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141: Topic 3- Ch27
AGGREGATE SUPPLY AND
AGGREGATE DEMAND
Parkin: Macroeconomics. Adapted
by Dr. Mohamed A abdalla
1
Production and Prices
Aggregate Supply (AS) and Aggregate Demand (AD)
model is used to:
determine macroeconomic equilibrium
Explain:
 Economic growth?
 Inflation?
Why do we have business cycles?
How do policy actions by the government affect output
and prices?
Parkin: Macroeconomics. Adapted
by Dr. Mohamed A abdalla
2
Aggregate Supply
The aggregate (or total) quantity of goods and services
supplied depends on three factors:
 The quantity of labor (L )
 The quantity of capital (K )
 The state of technology (T )
The aggregate production function shows how
quantity of real GDP supplied, Y, depends on labor,
capital, and technology.
Parkin: Macroeconomics. Adapted
by Dr. Mohamed A abdalla
3
Aggregate Supply
At any given time, capital and the state of technology are
fixed but labor can vary.
The higher the real wage rate, the smaller is the quantity of
labor demanded and the greater is the quantity of labor
supplied.
The wage rate that makes the quantity of labor demanded
equal to the quantity supplied is the equilibrium wage rate
and at that wage the level of employment is fullemployment level and the unemployment rate is the
natural rate of unemployment, output produced is
potential GDP.
Parkin: Macroeconomics. Adapted
by Dr. Mohamed A abdalla
4
Aggregate Supply
 Prices that may change are two sets of prices:
Prices of goods and services (Price level).
Prices of productive resources, or inputs.
Depending on changes in these price sets and response
to them we distinguish between:
 Short-run aggregate supply (SAS): Price level
changes but time is too short for prices of inputs to change.
Long-run aggregate supply (LAS): all prices
change by same proportion, and time is long enough to
respond to all changes.
Parkin: Macroeconomics. Adapted
by Dr. Mohamed A abdalla
5
Aggregate Supply
Long-Run Aggregate Supply
The long-run aggregate supply curve (LAS) is
the relationship between the quantity of real GDP
supplied and the price level when real GDP
equals potential GDP.
The LAS curve is vertical because prices change
by same proportion, thus potential GDP is
independent of the price level.
Parkin: Macroeconomics. Adapted
by Dr. Mohamed A abdalla
6
Aggregate Supply
Along the LAS curve all
prices and money wage
rates vary by the same
percentage so that
relative prices and the real
wage rate remain
constant.
Relative price is the price
of one good or service to
the price of another.
Parkin: Macroeconomics. Adapted
by Dr. Mohamed A abdalla
7
Aggregate Supply
Short-Run Aggregate Supply
The short-run aggregate supply curve (SAS)
is the relationship between the quantity of real
GDP supplied and the price level in the short-run
when the money wage rate, the prices of other
resources, and potential GDP remain constant.
Parkin: Macroeconomics. Adapted
by Dr. Mohamed A abdalla
8
Aggregate Supply
Along the SAS curve, rise
in the price level with no
change in the money
wage rate and other input
prices increases the
quantity of real GDP
supplied—the SAS curve
is upward sloping.
Parkin: Macroeconomics. Adapted
by Dr. Mohamed A abdalla
9
Aggregate Supply
Along the SAS curve, real
GDP might be above,
equal to, or below potential
GDP.
Parkin: Macroeconomics. Adapted
by Dr. Mohamed A abdalla
10
Aggregate Supply
Movement along the LAS
and SAS Curves
A change in the price level
with an equal percentage
change in the money wage
causes a movement along
the LAS curve.
A change in the price level
with no change in the
money wage causes a
movement along the SAS
curve.
Parkin: Macroeconomics. Adapted
by Dr. Mohamed A abdalla
11
Aggregate Supply
Changes in Aggregate Supply
Aggregate supply changes when there are changes in
potential GDP or changes in prices of inputs.
When potential GDP increases, both the LAS and SAS
curves shift rightward.
Potential GDP changes, for three reasons
 Change in the full-employment quantity of labor.
 Change in the quantity of capital (physical or human).
