Macroeconomics

AGGREGATE DEMAND
AND
AGGREGATE SUPPLY

Instructor
 AGGREGATE DEMAND AND SUPPLY
TABLE OF CONTENTS

Front Page i.
Table of Contents ii.

Aggregate Demand and Aggregate Supply

Three Key Facts About Economic Fluctuations 03

Fact 1 03
Fact 2 04
Fact 3 05
Explaining Short-Run Economic Fluctuations 05
Short-run and Long-run 05
Basic Model of Economic Fluctuations 07
The Aggregate-Demand Curve 07
Why ADC Downward Sloping 08
The Interest-Rate Effect 08
The Wealth Effect 08
The Exchange-Rate Effect 08
Why ADC Might Shift 10
The Aggregate-Supply Curve 10
The Long-Run Aggregate-Supply Curve 11
Why the Long-Run ASC Might Shift 11
The Short-Run Aggregate-Supply Curve 12
The New Classical Misperceptions Theory 12
The Keynesian Sticky-Wage Theory 12
The New Keynesian Sticky-Price Theory 13
Why the Short-run ASC Might Shift 14
Two Causes of Recession 14
Effects of a Shift in the Aggregate Demand 15
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Effects of a Shift in the Aggregate Supply 16
References 18
Presentation Strategy 19
Class Evaluation 20
Individual Tasks 22
Individual Presentation Grade 23
Group Presentation Grade 24

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THREE KEY FACTS ABOUT ECONOMIC FLUCTUATIONS

Fact 1: Economic fluctuations are irregular.

 Economic fluctuations are often called the business cycle and correspond to
changes in business conditions.
 When real GDP grows rapidly, business is good.
 During such periods of economic expansion, most firms find that customers are
plentiful and that profits are growing.
 When real GDP falls during recessions, businesses have trouble.
 During such periods of economic contraction, most firms experience declining sales
and dwindling profits.
 Economic fluctuations are not at all regular, and they are almost impossible to
predict with much accuracy.

Figure A shows the real GDP of the U.S. economy since 1965. The shaded areas
represent times of recession. As the figure shows, recessions do not come at regular
intervals. Sometimes recessions are close together, such as the recessions of 1980
and 1982. Sometimes the economy goes many years without a recession. The
longest period in U.S. history without a recession was the economic expansion from
1991 to 2001.

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Fact 2: Most macroeconomic quantities fluctuate together.

 Real GDP measures the value of all final goods and services produced within a given
period of time.
 It also measures the total income (adjusted for inflation) of everyone in the
economy.
 Most macroeconomic variables that measure some type of income, spending, or
production fluctuates closely together.
 When real GDP falls in a recession, so do personal income, corporate profits,
consumer spending, investment spending, industrial production, retail sales, home
sales, auto sales, and so on.
 Although many macroeconomic variables fluctuate together, they fluctuate by
different amounts.

Figure B shows, investment spending varies greatly over the business cycle. Even
though investment averages about one-seventh of GDP, declines in investment
account for about two thirds of the declines in GDP during recessions. In other
words, when economic conditions deteriorate, much of the decline is attributable
to reductions in spending on new factories, housing, and inventories.

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Fact 3: As output falls, unemployment rises.

 Changes in the economy’s output of goods and services are strongly correlated with
changes in the economy’s utilization of its labor force.
 When real GDP declines, the rate of unemployment rises.
 When firms choose to produce a smaller quantity of goods and services, they lay off
workers, expanding the pool of unemployed.

Figure C shows the unemployment rate in the U.S. economy since 1965. Once again,
recessions are shown as the shaded areas in the figure. The figure shows clearly the
impact of recessions on unemployment. In each of the recessions, the
unemployment rate rises substantially. When the recession ends and real GDP
starts to expand, the unemployment rate gradually declines. The unemployment
rate never approaches zero; instead, it fluctuates around its natural rate of about 5
or 6 percent.

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EXPLAINING SHORT-RUN ECONOMIC FLUCTUATIONS

How the short run differs from the long run

 Classical dichotomy is the separation of variables into real variables and nominal
variables.
 According to the classical macroeconomic theory, changes in money supply affect
nominal variables but not real variables in the long run.
 Most economists believe that classical theory describes the world in the long run
but not in the short run.
 Changes in the nominal interest rate affect the overall level of prices and other
nominal variables but do not affect real GDP, unemployment or other real
variables.
 Most economists believe that, in the short run, real and nominal variables are
highly interrelated.

The Basic Model of Economic Fluctuations

 The model of short-run economic fluctuations focuses on two variables.
 The first variable is the economy’s output of goods and services, as measured by
real GDP.
 The second variable is the inflation rate, as measured by the CPI or the GDP
deflator.
 The output is a real variable, whereas the inflation rate is a nominal variable.

It is stated in the Figure above that on the vertical axis is the overall inflation rate in
the economy. On the horizontal axis is the overall quantity of goods and services.

