Download Lecture 12 - Har Wai Mun

UBEA 1013: ECONOMICS
CHAPTER 12:
AGGREGATE DEMAND-SUPPLY MODEL
12.1 Aggregate Demand Curve
12.2 Aggregate Supply Curve
12.3 Equilibrium & Changes
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UBEA 1013: ECONOMICS
12.1 Aggregate Demand Curve
Aggregate Demand (AD) is the total demand for all
goods & services in the economy.
AD curve plots aggregate demand against price (P).
But aggregate demand is not only influence by price
but other factors as follow:
a. Federal Budget (Fiscal policy)
i) Government spending
ii) Taxes
Shift in
AD curve
b. Money supply (Monetary policy)
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UBEA 1013: ECONOMICS
Movement Along the AD curve: P & Y Relationship
• The aggregate demand
(AD) curve is a curve
that shows the negative
relationship between
aggregate output
(income) and the price
level.
• To derive the aggregate demand curve, we examine
what happens to aggregate output (income) (Y) when
the price level (P) changes, assuming no changes in
government spending (G), net taxes (T), or the
monetary policy variable (Ms).
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UBEA 1013: ECONOMICS
The Impact of an Increase in the Price Level on the
Economy – Assuming No Changes in G, T, and Ms
 P  M   r   I   AE   Y 
d
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UBEA 1013: ECONOMICS
Reason for a downward slopping AD curve:
Generally:
• A higher price level causes the demand for money
to rise, which causes the interest rate to rise.
• Then, the higher interest rate causes aggregate
output to fall.
The consumption link:
• P ↑ »» r ↑ »» C ↓ »» Y ↓
• Note: Interest rate reflects the cost of borrowing &
negative relationship with consumption (Refer 10.1B)
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UBEA 1013: ECONOMICS
Reason for a downward slopping AD curve:
The real wealth effect:
• P ↑ »» real wealth (W) ↓ »» C ↓ »» Y ↓
• Note: Positive relationship between wealth &
consumption (Refer 10.1B)
Therefore:
• Change in P »» movement along the AD curve
• BUT change in G, T or MS »» shifting the AD curve
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UBEA 1013: ECONOMICS
Shift of Aggregate Demand Curve:
• An increase in the quantity
of money supplied (MS) at
a given price level shifts
the aggregate demand
curve to the right.
• An increase in government
purchases/demand (G) or
a decrease in net taxes
shifts the aggregate
demand curve to the right.
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UBEA 1013: ECONOMICS
Factors That Shift the Aggregate Demand Curve
Expansionary monetary policy
Contractionary monetary policy
Ms
Ms
AD curve shifts to the right
AD curve shifts to the left
Expansionary fiscal policy
Contractionary fiscal policy
G
T
G
T
AD curve shifts to the right
AD curve shifts to the right
AD curve shifts to the left
AD curve shifts to the left
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UBEA 1013: ECONOMICS
Aggregate Expenditure & Aggregate Demand:
• At every point along the aggregate demand
curve, the aggregate quantity of output
demanded is exactly equal to planned
aggregate expenditure.
Y=C+I+G
equilibrium condition
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UBEA 1013: ECONOMICS
12.2 Aggregate Supply Curve
Aggregate Supply (AS) is the total supply for all goods &
services in the economy.
Movement Along the AS curve: P & Y Relationship
AD curve shows the relationship between the aggregate
quantity of output supplied by all firms in an economy
and the overall price level.
• In the short run, the
aggregate supply curve
(the price/output response
curve) has a positive
slope.
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UBEA 1013: ECONOMICS
• At low levels of aggregate
output, the curve is fairly
flat. As the economy
approaches capacity, the
curve becomes nearly
vertical. At capacity, the
curve is vertical.
• As the economy approaches maximum capacity, firms
respond to further increases in demand only by raising
prices (e.g. from C to D)
• When the economy is operating at low levels of output,
an increase in aggregate demand is likely to result in an
increase in output with little or no increase in the overall
price level (e.g. from A to B)
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UBEA 1013: ECONOMICS
Shift of Aggregate Supply Curve:
But aggregate supply is not only influence by price but other
factors that shift the AS curve as follow:
Factors That Shift the Aggregate Supply Curve
Shifts to the Right
Shifts to the Left
Increases in Aggregate Supply
Decreases in Aggregate Supply
Lower costs
lower input prices
lower wage rates
Higher costs
higher input prices
higher wage rates
Economic growth
more capital
more labor
technological change
Stagnation
capital deterioration
Public policy
supply-side policies
tax cuts
deregulation
Public policy
waste and inefficiency
over-regulation
Good weather
Bad weather, natural
disasters, destruction
from wars
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UBEA 1013: ECONOMICS
Shift of Aggregate Supply Curve:
• A cost shock, or supply shock, is a change in
costs that shifts the aggregate supply (AS) curve.
