MACROECONOMICS I
Aggregate Demand
and Aggregate Supply
Lecture 9
April 29, 2022
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LOOK FOR THE ANSWERS TO THESE
QUESTIONS:
• What are economic fluctuations? What are their
characteristics?
• How does the model of aggregate demand and
aggregate supply explain economic fluctuations?
• Why does the Aggregate-Demand curve slope
downward? What shifts the AD curve?
• What is the slope of the Aggregate-Supply curve in
the short run? In the long run?
What shifts the AS curve(s)?
2
INTRODUCTION
Real GDP over the long run
 Grows about 3% per year on average
GDP in the short run
 Fluctuates around its trend
Recessions
 Periods of falling real incomes and rising
unemployment
Depressions
 Severe recessions (very rare)
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THREE FACTS ABOUT ECONOMIC FLUCTUATIONS
FACT 1: Economic fluctuations are irregular and unpredictable
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THREE FACTS ABOUT ECONOMIC FLUCTUATIONS
FACT 2: Most macroeconomic quantities fluctuate together.
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THREE FACTS ABOUT ECONOMIC FLUCTUATIONS
FACT 3: As output falls, unemployment rises.
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CLASSICAL ECONOMICS—A RECAP
The Classical Dichotomy:
the separation of variables into two groups:
 Real – quantities, relative prices
 Nominal – measured in terms of money
The neutrality of money:
Changes in the money supply affect nominal
but not real variables
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CLASSICAL ECONOMICS—A RECAP
Classical theory
 Describes the world in the long run, but not the
short run
In the short run
 Changes in nominal variables (like the money
supply or P) can affect real variables (like Y or
the u-rate).
 We use a new model…
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MODEL OF AGGREGATE DEMAND AND AGGREGATE SUPPLY
9
P
Y
AD
SRAS
P1
Y1
The price
level
Real GDP, the
quantity of output
“Aggregate
Demand”
“Short-Run
Aggregate Supply”
The model
determines the
equilibrium
price level
and equilibrium
output (real GDP).
THE AGGREGATE-DEMAND (AD) CURVE
The AD curve shows
the quantity of all
goods and services
demanded
in the economy at any
given price level.
10
P
Y
AD
P1
Y1
P2
Y2
WHY THE AD CURVE SLOPES DOWNWARD
Y = C + I + G + NX
Assume G is fixed
by government policy.
To understand the slope
of AD, must determine
how a change in P
affects C, I, and NX.
11
P
Y
AD
P1
Y1
P2
Y2 Y1
THE WEALTH EFFECT (P AND C)
Suppose the price level, P, declines
 Increase in the real value of money
 Consumers are wealthier
 Increase in consumer spending, C
 Increase in quantity demanded of goods and
services
↓ 𝑃 → ↑ 𝑟𝑒𝑎𝑙 𝑚𝑜𝑛𝑒𝑦 𝑣𝑎𝑙𝑢𝑒 → ↑ 𝐶𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛
12
THE INTEREST-RATE EFFECT (P AND I)
Suppose the price level, P, declines
 Buying goods and services requires fewer dollars
 People buy bonds and other assets
 Decrease in the interest rate
 Increase spending on investment goods, I
 Increase in quantity demanded of goods and
services
↓ 𝑃 → ↓ 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 → ↑ 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
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THE EXCHANGE-RATE EFFECT (P AND NX)
Suppose the U.S. price level, P, declines
 Decrease in the interest rate
 Savers buy assets abroad (higher ir)
 U.S. dollar depreciates
 Stimulates U.S. net exports, NX
 Increase in quantity demanded of goods and
services
↓ 𝑃 → ↓ 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 → ↑ 𝑁𝑒𝑡 𝐸𝑥𝑝𝑜𝑟𝑡
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THE SLOPE OF THE AD CURVE: SUMMARY
An increase in P reduces
the quantity of goods
and services demanded
because:
• the wealth effect (C
falls)
• the interest-rate
effect (I falls)
• the exchange-rate
effect (NX falls)
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P
Y
AD
P1
Y1
P2
Y2
WHY THE AD CURVE MIGHT SHIFT
Any event that changes C, I,
G, or NX—except
a change in P—will shift the
AD curve.
