Title: CHAPTER Aggregate Supply and Aggregate Demand
1 CHAPTER Aggregate Supply and
Aggregate Demand
11
2Aggregate Supply and Aggregate Demand
- Aggregate Demand
- Slope of the AD Curve
- Deriving AD from IS/LM
- Factors that Shift the AD Curve
- Aggregate Supply in the Short Run
- Slope of the AS Curve
- Factors that Shift the AS Curve
- Short-Run Equilibrium
3Aggregate Supply and Aggregate Demand
- Long-Run Equilibrium
- Why Equilibrium Deviates from Potential
- Aggregate Demand Management in the AS/AD Model
- Inflation, Potential Output, and the Output Gap
- Importance of Expectations
4Aggregate Demand
- The aggregate demand (AD) curve shows the
combinations of price levels and income levels at
which the goods and money market are both in
equilibrium. - The aggregate demand curve shows an inverse
relationship between the price level and income
levels because of the - Interest rate effect
- International effect
5The Interest Rate Effect
The price level increases
Real money balances decrease
People sell bonds to increase money balances
Bond prices fall and interest rates increase
Investment decreases, which decreases total
expenditures
6The International Effect
The price level increases
The real exchange rate rises
Exports become more expensive and decrease
Imports become cheaper and increase
Net exports decrease, which decreases total
expenditures
7Interest Rate and International Effects
LM1 (PP1)
LM0 (PP0)
Real Interest Rate ()
B
C
A
IS0 (PP0)
IS1 (PP1)
Aggregate Output
Y2
Y1
Y0
8From IS/LM to AD
LM2 (PP2)
LM1 (PP1)
LM0 (PP0)
Real Interest Rate ()
B
C
A
IS0 (PP0)
IS1 (PP1)
IS2 (PP2)
Real Output, Income
Y2
Y1
Y0
C
P2
B
Price Level
P1
Aggregate Demand
A
P0
Real Output, Income
Y2
Y1
Y0
9The Slope of AD
- The AD Curve is flatter if
- The interest rate effect is larger
- The international effect is larger
- The marginal propensity to consume and the
multiplier are larger
10Shifts in the AD Monetary Policy
LM0 (P0)
LM1 (P0)
A
Real Interest Rate ()
1. Expansionary monetary policy shifts the LM
curve to the right.
B
IS
Real Output, Income
Y0
Y1
2. Equilibrium income rises at every price
level. The AD curve shifts to the right, too.
Price Level
B
Aggregate Demand
P0
A
Real Output, Income
Y1
Y0
11Shifts in the AD Fiscal Policy
LM0 (P0)
B
1. Expansionary fiscal policy shifts the IS
curve to the right.
Real Interest Rate ()
A
IS1(P0)
IS0(P0)
Real Output, Income
Y0
Y1
2. Equilibrium income rises at every price
level. The AD curve shifts to the right, too.
Price Level
B
Aggregate Demand
P0
A
Real Output, Income
Y1
Y0
12Aggregate Supply in the Short Run
- The aggregate supply (AS) curve shows how the
price level responds to changes in aggregate
output. - AS is positively sloped because
- as firms produce more they demand more inputs
- the market supply of factors of production is
positively sloped - firms costs increase
- firms respond by raising prices resulting in an
upward sloping AS
13Factors that Shift the AS Curve
- Factors that reduce the costs of production,
independent of demand, shift the AS to the right - Increases in productivity
- Factors that increase the costs of production,
independent of demand, will shift AS to the left - Workers negotiate for higher wages because they
expect increases in inflation - Adverse supply shocks - natural disasters or oil
supply disruptions, that increase costs of
important inputs
14The AS Curve - Its Slope and Shifts
AS1
1. The AS curve shifts up when input costs
rise independently of demand.
2. Demand for inputs rises, increasing
their prices. As input prices rise, so do
product prices.
Aggregate Supply
AS0
Price Level
Price Level
AS2
P1
P0
2. The AS curve shifts down when worker
productivity rises.
1. As real output rises.
Real output, Income
Real output, Income
Y1
Y0
15Short Run Equilibrium AD Increases
1. The economy is in equilibrium at A and
expansionary monetary policy increases AD to AD1.
Aggregate Supply
Price Level
B
2. If prices are constant, income increases to
Y2.
P1
A
P0
AD1
3. With flexible prices, output increases only
to Y1.
AD0
Real output, Income
Y2
Y1
Y0
16Short Run Equilibrium AS Decreases
1. The economy is in equilibrium at A and a
significant portion of capital is damaged by an
earthquake.
AS1
AS0
Price Level
B
2. This increases production costs and shifts AS
to AS1.
P1
A
P0
3. The economy moves to B with higher prices and
lower output.
AD
Real output, Income
Y0
Y1
17Long Run Equilibrium AD Increases
Potential Output
Price Level
C
P2
A
P0
AD1
AD0
Real output, Income
Y0
18Long Run Equilibrium AS Decreases
AS1
AS0
Price Level
C
P2
B
P1
P0
AD
Y0
Real output, Income
Y1
19Alternative Adjustment to Long-Run Equilibrium
AS0
AS1
Price Level
P0
P1
A
B
P2
AD
Real output, Income
Y0
Y1
20Alternative Adjustment to Long Run Equilibrium
Potential Output
Price Level
AS0
C
P0
P1
A
AD1
AD0
Y0
Y1
Real output, Income
21Why Output Deviates From Potential and the AS is
Positively Sloped
- Worker Misperception Model
- Workers supply more labor when nominal wages
increase even if real wages have not - Imperfect Information Model
- Firms respond to nominal price increases of their
product by producing more even if its relative
price is the same - Sticky Wage and Price Model
- Firms have contractual relations with customers
and do not raise prices, even if demand
increases.
