Chapter Four

Aggregate Demand and Supply Analysis

4.1. Aggregate demand
 Aggregate demand is a measurement of the total amount of demand
for all finished goods and services produced in an economy.

 It refers to the quantity demanded of all goods and services (Real

GDP) at different price levels, ceteris paribus.

 In other words, it is the quantity demanded of goods and services

by people, firms, government, or the quantity demanded of Real
GDP, at various price levels, ceteris paribus.
 Cont.
4.1.1. Aggregate Demand curve
 An aggregate demand (AD) curve is the graphical representation of
aggregate demand.

 An AD curve is shown in figure below Notice that it is downward

sloping, indicating an inverse relationship between the price level (P)
and the quantity demanded of Real GDP (Q): As the price level rises,
the quantity demanded of Real GDP falls, and as the price level falls,
the quantity demanded of Real GDP rises, ceteris paribus.
 Cont.

 The AD curve slopes downward means there is an inverse relationship

between the price level and the quantity demanded of Real GDP.

 This inverse relationship, and the resulting downward slope of the AD

curve, is explained by the real balance effect, the interest rate effect,
and the international trade effect.
 Cont.
1. Real balance effect: The real balance effect states that the inverse
relationship between the price level and the quantity demanded of
Real GDP is established through changes in the value of monetary
wealth, or money holdings. To illustrate, consider a person who has
$50,000 in cash.

 Suppose the price level falls. As this happens, the purchasing power of
the person’s $50,000 rises. That is, the $50,000, which once could buy
100 television sets at $500 each, can now buy 125 sets at $400 each.
An increase in the purchasing power of the person’s $50,000 is
identical to saying that his monetary wealth has increased.
 Cont.

 (After all, isn’t the $50,000 more valuable when it can buy more than
when it can buy less?) And as he becomes wealthier, he buys more
goods.

 In summary, a fall in the price level causes purchasing power to rise,

which increases a person’s monetary wealth. As people become
wealthier, the quantity demanded of Real GDP rises.
 Cont.

 Suppose the price level rises. As this happens, the purchasing power
of the $50,000 falls. That is, the $50,000, which once could buy 100
television sets at $500 each, can now buy 80 sets at $625 each.

 A decrease in the purchasing power of the person’s $50,000 is

identical to saying that his monetary wealth has decreased. And as he
becomes less wealthy, he buys fewer goods.

 In summary, a rise in the price level causes purchasing power to fall,

which decreases a person’s monetary wealth.

 As people become less wealthy, the quantity demanded of Real GDP

falls.
Cont.
 Cont.

2. Interest rate effect: The interest rate effect states that the inverse
relationship between the price level and the quantity demanded of Real
GDP is established through changes in household and business spending
that is sensitive to changes in interest rates.

 Let’s consider a person who buys a fixed bundle of goods (food,

clothing, and shelter) each week.

 Suppose the price level falls, increasing the purchasing power of the
person’s money.

 With more purchasing power (per dollar), she can purchase her fixed
bundle of goods with less money.
 Cont.
 What does she do with (part of) this increase in her monetary wealth?
She saves it. In terms of simple supply-and-demand analysis, the
supply of credit increases.

 Subsequently, the price of credit, which is the interest rate, drops.

 As the interest rate drops, households and businesses borrow more, so

they end up buying more goods. Thus, the quantity demanded of Real
GDP rises.
Cont.
 Cont.

3. International trade effect: The international trade effect states that

the inverse relationship between the price level and the quantity
demanded of Real GDP is established through foreign sector spending
which includes spending on imports and exports.

 Suppose the price level in the United States falls. As this happens,
U.S. goods become relatively cheaper than foreign goods.

 As a result, both Americans & foreigners buy more U.S. goods. The
quantity demanded of (U.S.) Real GDP rises.
 Cont.
 Similarly, say the price level in the United States rises. As this
happens, U.S. goods become relatively more expensive than foreign
goods. As a result, both Americans and foreigners buy fewer U.S.
goods. The quantity demanded of (U.S.) Real GDP falls.
 Cont.
 We explained that the aggregate demand curve is downward sloping because
of the real balance, interest rate, and international trade effects.

 Keep in mind what caused these three effects: a change in the price level.

 In other words, when we were discussing, say, the interest rate effect, we
were discussing the interest rate effect of a change in the price level.

 Why is this an important point? Because the interest rate can change due to
things other than the price level changing, and not everything that change
the interest rate leads to a movement from one point to another point on the
AD curve.