Example:
A stock market boom makes
households feel wealthier, C
rises,
the AD curve shifts right.
16
P
Y
AD1
AD2
Y2
P1
Y1
WHY THE AD CURVE MIGHT SHIFT
Changes in C
 Stock market boom/crash
 Preferences: consumption/saving tradeoff
 Tax hikes/cuts
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Changes in I
 Firms buy new computers, equipment, factories
 Expectations, optimism/pessimism
 Interest rates,
 Monetary policy,
 Investment Tax Credit or other tax incentives
WHY THE AD CURVE MIGHT SHIFT
Changes in G
 Federal spending, e.g., defense
 State & local spending, e.g., roads, schools
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Changes in NX
 Booms/recessions in countries that buy our exports
 Appreciation/depreciation resulting from international
speculation in foreign exchange market
19
ACTIVE LEARNING 1 THE AGGREGATE-DEMAND CURVE
What happens to the AD curve in each of the
following scenarios?
A. A ten-year-old investment tax credit expires.
B. The U.S. exchange rate falls.
C. A fall in prices increases the real value of
consumers’ wealth.
D. State governments replace their sales taxes with
new taxes on interest, dividends, and capital
gains.
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ACTIVE LEARNING 1 ANSWERS
A. A ten-year-old investment tax credit expires.
 I falls, AD curve shifts left.
B. The U.S. exchange rate falls.
 NX rises, AD curve shifts right.
C. A fall in prices increases the real value of consumers’
wealth.
 Move down along AD curve (wealth-effect).
D. State governments replace their sales taxes with
new taxes on interest, dividends, and capital gains.
 C rises, AD shifts right.
THE AGGREGATE-SUPPLY (AS ) CURVES
The AS curve shows the
total quantity of
goods and services firms
produce and sell at any
given price level.
AS is:
▪ upward-sloping in
short run
▪ vertical in long run
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P
Y
SRAS
LRAS
THE LONG-RUN AGGREGATE-SUPPLY CURVE (LRAS)
The natural rate of output
(YN) is the amount of output
the economy produces when
unemployment is at its natural
rate.
Also called potential output
or
full-employment output.
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P
Y
LRAS
YN
WHY LRAS IS VERTICAL
YN determined by the
economy’s stocks of labor,
capital, and natural
resources, and the level of
technology.
An increase in P
does not affect any of
these, so it does not
affect YN.
(Classical dichotomy) 23
P
Y
LRAS
P1
P2
YN
WHY THE LRAS CURVE MIGHT SHIFT
Any event that changes
any of the determinants
of YN will shift LRAS.
Example: Immigration
increases L,
causing YN to rise.
24
P
Y
LRAS1
YN
LRAS2
YN
’
WHY THE LRAS CURVE MIGHT SHIFT
Changes in L or natural rate of unemployment
 Immigration
 Baby-boomers retire
 Government policies reduce natural u-rate
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Changes in K or H
 Investment in factories, equipment
 More people get college degrees
 Factories destroyed by a hurricane
WHY THE LRAS CURVE MIGHT SHIFT
Changes in natural resources
 Discovery of new mineral deposits
 Reduction in supply of imported oil
 Changing weather patterns that
affect agricultural production
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Changes in technology
 Productivity improvements from technological progress
LRAS1990
USING AD & AS TO DEPICT LONG-RUN GROWTH & INFLATION
Over the long run,
tech. progress shifts
LRAS to the right
and growth in the
money supply shifts
AD to the right.
Result:
ongoing inflation and
growth in output.
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P
Y
AD2000
LRAS2000
AD1990
Y2005Y1995
AD2010
LRAS2010
Y2015
P1990
P2000
P2010
SHORT RUN AGGREGATE SUPPLY (SRAS)
The SRAS curve
is upward sloping:
Over the period
of 1–2 years,
an increase in P
causes an increase in
the quantity of goods
and services supplied.
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P
Y
SRAS
Y2
P1
Y1
P2
WHY THE SLOPE OF SRAS MATTERS
If AS is vertical,
fluctuations in AD
do not cause
fluctuations in output or
employment.
If AS slopes up,
then shifts in AD
do affect output and
employment.
