Demand Supply

Principles of Macroeconomics: Ch. 19 Second Canadian Edition

Aggregate Demand and

Aggregate Supply


Overview

Three key factors about economic fluctuations.

The aggregate demand and aggregate supply model.

The aggregate demand curve.The aggregate supply curve.Equilibrium in the long-run.


Short-Run Economic Fluctuations

Economic activity fluctuates from year to year. In some years, the production of goods and services rises. In other years normal growth does not occur, leading to recession.

A recession is a situation of declining real GDP, falling incomes and rising unemployment for two consecutive quarters.


Three Key Facts About Economic Fluctuations

Economic Fluctuations are Irregular and Unpredictable.– Recessions occur with unpredictable

frequency and duration.

Most Macroeconomic Variables Fluctuate Together.– Most macroeconomic variables are

closely related and move together.


Three Key Facts About Economic Fluctuations

As Output Falls, Unemployment Rises.– Changes in real GDP and the

unemployment rate are inversely related.


Quick Quiz!

List and discuss three key facts about economic fluctuations.


Overview





Economic Fluctuations

Although there remains some debate about how to analyze short-run fluctuations, most economists use the model of aggregate demand and aggregate supply.


The Basic Model of Economic Fluctuations

Two variables are used in developing a model to analyze the short-run fluctuations:1. The economy’s output of goods and

services, measured by real GDP

2. The overall price level, measured by the CPI or GDP Deflator

The Model: Aggregate Demand and Aggregate Supply


The Aggregate Demand and Aggregate Supply Model

Quantity of Output

PriceLevel

AggregateSupply

AggregateDemand

PE

QE


Aggregate Demand and Aggregate Supply

The Aggregate Demand Curve shows the quantity of goods and services that households, firms and the government are willing to buy at different prices.

The Aggregate Supply Curve shows the quantity of goods and services that firms would be willing to produce and sell at different prices.


Overview





The Aggregate Demand Curve

The aggregate demand for goods and services may be referred to as:

Y = C + I + G + NXWhy is the aggregate demand curve

downward sloping?1. Pigou’s Wealth Effect2. Keynes’ Interest Rate Effect3. Real Exchange Rate Effect


Three Reasons for the Downward Slope of the Aggregate Demand

Pigou’s Wealth Effect: “Consumers feel wealthier, which stimulates the demand for consumption goods.”– A decrease in the price level makes

consumers feel more wealthy, which in turn encourages them to spend more.

– The increase in consumer spending means a larger quantity of goods and services demanded.



Keynes’ Interest-Rate Effect: “The lower the price level, the less money households need to hold to buy the goods and services they want.”– A lower price level reduces the interest

rate, encourages greater spending on investment goods, and thereby increases the quantity of goods and services demanded.



Real Exchange-Rate Effect: “When prices of Bangladesh goods go down, foreigners buy more of our goods and we purchase less of their goods.”– When a fall in the Bangladesh price level

causes the real exchange rate to depreciate, this stimulates Bangladesh net exports, thereby increasing the quantity of goods and services demanded.


Factors that might shift the Aggregate Demand Curve

Shifts in the aggregate demand curve may arise because of:1. Changes in spending plans by

consumers or firms.2. Changes in fiscal or monetary policy.

“Anything that causes buyers to want to purchase more or less than before will cause the aggregate demand schedule

to shift.”


Shifts in the Aggregate Demand Curve

Quantity of Output

PriceLevel

AggregateSupply

Aggregate Demand

AD

AD


Quick Quiz!Explain the three reasons

why the aggregate demand curve slopes downward.

Give an example of an event that would shift the aggregate demand curve. Which way would this event shift the curve?


Overview





The Long-Run Aggregate Supply CurveThe Long-Run Aggregate Supply

Curve is vertical at full-employment GDP with respect to the price level.

In the long-run the quantity of output supplied depends on the economy’s resource endowment, technology, and its governing institutions. The price level does not affect these variables in the long-run.


The Long-Run Aggregate Supply Curve

Quantity of Output

PriceLevel

AggregateSupply

AggregateDemand

The Long-RunAggregate

Supply Curve


The Long-Run Aggregate Supply Curve

Quantity of Output

PriceLevel

AggregateSupply

AggregateDemand

Output at Full Employment


Shifts in the Long-Run Aggregate Supply Curve

Over time, any change in the factors that determine the long-run aggregate supply will cause the curve to shift.– An event that reduces potential output

shifts the schedule to the left.– Any change that increases the economy’s

potential output will shift the curve to the right.


