Chapter 6 Aggregate demand and

aggregate supply
Mentor Pham Xuan Truong
[email protected]
Content
I Fluctuation of the economy in the short run and its
trend in the long run
II Aggregate demand and Aggregate supply model (AD –
AS model)
III Explain behaviors of the economy via AD – AS
model
 I Fluctuation of the economy in the short
run and its trend in the long run
The fact from Vietnam (short run)
10 Economic growth from 1986 to 2020
9.5 9.3
9
8.7 8.8
8.4 8.48
8 8.1 8.2 8.17
7.8
7.3
7 6.9 7.1 7.087.02
6.78 6.68 6.81
6.23 6.21
6 6 5.8 5.8 5.8 5.89 5.98
5.32 5.3
5 5.1 5.03
4.7 4.8
4
3.6
3 2.91
2.8
2

0
19861987198819891990199119921993199419951996199719981999200020012002200320042005200620072008200920102011201220132014201520162017201820192020
I Fluctuation of the economy in the short
run and its trend in the long run
The fact from the US (long run)
Real GDP from 1965 to 2010
 I Fluctuation of the economy in the short
run and its trend in the long run
 Economic activity: fluctuates from year to year however keep
upward trend in long run. Economists call economic fluctuation
in short run as Business cycle

 Recession: economic contraction = period of declining real

incomes and rising unemployment (especially, depression =
severe recession), the lowest point is trough or bottom
 Expansion: economic expansion = period of rising real incomes
and declining unemployment (especially, boom = severe
I Fluctuation of the economy in the short
run and its trend in the long run
3 key facts about economic fluctuations
1. Economic fluctuations are irregular and
unpredictable
2. Most macroeconomic quantities fluctuate together
3. As output falls, unemployment rises
This figure at the next slides will show real GDP in
panel (a), investment spending in panel (b), and
unemployment in panel (c) for the U.S. economy
using quarterly data since 1965. Recessions are
shown as the shaded areas. Notice that real GDP and
investment spending decline during recessions, while
unemployment rises.
I Fluctuation of the economy in the short
run and its trend in the long run
3 key facts about economic fluctuations
I Fluctuation of the economy in the short
run and its trend in the long run
3 key facts about economic fluctuations
I Fluctuation of the economy in the short
run and its trend in the long run
3 key facts about economic fluctuations
II AD – AS model
Economists use the model of aggregate demand and aggregate
supply to analyze economic fluctuations. On the vertical axis
is the overall level of prices. On the horizontal axis is the
economy’s total output of goods and services. Output and the
price level adjust to the point at which the aggregate-supply
and aggregate-demand curves intersect.
II AD – AS model
1 Aggregate demand
- Aggregate-demand curve shows the total quantity of
goods and services that households, firms, the
government, and customers abroad want and are able to
buy at each price level, other things equal
- Aggregate demand curve is downward sloping
In the next slides, we will examine two topics
+ Why the AD curve slopes downward
+ When the AD curve might shift
II AD – AS model
1 Aggregate demand
Why the aggregate-demand (AD) curve slopes
downward
Formula of AD: AD = C + I + G + NX
Three effects that causes downward sloping AD curve
Wealth effect (C )
Interest-rate effect (I)
International trade effect (NX)
Assumption: government spending (G) is fixed by
policy
II AD – AS model
Why the aggregate-demand (AD) curve slopes downward
Price level & consumption (C ): wealth effect
Decrease in price level → Increase - real value of money →
Consumers – wealthier → Increase in consumer spending →
Increase in quantity demanded of goods & services
Price level & investment (I): interest-rate effect
Decrease in price level → Decrease – interest rate → Increase
spending on investment goods → Increase in quantity demanded of
goods & services
Price level & net exports (NX): international trade effect
Decrease in domestic price level → Decrease – interest rate →
Domestic currency – depreciates → Stimulates net exports →
Increase in quantity demanded of goods & services
 II AD – AS model
Why the aggregate-demand (AD) curve slopes downward
A fall in price level increases quantity of goods& services
demanded because:
1. Consumers are wealthier - stimulates the demand for
consumption goods
2. Interest rates fall - stimulates the demand for investment goods
3. Currency depreciates - stimulates the demand for net exports
A rise in price level Decreases quantity of goods and services
demanded, because:
1. Consumers are poorer – depress consumer spending
2. Higher interest rates fall - depress investment spending
3. Currency appreciates – depress net exports
 The aggregate-demand curve
Price
Level

P1
1. A decrease
in the price
level . . . P2

Aggregate demand

Y1 Y2 Quantity of Output
2. . . . increases the quantity of
goods and services demanded
A fall in the price level from P1 to P2 increases the quantity of goods and services demanded
from Y1 to Y2. There are three reasons for this negative relationship. As the price level falls, real
wealth rises, interest rates fall, and the exchange rate depreciates. These effects stimulate
spending on consumption, investment, and net exports. Increased spending on any or all of
these components of output means a larger quantity of goods and services demanded.
 II AD – AS model
When the AD curve might shift
Changes in consumption, C : events - change how much
people want to consume at a given price level
E.g. Tax cut → Increase in consumer spending → Aggregate
demand - shift right
Changes in investment, I: events - change how much firms
want to invest at a given price level
E.g. Better technology, Preferable Tax policy, Money supply
increase → Increase in investment → Aggregate demand -
shift right
 II AD – AS model
When the AD curve might shift
Changes in government purchases, G: policy makers – change
government spending at a given price level
E.g. Build new roads → Increase in government purchases →
Aggregate demand - shift right
Changes in net exports, NX: events - change net exports for a
given price level
E.g. Recession in Europe → Decrease net exports → Aggregate
demand – shift left
International speculators – change in exchange rate →
Increase in net exports → Aggregate demand - shift right
The aggregate-demand curve: summary (a)
Why Does the Aggregate-Demand Curve Slope Downward?
1. The Wealth Effect: A lower price level increases real wealth,
which stimulates spending on consumption.