 Some things that change the interest rate can lead to a shift in the AD curve
instead.
 Cont.
4.1.2. Changes in Aggregate Demand
 A change in the quantity demanded of Real GDP is brought about by a
change in the price level. As the price level falls, the quantity
demanded of Real GDP rises, ceteris paribus.
 In figure 1.5(a), a change in the quantity demanded of Real GDP is
represented as a movement from one point (A) on AD1 to another
point (B) on AD1.
 A change in aggregate demand is represented in panel (b) as a shift in
the aggregate demand curve from AD1 to AD2. Notice that when the
aggregate demand curve shifts, the quantity demanded of Real GDP

changes even though the price level remains constant.

 Cont.
 For example, at a price level (index number) of 180, the quantity
demanded of Real GDP on AD1 in panel (b) is $6.0 trillion. But at the
same price level (180), the quantity demanded of Real GDP on AD2 is
$6.5 trillion.
 Cont.

 What can change aggregate demand?

 In other words, what can cause aggregate demand to rise and what can
cause it to fall?

 The simple answer is that aggregate demand changes when the

spending on the goods and services changes.

 If spending increases at a given price level, aggregate demand rises; if

spending decreases at a given price level, aggregate demand falls.

 Cont.
 When individuals, firms, and governments want to buy more goods
and services even though the prices of these goods have not changed,
then we say that aggregate demand has increased.

 As a result, the AD curve shifts to the right. Of course, when

individuals, firms, and governments want to buy fewer goods and
services at a given price level, then we say that aggregate demand
has decreased. As a result, the AD curve shifts to the left.
 Cont.
4.2. Aggregate supply
 Aggregate supply is a measurement of the total amount of supply of
all finished goods and services produced in an economy.

 It refers to the quantity supplied of all goods and services (Real GDP)
at different price levels, ceteris paribus.

 In other words, it is the quantity supplied of goods and services by

firms, or the quantity supplied of Real GDP, at various price levels,
ceteris paribus
 Cont.
4.2.1 Short-Run Aggregate Supply (SRAS)
 Aggregate demand is one side of the economy; aggregate supply is the
other side.
 Aggregate supply refers to the quantity supplied of all goods and
services (Real GDP) at various price levels, ceteris paribus.
 Aggregate supply includes both short-run aggregate supply (SRAS)
and long-run aggregate supply (LRAS).
 A short-run aggregate supply (SRAS) curve is illustrated in figure
below.
 It shows the quantity supplied of all goods and services (Real GDP or
output) at different price levels, ceteris paribus
 Cont.
 Notice that the SRAS curve is upward sloping: As the price level rises,
firms increase the quantity supplied of goods and services; as the price
level drops, firms decrease the quantity supplied of goods and
services.


 Cont.
Changes in Short-Run Aggregate Supply

 A change in the quantity supplied of Real GDP is brought about by a

change in the price level.

 A change in quantity supplied is a movement along the SRAS curve.

 But what can change short-run aggregate supply & shift the curve?

 The factors that can shift the SRAS curve include wage rates, prices of

non labor inputs, productivity, and supply shocks.

 Cont.

Wage Rates: Changes in wage rates have a major impact on the position
of the SRAS curve because wage costs are usually a firm’s major cost
item.

 Higher wage rates mean higher costs and, at constant prices, translate
into lower profits and a reduction in the number of units (of a given
good) managers of firms will want to produce.

 Lower wage rates mean lower costs and, at constant prices, translate
into higher profits and an increase in the number of units (of a given
good) managers will decide to produce
 Cont.
Prices of Non-labor Inputs: There are other inputs to the production
process besides labor.

 Changes in their prices affect the SRAS curve in the same way as
changes in wage rates do.

 An increase in the price of a non-labor input (e.g., oil) shifts the SRAS
curve leftward; a decrease in the price of a non-labor input shifts the
SRAS curve rightward.
 Cont.
Productivity: Productivity describes the output produced per unit of input
employed over some period of time.
 Although various inputs can become more productive, let’s consider the
input labor.
 An increase in labor productivity means businesses will produce more
output with the same amount of labor.
 This causes the SRAS curve to shift rightward. A decrease in labor
productivity means businesses will produce less output with the same
amount of labor. This causes the SRAS curve to shift leftward.
 A host of factors lead to increased labor productivity, including a more
educated labor force, a larger stock of capital goods, and technological
advancements.
 Cont.
Supply Shocks: Major natural or institutional changes on the supply side
of the economy that affect aggregate supply are referred to as supply
shocks.

 Supply shocks are of two varieties.

 Adverse supply shocks (such as bad weather, major cutback in the

supply of oil) shift the SRAS curve leftward, and beneficial supply
shocks shift it rightward.

 Example: major oil discovery, unusually good weather.