29
P
Y
AD1
SRAS
LRAS
ADhi
ADlo
Y1
Plo
Ylo
Phi
Yhi
Phi
Plo
THREE THEORIES OF SRAS
Theories that explain why the AS curve slopes
upward in short-run:
 Sticky-wage theory
 Sticky-price theory
 Misperceptions theory
In each, some type of market imperfection:
Output deviates from its natural rate when the
actual price level deviates from the price level
people expected.
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1. THE STICKY-WAGE THEORY
Imperfection:
 Nominal wages are sticky in the short run,
they adjust sluggishly.
 Due to labor contracts, social norms
 Firms and workers set the nominal wage in
advance based on PE, the price level they
expect to prevail.
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1. THE STICKY-WAGE THEORY
If P > PE,
 Revenue is higher, but labor cost is not.
 Production is more profitable, so firms increase
output and employment.
Hence, higher P causes higher Y, so the SRAS
curve slopes upward.
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2. THE STICKY-PRICE THEORY
Imperfection:
 Many prices are sticky in the short run.
➢ Due to menu costs, the costs of adjusting
prices.
➢ Examples: cost of printing new menus,
the time required to change price tags
 Firms set sticky prices in advance based on PE
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2. THE STICKY-PRICE THEORY
Suppose the Fed increases the money supply unexpectedly
 In the long run, P will rise
 In the short run:
 Firms without menu costs can raise their prices
immediately
 Firms with menu costs wait to raise prices. With
relatively low prices: increase demand for their
products: increase output and employment
Hence, higher P is associated with higher Y, so the SRAS
curve slopes upward.
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3. THE MISPERCEPTIONS THEORY
Imperfection:
 Firms may confuse changes in P with changes in the
relative price of the products they sell.
If P rises above PE
 A firm sees its price rise before realizing all prices
are rising.
 The firm may believe its relative price is rising, and
may increase output and employment.
So, an increase in P can cause an increase in Y, making the
SRAS curve upward-sloping. 35
WHAT THE 3 THEORIES HAVE IN COMMON:
In all 3 theories, Y deviates from YN when P deviates from PE.
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Y = YN + a(P – PE)
Output
Natural rate
of output
(long-run)
a > 0, measures
how much Y
responds to
unexpected
changes in P
Actual
price level
Expected
price level
37
P
Y
SRAS
YN
When P > PE
Y > YN
When P < PE
Y < YN
PE
the expected
price level
Y = YN + a(P – PE)
SRAS AND LRAS
The imperfections in these theories are temporary.
Over time,
 Sticky wages and prices become flexible
 Misperceptions are corrected
In the LR,
 PE = P
 AS curve is vertical
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LRAS
SRAS AND LRAS
In the long run,
PE = P
and
Y = YN.
39
P
Y
SRAS
PE
YN
Y = YN + a(P – PE)
WHY THE SRAS CURVE MIGHT SHIFT
Everything that shifts LRAS
shifts SRAS, too.
Also, PE shifts SRAS:
If PE rises,
workers & firms set higher
wages.
At each P,
production is less profitable,
Y falls, SRAS shifts left.
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LRASP
Y
SRAS
PE
YN
SRAS
PE
THE LONG-RUN EQUILIBRIUM
In the long-run
equilibrium,
PE = P,
Y = YN ,
and unemployment is
at its natural rate.
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P
Y
AD
SRAS
PE
LRAS
YN
ECONOMIC FLUCTUATIONS
Four steps to analyzing economic fluctuations
1. Determine whether the event shifts AD or AS.
2. Determine whether curve shifts left or right.
3. Use AD–AS diagram to see how the shift
changes Y and P in the short run.
4. Use AD–AS diagram to see how economy
moves from new SR equilibrium to new LR
equilibrium.
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LRAS
YN
THE EFFECTS OF A SHIFT IN AD
Event: Stock market crash
1. Affects C, AD curve
2. C falls, so AD shifts left
3. SR equilibrium at B.
P and Y lower,
unemployment higher
4. Over time, PE falls,
SRAS shifts right,
until LR equilibrium at C. Y
and unemployment back
at initial levels.