 Advance in technology.
Parkin: Macroeconomics. Adapted
by Dr. Mohamed A abdalla
12
Aggregate Supply
The figure shows how
these factors shift the
LAS curve and have
the same effect on the
SAS curve.
@ same price level,
both PGDP and RGDP
increase.
Parkin: Macroeconomics. Adapted
by Dr. Mohamed A abdalla
13
Aggregate Supply
A rise in the money wage rate,
or price of any other productive
resource, decreases short-run
aggregate supply and shifts the
SAS curve leftward.
But it has no effect on long-run
aggregate supply, since no
change in relative prices.
Along the same SAS, money
wage rate is constant.
 Money wage rate is higher on
the SAS to the left than on the
SAS to the right, given a price
level.
Parkin: Macroeconomics. Adapted
by Dr. Mohamed A abdalla
14
Aggregate Demand
The quantity of real GDP demanded, Y, is the total amount
of final goods and services produced in the country that
people, businesses, governments, and foreigners plan to
buy.
This quantity is the sum of consumption expenditures, C,
investment, I, government purchases, G, and net exports,
X – M. That is:
Y = C + I + G + X – M.
Parkin: Macroeconomics. Adapted
by Dr. Mohamed A abdalla
15
Aggregate Demand
The Aggregate Demand Curve
Aggregate demand is the relationship between
the quantity of real GDP demanded and the price
level.
The aggregate demand (AD) curve plots the
quantity of real GDP demanded against the price
level. It slopes downward.
Parkin: Macroeconomics. Adapted
by Dr. Mohamed A abdalla
16
Aggregate Demand
The AD curve slopes
downward for two
reasons
 A wealth effect
 Substitution effects
Parkin: Macroeconomics. Adapted
by Dr. Mohamed A abdalla
17
Aggregate Demand
Changes in Aggregate Demand
When price level only changes, there is movement along
the AD curve.
A change in any influence on buying plans other than the
price level changes aggregate demand.
The main influences on aggregate demand are:
 Expectations
 Fiscal and monetary policy
 The world economy.
Parkin: Macroeconomics. Adapted
by Dr. Mohamed A abdalla
18
Aggregate Demand
Changes in Aggregate Demand
Expectations about future income, future inflation, and
future profits change aggregate demand.
Fiscal policy is the government’s attempt to influence
economic activity by changing its taxes, spending, deficit,
and debt policies.
Monetary policy is changes in the interest rate and
quantity of money.
The world economy influences aggregate demand in
two ways: change in the foreign exchange rate, and
change in foreign income.
Parkin: Macroeconomics. Adapted
by Dr. Mohamed A abdalla
19
Aggregate Demand
The figure illustrates
changes in aggregate
demand.
When aggregate demand
increases, the AD curve
shifts rightward…
… and when aggregate
demand decreases, the
AD curve shifts leftward.
Parkin: Macroeconomics. Adapted
by Dr. Mohamed A abdalla
20
Macroeconomic Equilibrium: short-run equilibrium
Quantity of real GDP
demanded equals the
quantity of real GDP
supplied at the intersection
of AD and the SAS curves.
If real GDP is below
equilibrium GDP, firms
increase production and
raise prices…
… and if real GDP is above
equilibrium GDP, firms
decrease production and
lower prices.
Parkin: Macroeconomics. Adapted
by Dr. Mohamed A abdalla
21
Macroeconomic Equilibrium: short-run equilibrium
These changes bring a
movement along the SAS
curve towards equilibrium.
In short-run equilibrium,
real GDP can be greater
than or less than potential
GDP, and the economy
could be above, below or
at full employment level.
Parkin: Macroeconomics. Adapted
by Dr. Mohamed A abdalla
22
Macroeconomic Equilibrium: Long-run equilibrium
long-run equilibrium.
Long-run equilibrium occurs
where the AD and LAS
curves intersect and results
when the money wage has
adjusted to put the SAS
curve through the long-run
equilibrium point.
It occurs when real GDP
equals potential GDP—
when the economy is on its
LAS curve, producing at
full-employment level.