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The aggregate-demand curve shows the quantity of goods and services that
households, firms and the government want to buy at any inflation rate. The
aggregate-supply curve shows the quantity of goods and services that firms produce
and sell at any inflation rate. According to this model, the inflation rate and the
quantity output adjust to bring aggregate demand and aggregate supply into
balance.

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THE AGGREGATE-DEMAND CURVE

Aggregate-demand curve tells us the quantity of all goods and services demanded
in the economy at any given inflation rate.

Why the aggregate-demand curve is down-sloping

 The four components of GDP (Y) contribute to the aggregate demand for goods and
services.
 Y = C + I + G + NX
 Each of these four components contributes to the aggregate demand for goods and
services.
 Government spending is assumed to be a fixed policy variable, but the other three
components of spending-consumption, investment and net exports- depend on
economic conditions and, in particular, on the inflation rate.

As illustrated in the above figure, the aggregate demand curve is downward sloping.
This means that, other thing being equal, a fall economy’s overall inflation rate
(from, say, π1 to π2) tends to raise the quantity of goods and services demanded
(from Y1 to Y2).

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The Inflation Rate and Investment: The Interest Rate Effect

 A lower inflation rate reduces the interest rate, which encourages greater spending
on investment goods.
 This increase in investment spending means a larger quantity of goods and services
demanded.

The Inflation Rate and Consumption: The Wealth Effect

 A decrease in the inflation rate makes consumers feel wealthier, which in turn
encourages them to spend more.
 This increase in consumer spending means larger quantities of goods and services
demanded.

The Inflation Rate and Net Exports: The Exchange-Rate Effect

 When a fall in the Australia inflation rate causes Australia interest rates to fall, the
real exchange rate depreciates, which stimulates Australia net exports.
 The increase in net export spending means a larger quantity of goods and services
demanded.

Why the Aggregate-Demand Curve Might Shift

 Shifts arising from:

1. Consumption
2. Investment
3. Government Purchases
4. Net Exports

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The downward slope of aggregate-demand curve shows that a fall in the inflation
rate raises the overall quantity of goods and services demanded. Many other factors
beyond the inflation rate, however, affect the quantity of goods and services
demanded. When one of these factors changes, the aggregate-demand curve shifts.

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AGGREGATE-SUPPLY CURVE
Aggregate-supply curve tells us the quantity of goods and services that firms
produce and sell at any given inflation rate. The relationship between the inflation
rate and the quantity supplied depends on the time horizon. In the long-run, the
aggregate-supply curve is vertical, whereas in the short-run, the aggregate supply
curve is upward sloping.

The Long-Run Aggregate-Supply Curve

 In the long run, an economy’s production of goods and services depends on its
supplies of labor, capital, and natural resources and on the available technology
used to turn these factors of production into goods and services.
 The inflation rate does not affect these variables in the long run.

The long-run aggregate-supply curve is vertical at the natural rate of output. This
level of production is also referred to as potential output or full-employment
output.

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Why the Long-Run Aggregate-Supply Curve Might Shift

 Shifts arising
1. Labor
2. Capital
3. Natural Resources
4. Technological Knowledge
 The position of the long run aggregate supply curve shows the quantity of goods
and services predicted by classical macroeconomic theory.
 This level of production is sometimes called potential output or full-employment
output or trend output.
 In the short run, output can either fall below or rise above this level.
 The economy produces when unemployment is at its natural or normal rate.
 The natural rate of output is the level of production towards which the economy
gravitates in the long run.
 Any change in the economy that alters the natural rate of output shifts the long-run
aggregate-supply curve.
 The shifts may be categorized according to the various factors in the classical model
that affect output.

The Short-Run Aggregate-Supply Curve

 In the short run, an increase in the overall inflation rate in the economy tends to
raise the quantity of goods and services supplied.
 A decrease in the level of inflation rate tends to reduce the quantity of goods and
services supplied.

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The Misperceptions Theory

 Changes in the overall inflation rate temporarily mislead suppliers about what is
happening in the markets in which they sell their output:
 A lower inflation rate causes misperceptions about relative prices.
 These misperceptions induce suppliers to decrease the quantity of goods and
services supplied.

The Sticky-Wage Theory

 Nominal wages are slow to adjust, or are “sticky” in the short run:
1. Wages do not adjust immediately to a fall in the inflation rate.
2. A lower inflation rate makes employment and production less profitable.
3. This induces firms to reduce the quantity of goods and services supplied.

The Sticky-Price Theory

 Prices of some goods and services adjust sluggishly in response to changing

economic conditions:
1. An unexpected fall in the price level leaves some firms with higher-than-
desired prices.
2. This depresses sales, which induces firms to reduce the quantity of goods
and services they produce.

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Why the Short-Run Aggregate-Supply Curve Might Shift

 Shifts arising
1. Labor
2. Capital
3. Natural Resources
4. Technology
5. Expected Price Level
 An increase in the expected inflation rate reduces the quantity of goods and
services supplied and shift the short-run aggregate supply curve to the left.
 A decrease in the expected inflation rate raises the quantity of goods and services
supplied and shift the short-run aggregate supply curve to the right.

