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Aggregate Demand

and
Aggregate Supply

Q: Why does Output fluctuate in the short-run?


Q: How MP and FP can control such fluctuations?

Ref. Ch 20 and 21 of Prescribed Mankiw Texbook


Facts About Economic Fluctuations
• Economic activity fluctuates from year to year.
1 Economic fluctuations are irregular and unpredictable.
2. Most macroeconomic quantities fluctuate together.
3. As output falls, unemployment rises.
 Economist use the model of Aggregate Demand and Aggregate
Supply
 To explain short-run fluctuations in economic activity around its long-
run trend.

Business
Economic cycle
activity

Time
Facts About Economic Fluctuations
Real GDP Growth Rate:
GDP at FC (constant price) base year (1999-2000)
12.00
Business Cycle
10.00

8.00

6.00

4.00

2.00

0.00

-2.00

-4.00

-6.00
2
Trend Line or Potential Growth Rate of output
Facts About Economic Fluctuations
Business Cycles in India

PERIOD V 2001-2002
PERIOD VI 2007-2009
Facts About Economic Fluctuations
Business Cycle and Inflation rate

OPEC crisis
Asian Financial crisis
Business Cycles

b. Business Cycle: Inflation rate


The Model of
Aggregate Demand and Aggregate Supply
P
The price
level
SRAS

P1

AD

Y
Y1
The model determines the Real GDP, the
eq’m price level and eq’m quantity of output
output (real GDP).
THE AGGREGATE-DEMAND CURVE...
Y=C+I+G+X-M
The Aggregate Demand Curve
The downward slope of the aggregate-demand
Price
curve shows that a fall in the price level raises
Level
the overall quantity of goods and services demanded.

AD=C+I+G+NX

P2
1. A decrease
Aggregate
in the price
demand
level . . .

0 Y Y2 Quantity of
Output
2. . . . increases the quantity of
goods and services demanded.
Aggregate Demand Curve: Why Slopes Downward

1. The Price Level (P) and Consumption (C): The Wealth Effect

When ↓P=> ↑M/P=> ↑Wealth of Consumer=> ↑C=> ↑AD

2. The Price Level (P) and Investment (I): The Interest Rate Effect
When ↓P=> ↑M/P=> ↓i=> ↑ I=> ↑AD

3. The Price Level (P) and Net Exports (X-M): The Exchange-Rate
Effect

When ↓P=> ↑M/P=> ↓i ( in India)=> Depreciation of

Exchange rate( India) => ↑(↑ X- ↓ M)=> ↑ AD


Aggregate Demand Curve: Why Shifts?

Price Shifted either due to increase in


Level C, I, G, X-M

P1

D2
Aggregate
demand, D1

0 Y1 Y2 Quantity of
Output
Aggregate Demand Curve: Why Shifts?
Shift Factors in AD Curve

• Consumption: • Investment is Spending  Government


on:
– Tax rates – Machinery • Defence
– Incomes – short term – Equipment
and expected – Buildings • Health
income over lifetime
– Infrastructure • Social Welfare
– Wage increases
• Influenced by:
– Credit
– Expected rates of • Education
– Interest rates return
– Wealth – Interest rates • Foreign Aid
• Property – Expectations of • Regions
• Shares future sales
• Savings – Expectations of • Industry
future inflation rates
• Bonds • Law and Order
• Money Supply
Q1. 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.
Q1. Answers

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.
THE AGGREGATE-SUPPLY CURVE:

Q= A f(N,L,K,O)

1. Long Run Aggregate Supply Curve


2. Short Run Aggregate Supply Curve
A. Long Run Aggregate Supply Curve: LRASC
(Classical)

Price
Level

Long-run
Aggregate
Supply curve

P2
2. . . . does not affect
1. A change the quantity of goods
in the price and services supplied
level . . . in the long run.

0 Natural rate Quantity of


of output Output
A. Long Run Aggregate Supply Curve: Why
Shift???

