Aggregate demand and supply

PREPARED BY

UMAIR

The AS/AD model is the basic macroeconomic tool for studying output fluctuations and the determination of the price level and the inflation rate◦Can be used to explain how the economy deviates from a path

of smooth growth over time, and to explore the consequences of government policies intended to reduce unemployment and output fluctuations, and maintain stable prices

Introduction

Aggregate demand – a relationship between the price level and the equilibrium quantity of real GDP demanded.

Aggregate supply – a relationship between the price level and the equilibrium quantity of real GDP supplied.

Intersection of AS and AD curves determines the equilibrium level of output and price level

Introduction

AS, AD, and Equilibrium

AS and AD intersect at point E in Figure

Equilibrium: AS = ADEquilibrium output is Y0

Observed level of output in the economy at particular point in time

Equilibrium price level is P0

Observed price level in the economy at particular point in time

AS, AD, and Equilibrium

The amount of the increase/decrease in P and Y after a shift in either aggregate supply or aggregate demand depends on:

1. The slope of the AS curve2. The slope of the AD curve3. The extent of the shift of AS/AD

Aggregate demand (AD) consists of spending on GDP by:◦ consumers (C)◦ firms (I)◦ the government (G), and◦ the foreign sector (NX)

Anything that increases C, I, G, or NX at a given price level results in an increase in AD.

Aggregate demand

Income Wealth Expected future income and wealth Demographics Taxes

Factors affecting Consumption

Interest rate Technology Cost of capital goods Capacity utilization

Factors affecting Investment

Determined by government authorities

Government spending

Foreign and domestic income Foreign and domestic price levels Exchange rates Government policy (tariffs, trade restrictions, etc.)

Factors affecting net exports

AE = C+I+G+NX AE is affected by any factor that changes C, I, G, or

NX.

Aggregate expenditures

Note that AD curve is not the same as the demand curve for a particular good◦ negative slope is NOT the result of income and substitution

effects Why is it downward sloping?◦Wealth effect◦ Interest rate◦ International trade effect

Aggregate demand

As the price level rises:◦ the real value of dollar-denominated assets decline (real wealth

declines)◦ this decline in wealth results in a reduction in consumption

spending This affect is also called the real-balance effect (or

Pigou effect)

Wealth effect

As the price level rises:◦ Individuals must hold more money to pay for transactions◦To acquire more money, households sell bonds, and other

financial assets.◦As more bonds are sold, the price of bonds declines◦A decline in bond prices results in a higher rate of return

(interest rate) on bonds and other financial assets◦A higher interest rate results in a reduction in investment

and consumption spending

Interest-rate effect

As the domestic price level rises:◦ Imports become relatively cheaper,◦ Exports become relatively more expensive◦ Exports decline, imports rise, and net exports decline

International trade effect

As the price level rises, AE falls due to the combined wealth, interest-rate, and international trade effects

Combined price-level effects

Anything that changes C, I, G, or NX at a given price level will cause the AD curve to shift

Effects of:◦ Expectations (consumer and investor confidence)◦ Foreign income and price levels◦Government policy

Non-price determinants of AD

Price-level effects◦Assumption: Resource prices adjust more slowly than output

prices◦As price level rises, production becomes more profitable and

the quantity of output supplied rises.

Aggregate supply

Aggregate supply

Short-run Aggregate Supply

Long-run Aggregate Supply

Resource and output prices are assumed to be flexible in the long run. Output = potential real GDP.

Resource prices Technology Expectations

Changes in Short-Run AS

Changes in the quantity and/or quality of resources Technology

Changes in Long-Run AS