Aggregate Demand and

Aggregate Supply

Principles of Macroeconomics: Ch. 19 Second Canadian Edition

 Overview
Three key factors about economic
fluctuations.
The aggregate demand and aggregate
supply model.
The aggregate demand curve.
The aggregate supply curve.
Equilibrium in the long-run.

Principles of Macroeconomics: Ch. 19 Second Canadian Edition

 Short-Run Economic Fluctuations
Economic activity fluctuates from year
to year. In some years, the production
of goods and services rises. In other
years normal growth does not occur,
leading to recession.
A recession is a situation of declining
real GDP, falling incomes and rising
unemployment for two consecutive
quarters.
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
 Three Key Facts About Economic
Fluctuations
 Economic Fluctuations are Irregular
and Unpredictable.
– Recessions occur with unpredictable
frequency and duration.
 Most Macroeconomic Variables
Fluctuate Together.
– Most macroeconomic variables are
closely related and move together.

Principles of Macroeconomics: Ch. 19 Second Canadian Edition

 Three Key Facts About Economic
Fluctuations
As Output Falls, Unemployment Rises.
– Changes in real GDP and the
unemployment rate are inversely related.

Principles of Macroeconomics: Ch. 19 Second Canadian Edition

 Quick Quiz!

List and discuss

three key facts
about economic
fluctuations.

Principles of Macroeconomics: Ch. 19 Second Canadian Edition

 Overview
 Three key factors about economic
fluctuations.
The aggregate demand and aggregate
supply model.
The aggregate demand curve.
The aggregate supply curve.
Equilibrium in the long-run.

Principles of Macroeconomics: Ch. 19 Second Canadian Edition

 Economic Fluctuations
Although there remains some debate
about how to analyze short-run
fluctuations, most economists use the
model of aggregate demand and
aggregate supply.

Principles of Macroeconomics: Ch. 19 Second Canadian Edition

 The Basic Model of Economic
Fluctuations
Two variables are used in developing a
model to analyze the short-run
fluctuations:
1. The economy’s output of goods and
services, measured by real GDP
2. The overall price level, measured by the
CPI or GDP Deflator
The Model: Aggregate Demand and
Aggregate Supply
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
 The Aggregate Demand and
Aggregate Supply Model
Price Aggregate
Level Supply

PE

Aggregate
Demand

QE Quantity of Output
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
 Aggregate Demand and
Aggregate Supply
The Aggregate Demand Curve shows
the quantity of goods and services that
households, firms and the government
are willing to buy at different prices.
The Aggregate Supply Curve shows
the quantity of goods and services that
firms would be willing to produce and
sell at different prices.
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
 Overview
 Three key factors about economic
fluctuations.
 The aggregate demand and aggregate
supply model.
The aggregate demand curve.
The aggregate supply curve.
Equilibrium in the long-run.

Principles of Macroeconomics: Ch. 19 Second Canadian Edition

 The Aggregate Demand Curve
The aggregate demand for goods and
services may be referred to as:
Y = C + I + G + NX
Why is the aggregate demand curve
downward sloping?
1. Pigou’s Wealth Effect
2. Keynes’ Interest Rate Effect
3. Real Exchange Rate Effect

Principles of Macroeconomics: Ch. 19 Second Canadian Edition

 Three Reasons for the Downward
Slope of the Aggregate Demand
Pigou’s Wealth Effect: “Consumers
feel wealthier, which stimulates the
demand for consumption goods.”
– A decrease in the price level makes
consumers feel more wealthy, which in
turn encourages them to spend more.
– The increase in consumer spending
means a larger quantity of goods and
services demanded.

Principles of Macroeconomics: Ch. 19 Second Canadian Edition

 Three Reasons for the Downward
Slope of the Aggregate Demand
Keynes’ Interest-Rate Effect: “The
lower the price level, the less money
households need to hold to buy the
goods and services they want.”
– A lower price level reduces the interest
rate, encourages greater spending on
investment goods, and thereby increases
the quantity of goods and services
demanded.

Principles of Macroeconomics: Ch. 19 Second Canadian Edition

 Three Reasons for the Downward
Slope of the Aggregate Demand
Real Exchange-Rate Effect: “When
prices of Bangladesh goods go down,
foreigners buy more of our goods and
we purchase less of their goods.”
– When a fall in the Bangladesh price level
causes the real exchange rate to depreciate,
this stimulates Bangladesh net exports,
thereby increasing the quantity of goods and
services demanded.

