ECO121- MACROECONOMICS

Chapter 33: Aggregate Demand and Aggregate Supply

Taught by Que Anh Nguyen - FPT School of Business (FSB)

Original Slides by Ron Cronovich

Based on: N. Gregory Mankiw, Principles of Economics (6ed)

OBJECTIVES

▪ 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)?
Introduction

▪ Over the long run, real GDP grows about 3% per year on average.

▪ In the short run, GDP fluctuates around its trend.

▪ Recessions: periods of falling real incomes and rising unemployment
Ex: From the fourth quarter of 2007 to the second quarter of 2009, real GDP for the U.S.
economy fell by 4.0 percent. The unemployment rate rose from 4.4 percent in May 2007 to
10.0 percent in October 2009

▪ Depressions: severe recessions (very rare)

▪ Short-run economic fluctuations are often called business cycles.

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1. Three Facts About Economic Fluctuations

FACT 1: Economic fluctuations are irregular and unpredictable.

U.S. real GDP,

billions of 2000 dollars

The shaded
bars are
recessions

3
1. Three Facts About Economic Fluctuations
FACT 2: Most macroeconomic quantities fluctuate together.

4
 1. Three Facts About Economic Fluctuations

FACT 3: As output falls, unemployment rises.

Unemployment rate,
percent of labor force

5
Introduction, continued

▪ Explaining these fluctuations is difficult, and the theory of economic fluctuations is

controversial.
▪ Most economists use the model of aggregate demand and aggregate supply
to study fluctuations.
▪ This model differs from the classical economic theories economists use to explain the
long run.

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2. Explaining Short-Run Economic Fluctuations
2.1. The Assumptions of Classical Economics

▪ The previous chapters are based on the ideas of classical economics, especially:
▪ 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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2. Explaining Short-Run Economic Fluctuations
2.2. The Reality of Short-Run Fluctuations

▪ Most economists believe 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 push
real variables (like Y (real GDP) or the u-rate) away from its long-run trend..
▪ To study the short run, we use a new model.

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 2. Explaining Short-Run Economic Fluctuations
2.3. The Model of Aggregate Demand and Aggregate Supply
P
The price
level “Aggregate
▪ 1stvariable: the economy’s output of Demand” SRAS
goods and services, as measured by
real GDP. → real GDP “Short-Run
▪ 2nd variable: average level of prices, as P1 Aggregate
measured bythe CPI or the GDP Supply”
deflator → nominal variable The model determines
the eq’m price level
AD

Y
Y1
and eq’m output
(real GDP). Real GDP, the
quantity of output 9
3. The Aggregate-Demand (AD) Curve
3.1. Why the Aggregate-Demand Curve Slopes Downward

The AD curve shows the quantity of all P

g&s demanded in the economy at any
given price level.
P2

Y = C + I + G + NX
Assume G fixed by govt policy.
P1
To understand the slope of AD, we must
AD
determine how a change in P affects C, I,
and NX.
Y
Y2 Y1
10
3. The Aggregate-Demand (AD) Curve
3.1. Why the Aggregate-Demand Curve Slopes Downward

The Wealth Effect (P and C )

Suppose P rises.
▪ The dollars people hold buy fewer g&s, so real wealth is lower.
▪ People feel poorer.
Result: C falls → fewer g&s demanded
Vice versa:
Suppose P falls.
▪ The dollars you hold rise in value, increasing your real wealth
▪ People feel richer thanks to the increase in ability to buy g&s
▪ Result: C rises → more g&s demanded
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3. The Aggregate-Demand (AD) Curve
3.1. Why the Aggregate-Demand Curve Slopes Downward
The Interest-Rate Effect (P and I )
Suppose P rises.
▪ Buying g&s requires more dollars.
▪ To get these dollars, people sell bonds or other assets. → drives up interest rates.
Result: I falls. (Recall, I depends negatively on interest rates.). Also may C falls
→ fewer g&s demanded
Vice versa:
Suppose P falls.
▪ Buying g&s requires less dollars.
▪ Households try to reduce their holdings of money by invest in interest-bearing assets. → drives
down interest rates.
Result: I rises. (Recall, I depends negatively on interest rates.); also may C rises
→ more g&s demanded 12
3. The Aggregate-Demand (AD) Curve
3.1. Why the Aggregate-Demand Curve Slopes Downward

