in </li></ul><ul><li>case the equilibrium level of </li></ul><ul><li>income rises, which occurs due to </li></ul><ul><li>increase in the nominal stock of </li></ul><ul><li>money. </li></ul>06/07/09 LM 1 E 1 E 1 i 1 i 0 Interest Rate Y 0 E Income and Output LM IS Y 1 AD E E 1 P 0 P’ Price Level Y 0 K Output and Spending AD’ Y 1
  9. 9. Aggregate Supply in Short Run and Long Run <ul><li>Aggregate supply explains the production and pricing side of the economy and also explains the behavior of businesses as a whole, which is contrary to the Keynesian model where the price level is assumed to be constant and output is determined by the demand. </li></ul>06/07/09
  10. 10. Aggregate Supply in Short Run and Long Run <ul><li>In the short run, </li></ul><ul><ul><li>the interaction between the AD and AS determines the level of output, employment, capacity utilization and price levels. In the long run, AS is the major factor behind economic development. </li></ul></ul><ul><ul><li>the aggregate supply is upward sloping from right to left implying that the quantity supplied at a point of time is limited. </li></ul></ul><ul><ul><li>The discrepancies between actual and expected price level causes changes in output and employment. </li></ul></ul>06/07/09
  11. 11. Aggregate Supply in Short Run and Long Run <ul><li>Aggregate Supply in the Long Run </li></ul><ul><li>In the long run, other things being equal, </li></ul><ul><li>the gap between expected and actual price level narrows as the costs incurred by the firms rise as economic agents react to higher prices. </li></ul><ul><li>the natural rate of output is the equilibrium rate of output for the economy. </li></ul>06/07/09
  12. 12. Aggregate Supply in the Short Run and Long Run 06/07/09 AS L AS S P Price Level Q Output (Y)
  13. 13. Short Run and Long Run Equilibrium between Aggregate Demand and Aggregate Supply 06/07/09 AD AS L AS S P Price Level Q Output (Y)
  14. 14. Factors Affecting Aggregate Demand <ul><li>Change in Income </li></ul><ul><li>Rate of Interest </li></ul><ul><li>Government Policy </li></ul><ul><li>Change in Exchange Rate </li></ul><ul><li>Change in the Expected Rate of Inflation </li></ul><ul><li>Change in Business Expectations </li></ul>06/07/09
  15. 15. Factors Affecting Aggregate Supply <ul><li>Change in Costs of Production </li></ul><ul><li>Supply Shock or Supply Disturbances </li></ul><ul><li>Investment Spending and Technological Changes </li></ul><ul><li>Availability of Raw Materials </li></ul><ul><li>Supply of Labor </li></ul><ul><li>Human Capital </li></ul><ul><li>Incentives </li></ul>06/07/09
  16. 16. Aggregate supply, aggregate demand and level of employment <ul><li>The AD and AS curve determine the equilibrium price level and output of an economy. Based on this level of output, there is some employment, which is given by the production function for the corresponding level of output. According to JM Keynes this level of employment may fall from the desirable level of employment </li></ul>06/07/09

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