22Aggregate Demand Management
- Offsetting Aggregate Demand Shocks
- Offset negative shocks that push output below
potential with expansionary monetary and fiscal
policy - Offset positive shocks that push output above
potential with contractionary monetary and fiscal
policy - Offsetting Aggregate Supply Shocks
- Adverse AS shocks cause stagflation- simultaneous
inflation and decreases in output - Stagflation creates a policy dilemma, requiring a
choice between more inflation or increasing output
23Adjustment After an Adverse Supply Shock
Potential Output
AS1
Price Level
AS0
P2
C
P1
B
P0
A
AD1
AD0
Y0
Y1
Real output, Income
24Stagflation During the 1970s
Percent Change Percent Change in Real
Output in Inflation 1972 5.5 4.2 1973 5.8
5.6 1974 -0.6 8.9 1975
-0.4 9.4 1976 5.4 5.8 1977 4.7 6.5 197
8 5.4 7.3
25Real Business Cycle Theory
- Technology shocks are the source of output
fluctuations in the economy. - Fluctuations are not deviations of output from
potential, but fluctuations of potential output. - Policy should not be used to smooth out
fluctuations since a change in output may be
caused by a change in potential output or a shift
in short-run AS or AD.
26Inflation and the Output Gap
27Actual and Potential Output
28Expectations and the AS Curve
Potential Output
AS1
Price Level
AS0
P1
B
P0
A
AD1
AD0
Real output, Income
Y0
29Reasonable Expectations
- Most people form reasonable expectations -
expectations based on relevant information. - People form expectations with a combination of
extrapolations from the past and predictions of
the future, based on theory. - People will not make the same mistakes over and
over again in forming their expectations.
30Rational Expectations
- Rational expectations are expectations based on
the predictions of an economic model. - The economic model distinguishes rational
expectations from reasonable expectations. - People figure out economic models an base their
expectations on them.
31Policy and Expectations
- The more stable the economy and the more
consistently policy impacts the economy, the more
reasonable expectations become rational
expectations. - The distinction between rational and reasonable
expectations is important in determining policy
effects - Rational expectations AD policy affects only
the price level, not real output - Reasonable expectations AD policy may work
because the model changes
32An Unconventional View of Expectations and AD/AS
- Aggregate demand policy matters in both the short
run and the long run. - There are many levels of potential output which
can be equilibrium, depending on aggregate
demand. - High aggregate demand can cause technological
change which can increase potential output.
33Inflation in the AS/AD Model
Potential Output
AS1
Price Level
AS0
P1
B
P2
C
AD1
A
P0
AD2
AD0
Real output, Income
Y0
Y1
34The U.S. Economy at the End of the 1990s
Potential Output
Potential Output
Price Level
Price Level
AS
AS
B
B
P1
P1
P0
P0
A
A
AD1
AD1
AD0
AD0
Y0
Y1
Y1
Y0
Real output, Income
Real output, Income
The Conventional View
The Unconventional View
35Summary of Short-Run Models
36Summary of Short-Run Models
37Determinants of the Slope of AD
- The AD Curve is Flat if
- Investment is responsive to changes in the
interest rate - The multiplier is large
- The LM curve is highly responsive to changes in
income - The international effect is large
38A Flat IS Curve Means a Flat AD Curve
LM0
LM1
r0
Real Interest Rate ()
r1
IS
Real Output, Income
Y0
Y1
Price Level
Aggregate Demand
P0
P1
Real Output, Income
Y1
Y0
39Income-Sensitive LM Means a Flat AD
LM0 (P0)
LM1 (P0)
Real Interest Rate ()
r0
IS
r1
Real Output, Income
Y0
Y1
Price Level
P0
Aggregate Demand
P1
Real Output, Income
Y1
Y0
40Large International Effect Means Flat AD
LM0
LM1
Real Interest Rate ()
IS1
IS0
Real Output, Income
Y0
Y1
Price Level
P0
Aggregate Demand
P1
Real Output, Income
Y1
Y0
41An Alternative AD/AS Model
- Criticisms of the AD/AS Model
- The curves are confusing because they are not
micro supply and demand curves - The model does not adequately explain how the
economy reaches equilibrium - The alternative AD/AS model develops the AS and
AD curves with inflation and real output on the
axes.
42The Alternative AD Curve
Slope of the Alternative AD Curve
More inflation
Higher real interest rates
Lower quantity of aggregate expenditures
Downward sloping AD curve
Shifts in the AD Curve
Fiscal policy
Changes in the Feds policy rule
43The Alternative AD/AS Model
Potential Output
Inflation
Short-run AS is horizontal because of inflation
inertia caused by slowly moving expectations of
inflation.
A
?0
AS
AD
Real output, Income
Y0
44Adjustment to Long-Run Equilibrium
Potential Output
Potential Output
Inflation
Inflation
A
AS0
?0
D
B
AS1
AS1
?1
?1
C
?0
AS0
AD
AD
Y1
Y0
Y0
Y1
Real output, Income
Real output, Income
45Expansionary Monetary Policy
Potential Output
Inflation
C
AS1
?1
A
B
?0
AS0
AD1
AD0
Real output, Income
Y0
Y1
46Contractionary Fiscal Policy
Potential Output
Inflation
A
B
?0
AS0
C
?1
AS1
AD0
AD1
Real output, Income
Y0
Y1
47An Adverse Supply Shock
Potential Output
Inflation
B
AS1
?1
A
?0
AS0
AD
Real output, Income
Y0
Y1