Any event that changes any of P LRAS1 LRAS2


the determinants of YN will shift
LRAS.
 Shifts might arise from
changes in:
• Labor (ex. Immigration)
• Capital (ex. more factories)
• Natural Resources (ex. new
mineral deposits)
Y
• Technological Knowledge YN Y’
N

The most important forces that govern the economy in the long run are technology and
monetary policy.
B. Short-Run Aggregate-Supply Curve: SRASC
(Keynesian)

Price
Level

Short-run
aggregate
supply

P2
1. A decrease 2. . . . reduces the quantity
in the price of goods and services
level . . . supplied in the short run.

0 Y2 Y Quantity of
Output
B. Short-Run Aggregate-Supply Curve: SRASC
(Keynesian)

• If P > PE,
Revenue is higher, Production is more profitable,
so firms increase output and employment

• Hence, higher P causes higher Y,


so the SRAS curve slopes upward.

1. The Sticky-Wage Theory (W fixed in SR)

2. The Sticky-Price Theory (P fixed) ( Ex. Menu Cost)

3. The Misperceptions Theory ( Relative Price Rise)


B. Short-Run Aggregate-Supply Curve: Why
Shift???
Everything that shifts LRAS shifts
SRAS, too.
Shifts in SRAS Curve due to:
P LRAS
 Expected Price Level(Pe).
SRAS
 Labor. SRAS
 Capital.
P=P’E
 Natural Resources.
 Technology
P=PE
If PE rises, workers & firms set higher
wages,
At each P, production is less
profitable, Y falls, SRAS shifts left Y
YN
An increase in the expected price level, Pe, shifts the aggregate supply curve
up and conversely true.
The Aggregate-Supply curve

What happens to the AS curve in each of the


following scenarios?
A. An expected increase in Price level.
B. Natural Calamities
C. Advancement of New in Technology
D. Labour Union goes for a strike
Answers

A. An expected increase in Price level.


Expected P ↑, ↓ Qty Supply , AS curve shifts
left.
B. Adverse Natural calamities .
AS curve shifts left .
C. Advancement of New in Technology
AS curve shifts right
D. Labour Union goes for a strike
AS curve shifts to left due to wage bargaining
AD-AS Equilibrium
in the Short Run and Long Run
The Short-Run and Long-Run Equilibrium
In the long-run equilibrium, PE = P, & Y = YN ,
and unemployment is at its natural rate.
Price
Level
Long-run
aggregate
Short-run
supply
aggregate
supply

Equilibrium A
price

Aggregate
demand
0 Natural rate Quantity of
of output Output
Long-Run Growth and Inflation

2. . . . and growth in the Long-run


money supply shifts aggregate
aggregate demand . . . supply,
LRAS1980 LRAS1990 LRAS2000
Price
Level

1. In the long run,


technological
progress shifts
P2000 long-run aggregate
supply . . .
4. . . . and
ongoing inflation.
P1990
Aggregate
Demand, AD2000
P1980
AD1990

AD1980

0 Y1980 Y1990 Y2000 Quantity of


Output
3. . . . leading to growth
in output . . .
Causes Of Economic Fluctuations

Two Causes:
1. Shifts in Aggregate Demand
2. Shifts in Aggregate Supply
1. Shifts in Aggregate Demand
Event: Stock market
2. . . . causes output to fall in the short run . . .leading to recession
crash
Price Affects C, AD curve
Level
Long-run Short-run aggregate
aggregate supply, AS
supply
AS2

3. . . . but over
time, the short-run
P A aggregate-supply
curve shifts . . .
P2 B
1. A decrease in
aggregate demand . . .
P3 C
Aggregate
demand, AD
AD2
0 Y2 Y Quantity of
4. . . . and output returns Output
to its natural rate.
Question: Working with the model

 Draw the AD-SRAS-LRAS diagram for the


Indian economy starting in a long-run
equilibrium.

 A boom occurs in China.


