Macroeconomics: Aggregate Demand and Supply

AGGREgate supply and demand

Goods and Money Market Equilibrium: Bringing Everything Together

Review

• The goods market is in equilibrium where Y = AE.

• The money market is in equilibrium at that interest rate

where money demanded is equal to money supplied.

• The goods and money market are related because income

affects our demand for money, and the interest rate

determines the amount of investment.

• There is an interest rate and a level of income at which both

the goods and money markets are in equilibrium.

• Fiscal and monetary policies affect the equilibrium amount

of goods and services provided in the economy.

What we know about macroeconomics.

A Note on AD–AS Curves

• Aggregate demand and aggregate supply curves resemble

“traditional” demand and supply curves but are very

different.

• An individual or market supply curve depicts the

quantities that are demanded or supplied for a given

price level ceteris paribus.

• At the economy-wide level, we are unable to fully make

use of the assumption that everything else is constant.

• Recall: the goods market and money market are

intimately related through the demand for money and the

interest rate.

Points to ponder about aggregate demand and aggregate supply curves.

First: Aggregate DemandDeriving the aggregate demand curve (one perspective).

AE

Y

r

Ms

45º

Ms

Md

AE


AE

Y45º

AE

r

Ms

Md

Ms


AE

Y45º

AE

r

Ms

Md

Ms


P

Y

The aggregate demand (AD)

curve depicts the demand

for goods and services in the

economy at any given price

level.

We have shown that as the

price level rises, the interest

rate rises.

Consequently, the

equilibrium amount of goods

consumed in the economy

will fall.


P

Y





level.



rate rises.

Consequently, the



will fall.Y0

P0


P

Y





level.



rate rises.

Consequently, the



will fall.

P1

Y1

Y0

P0


P

Y





level.



rate rises.

Consequently, the



will fall.

P1

Y1

Y2

P2


P

Y





level.



rate rises.

Consequently, the



will fall.Y3

P3

Y2

P2


P

Y

AD





level.



rate rises.

Consequently, the



will fall.

Next: Aggregate SupplyDeriving the aggregate supply curve.

P

Y

There are two things to

consider when deriving the

aggregate supply curve.

First, despite an overall

increase in the price level,

input prices may be fixed in

the short run.

Second, at low levels of

production, capacity is

underutilized.AD


P

Y

AD

At low levels of production,

there is room for an increase

in output that does not really

affect the price level.


P

Y

AD

At low levels of production,

there is room for an increase

in output that does not really

affect the price level.

As more capacity becomes

utilized, input prices also

begin to rise, and firms are

only able to produce more

by raising prices.

Hence, output can only

expand if the price level also

increases.

P

Y

AD

AS


This is the same as saying

that the economy can only

supply more goods and

services at higher price

levels.

In the short-run, this implies

that the aggregate supply

curve is upward sloping.

Note that the intersection

of AD and AS represents

the equilibrium price level

in the economy.


P

Y

The difference between

short- and long-run AS

curves has to do with input

prices, which are fixed in the

short-run.

AS

What about the long-run?

AD


P

Y

AS

AD


P

Y

AS

Suppose we are at a high

level of output and there is

an increase in aggregate

demand.

AD


P

Y

AS




demand.

AD curve and the

equilibrium point shift

outward.

AD


P

Y

AD

AS




demand.

AD curve and the


outward.


P

Y

AD

AS




demand.

AD curve and the


outward.

However, over time the price

of inputs adjusts, causing

the AS curve to shift inward.


P

Y

AD

AS




demand.

AD curve and the


outward.





P

Y

AD

AS

Overall prices rise, but we

are back to the amount of

output originally produced.




demand.

AD curve and the


outward.





P

Y

AD

AS

Overall prices rise, but we

are back to the amount of

output originally produced.




demand.

AD curve and the


outward.





P

Y

AD

In the long-run the AS curve

will be vertical.(LR)AS

This merely demonstrates

that there is a limit to what

an economy can

conceivably produce.

For this reason, the long-run

AS curve can be considered

as an economy’s “potential

GDP.”

AS–AD Analysis

• If we hold the price level fixed, then changes in other

variables will cause the aggregate demand and supply

curves to shift.

• Factors affecting aggregate demand:

• Money Supply (+)

• Government Spending (+)

• Taxes (–)

• Factors affecting aggregate supply:

• Input Prices/Costs (–)

• Economic Growth (+)

Taking stock of the interaction between aggregate demand and supply.

Policy Effects: Short-RunFiscal and monetary policy in the short-run.

P

Y

At lower levels of income,

expansionary policies are

more effective.

As the economy expands,

the price level rises.

However, this increase in

prices is smaller than the

expansion in output.

ADADLow

ADHigh

Policy Effects: Short-RunFiscal and monetary policy in the short-run.

P

Y

ADLow

AD

At higher levels of income,

economic expansion results

in much larger increases in

the price level.

This is mainly because the

economy is already

performing at or near

capacity.

Hence, expansionary

policies in such cases are

less effective.

Education

Macroeconomics: Aggregate Demand and Supply