The Exchange-Rate Effect (P and NX )

Suppose P rises.
▪ U.S. interest rates rise (the interest-rate effect).
▪ Foreign investors desire more U.S. bonds.
▪ Higher demand for $ in foreign exchange market.
▪ U.S. exchange rate appreciates.
▪ U.S. exports more expensive to people abroad, imports cheaper to U.S.
residents.
Result: NX falls.→ less g&s demanded

13
3. The Aggregate-Demand (AD) Curve
3.1. Why the Aggregate-Demand Curve Slopes Downward

The Slope of the AD Curve: Summary

An increase in P reduces the quantity of g&s P

demanded because:

▪ the wealth effect (C falls): P2

Consumers become wealthier,
stimulating the demand for
consumption goods
▪ the interest-rate effect (I falls):
Interest rates fall, stimulating the
P1
demand for investment goods
AD
▪ the exchange-rate effect (NX falls):
the currency depreciates, stimulating the Y
demand for net exports. Y2 Y1
14
3. The Aggregate-Demand (AD) Curve
3.2. 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. P
Example:
A stock market boom makes households feel
wealthier, C rises,
the AD curve shifts right. P1

AD2
AD1
Y
Y1 Y2
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3. The Aggregate-Demand (AD) Curve
3.2. Why the AD Curve Might Shift

▪ Changes in C
▪ Stock market boom/crash
▪ Preferences re: consumption/saving tradeoff
▪ Tax hikes/cuts
▪ Changes in I
▪ Firms buy new computers, equipment, factories
▪ Expectations, optimism/pessimism
▪ Money supply impacting interest rates, monetary policy
▪ Investment Tax Credit or other tax incentives

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3. The Aggregate-Demand (AD) Curve
3.2. Why the AD Curve Might Shift

▪ Changes in G
▪ Federal spending, e.g., defense
▪ State & local spending, e.g., roads, schools

▪ Changes in NX
▪ Booms/recessions in countries that buy our exports.
▪ Appreciation/depreciation resulting from international speculation in FX market

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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- The Aggregate-Demand Curve

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 sales taxes with new taxes on interest, dividends, and
capital gains.
C rises, AD shifts right.

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4. The Aggregate-Supply (AS) Curves

The AS curve shows the total quantity of P LRAS

g&s firms produce and sell at any
given price level. SRAS

AS is:
▪ upward-sloping in short run

▪ vertical in long run

Y
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 4. The Aggregate-Supply (AS) Curves
4.1. Why the Aggregate-Supply Curve Is Vertical in the Long Run

P LRAS
The natural rate of output (YN) is the
amount of output
the economy produces when
unemployment is at its natural rate.
YN is also called potential output
or full-employment output.

Y
YN
21
4. The Aggregate-Supply (AS) Curves
4.1. Why the Aggregate-Supply Curve Is Vertical in the Long Run

P LRAS
YN determined by the economy’s
stocks of labor, capital, and natural
resources, and on the level of
technology. P2
An increase in P does not affect any
of these, so it does not affect YN. P1
(Classical dichotomy)

Y
YN
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 4. The Aggregate-Supply (AS) Curves
4.2. Why the LRAS Curve Might Shift