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UBEA 1013: ECONOMICS
12.3 Equilibrium & Changes
Equilibrium: AD = AS
• The equilibrium price
level is the point at
which the aggregate
demand and aggregate
supply curves intersect.
• P0 and Y0 correspond to equilibrium in the goods
market and the money market and a set of
price/output decisions on the part of all the firms in
the economy.
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UBEA 1013: ECONOMICS
Changes in Equilibrium:
Policy Effectiveness & Inflation
• Shift in AD or AS due to fiscal or monetary policy
causes changes in equilibrium.
• However, the effectiveness of respective policies
depends on the slope of the AD curve or
(especially) AS curve
• Price level increase implied inflation
• Inflation that is caused by an increase in aggregate
demand is called “demand – pulled inflation”. (AD
curve shift)
• Inflation that is caused by an increase in costs is
called “costs – pushed inflation”. (AS curve shift)
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UBEA 1013: ECONOMICS
Recap:
• Inflation is an increase in the overall price level.
• Sustained inflation occurs when the overall price
level continues to rise over some fairly long period of
time.
• Stagflation occurs when output is falling at the same
time that prices are rising.
• One possible cause of stagflation is an increase in
costs.
• Hyperinflation is a period of very rapid increases in
the price level.
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UBEA 1013: ECONOMICS
Changes in Equilibrium:
Policy Effectiveness & Demand – Pull Inflation
• AD can shift to the right for
a number of reasons,
including an increase in the
money supply, a tax cut, or
an increase in government
spending.
• Expansionary policy works
well when the economy is
on the flat portion of the AS
• In this case, policy effective:
curve, causing little change
Output increase with low
in P relative to the output
inflation.
increase.
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UBEA 1013: ECONOMICS
• On the steep portion of the
AS curve, expansionary
policy does not work well.
The multiplier is close to
zero.
• When the economy is
operating near full capacity,
an increase in AD will result
in an increase in the price
level with little increase in
• In this case, policy
output.
ineffective: Output increase
with high demand – pulled
inflation.
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UBEA 1013: ECONOMICS
• If the AS curve is vertical (in
the long run), neither
monetary policy nor fiscal
policy has any effect on
aggregate output.
• The multiplier effect of a
change in government
spending or taxes on
aggregate output is zero.
• Expansionary policy or
further increase in demand
will cause hyperinflation.
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UBEA 1013: ECONOMICS
Changes in Equilibrium: Costs – Push Inflation
• AS can shift to the left for a
number of reasons,
including higher costs, a tax
increase, natural disaster,
or destruction from war.
• Those factors could reduce
the output while pushing the
price up or causing inflation.
• The steeper the AD curve (less responsive of output
change to change in price level), the greater the effect
those factors to inflation.
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UBEA 1013: ECONOMICS
Changes in Equilibrium: Costs – Push Inflation
• If inflation is caused by an
increase in cost (especially
cost shock), it could be
referred as “costs – push
inflation” or “supply – side
inflation”.
• Recall that if output fall while
price level rising (inflation), it
is a stagflation situation.
• Cost shocks are bad news for policy makers. The only
way to counter the output loss is by having the price level
increase even more than it would without the policy action.
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UBEA 1013: ECONOMICS
Changes in Equilibrium: Case Study
Case 1:
• Currently, oil shock
happened (crude oil price
above US$60 per barrel)
• If government practices
expansionary policy, inflation
can be expected but can
prevent economic recession
(fall in output)
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UBEA 1013: ECONOMICS
Case 2:
• If economic growth (AS↑)
due to FDI (more capital) >>
Y↑&P↓
• If government practices
expansionary policy, output
can increase further
without limited inflation
problem.
• If wages increase, wealth
increase, C ↑, AD ↑ & output
can increase further.
• Therefore, FDI is a good
way to boost economy
growth.
END
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