AGGREGATE DEMAND &AGGREGATE SUPPLY XII CLASS CBSE

1. Aggregate Demand and
Aggregate Supply

2. 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 incomes, and
rising unemployment. Since 1965, the U.S. economy has
suffered six recessions.
• A depression is a severe recession. The Great Depression
occurred in 1929-1941 when output fell by about 30
percent and unemployment rose to 25 percent.

3. THREE KEY FACTS ABOUT ECONOMIC
FLUCTUATIONS
• Economic fluctuations are irregular and
unpredictable.
– Fluctuations in the economy are often called the
business cycle. Stylized model of the business
cycle.
• Most macroeconomic variables fluctuate
together.
• As output falls, unemployment rises.

4. Figure 1 A Look At Short-Run Economic
Fluctuations
Billions of
1996 Dollars
Real GDP
(a) Real GDP
$10,000
9,000
8,000
7,000
6,000
5,000
4,000
3,000
2,000
1965 1970 1975 1980 1985 1990 1995 2000
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5. THREE KEY FACTS ABOUT
ECONOMIC FLUCTUATIONS
• 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.

6. Figure 1 A Look At Short-Run Economic
Fluctuations
Billions of
1996 Dollars
(b) Investment Spending
$1,800
1,600
1,400
1,200
1,000
800
600
400
200
1965 1970 1975 1980 1985 1990 1995 2000
Investment spending
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7. THREE KEY FACTS ABOUT
ECONOMIC FLUCTUATIONS
• 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.

8. Figure 1 A Look At Short-Run Economic
Fluctuations
Percent of
Labor Force
(c) Unemployment Rate
0
2
4
6
8
10
12
1965 1970 1975 1980 1985 1990 1995 2000
Unemployment rate
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9. EXPLAINING SHORT-RUN ECONOMIC
FLUCTUATIONS
• Short-run versus the long-run: Price Flexibility
– LR: 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 = Monetary is neutral.
• The aggregate supply curve is vertical and prices adjust fully.
– SR: Most economists believe that prices do not adjust fully in the
short-run and therefore output will change.
• Changes in the money supply can affect real variables in the short-run
= Money is not neutral.
• Aggregate supply is upward sloping.
• Therefore, aggregate demand as well as aggregate supply
are important in determining output and prices in the short-
run.

10. 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.

11. • The Basic Model of Aggregate Demand and
Aggregate Supply
– The aggregate-demand curve shows the quantity of
goods and services that households, firms, and the
government want to buy at each price level.
• The Basic Model of Aggregate Demand and
Aggregate Supply
– The aggregate-supply curve shows the quantity of
goods and services that firms choose to produce and
sell at each price level.

12. Figure 2 Aggregate Demand and Aggregate
Supply...
Quantity of
Output
Price
Level
0
Aggregate
supply
Aggregate
demand
Equilibrium
output
Equilibrium
price level
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13. THE AGGREGATE-DEMAND
CURVE
• The four components of GDP (Y) contribute
to the aggregate demand for goods and
services.
Y = C + I + G + NX

14. Figure 3 The Aggregate-Demand Curve...
Quantity of
Output
Price
Level
0
Aggregate
demand
P
Y Y2
P2
1. A decrease
in the price
level . . .
2. . . . increases the quantity of
goods and services demanded.
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15. Why the Aggregate-Demand Curve Is
Downward Sloping
• The AD is not downward sloping for the reasons a demand
curve in microeconomics is downward sloping
(substitution and income effects)
• Remember our analysis of the Wealth Portfolio – If P falls
the value of money increases, people are then holding
excess cash balances so they either spend it or lend it:
– Spend it : The Price Level and Consumption: The Wealth Effect
– Lend it: The Price Level and Investment: The Interest Rate Effect
– The result of lend it: The Price Level and Net Exports: The
Exchange-Rate Effect

16. • The Price Level and Consumption: The Wealth
Effect
– A decrease in the price level increases the value of
money in one’s portfolio and 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.
– P↓ → VofM↑ → wealth↑ → spend it → C↑ →AD↑