 Cont.
Putting AD & SRAS Together: Short-Run Equilibrium
 In this section, we put aggregate demand and short-run aggregate
supply together to achieve short-run equilibrium in the economy.

 Aggregate demand and short-run aggregate supply determine the price

level, Real GDP, and the unemployment rate in the short run.

 Figure 1.7 shows an aggregate demand (AD) curve and a short-run

aggregate supply (SRAS) curve.
 Cont.
Putting AD & SRAS Together: Short-Run Equilibrium
 We consider the quantity demanded of Real GDP and the quantity
supplied of Real GDP at three different price levels: P1, P2, and PE.

 At P1, the quantity supplied of Real GDP (Q2) is greater than the
quantity demanded (Q1). There is a surplus of goods. As a result, the
price level drops, firms decrease output, and consumers increase
consumption.

 Why do consumers increase consumption as the price level drops? At

P2, the quantity supplied of Real GDP (Q1) is less than the quantity
demanded (Q2). There is a shortage of goods.
 Cont.
 As a result, the price level rises, firms increase output, and consumers
decrease consumption.

 In instances of both surplus and shortage, economic forces are moving

the economy toward E, where the quantity demanded of Real GDP
equals the (short-run) quantity supplied of Real GDP. This is the point
of short-run equilibrium.

 PE is the short-run equilibrium price level; Q E is the short-run

equilibrium Real GDP.
 Cont.
 A change in aggregate demand, short-run aggregate supply, or both
will obviously affect the price level and/or Real GDP.

 For example, an increase in aggregate demand raises the equilibrium

price level and, in the short run, Real GDP.

 An increase in short-run aggregate supply lowers the equilibrium price

level and raises Real GDP. A decrease in short-run aggregate supply
raises the equilibrium price level and lowers Real GDP.
Cont.
 Cont.
4.2.2. Long-Run Aggregate Supply (LRAS)
 As an earlier section explains, economists give different reasons for an
upward-sloping SRAS curve. It follows, then, that short-run equilibrium
identifies the Real GDP the economy produces when either of these two
conditions hold.
 In time, though, wages will become unstuck and misperceptions will turn
into accurate perceptions.
 When this happens, the economy is said to be in the long run. In other
words, in the long run, these two conditions do not hold.
 An important macroeconomic question is: Will the level of Real GDP the
economy produces in the long run be the same as in the short run? Most
economists say that it will not be.
 Cont.

 They argue that in the long run, the economy produces the
full-employment Real GDP or the Natural Real GDP (QN).

 Natural Real GDP: is The Real GDP that is produced at the

natural unemployment rate.

 It is the Real GDP that is produced when the economy is in

long-run equilibrium.
 Cont.
 The aggregate supply curve that identifies the output the economy
produces in the long run is the long-run aggregate supply curve.

 It is shown as the vertical line in as follows.

 Cont.
 It follows that long-run equilibrium identifies the level of Real GDP
the economy produces when wages and prices have adjusted to their
(final) equilibrium levels and there are no misperceptions on the part
of workers.

 Graphically, this occurs at the intersection of the AD and LRAS curves.

Furthermore, the level of Real GDP that the economy produces in
long-run equilibrium is Natural Real GDP (QN).
 Cont.

 Generally, there are two equilibrium states in an economy: short-run

equilibrium and long-run equilibrium.

 These two equilibrium states are graphically shown in figure 1.9. In

panel (a) of the figure, the economy is at point 1, producing Q1
amount of Real GDP.

 Notice that at point 1, the quantity supplied of Real GDP (in the short
run) is equal to the quantity demanded of Real GDP, and both are Q1.

 The economy is in short-run equilibrium. In panel (b) of the figure,

the economy is at point 1, producing QN. In other words, it is
producing Natural Real GDP.
 Cont.

 The economy is in long-run equilibrium when it produces QN.

 Notice that in both short-run and long-run equilibrium, the quantity

supplied of Real GDP equals the quantity demanded.

 So what is the difference between short-run equilibrium and long-run

equilibrium?

 In long-run equilibrium, quantity supplied and demanded of Real GDP

equal Natural Real GDP [see panel (b)].

 But in short-run equilibrium, quantity supplied and demanded of Real

GDP are either more than or less than Natural Real GDP.
 Cont.

