Download Aggregate Demand and Aggregate Supply

Aggregate Demand and
Aggregate Supply
Modeling the Aggregate Economy
• Aggregate Demand
– Aggregate demand is a schedule relating the total
demand for all goods and services in an economy
to the general price level in that economy.
• Aggregate Supply
– Aggregate supply is a schedule relating the total
supply of all goods and services in an economy to
the general price level.
Aggregate Demand Determinants
Consumption
Investment
Government
Net Exports
Nonfinancial
Markets
Money
Financial
Assets
Financial
Markets
Aggregate
Demand
Aggregate Demand
P
Aggregate demand is a schedule
relating the total demand for all
goods and services in an economy
to the general price level in that economy.
AD
0
Y
Aggregate Demand
• The aggregate demand curve slopes down
because as the general price level rises, the
amount of goods and services that can be
purchased with the given stock of money and
other financial assets declines.
• In addition, the aggregate demand curve slopes
down because as the price level rises, a
nation’s goods and services become less
competitive in the international markets.
Shifting Aggregate Demand
Anything that causes aggregate spending to
change (holding the price level constant)
shifts the aggregate demand curve.
P
Increases in AD shift the curve to the right.
Decreases in AD shift the curve to the left.
0
AD
AD2 3
AD1
Y
Aggregate Supply
• Aggregate supply is a schedule relating
the total supply of all goods and
services in an economy to the general
price level.
Aggregate Supply: Determinants
Labor Costs
Capital Costs
Materials Cost
Productivity
Capacity
Expectations
Profit Margins
Aggregate
Supply
Production
Costs
Aggregate Supply
P
AS
P
P
AS
AS
0
Y
0
Y
0
Y
Aggregate Supply
• The aggregate supply curve may be flat,
upward sloping or vertical.
• Horizontal aggregate supply implies that
increasing aggregate output puts no pressure
on prices.
• Aggregate supply curves are horizontal when
resources are in ample supply.
Aggregate Supply
• Vertical aggregate supply implies that in
attempts to increase aggregate output result in
an increase in the price level only.
• Aggregate supply curves are vertical in the
long run where full employment of all
resources exists.
• Aggregate supply in the long run does not
depend on the price level.
Aggregate Supply
• Upward sloping aggregate supply implies that
attempts to increase aggregate output result in
an increase in both output and the price level.
– When the demand for goods and services rises,
firms increase their demand for inputs.
• When all firms demand more inputs and the market
supply of inputs is upward sloping, firms’ costs rise.
Firms respond by raising prices.
Shifting Aggregate Supply
P
AS1
AS2
AS3
Anything that causes aggregate supply to
change (holding the price level constant)
shifts the aggregate supply curve.
Increases in AS shift the curve to the right.
Decreases in AS shift the curve to the left.
0
Y
Aggregate Demand and Supply:
Determinants
Consumption
Investment
Government
Net Exports
Nonfinancial
Markets
Money
Financial Assets
Financial
Markets
Aggregate
Demand
Price Level
Real Output
Labor Costs
Capital Costs
Materials Cost
Productivity
Capacity
Expectations
Profit Margins
Aggregate
Supply
Production Costs
Aggregate Demand and Supply: Long
Run
P
AS
The intersection of AD and AS determines
the price level.
In the long run, changes in AD do not change Y.
Increases in AD cause P to rise while decreases
in AD cause P to fall.
AD3
AD2
0
AD1
Y
Aggregate Demand and Supply:
Short Run
P
AS
The intersection of AD and AS determines
the price level.
In the short run, changes in AD change P and Y.
Increases in AD cause Y and P to rise while
decreases in AD cause Y and P to fall.
AD3
AD2
0
Y1 Y2 Y3
AD1
Y
Aggregate Demand and Supply:
Short Run
AS1
P
AS2
AS3
The intersection of AD and AS determines
the price level.
In the short run, changes in AS change P and Y.
Increases in AS cause Y to rise and P to fall while
decreases in AS cause Y to fall and P to rise.
AD1
0
Y1 Y2 Y3
Y
Aggregate Demand and Supply:
Short Run
P
ASlr
ASsr
Long run equilibrium occurs at the
intersection of aggregate demand and the
long run aggregate supply curve where
P = P and Y = Y.
Since in the long run all prices have
adjusted, short run equilibrium occurs
at the same P-Y combination.
P
AD
0
Y
Y
Reduction in Aggregate Demand
ASlr
P
P
2
1
A decrease in aggregate demand from
AD1 to AD2 moves the economy from
point 1 to point 2.
At point 2, the economy is below Y*, the
natural rate of full employment.
ASsr
AS > AD, causing the price level to fall.
3
0
AD2
Y1
Y*
AD1 Decreases in P increase real money
balances, causing Y to rise from Y1 to Y*.
Y
Stabilization Policy
ASlr
P
To counter a decrease in aggregate
demand, the government could engage
in expansionary fiscal or monetary
policy.
P
2
1
ASsr
This would shift AD from AD2 to AD1.
AD1
0
AD2
Y1
Y*
Y
The economy moves from point 2 to
point 1.
Increase in Aggregate Demand
P
ASlr
P2
3
P1
1
An increase in aggregate demand moves
the economy from point 1 to point 2.
At point 2, the economy is above Y*, the
natural rate of full employment.
2
ASsr
AD > AS causes the price level to rise.
Increases in P decrease real money
AD2
balances, causing Y to fall from Y1 to
AD1
0
Y*.
Y* Y1
Y
Stabilization Policy
P
ASlr
To counter an increase in aggregate
demand, the government could engage
in contractionary fiscal or monetary policy
This would shift AD from AD2 to AD1.
P1
1
2
ASsr
The economy moves from point 2 to
point 1.
AD2
AD1
0
Y*
Y1
Y
Adverse Aggregate Supply Shock
ASlr
P
P2
P1
2
Adverse supply shocks push up costs and
prices. If aggregate demand is fixed,
the economy moves from point 1 to
point 2 as Y falls and P rises.
AS2
1
AS1
At point 2, AD < AS and Y1 < Y*.
AD
0
Y1 Y*
Y
Eventually, prices fall and the economy
moves back to Y*.
Accommodating an Adverse
Aggregate Supply Shock
ASlr
P
P2
P1
2
3
1
To counter an adverse supply shock,
the government could act to
shift AD1 up to AD2.
AS2
AS1
AD2
AD1
0
Y1 Y*
Y
The economy moves to point 3. There
is no reduction in Y, but the cost of
this policy is a permanently higher
P.
Conclusions: Long Run
• The crucial difference between the long and
short run is that output is inflexible in the
long run but not the short run.
• The long run aggregate supply curve is
vertical. Therefore, shifts in aggregate
demand cannot change output in the long
run.
Conclusions: Short Run
• The short run aggregate supply curve is
upward sloping because of mark-up pricing.
• Therefore, shifts in aggregate demand can
change levels of output and price levels.
• Shocks to aggregate demand and short run
aggregate supply can cause fluctuations in
economic activity.
Conclusions: Short Run
• Since the government can shift aggregate
demand with fiscal and monetary policy,
stabilization policies can be used to offset the
impact of shifts in aggregate demand and
aggregate supply.
• But, accommodating an adverse supply shock
results in a permanently higher price level.