The Short-Run Aggregate Supply Curve

In the short-run, an increase in the overall level of prices in the economy tends to raise the quantity of goods and services supplied, and a decrease in the level of prices tends to reduce the quantity of goods and services supplied.


Reasons for the Upward Slope of the Aggregate Supply Curve

There are three alternative explanations for the upward slope of the short-run aggregate supply curve.– New Classical Misperceptions Theory– The Keynesian Sticky-Wage Theory– The New Keynesian Sticky-Price Theory



The New Classical Misperceptions Theory: “A higher price level signals to each firm a greater demand for their product inducing them to produce more.”– Changes in the overall price level can

temporarily mislead suppliers about what is happening in the markets in which they sell their output.



The Keynesian Sticky-Wage Theory: “The higher product prices cause a temporary decrease in real wages stimulating employment and output.”– Nominal wages are slow to adjust, or are

“sticky” in the short-run, thus a lower price level makes employment and production less profitable, which induces firms to reduce production.



The New Keynesian Sticky-Price Theory: “Prices that do not increase immediately are temporarily low thereby stimulating spending and output on those goods.”– Prices of some goods and services adjust

sluggishly in response to changing economic conditions.

– Remember Menu Costs.


What Might Cause the Aggregate Supply Curve to Shift?

Three factors may lead to a shift in the short-run aggregate supply curve.– Changes in Factor (input) Prices– Changes in Productivity– Legal-Institutional Environment


Shifts in the Aggregate Supply Curve

Quantity of Output

PriceLevel

AggregateDemand

Aggregate Supply

AS

AS



Changes in factor (input) prices: Changes in the prices of domestic or imported resources will change the cost of producing final goods. – An increase in input prices will shift the

supply curve to the left. – A decrease in input prices will shift the

supply curve to the right.



Changes in productivity: If changes in the resource markets increase factor productivity, more goods can be made available at a lower cost. New technologies can increase the output per unit of labour or capital and hence make available more final goods.



Legal-institutional environment: Burdensome taxes and counterproductive regulations can increase the cost of production and discourage firms from producing.


Quick Quiz!

Explain why the long-run aggregate supply curve is vertical.

Explain three theories for why the short-run aggregate supply curve is upward sloping.


Overview





Equilibrium in the Long-Run

Equilibrium output and price level are determined by the intersection of the aggregate demand curve and the long-run aggregate supply curve.

Output is at its natural rate and the short-run aggregate supply curve passes through the point of intersection.


Equilibrium in the Long-Run

Quantity of Output

PriceLevel

AggregateSupply

AggregateDemand

QE

PE


Sources of Recession

Two sources from which a recession in the economy may occur:– A decrease in aggregate demand – A decrease in aggregate supply

Shifts in the aggregate demand or the aggregate supply curves result in fluctuations in the economy’s output of goods and services.


Source of Recession A Decrease in Aggregate Demand

A decrease in one or more components of the total spending function will cause the aggregate demand schedule to shift leftward.– Output will fall below the full employment

output– Unemployment will rise


A Decrease in Aggregate Demand

Quantity of Output

PriceLevel

AggregateSupply

AggregateDemand

QE

PE



Quantity of Output

PriceLevel

AggregateSupply

AggregateDemand

QE

PE



Quantity of Output

PriceLevel

AggregateSupply

AggregateDemand

QE

PE


Source of Recession A Decrease in Aggregate Supply

A decrease in short-run aggregate supply will result in a new equilibrium along the aggregate demand curve below full employment.

A fall in total output below full output– An increase in unemployment


A Decrease in Aggregate Supply

Quantity of Output

PriceLevel

AggregateSupply

AggregateDemand

QE

PE



Quantity of Output

PriceLevel

AggregateSupply

AggregateDemand

QE

PE



Quantity of Output

PriceLevel

AggregateSupply

AggregateDemand

QE

PE



When the economy falls due to a decrease in the aggregate supply, the price level rises and output decreases. This is called Stagflation.


Actions by Policy-makers During Periods of Recession

Policy-makers, when faced by decreasing aggregate demand or supply could:– Do nothing, assuming that perceptions

will adjust prices and wages.– Take action to increase aggregate

demand (implement monetary and fiscal policy).


Quick Quiz!

Suppose that the election of a popular prime ministerial candidate suddenly increases people’s confidence in the future.

Use the model of aggregate supply and aggregate demand to analyze the effect on the economy.


Overview




Documents

Demand Supply