Figure 1: Equilibrium States of the Economy

 Cont.
4.2.3. Determinants of change in Aggregate Supply
Determinants of Aggregate supply are different factors in an economy that can
change, or shift, the aggregate supply curve.
Factor Prices: Factor prices represent the cost of resources used to produce
goods.
 This includes raw materials such as lumber or steel, as well as energy or
wages. This determinant effects Aggregate because if factor prices rise, then
firms will be able to supply fewer goods at a given price, and vice versa if
the fall.
 For example, if the price of steel rises, it would cost more for auto
manufactures to make cars. Therefore, manufactures would be able to make
fewer cars at the same aggregate price level as before the rise in factor
prices.
 Cont.
• Technology: Technology is a determinant of aggregate supply
because it impacts productivity. If productivity rises from the
introduction of new technology, then firms will be able to produce
more good at the same aggregate price level. It's hard to envision a
decrease or loss in technology which leads to lower productivity, but
a software virus could disable computers and automated production.

• Labor Productivity: An increase in labor productivity can determine a

firm's level of output. For example, if the workforce becomes better
educated, allowing them to work more efficiently, then goods can be
produced at higher rate at the same given price level.
 Cont.

 Availability of Factors of Production: The availability of things used

in producing goods and services is another determinant of aggregate
supply.

 If the availability of factors of production increases, then firms can

produce more goods at a given price, and vice versa. For example, say
a new disease wipes out the chicken population, if that were to
happen, then a restaurant that makes fried chicken would not be able
to supply the same amount of that good at the same given price level
as before.
 Cont.

• Capital Productivity: Capital productivity measure how efficiently

capital is being used to produce goods and services. This is also a
determinant of aggregate supply. If firms began to mismanage their
capital, causing them to use it inefficiently, then their level output or
supply would drop at the same given price.

• Government Rules, Taxes, and Subsidies: The final three

determinants of aggregate supply are all related in that they are
determined by the government.
 Cont.
 If there is a change in government rules such as new regulations on
the treatment of livestock, that would lower the output of meat
factories.

 Conversely, if the government increased subsidies for farmers that

raised livestock, that would increase the level of output.

 Taxes are the final determinant of aggregate supply.

 Cont.

 If income taxes rise, then the labor force will demand higher
wages causing a decrease in output at the same aggregate price
level.

 Taxes can also affect firms more directly in the form of

corporate taxes.

 If corporate taxes are lowered, that would increase the amount

of supply firms would be able to supply at the given price level.
 Cont.
4.2.4. Aggregate supply models
 The aggregate supply curve shows the relationship between the
price level and output.
 While the long run aggregate supply curve is vertical, the short
run aggregate supply curve is upward sloping.
 There are four major models that explain why the short-term
aggregate supply curve slopes upward.

1) The sticky-wage model.

2) The worker-misperception model.
3) The imperfect-information model
4) The sticky- price model.
 Cont.
Sticky-Wage Model

 The sticky-wage model of the upward sloping short run aggregate

supply curve is based on the labor market.

 In many industries, short run wages are set by contracts.

 That is, workers are paid based on relatively permanent pay schedules
that are decided upon by management or unions or both.

 When the economy changes, the wage the workers receive cannot
adjust immediately.
 Cont.

 Given that wages are sticky, the chain of events leading from an
increase in the price level to an increase in output is fairly
straightforward.

 When the price level rises, the nominal wage remains fixed because
this is solely based on the dollar amount of the wage.

 The real wage, on the other hand, falls because this is based on the
purchasing power of the wage.

 A higher price level means that a given wage is able to purchase fewer
goods and services.
 Cont.
 When the real wage that firms pay employees falls, labor becomes
cheaper.

 However, since the amount of output produced for each unit of labor
is still the same, firms choose to hire more workers and increase
revenues and profits.

 When firms hire more labor, output increases. Thus, when the price
level rises, output increases because of sticky wages.

 Summary, When the price level rises, real wages fall. When real
wages fall, labor becomes cheaper. When labor becomes cheaper,
firms hire more labor. When firms hire more labor, output increases.
 Cont.
Worker-Misperception Model
 The worker-misperception model of the upward sloping short- run aggregate
supply curve is again based on the labor market.
 This time, unlike in the sticky-wage model, wages are free to move as the
economy changes.
 The amount of work that an employee is willing to supply is based on the
expected real wage.
 That is, workers know how many dollars they are being paid, the nominal
wage, but workers can only guess at how much goods and services they can
purchase with this wage, the real wage.
 In general, the higher the real wage, the more work that workers are willing
to supply.
 Cont…
 Now let's say that the price level increases.

 Because we assume that firms have more information than workers

do, firms will give workers a raise so that their nominal wage
increases with the price level.

 But since the workers do not realize that the price level increased, they
will believe that their real wage increased, not just their nominal
wage. At a higher real wage, workers are induced to work more.

 When workers work more, output increases. Thus, when the price
level increases, output also increases because of worker-
misperception.
 Cont.

