Aggregate Demand and Aggregate Supply

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.

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.

Three Key Facts About Economic Fluctuations

Economic Fluctuations are Irregular and
Unpredictable.

Most Macroeconomic Variables Fluctuate

Recessions occur with unpredictable frequency and duration.

Together. Most macroeconomic variables are closely related and move together. As Output Falls, Unemployment Rises.

Changes in real GDP and the unemployment rate are inversely related.

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.

The Basic Model of Economic Fluctuations

model to analyze the short-run fluctuations:
1. The economys 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

The Aggregate Demand and Aggregate Supply Model

Price Level Aggregate Supply

PE

Aggregate Demand QE Quantity of Output

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.

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. Pigous Wealth Effect 2. Keynes Interest Rate Effect 3. Real Exchange Rate Effect

Three Reasons for the Downward Slope of the Aggregate Demand

Pigous 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.

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.

Three Reasons for the Downward Slope of the Aggregate Demand

Real Exchange-Rate Effect: When prices of Canadian goods go down, foreigners buy more of our goods and we purchase less of their goods.

When a fall in the Canadian price level causes the real exchange rate to depreciate, this stimulates Canadian net exports, thereby increasing the quantity of goods and services demanded.

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.

Shifts in the Aggregate Demand Curve

Price Level Aggregate Supply

AD
AD
Aggregate Demand

Quantity of Output

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 economys resource endowment, technology, and its governing institutions. The price level does not affect these variables in the long-run.

The Long-Run Aggregate Supply Curve

Price Level
Aggregate Supply

The Long-Run Aggregate Supply Curve

Aggregate Demand

Quantity of Output

The Long-Run Aggregate Supply Curve

Price Level
Aggregate Supply

Output at Full Employment

Aggregate Demand

Quantity of Output

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 economys potential output will shift the curve to the right.

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.

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

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.

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.

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.

What Might Cause the Aggregate Supply Curve to Shift?

Three factors may lead to a shift in the shortrun aggregate supply curve.

Changes in Factor (input) Prices Changes in Natural Resources Changes in Productivity Changes in Legal-Institutional Environment Changes in Technological Knowledge

Shifts in the Aggregate Supply Curve

Price Level

AS

Aggregate Supply

AS

Aggregate Demand

Quantity of Output

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.

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.

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.

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.

Equilibrium in the Long-Run

Price Level Aggregate Supply

PE
Aggregate Demand

QE

Quantity of Output

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 economys output of goods and services.

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

A Decrease in Aggregate Demand

Price Level Aggregate Supply

PE
Aggregate Demand

QE

Quantity of Output

A Decrease in Aggregate Demand

Price Level Aggregate Supply

PE
Aggregate Demand

QE

Quantity of Output

A Decrease in Aggregate Demand

Price Level Aggregate Supply

PE
Aggregate Demand

QE

Quantity of Output

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

A Decrease in Aggregate Supply

Price Level Aggregate Supply

PE
Aggregate Demand

QE

Quantity of Output

A Decrease in Aggregate Supply

Price Level Aggregate Supply

PE
Aggregate Demand

QE

Quantity of Output

A Decrease in Aggregate Supply

Price Level Aggregate Supply

PE
Aggregate Demand

QE

Quantity of Output

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.

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).