Any event that changes any of the determinants of YN

will shift LRAS.
P LRAS1 LRAS2
1. Changes in L or natural rate of unemployment
▪ Immigration vs. workers left the economy to go
abroad
▪ Baby-boomers retire
▪ Govt policies increase natural u-rate
(unemployment insurance more generous)
▪ Govt policies decrease natural u-rate (job training
program for unemployed workers)
▪ Govt policies decreases natural u-rate
Example: Immigration increases L, causing YN to rise.
Y
YN Y’
N 23
4. The Aggregate-Supply (AS) Curves
4.2. Why the LRAS Curve Might Shift

2. Changes in K or H
▪ Investment in factories, equipment
▪ More people get college degrees
▪ Factories destroyed by a hurricane
3. Changes in natural resources
▪ Discovery of new mineral deposits
▪ Reduction in supply of imported oil
▪ Changing weather patterns that affect agricultural production
4. Changes in technology
▪ Productivity improvements from technological progress (invention of the computer,
opening up international trade, etc.)

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 4. The Aggregate-Supply (AS) Curves
4.3. Using AD & AS to Depict LR Growth and Inflation

LRAS2000
Over the long run, tech. progress shifts P LRAS1990
LRAS to the right LRAS1980
and growth in the money supply shifts AD
to the right.
P2000
Result:
P1990
ongoing inflation and growth in output.
AD2000
P1980
The short-run fluctuations in output and the price
level should be viewed as deviations from the long- AD1990
run trends of output growth and inflation. AD1980
Y
Y1980 Y1990 Y2000
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 4. The Aggregate-Supply (AS) Curves
4.4. Why SRAS Slopes Upwards in the Short Run

P
▪ The Short Run Aggregate Supply
(SRAS) curve is upward sloping:
SRAS

▪ Over the period of 1-2 years, P2

an increase in P causes an increase
in the quantity of g & s supplied. P1

Y
Y1 Y2
26
4. The Aggregate-Supply (AS) Curves
4.4. Why SRAS Slopes Upwards in the Short Run

P LRAS
If AS is vertical, fluctuations in AD do
not cause fluctuations in output or Phi
employment.
SRAS
Phi
If AS slopes up, then shifts in AD
do affect output and employment.
ADhi
Plo
AD1
Plo
ADlo
Y
Ylo Y1 Yhi 27
4. The Aggregate-Supply (AS) Curves
4.4. Why SRAS Slopes Upwards in the Short Run

Three Theories of SRAS

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.

▪ When the price level rises above the level that people expected, output rises
above its natural level and vice versa

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 4. The Aggregate-Supply (AS) Curves
4.4. Why SRAS Slopes Upwards in the Short Run
1. The Sticky-Wage Theory

▪ Imperfection:
Nominal wages are sticky in the short run (long-term contracts between workers and
firms), they adjust slowly.

▪ 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.

29
 4. The Aggregate-Supply (AS) Curves
4.4. Why SRAS Slopes Upwards in the Short Run
 The Sticky-Wage Theory
▪ If P > PE, revenue is higher, but labor cost is not.
→ Production is more profitable → Firms increase output and employment.

▪ Hence, higher P causes higher Y, so the SRAS curve slopes upward.

Ex. A year ago a firm expected the price level today (PE ) = 100, and it signed a contract
with its workers agreeing to pay them, say, $20 an hour.
▪ The price level turns out to be (P) = 95.
→ Prices have fallen below expectations (P<PE), the firm gets 5% less than expected for
each unit of its product sold.
→ Less profitable production makes the firm hires fewer workers and reduces the
quantity of output supplied.
→ Employment and production will remain below their long-run levels
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 4. The Aggregate-Supply (AS) Curves
4.4. Why SRAS Slopes Upwards in the Short Run

The Sticky-Price Theory

▪ Imperfection:
Many prices are sticky in the short run that not all prices adjust immediately to changing
conditions.
▪ 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.

31
 4. The Aggregate-Supply (AS) Curves
4.4. Why SRAS Slopes Upwards in the Short Run

 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. Meantime, their prices are relatively low, which
increases demand for their products,

→ so they increase output and employment.

▪ Hence, higher P is associated with higher Y, so the SRAS curve slopes upward.