17. • The Price Level and Investment: The Interest Rate
Effect
– A lower price level increases the value of cash holdings
and wealth, people lend more, this 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.
– P↓ → VofM↑ → wealth↑ → lend it → SLF↑ → r↓ → I↑
→ AD↑

18. • The Price Level and Net Exports: The Exchange-
Rate Effect
– A lower price level increases the value of cash holdings
and wealth, people lend more, this reduces the interest
rate, NCO increases the supply of dollars increases, 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.
– P↓ → VofM↑ → wealth↑ → lend it → SLF↑ → r↓ → S$ ↑
→ eP/P*
↓ → NX↑ → AD↑

19. Shifts in the Aggregate-Demand Curve
• 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.
• Shifts arise from autonomous (not related to P or Q in US)
– Consumption – consumer confidence
– Investment – business confidence
– Government Purchases – Military, Medicare
– Net Exports – ROW incomes↑

20. Shifts in the Aggregate Demand
Curve
Quantity of
Output
Price
Level
0
Aggregate
demand, D1
P1
Y1
D2
Y2

21. THE AGGREGATE-SUPPLY CURVE
• In the long-run, aggregate-supply curve is vertical.
This is the Classical view.
• In the short run, the aggregate-supply curve is
upward sloping. This a modification of the
Keynesian view.
• 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. Q= A F(K/L, H/L, NR/L)
– The price level does not affect these variables in the
long run.

22. Figure 4 The Long-Run Aggregate-Supply
Curve
Quantity of
Output
Natural rate
of output
Price
Level
0
Long-run
aggregate
supply
P2
1. A change
in the price
level . . .
2. . . . does not affect
the quantity of goods
and services supplied
in the long run.
P
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23. 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.

24. 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

25. Figure 5 Long-Run Growth and Inflation
Quantity of
Output
Y1980
AD1980
AD1990
Aggregate
Demand, AD2000
Price
Level
0
Long-run
aggregate
supply,
LRAS1980
Y1990
LRAS1990
Y2000
LRAS2000
P1980
1. In the long run,
technological
progress shifts
long-run aggregate
supply . . .
4. . . . and
ongoing inflation.
3. . . . leading to growth
in output . . .
P1990
P2000
2. . . . and growth in the
money supply shifts
aggregate demand . . .
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26. 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.

27. 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.

28. Figure 6 The Short-Run Aggregate-Supply
Curve
Quantity of
Output
Price
Level
0
Short-run
aggregate
supply
1. A decrease
in the price
level . . .
2. . . . reduces the quantity
of goods and services
supplied in the short run.
Y
P
Y2
P2
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29. Why the Aggregate-Supply Curve
Slopes Upward in the Short Run
To understand an upward sloping short-run supply
curve we need to understand expectations.
Specifically, expectations about prices.
– Remember nominal interest rates equals the real rate of
interest plus the rate of inflation: i=r+%ΔP
– Borrowers and lenders must form expectations about
what prices will be in the future before they agree to
lend and borrow.
– In the macroeconomy, individuals form expectations
about the price level (inflation later on).
• Workers form Pewhen negotiating form nominal wages (W).
• Business form Pe ,especially about inputs, when setting prices.

30. • The expected price level Pe is the link between
aggregate supply in the short-run and in the long-
run.
• In the long-run P=Pe, people can’t be “fooled”,
but in the short-run P can be less than, equal to, or
more than Pe.
• Three theories of upward-sloping short-run
aggregate supply:
– The Misperceptions Theory
– The Sticky-Wage Theory
– The Sticky-Price Theory

31. • The Misperceptions Theory
– Changes in the overall price level temporarily
mislead suppliers about what is happening in
the markets in which they sell their output:
– A lower price level causes misperceptions
about relative prices.
• These misperceptions induce suppliers to decrease
the quantity of goods and services supplied.

32. The Sticky-Wage Theory
• The Sticky-Wage Theory
– Nominal wages are slow to adjust, or are
“sticky” in the short run:
• Wages do not adjust immediately to a fall in the
price level.
• A lower price level makes employment and
production less profitable.
• This induces firms to reduce the quantity of goods
and services supplied.