 Let's summarize the chain of events that leads from an increase in the
price level to an increase in output in the worker-misperception
model.

 When the price level rises, firms increase nominal wages. When
nominal wages increase, workers--due to misperceptions--believe that
real wages also increase.

 When workers believe that real wages increase, workers provide

more labor. When workers provide more labor, output increases.
Imperfect-Information Model

 The imperfect-information model of the upward sloping short- run

aggregate supply curve is again based on the labor market.

 In this model, unlike either the sticky-wage model or the worker-

misperception model, neither the worker nor the firm has complete
information.

 That is, neither is better informed than the other is about the real
wage, the nominal wage, or the price level.
 Cont.
 In this model, producers are considered to be really only aware of the
price of the goods and services that they produce.

 That is, producers are unable to recognize overall increases in the

price level because they are focused on their products only. Instead,
producers only recognize changes in the prices of the goods and
services that they produce.

 Given that producers are unable to recognize changes in the overall

price level, they are likely to confuse changes in the goods and
services they produce (relative changes in the price level) with
changes in the overall price level (absolute changes in the price level).
 Cont.
 It is important to understand the implications of both relative
changes in the price level and absolute changes in the price level.

 When a relative change in the price level occurs, producers of some

goods and services are better off because the price of their output
increases to a greater extent than the overall price level.

 Both the real wage and the nominal wage earned by these producers
increase.

 When an absolute change in the price level occurs, all producers are
affected equally and the nominal wage increases while the real
wage remains constant.
 Cont.
 Recall that workers are willing to provide more labor when the wage
is high. That is, they will work harder when they are getting paid more
for their work.
 Also recall that workers cannot differentiate between relative changes
in the price level and absolute changes in the price level.
 Thus, when a workers sees a change in the price level, she will likely
believe that it is a relative change in the price level, even if it is an
absolute change in the price level.
 Because of this, the workers will work more and produce more output
when the price level rises. Thus, an increase in the price level causes
output to rise.
 Cont.

 Let's summarize the chain of events that leads from an increase in the
price level to an increase in output in the imperfect-information
model.

 When the overall price level rises, workers mistake it for a relative
increase in the price level. When the relative price level rises, the real
wage earned by workers rises.

 When the real wage earned by workers rises, the amount of labor
supplied by workers increases. When the amount of labor supplied by
workers increases, output increases.
 Cont.
Sticky-Price Model
 The sticky-price model of the upward sloping short-run aggregate
supply curve is based on the idea that firms do not adjust their price
instantly to changes in the economy.

 There are numerous reasons for this. First, many prices, like wages,
are set in relatively long-term contracts.

 Second, firms hold prices stable to keep from annoying regular

customers. It would really be a pain if the price of a newspaper
changes from 24 cents to 25 cents to 23 cents as the price of paper and
ink changed.
 Cont.

 Third, firms hold prices stable because of menu costs. Menu costs are
those costs that are associated with printed catalogues and menus.

 It would be very expensive to constantly change catalogues and

menus in response to economic changes.

 But how does the fact the prices are sticky in the short run lead to an
upward sloping relationship between the price level and output?

 When firms prepare to set their prices, they take into account the
expected price level.

 When the expected price level is high, firms set their prices high to
compensate for the high price of inputs.
 Cont.
 When the price charged for output is high, firms produce more output, as
the incentive for production is also high.
 Thus, an increase in the price level leads rather directly to an increase in
output in the sticky-price model.
 There is another way to conceptualize the relationship between the price
level and output in the sticky-price model.
 When the level of output is high, the demand for goods and services is also
high. Thus, when firms set their sticky- prices, they set them high to account
for the high demand.
 When firms set their prices high, the overall price level increases. Thus, a
high level of output leads to a high level of demand, which leads to a high
price level.
 Cont.
 Let's summarize the two chains of events that characterize the relationship
between the price level and output in the sticky-price model.

 First, when firms expect a high price level they set their relatively sticky
prices high. Other firms follow suit and set their prices high as well.

 Thus, a high expected price level leads to a high actual price level. When the
expected price level is high, producers produce more output. Second,

 when the level of output is high, the demand for goods and services is also
high. When the demand for goods and services is high, the price charged for
goods and services is also high.
 Cont.

 When the price charged for goods and services is high, firms set their
relatively sticky prices high.

 When some firms set their relatively sticky prices high, other firms
follow suit. Thus, the overall price level increases.
 QUIZ (5%)

1. Explain the worker-misperception model of the upward

sloping short- run aggregate supply curve? (2pts)

2. What is the difference between short-run equilibrium

and long-run equilibrium? (2pts)

3. Discuss on determinants of change in Aggregate Supply?

(1pts)