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TWO CAUSES OF RECESSION

The Effects of a Shift in Aggregate Demand

The long-run equilibrium of the economy is found where the aggregate-demand

curve crosses the long-run aggregate-supply curve (point A). When the economy
reaches this long-run equilibrium, the expected price level will have adjusted to
equal the actual price level. As a result, the short-run aggregate-supply curve
crosses this point as well.

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A fall in aggregate demand is represented with a leftward shift in the aggregate-
demand curve from AD1 to AD2. In the short run, the economy moves from point A
to point B. Output falls from Y1 to Y2, and the price level falls from P1 to P2. Over
time, as the expected price level adjusts, the short-run aggregate-supply curve
shifts to the right from AS1 to AS2, and the economy reaches point C, where the
new aggregate-demand curve crosses the long-run aggregate supply curve. In the
long run, the price level falls to P3, and output returns to its natural rate, Y1.

The Effects of Shift in Aggregate Supply

When some event increases firms’ costs, the short-run aggregate-supply curve shifts
to the left from AS1 to AS2. The economy moves from point A to point B. The result
is stagflation: Output falls from Y1 to Y2, and the price level rises from P1 to P2.

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Faced with an adverse shift in aggregate supply from AS1 to AS2, policymakers who
can influence aggregate demand might try to shift the aggregate-demand curve to
the right from AD1 to AD2. The economy would move from point A to point C. This
policy would prevent the supply shift from reducing output in the short run, but
the price level would permanently rise from P1 to P3.

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REFERENCES

Robin Stonecash, J. L. (2015). Principles of Macroeconomics (6th ed.). (C. T.

Services, Trans.) Cengage Learning Australia Pty Limited.

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PRESENTATION STRATEGY

Powerpoint Presentation is the presentation strategy that our group has

chosen.

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CLASS EVALUATION

True or False
_______1. Economic fluctuations are irregular and unpredictable.
_______2. Most macroeconomic quantities do not fluctuate together.
_______3. As output falls, unemployment decreases.
_______4. The model of aggregate demand and aggregate supply is the model that most
economists use to explain short-run fluctuations in the economic activity around its long-
run trend.
_______5. The model of short-run economic fluctuations focuses only on one variable.

Multiple Choice

1. What is the main difference between the Aggregate Expenditures Model and the AD/ AS
model?

a. The Aggregate Expenditures Model focuses on the supply side of the economy,
while the AD/ AS model focuses on the demand side
b. The Aggregate Expenditures Model analyzes changes in the price level, while the
AD/ AS model does not.
c. The Aggregate Expenditures Model emphasizes changes in Real GDP, whereas the
AD/ AS model allows economists to analyze changes in both Real GDP and the
price level.
d. None of the above

2. The Aggregate Demand curve shows the relationship between Real GDP and _____, all
else equal

a. Price level
b. Aggregate Expenditure
c. The real interest rate
d. Consumption spending

3. Which of the following is not a reason for the downward-slope of the aggregate demand
curve?

a. The real-balances effect

b. The substitution effect
c. The interest-rate effect
d. The foreign trade effect

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4. Which of the following economic changes could cause a decrease in equilibrium Real
GDP and an increase in equilibrium price level?

a. An increase in the value of the Canadian dollar, all else equal

b. An increase in productivity.
c. Businesses expect lower profits in the future.
d. Firms experience an increase in wages

5. Whenever the economy is in recession, we can expect:

a. Investment to decrease
b. Unemployment to decrease
c. Incomes to increase
d. All of the above

Identification

____________________1. The upward slope of the short-run aggregate-supply curve is

based on the work of __________.

____________________2-3. The new classical misperception theory is based on the work of

two economist namely ____________ and ____________.

____________________4. The aggregate-supply curve is _____________ rather than

upward-sloping.

____________________5. According to this theory, changes in the inflation rate can

temporarily mislead suppliers about what is happening in the markets in which they sell
their output.

ANSWER KEY

1. T 1. C. 1. John Maynard Keynes

2. F 2. A. 2. Milton Friedman
3. F 3. B. 3. Robert Lucas
4. T 4. D. 4. Vertical
5. F 5. A. 5. New Classical Misperceptions Theory

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INDIVIDUAL TASKS

Name Task Done Leader’s Grade

(Alphabetically Arrange) (10 Points)

*Three Key Facts About

Economic Fluctuations
*Explaining Short-run
Economic Fluctuations
10
*True of False
*Compilation of paper and
editing
*Print
*Aggregate-Demand Curve
*Aggregate-Supply Curve 9
*Multiple Choice
*Theories
*Two Causes of Recession 8
*Identification

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Individual Presentation
Content Mastery Discussion Total Points Final
Name
(20 (10 (20 points) Earned Rating
points) points)

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GROUP PRESENTATION GRADE

Individual Paper Powerpoint Individual Final

Name
Presentation Presentation Presentation Tasks Rating

Date : ___________________

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