33. The Sticky-Price Theory
– Prices of some goods and services adjust
sluggishly in response to changing economic
conditions:
• An unexpected fall in the price level leaves some
firms with higher-than-desired prices.
• This depresses sales, which induces firms to reduce
the quantity of goods and services they produce.

34. Why the Short-Run Aggregate-Supply Curve
Might Shift
• Shifts arising
– Labor
– Capital
– Natural Resources.
– Technology.
– Expected Price Level.
• 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.

35. Figure 7 The Long-Run Equilibrium
Natural rate
of output
Quantity of
Output
Price
Level
0
Short-run
aggregate
supply
Long-run
aggregate
supply
Aggregate
demand
AEquilibrium
price
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36. Figure 8 A Contraction in Aggregate Demand
Quantity of
Output
Price
Level
0
Short-run aggregate
supply, AS
Long-run
aggregate
supply
Aggregate
demand, AD
AP
Y
AD2
AS2
1. A decrease in
aggregate demand . . .
2. . . . causes output to fall in the short run . . .
3. . . . but over
time, the short-run
aggregate-supply
curve shifts . . .
4. . . . and output returns
to its natural rate.
CP3
BP2
Y2
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37. 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.
• 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.

38. Figure 10 An Adverse Shift in Aggregate Supply
Quantity of
Output
Price
Level
0
Aggregate demand
3. . . . and
the price
level to rise.
2. . . . causes output to fall . . .
1. An adverse shift in the short-
run aggregate-supply curve . . .
Short-run
aggregate
supply, AS
Long-run
aggregate
supply
Y
A
P
AS2
B
Y2
P2
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39. 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.
• 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.

40. Figure 11 Accommodating an Adverse Shift in
Aggregate Supply
Quantity of
Output
Natural rate
of output
Price
Level
0
Short-run
aggregate
supply, AS
Long-run
aggregate
supply
Aggregate demand, AD
P2
A
P
AS2
3. . . . which
causes the
price level
to rise
further . . .
4. . . . but keeps output
at its natural rate.
2. . . . policymakers can
accommodate the shift
by expanding aggregate
demand . . .
1. When short-run aggregate
supply falls . . .
AD2
CP3
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41. Short-run vs. Long-run Adjustment
• The economy may contract or expand in the short-run, but
it will return to the long-run level of output and the natural
rate of unemployment (full-employment or YFE).
• Aggregate supply is the curve that shifts to return the
economy to full employment.
• Given that we have emphasized sticky wages, over other
theories of the slope of the AS curve, lets use wage
flexibility in the long-run to explain how the AS shifts and
returns the economy to YFE
• The basic idea is that wages will adjust upwards when
Yactual> YFE or the unemployment rate is below the natural
rate and downwards if Yactual<YFE.

42. • If Yactual> YFE, Uactual<UNR, this will cause nominal
wages (W) to rise in the long-run and the AS will
decrease or shift up and to the left.
• If Yactual< YFE, Uactual>UNR, this will cause nominal
wages (W) to fall in the long-run and the AS will
increase or shift down and to the right.
• In both cases, nominal wages will continue to
adjust until we return to the UNR and YFE is restored.

43. Adjustment to Shifts in AD and AS
• Positive AD shock, AD↑, P↑, Y↑, Yactual> YFE, Uactual<UNR, W↑,
AS↓, until Yactual=YFE, Uactual=UNR(Figure 7 above)
• Negative AD shock, AD↓, P↓, Y↓, Yactual<YFE, Uactual>UNR, W↓,
AS↑, until Yactual=YFE, Uactual=UNR(Figure 7 above)
• Positive AS shock, AS↑, P↓, Y↑, Yactual> YFE, Uactual<UNR, W↑,
AS↓, until Yactual=YFE, Uactual=UNR(Figure 8 above)
• Negative AS shock, AS↓, P↑, Y↓, Yactual<YFE, Uactual>UNR, W↓,
AS↑, until Yactual=YFE, Uactual=UNR(Figure 8 above)

44. 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.

45. 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.

46. 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.

47. 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.

48. 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.

49. Summary
• A second possible cause of economic
fluctuations is a shift in aggregate supply.
• Stagflation is a period of falling output and
rising prices.