Principles of Macroeconomics: Ch. 19 Second Canadian Edition

 Factors that might shift the
Aggregate Demand Curve
Shifts in the aggregate demand curve
may arise because of:
1. Changes in spending plans by
consumers or firms.
2. Changes in fiscal or monetary policy.
“Anything that causes buyers to want to
purchase more or less than before will
cause the aggregate demand schedule
to shift.”
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
 Shifts in the Aggregate Demand Curve
Price Aggregate
Level Supply

AD
AD Aggregate Demand

Quantity of Output
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
 Quick Quiz!
Explain the three reasons
why the aggregate
demand curve slopes
downward.
Give an example of an
event that would shift the
aggregate demand curve.
Which way would this
event shift the curve?
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
 Overview
 Three key factors about economic
fluctuations.
 The aggregate demand and aggregate
supply model.
 The aggregate demand curve.
The aggregate supply curve.
Equilibrium in the long-run.

Principles of Macroeconomics: Ch. 19 Second Canadian Edition

The Long-Run Aggregate Supply Curve
The Long-Run Aggregate Supply
Curve is vertical at full-employment
GDP with respect to the price level.
In the long-run the quantity of output
supplied depends on the economy’s
resource endowment, technology, and
its governing institutions. The price
level does not affect these variables in
the long-run.

Principles of Macroeconomics: Ch. 19 Second Canadian Edition

The Long-Run Aggregate Supply Curve
Price Aggregate
Level Supply

The Long-Run
Aggregate
Supply Curve

Aggregate
Demand

Quantity of Output
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
The Long-Run Aggregate Supply Curve
Price Aggregate
Level Supply

Output at
Full Employment

Aggregate
Demand

Quantity of Output
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
 Shifts in the Long-Run Aggregate
Supply Curve
Over time, any change in the factors
that determine the long-run aggregate
supply will cause the curve to shift.
– An event that reduces potential output
shifts the schedule to the left.
– Any change that increases the economy’s
potential output will shift the curve to the
right.

Principles of Macroeconomics: Ch. 19 Second Canadian Edition

 The Short-Run Aggregate
Supply Curve
In the short-run, an increase in the
overall level of prices in the economy
tends to raise the quantity of goods
and services supplied, and a decrease
in the level of prices tends to reduce
the quantity of goods and services
supplied.

Principles of Macroeconomics: Ch. 19 Second Canadian Edition

Reasons for the Upward Slope of the
Aggregate Supply Curve
There are three alternative
explanations for the upward slope of
the short-run aggregate supply curve.
– New Classical Misperceptions Theory
– The Keynesian Sticky-Wage Theory
– The New Keynesian Sticky-Price Theory

Principles of Macroeconomics: Ch. 19 Second Canadian Edition

Reasons for the Upward Slope of the
Aggregate Supply Curve
The New Classical Misperceptions
Theory: “A higher price level signals
to each firm a greater demand for their
product inducing them to produce
more.”
– Changes in the overall price level can
temporarily mislead suppliers about what
is happening in the markets in which they
sell their output.

Principles of Macroeconomics: Ch. 19 Second Canadian Edition

Reasons for the Upward Slope of the
Aggregate Supply Curve
The Keynesian Sticky-Wage Theory:
“The higher product prices cause a
temporary decrease in real wages
stimulating employment and output.”
– Nominal wages are slow to adjust, or are
“sticky” in the short-run, thus a lower
price level makes employment and
production less profitable, which induces
firms to reduce production.

Principles of Macroeconomics: Ch. 19 Second Canadian Edition

Reasons for the Upward Slope of the
Aggregate Supply Curve
The New Keynesian Sticky-Price
Theory: “Prices that do not increase
immediately are temporarily low
thereby stimulating spending and
output on those goods.”
– Prices of some goods and services adjust
sluggishly in response to changing
economic conditions.
– Remember Menu Costs.

Principles of Macroeconomics: Ch. 19 Second Canadian Edition

 What Might Cause the Aggregate
Supply Curve to Shift?
Three factors may lead to a shift in the
short-run aggregate supply curve.
– Changes in Factor (input) Prices
– Changes in Productivity
– Legal-Institutional Environment

Principles of Macroeconomics: Ch. 19 Second Canadian Edition

 Shifts in the Aggregate Supply Curve
Price AS Aggregate Supply
Level
AS

Aggregate
Demand

Quantity of Output
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
 What Might Cause the Aggregate
Supply Curve to Shift?
Changes in factor (input) prices:
Changes in the prices of domestic or
imported resources will change the
cost of producing final goods.
– An increase in input prices will shift the
supply curve to the left.
– A decrease in input prices will shift the
supply curve to the right.