Use your diagram to determine
the SR and LR effects on Indian GDP,
the price level, and unemployment.
Answers Due to Increased demand for Indian product in
Chinese Market . Indian export increases

Event: Boom in China


P LRAS
1. Affects NX, AD curve SRAS2
2. Shifts AD right
3. SR eq’m at point B. P3 C SRAS1
P and Y higher,
P2 B
unemp lower
P1 A AD2
4. Over time, PE rises,
SRAS shifts left, AD1
until LR eq’m at C. Y
Y and unemp back YN Y2
at initial levels.
2. Shifts in Aggregate Supply
Event :natural calamities like earthquake,
Tsunami, Cyclone, drought
1. An adverse shift in the short-
SRASC Shift downward run aggregate-supply curve . . .
Price
Level

Long-run Short-run
aggregate AS2 aggregate
supply supply, AS

B
P2
A
P
3. . . . and
the price
level to rise.
Aggregate demand

0 Y2 Y Quantity of
2. . . . causes output to fall . . . Output
Accommodating an Adverse Shift in Aggregate Supply

1. When short-run aggregate


supply falls . . .
Price
Level
Long-run Short-run
aggregate AS2 aggregate
supply supply, AS

P3 C 2. . . . policymakers can
P2 accommodate the shift
A by expanding aggregate
3. . . . which P demand . . .
causes the
price level
to rise 4. . . . but keeps output AD2
further . . . at its natural rate.
Aggregate demand, AD

0 Natural rate Quantity of


of output Output
The Effects of a Shift in SRAS
Event: Oil prices rise
1. Increases costs, P LRAS
shifts SRAS
SRAS2
(assume LRAS constant)
2. SRAS shifts left SRAS1
B
3. SR eq’m at point B. P2
P higher, Y lower, P1 A
unemp higher
From A to B,
AD1
stagflation, Y
a period of Y2 YN
falling output
and rising prices.
Accommodating an Adverse Shift in SRAS
If policymakers do nothing,
4. Low employment P LRAS
causes wages to fall,
SRAS2
SRAS shifts right,
until LR eq’m at A. P3 C SRAS1
B
Or, P2
policymakers could use P1 A
fiscal or monetary policy AD2
to increase AD and
accommodate the AS AD1
Y
shift: Y2 YN
Y back to YN, but
P permanently higher.
Monetary and Fiscal Policy
on
Aggregate Demand

 Monetary and fiscal policy are sometimes used to offset those


shifts and stabilize the economy.
How Monetary Policy Influences Aggregate Demand
How Monetary Policy Influences Aggregate Demand
The Downward Slope of the Aggregate-
Demand Curve

(a) The Money Market (b) The Aggregate-Demand Curve

Interest Money Price


Rate supply Level
2. . . . increases the
demand for money . . .

r2 P2
Money demand at
price level P2 , MD2
r 1. An P
3. . . .
which increase
Money demand at in the Aggregate
increases
price level P , MD price demand
the
equilibrium 0 level . . . 0
Quantity fixed Quantity Y2 Y Quantity
interest
by the RBI of Money of Output
rate . . .
4. . . . which in turn reduces the quantity
of goods and services demanded.
How Monetary Policy Influences Aggregate Demand
Changes in the Money Supply

(a) The Money Market (b) The Aggregate-Demand Curve


Interest Price
Rate Money MS2 Level
supply,
MS

r 1. When the RBI P


increases the
money supply . . .
2. . . . the r2
AD2
equilibrium
interest rate Money demand Aggregate
falls . . . at price level P demand, AD
0 Quantity 0 Y Y Quantity
of Money of Output
3. . . . which increases the quantity of goods
and services demanded at a given price level.
Monetary policy
For each of the events below,
- determine the short-run effects on output
- determine how the RBI should adjust the money
supply and interest rates to stabilize output
A. BJP Govt tries to balance the budget by cutting govt
spending.

B. A stock market boom increases household wealth

C. War breaks out in the Middle East, causing oil prices


to soar.
Answers
A. BJP Govt tries to balance the budget by cutting govt spending.
This event would reduce Agg Demand and Output.
To stabilize output, the RBI should increase MS and reduce r to
increase AD.

B. A stock market boom increases household wealth.


This event would increase AD, raising output above its natural rate.
To stabilize output, the RBI should reduce MS and increase r to reduce AD.

C. War breaks out in the Middle East, causing oil prices to soar.
This event would reduce AS, causing output to fall.

To stabilize output, the RBI should increase MS and reduce r to increase


AD.
How Fiscal Policy Influences Aggregate Demand
A. Changes in Government Purchases (G0)

 When policymakers change the money supply or taxes, the


effect on aggregate demand is indirect—through the
spending decisions of firms or households.