32
4. The Aggregate-Supply (AS) Curves
4.4. Why SRAS Slopes Upwards in the Short Run

 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 → SRAS curve upward-sloping.

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4. The Aggregate-Supply (AS) Curves
4.4. Why SRAS Slopes Upwards in the Short Run

What the 3 Theories Have in Common:

In all 3 theories, Y deviates from YN when P deviates from PE.

Y = YN + a (P – PE)
Output
Expected
price level
Natural rate of
output (long-
a > 0, measures Actual price
run)
how much Y level
responds to
unexpected
changes in P
34
4. The Aggregate-Supply (AS) Curves
4.4. Why SRAS Slopes Upwards in the Short Run
What the 3 Theories Have in Common:
P
Y = YN + a (P – PE)
SRAS
When P > PE

the expected
price level PE

When P < PE

Y
YN

Y < YN Y > YN
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 4. The Aggregate-Supply (AS) Curves
4.4. Why SRAS Slopes Upwards in the Short Run

Y = YN + a (P – PE)
SRAS and LRAS
P LRAS
▪ The imperfections in these theories are temporary.
Over time, SRAS
▪ sticky wages and prices become flexible
▪ misperceptions are corrected
PE
In the long run,
▪ In the LR, PE = P
▪ PE = P and
▪ AS curve is vertical Y = YN.
Y
YN 36
 4. The Aggregate-Supply (AS) Curves
4.5. Why the SRAS Curve Might Shift

▪ Everything that shifts LRAS shifts P LRAS

SRAS, too (labor, capital, natural SRAS
SRAS
resources, or technological knowledge)
PE
▪ Also, PE shifts SRAS:

▪ If PE rises, workers & firms set higher PE

wages.

▪ At each P, production is less profitable,

Y falls, SRAS shifts left. Y
YN
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 5. Two Causes of Economic Fluctuations
5.1. Economic Fluctuations

We assume the economy begins in long-run

equilibrium P LRAS

SRAS
PE = P,

Y = YN ,
PE
and unemployment is at its
natural rate.
AD
Y
YN
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5. Two Causes of Economic Fluctuations
5.1. Economic Fluctuations

▪ Caused by events that shift the AD and/or AS curves.

▪ 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 eq’m to new LR
eq’m.

39
 5. Two Causes of Economic Fluctuations
5.2. The Effects of a Shift in AD
Event: Stock market crash

1. Affects C, AD curve
P LRAS
2. C falls, so AD shifts left
SRAS1
3. SR eq’m at B. P1 falls to P2 and Y1 falls to Y2,
unemp higher → The economy is in a
recession. P1 A SRAS2
4. Over time, PE falls and according to sticky-
P2 B
wage P2 > PE causes SRAS to shift right, until
LR eq’m at C. AD1
→ Y2 is back to Y1 and unemp back at initial P3 C
levels. AD2
Y
→ Price level has fallen sufficiently (to P3) Y2 Y1
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 5. Two Causes of Economic Fluctuations
5.2. The Effects of a Shift in AD

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%
▪ u-rate rose from 3% to 25%

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 5. Two Causes of Economic Fluctuations
5.2. The Effects of a Shift in AD

Two Big AD Shifts:

2. The World War II Boom
From 1939-1944,
▪ govt outlays rose from $9.1
billion to $91.3 billion
▪ Y rose 90%
▪ P rose 20%
▪ unemp fell from 17% to 1%

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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.