Principles of Macroeconomics: Ch. 19 Second Canadian Edition

 What Might Cause the Aggregate
Supply Curve to Shift?
Changes in productivity: If changes in
the resource markets increase factor
productivity, more goods can be made
available at a lower cost. New
technologies can increase the output
per unit of labour or capital and hence
make available more final goods.

Principles of Macroeconomics: Ch. 19 Second Canadian Edition

 What Might Cause the Aggregate
Supply Curve to Shift?
Legal-institutional environment:
Burdensome taxes and
counterproductive regulations can
increase the cost of production and
discourage firms from producing.

Principles of Macroeconomics: Ch. 19 Second Canadian Edition

 Quick Quiz!
Explain why the long-
run aggregate supply
curve is vertical.
Explain three theories
for why the short-run
aggregate supply
curve is upward
sloping.
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
 Overview
 Three key factors about economic
fluctuations.
 The aggregate demand and aggregate
supply model.
 The aggregate demand curve.
 The aggregate supply curve.
Equilibrium in the long-run.

Principles of Macroeconomics: Ch. 19 Second Canadian Edition

 Equilibrium in the Long-Run
Equilibrium output and price level are
determined by the intersection of the
aggregate demand curve and the long-
run aggregate supply curve.
Output is at its natural rate and the
short-run aggregate supply curve
passes through the point of
intersection.
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
 Equilibrium in the Long-Run
Price Aggregate
Level Supply

PE

Aggregate
Demand

QE Quantity of Output
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
 Sources of Recession
Two sources from which a recession in
the economy may occur:
– A decrease in aggregate demand
– A decrease in aggregate supply
Shifts in the aggregate demand or the
aggregate supply curves result in
fluctuations in the economy’s output
of goods and services.

Principles of Macroeconomics: Ch. 19 Second Canadian Edition

 Source of Recession
A Decrease in Aggregate Demand
A decrease in one or more
components of the total spending
function will cause the aggregate
demand schedule to shift leftward.
– Output will fall below the full employment
output
– Unemployment will rise

Principles of Macroeconomics: Ch. 19 Second Canadian Edition

 A Decrease in Aggregate Demand
Price Aggregate
Level Supply

PE

Aggregate
Demand

QE Quantity of Output
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
 A Decrease in Aggregate Demand
Price Aggregate
Level Supply

PE

Aggregate
Demand

QE Quantity of Output
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
 A Decrease in Aggregate Demand
Price Aggregate
Level Supply

PE

Aggregate
Demand

QE Quantity of Output
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
 Source of Recession
A Decrease in Aggregate Supply
A decrease in short-run aggregate
supply will result in a new equilibrium
along the aggregate demand curve
below full employment.
A fall in total output below full output
– An increase in unemployment

Principles of Macroeconomics: Ch. 19 Second Canadian Edition

 A Decrease in Aggregate Supply
Price Aggregate
Level Supply

PE

Aggregate
Demand

QE Quantity of Output
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
 A Decrease in Aggregate Supply
Price Aggregate
Level Supply

PE

Aggregate
Demand

QE Quantity of Output
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
 A Decrease in Aggregate Supply
Price Aggregate
Level Supply

PE

Aggregate
Demand

QE Quantity of Output
Principles of Macroeconomics: Ch. 19 Second Canadian Edition
 A Decrease in Aggregate Supply
When the economy falls due to a
decrease in the aggregate supply, the
price level rises and output decreases.
This is called Stagflation.

Principles of Macroeconomics: Ch. 19 Second Canadian Edition

 Actions by Policy-makers During
Periods of Recession
Policy-makers, when faced by
decreasing aggregate demand or
supply could:
– Do nothing, assuming that perceptions
will adjust prices and wages.
– Take action to increase aggregate
demand (implement monetary and fiscal
policy).

Principles of Macroeconomics: Ch. 19 Second Canadian Edition

 Quick Quiz!
 Suppose that the election
of a popular prime
ministerial candidate
suddenly increases
people’s confidence in the
future.
 Use the model of aggregate
supply and aggregate
demand to analyze the
effect on the economy.

Principles of Macroeconomics: Ch. 19 Second Canadian Edition

 Overview
 Three key factors about economic
fluctuations.
 The aggregate demand and aggregate
supply model.
 The aggregate demand curve.
 The aggregate supply curve.
 Equilibrium in the long-run.

Principles of Macroeconomics: Ch. 19 Second Canadian Edition