 When the government alters its own purchases of goods


or services, it shifts the aggregate-demand curve directly.

 There are two macroeconomic effects from the change in


government purchases:

• The multiplier effect
• The crowding-out effect
1. The Multiplier Effect

 Q. If suppose the Central Govt spends Rs 20 million to buy


helicopter from HAL this year , how it affects the AD or economy?

Ans: HAL’s revenue increases by Rs 20 million.


This money is distributed to HAL’s workers (as wages) and owners
(as profits or stock dividends). Since these people are also
consumers , they will spend a portion of the extra income which
further causes increases in AD via multiplier.

The multiplier is: Multiplier = 1/(1 – MPC)


Let the MPC = 3/4, then the multiplier will be
Multiplier = 1/(1 – 3/4) = 4

In this case, a Rs 20 milion increase in government spending for


buying Aircraft from HAL generates Rs 80 milion of increased
demand for goods and services.
1. The Multiplier Effect

Price
Level

2. . . . but the multiplier


effect can amplify the
shift in aggregate
demand.

Rs. 20 milion

AD3
AD2
Aggregate demand, AD1
0 Quantity of
1. An increase in government purchases Output
of Rs. 20 milion initially increases aggregate
demand by Rs. 20 milion . . .
2. The Crowding-Out Effect
• Q. If suppose the Central Govt spends Rs 20 million for buying
helicopter from HAL this year and money is financed through
borrowing from market , what will happen to AD and economy?
 An ↑Govt Exp.=> ↑ i=>↓I=>↓AD.
 This reduction in demand that results when a fiscal expansion
raises the interest rate is called the crowding-out effect.

 The crowding-out effect tends to dampen the effects of fiscal


policy on aggregate demand.

 When the government increases its purchases by Rs. 20 milion,


the aggregate demand for goods and services could rise by more
or less than Rs. 20 milion, depending on whether the multiplier
effect or the crowding-out effect is larger.
2.The Crowding-Out Effect

(a) The Money Market (b) The Shift in Aggregate Demand

Interest Price
Money 4. . . . which in turn
Rate Level
supply partly offsets the
2. . . . the increase in Rs.20 milion initial increase in
spending increases aggregate demand.
money demand . . .
r2

3. . . . which
increases AD2
the r
AD3
equilibrium M D2
interest
rate . . . Aggregate demand, AD1
Money demand, MD
0 Quantity fixed Quantity 0 Quantity
by the Fed of Money 1. When an increase in government of Output
purchases increases aggregate
demand . . .
B. Changes in Taxes(T)
• Q. If suppose the Central Govt spends Rs 20 million for buying
helicopter from HAL this year and money is financed through
raising Taxes (T) , what will happen to AD and economy?

 When Govt. ↑ Income T=> take home income of household


↓ => ↓ Pvt S ↓ also Pvt C => ↓ C leads to ↓ AD.

 The size of the shift in aggregate demand resulting from a


tax change is affected by the multiplier and crowding-out
effects.

 It is also determined by the households’ perceptions about


the permanency of the tax change.
Q.Fiscal policy effects

Suppose the economy is in recession and needs


policy intervention. Let Shifting the AD curve rightward
by Rs.200 billion would end the recession.

A. If MPC = 0.8 and there is no crowding out, how


much should Govt increase G to end the
recession?

B. If there is crowding out, will Govt need to


increase G more or less than this amount?
Answers
Suppose the economy is in recession and needs policy
intervention. Let Shifting the AD curve rightward by Rs.200b
would end the recession.
A. If MPC = 0.8 and there is no crowding out, how much
should Govt increase G to end the recession?
Multiplier = 1/(1 – .8) = 5
Increase G by Rs.40b
to shift agg demand by 5 x Rs.40b = Rs.200b.

B. If there is crowding out, will Govt need to increase G


more or less than this amount?
Crowding out reduces the impact of G on AD.
To offset this, Govt should increase G by a larger amount.
Thank You All