43
ACTIVE LEARNING 2- Working with the model

Event: Boom in Canada

1. Affects NX, AD curve P LRAS
SRAS2
2. Shifts AD right
3. SR eq’m at point B.
P and Y higher, unemp lower
P3 C SRAS1
4. Over time, PE rises,
SRAS shifts left, until LR eq’m at C. P2 B
Y and unemp back
at initial levels. P1 A AD2

AD1
Y
YN Y2

44
 5. Two Causes of Economic Fluctuations
5.3. The Effects of a Shift in SRAS

Event: Oil prices rise

P LRAS
1. Increases costs, shifts SRAS
(assume LRAS constant) SRAS2

2. SRAS shifts left SRAS1

B
3. SR eq’m at point B. P2
P higher, Y lower, unemp higher
P1 A
From A to B, stagflation,
a period of falling output
AD1
and rising prices. Y
Y2 YN
45
5. Two Causes of Economic Fluctuations
5.3. The Effects of a Shift in SRAS

Accommodating an Adverse Shift in SRAS

If policymakers do nothing,
P LRAS
4. Low employment causes wages
to fall SRAS2
→ SRAS shifts right, until LR eq’m
at A.
P3 C SRAS1
B
P2
Or, policymakers could use fiscal
or monetary policy to increase AD P1 A
AD2
and accommodate the AS shift:
Y back to YN, but AD1
P permanently higher. Y
Y2 Y1 46
5. Two Causes of Economic Fluctuations
5.3. The Effects of a Shift in SRAS

The 1970s Oil Shocks and Their Effects

1973-75 1978-80

Real oil prices + 138% + 99%

CPI + 21% + 26%

Real GDP – 0.7% + 2.9%

# of unemployed + 3.5 + 1.4

persons million million
47
 John Maynard Keynes, 1883-1946

▪ The General Theory of Employment, Interest, and

Money, 1936
▪ Argued recessions and depressions can result from
inadequate demand; policymakers should shift AD.
▪ Famous critique of classical theory:
The long run is a misleading guide to
current affairs. In the long run, we are all
dead.
Economists set themselves
too easy, too useless a task if in tempestuous seasons they
can only tell us when the storm is long past,
the ocean will be flat.
48
CONCLUSION

▪ This chapter has introduced the model of aggregate demand and aggregate supply,
which 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.

▪ In the next chapter, we will learn how policymakers can affect aggregate demand
with fiscal and monetary policy.

49
CHAPTER SUMMARY

▪ Short-run fluctuations in GDP and other macroeconomic quantities are

irregular and unpredictable. Recessions are periods of falling real GDP and
rising unemployment.

▪ Economists analyze fluctuations using the model of aggregate demand and

aggregate supply.

▪ The aggregate demand curve slopes downward because a change in the

price level has a wealth effect on consumption, an interest-rate effect on
investment, and an exchange-rate effect on net exports.

50
CHAPTER SUMMARY

▪ Anything that changes C, I, G, or NX

– except a change in the price level – will shift the aggregate demand curve.

▪ The long-run aggregate supply curve is vertical because changes in the price
level do not affect output in the long run.

▪ In the long run, output is determined by labor, capital, natural resources, and
technology; changes in any of these will shift the long-run aggregate supply
curve.

51
CHAPTER SUMMARY

▪ In the short run, output deviates from its natural rate when the price level is
different than expected, leading to an upward-sloping short-run aggregate supply
curve. The three theories proposed to explain this upward slope are the sticky
wage theory, the sticky price theory, and the misperceptions theory.

▪ The short-run aggregate-supply curve shifts in response to changes in the

expected price level and to anything that shifts the long-run aggregate supply
curve.

52
CHAPTER SUMMARY

▪ Economic fluctuations are caused by shifts in aggregate demand and aggregate

supply.

▪ When aggregate demand falls, output and the price level fall in the short run. Over
time, a change in expectations causes wages, prices, and perceptions to adjust, and
the short-run aggregate supply curve shifts rightward. In the long run, the economy
returns to the natural rates of output and unemployment, but with a lower price level.

▪ A fall in aggregate supply results in stagflation – falling output and rising prices.
Wages, prices, and perceptions adjust over time, and the economy recovers.

53
Homework

HOMEWORK:
- Problem 1, 2, 3 pg. 753; 10 pg. 754 MCQs
(Mankiw 9th ed)

54