Parkin: Macroeconomics. Adapted
by Dr. Mohamed A abdalla
23
Macroeconomic Equilibrium
Economic Growth and
Inflation
Economic growth occurs
because the quantity of
labor grows, capital is
accumulated, and
technology advances, all
of which increase potential
GDP and bring a rightward
shift of the LAS curve.
Parkin: Macroeconomics. Adapted
by Dr. Mohamed A abdalla
24
Macroeconomic Equilibrium
Economic Growth and
Inflation
Inflation occurs because
aggregate demand
increases by more than
long-run aggregate supply.
The AD curve shifts
rightward faster than the
rightward shift of the LAS
curve, so there is economic
growth with inflation.
Parkin: Macroeconomics. Adapted
by Dr. Mohamed A abdalla
25
Macroeconomic Equilibrium
• Economic Growth and Inflation
– If the AD curve shifts rightward by less than
the rightward shift of the LAS curve, there is
would be economic growth with negative
inflation.
– If the AD curve shifts rightward by same
distance as the rightward shift of the LAS
curve, there is economic growth with no
inflation.
Macroeconomic Equilibrium
The Business Cycle
The business cycle occurs because aggregate demand
and the short-run aggregate supply fluctuate but the
money wage does not change rapidly enough to keep
real GDP at potential GDP.
Parkin: Macroeconomics. Adapted
by Dr. Mohamed A abdalla
27
Macroeconomic Equilibrium
A below full-employment
equilibrium is an
equilibrium in which
potential GDP exceeds
real GDP.
Figures (a) and (d)
illustrate below fullemployment equilibrium.
The amount by which
potential GDP exceeds
real GDP is called a
recessionary gap.
Parkin: Macroeconomics. Adapted
by Dr. Mohamed A abdalla
28
Macroeconomic Equilibrium
A long-run equilibrium is
an equilibrium in which
potential GDP equals real
GDP.
Figures b) and (d) illustrate
long-run equilibrium.
Parkin: Macroeconomics. Adapted
by Dr. Mohamed A abdalla
29
Macroeconomic Equilibrium
An above fullemployment equilibrium
is an equilibrium in which
real GDP exceeds
potential GDP.
Figures (c) and (d)
illustrate above fullemployment equilibrium.
The amount by which real
GDP exceeds potential
GDP is called an
inflationary gap.
Parkin: Macroeconomics. Adapted
by Dr. Mohamed A abdalla
30
Macroeconomic Equilibrium
Fluctuations in Aggregate
Demand
The short- run effects:
Starting at long-run
equilibrium, an increase in
aggregate demand shifts
the AD curve rightward
Firms increase production
and rise prices—a
movement along the SAS
curve.
Parkin: Macroeconomics. Adapted
by Dr. Mohamed A abdalla
31
Macroeconomic Equilibrium
Fluctuations in
Aggregate Demand
The short- run effects:
Real GDP increases, the
price level rises, and in
the new short-run
equilibrium, there is an
inflationary gap.
Parkin: Macroeconomics. Adapted
by Dr. Mohamed A abdalla
32
Macroeconomic Equilibrium
Fluctuations in Aggregate
Demand
The long-run effects:
money wage rate begins to
rise and short-run
aggregate supply begins
to decrease.
The SAS curve shifts left.
The price level rises and
real GDP decreases until it
has returned to potential
GDP.
Parkin: Macroeconomics. Adapted
by Dr. Mohamed A abdalla
33
Macroeconomic Equilibrium
Fluctuations in Aggregate
Supply
Figure shows the effects of
a decrease in aggregate
supply.
Starting at long-run
equilibrium, a rise in the
price of oil decreases
short-run aggregate supply
and the SAS curve shifts
leftward.
Parkin: Macroeconomics. Adapted
by Dr. Mohamed A abdalla
34
Macroeconomic Equilibrium
Fluctuations in
Aggregate Supply
Real GDP decreases and
the price level rises.
The combination of
recession combined with
inflation is called
stagflation.
Parkin: Macroeconomics. Adapted
by Dr. Mohamed A abdalla
35