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P
Y
AD1
SRAS1
AD2
SRAS2
P1 A
P2
Y2
B
P3 C
TWO BIG AD SHIFTS: 1.THE GREAT DEPRESSION
From 1929–1933, money
supply fell 28% due to
problems in banking system
stock prices fell 90%,
reducing C and I
Y fell 27%
P fell 22%
Unemployment rate rose from
3% to 25%
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550
600
650
700
750
800
850
900
1929
1930
1931
1932
1933
1934
U.S. Real GDP,
billions of 2000 dollars
TWO BIG AD SHIFTS: 2.THE WORLD WAR II BOOM
From 1939–1944,
government outlays rose
from $9.1 billion
to $91.3 billion
Y rose 90%
P rose 20%
Unemployment fell
from 17% to 1%
45
800
1,000
1,200
1,400
1,600
1,800
2,000
1939
1940
1941
1942
1943
1944
U.S. Real GDP,
billions of 2000 dollars
46
ACTIVE LEARNING 2 WORKING WITH THE MODEL
Draw the AD-SRAS-LRAS diagram for the U.S.
economy starting in a long-run equilibrium.
A boom occurs in Canada. Use your diagram
to determine the SR and LR effects on U.S.
GDP, the price level, and unemployment.
47
ACTIVE LEARNING 2 ANSWERS
Event: Boom in Canada
1. Affects NX, AD curve
2. Shifts AD right
3. SR equilibrium at point B.
P and Y higher,
unemployment lower
4. Over time, PE rises, SRAS
shifts left, until LR
equilibrium at C.
Y and unemployment
back at initial levels.
LRAS
YN
P
Y
AD2
SRAS2
AD1
SRAS1
P1
P3 C
P2
Y2
B
A
LRAS
YN
THE EFFECTS OF A SHIFT IN SRAS
Event: Oil prices rise
1. Increases costs, shifts SRAS
(assume LRAS constant)
2. SRAS shifts left
3. SR equilibrium at point B.
P higher, Y lower,
unemployment higher
From A to B, stagflation, a
period of falling output
and rising prices. 55
P
Y
AD1
SRAS1
SRAS2
P1
A
P2
Y2
B
LRAS
YN
ACCOMMODATING AN ADVERSE SHIFT IN SRAS
If policymakers do nothing,
4. Low employment
causes wages to fall, SRAS
shifts right, until LR
equilibrium at A.
Or, policymakers could use
fiscal or monetary policy to
increase AD and accommodate
the AS shift:
Y back to YN, but
P permanently higher.
56
P
Y
AD1
SRAS1
SRAS2
P1
A
P2
Y2
B
AD2
P3 C
THE 1970S OIL SHOCKS AND THEIR EFFECTS
# of unemployed
persons
Real GDP
CPI
+ 1.4
million
+ 2.9%
+ 26%
+ 99%
+ 3.5
million
– 0.7%
+ 21%
+ 138%Real oil prices
1978–801973–75
CONCLUSION
This chapter has introduced the model of aggregate
demand and aggregate supply
 Helps explain economic fluctuations.
Keep in mind:
 These fluctuations are deviations from the long-run
trends explained by the models we learned in
previous chapters.
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SUMMARY
Short-run economic fluctuations around long-run trends
• Are irregular and largely unpredictable.
• When recessions occur, real GDP and other measures
of income, spending, and production fall, while
unemployment rises.
Classical economic theory assumption: nominal variables
such as the money supply and the price level do not
influence real variables such as output and employment.
• Accurate in the long run but not in the short run
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SUMMARY
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.
The aggregate-demand curve slopes downward:
• The wealth effect
• The interest-rate effect
• The exchange-rate effect
Any event or policy that raises consumption, investment,
government purchases, or net exports at a given price level
increases aggregate demand.
60
SUMMARY
Any event or policy that reduces consumption, investment,
government purchases, or net exports at a given price level
decreases aggregate demand.
The long-run aggregate-supply curve is vertical.
• The quantity of goods and services supplied depends on
the economy’s labor, capital, natural resources, and
technology but not on the overall level of prices.
Three theories explain the upward slope of the short-run
aggregate-supply curve.
61
SUMMARY
• Sticky-wage theory
• Sticky-price theory
• Misperceptions theory
All three theories imply that output deviates from its natural
level when the actual price level deviates from the price
level that people expected.
Shifts of short-run aggregate supply curve
• Events that alter the economy’s ability to produce output
Causes of economic fluctuations
• Shift in aggregate demand and aggregate supply
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