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

Shifts in Aggregate Demand

Decreases in Aggregate Demand

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

Shifts in Aggregate Demand

Decreases in Aggregate Demand

QReal Output

Agg

rega

te p

rice

leve

l

P

AD0AD1

Shifts in Aggregate Demand

Increases in Aggregate Demand1. 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

Shifts in Aggregate Demand

Increases in Aggregate Demand

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

Shifts in Aggregate Demand

Increases in Aggregate Demand

QReal Output

Agg

rega

te p

rice

leve

l

P

AD1AD0

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

Decreases in aggregate 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

Decreases in aggregate supplyDecrease in AS :

QReal output

Agg

rega

te p

rice

leve

l

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

Increases in aggregate supply

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

Increases in aggregate supplyIncrease in AS :

QReal output

Agg

rega

te p

rice

leve

l

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.

Macroeconomic equilibrium

AD

AS

Y0

P0

Real output

Pric

e

e

Macroeconomic equilibrium 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 curveShort run aggregate supply curve

SRAS

AD

Real output

Pric

e

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:

= capital’s share of total income:capital income = MPK x K = Y

labor income = MPL x L = (1 – )Y The Cobb-Douglas production function is:

where A represents the level of technology.

1Y AK L

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 classical AS curveThe long run AS curve

AS

Real output

Pric

e

AD

SRAS

e

The classical AS curve 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.