2. The Interest-Rate Effect: A lower price level reduces the

interest rate, which stimulates spending on investment.

3. The International trade Effect: A lower price level causes the

real exchange rate to depreciate, which stimulates spending on
net exports
 The aggregate-demand curve: summary (b)
When Might the Aggregate-Demand Curve Shift?
1. Shifts Arising from Consumption: An event that makes consumers spend more at a
given price level (a tax cut, a stock-market boom) shifts the aggregate-demand curve to
the right. An event that makes consumers spend less at a given price level (a tax hike, a
stock-market decline) shifts the aggregate-demand curve to the left.
2. Shifts Arising from Investment: An event that makes firms invest more at a given
price level (optimism about the future, a fall in interest rates due to an increase in the
.money supply) shifts the aggregate-demand curve to the right. An event that makes
firms invest less at a given price level (pessimism about the future, a rise in interest
rates due to a decrease in the money supply) shifts the aggregate-demand curve to the
left.

3. Shifts Arising from Government Purchases: An increase in government purchases

of goods and services (greater spending on defense or highway construction) shifts the
aggregate-demand curve to the right. A decrease in government purchases on goods
and services (a cutback in defense or highway spending) shifts the aggregate-demand
curve to the left.
4. Shifts Arising from Net Exports: An event that raises spending on net exports at a
given price level (a boom overseas, speculation that causes an exchange-rate
depreciation) shifts the aggregate-demand curve to the right. An event that reduces
spending on net exports at a given price level (a recession overseas, speculation that
II AD – AS model
2 Aggregate supply
- Aggregate-supply curve shows the total quantity of
goods and services that firms are able and choose to
produce and sell at each price level, other things equal
- Aggregate supply curve is Upward sloping in the short
run and vertical in the long run
In the next slides, we will examine two topics
+ Why the long run AS curve vertical and the short run AS
curve slopes upward
+ Why the long run AS curve and the short run AS curve
might shift
II AD – AS model
2 Aggregate supply
Why the aggregate-supply curve (LRAS) is vertical in the long run
Price level does not affect the long-run determinants of GDP:
+ Supplies of labor, capital, and natural resources
+ Available technology
In other words, GDP (output) in the long run is not determined by
price level. In the long run, when the economy adjusts itself, the
output always stay at natural level of output or potential output
(Y*).
Potential output is the output of economy when it utilizes all available
inputs at normal rate. Unemployment rate at potential output is at
natural level , therefore potential output is also called full-employment
output
 The long-run aggregate-supply curve
Price
Long-run
Level
aggregate
supply

P1
1. A change
in the price 2. . . . does not affect
level . . . P2 the quantity of goods
and services supplied
in the long run

Natural level Quantity of Output

of output
In the long run, the quantity of output supplied depends on the economy’s quantities
of labor, capital, and natural resources and on the technology for turning these inputs
into output. Because the quantity supplied does not depend on the overall price level,
the long-run aggregate-supply curve is vertical at the natural rate of output.
 II AD – AS model
2 Aggregate supply
Why the LRAS curve might shift
 Changes in labor
E.g. Quantity of labor – increases → Aggregate supply – shifts right
Natural rate of unemployment – increases → Aggregate supply –shifts left
 Changes in capital
E.g. Capital stock – decrease → Aggregate supply – shifts left
 Changes in natural resources
E.g. New discovery of natural resource → Aggregate supply – shifts right
Weather keeps fine → Aggregate supply – shifts right
Availability of natural resources declines → Aggregate supply – shifts left
 Changes in technology
E.g. New technology, for given labor, capital and natural resources → Aggregate

supply – shifts right

II AD – AS model
2 Aggregate supply
Using AD and LRAS to depict long-run growth and inflation
In long run: both AD and LRAS curve shift
+ Continual shifts of LRAS curve to right because of
technological progress
+ AD curve shifts to right because of monetary policy (central
bank increases money supply over time) and household
consumption increase
→ Result:
Continuing growth in output
Continuing inflation
 Long-run growth and inflation in the model of aggregate demand and aggregate supply

Price Long-run 1. In the long run, technological progress shifts long-run aggregate
Level aggregate supply, supply…
2. . . . and LRAS1980 LRAS1990 LRAS2000
growth in the
money supply
shifts aggregate
demand . . .

P2000
3. . . . leading to growth in
P1990 output . . .

P1980
AD2000
4. . . . and
AD1980 AD1990
ongoing inflation

Y1980 Y1990 Y2000 Quantity of Output

 II AD – AS model
2 Aggregate supply
Why the aggregate-supply (SRAS) curve slopes upward in the short-run
There are several theories to explain shape of SRAS: sticky wage theory,
sticky – price theory, misperception theory
+) Sticky-wage theory
Nominal wages - slow to adjust to changing economic conditions due to
 Long-term contracts: workers and firms
 Slowly changing social norms
 Notions of fairness - influence wage setting
Nominal wages - based on expected prices: don’t respond immediately
when actual price level – different from what was expected
Sticky-wage theory
If price level < expected: Firms – incentive to produce less output
If price level > expected: Firms – incentive to produce more output
II AD – AS model
2 Aggregate supply
Why the aggregate-supply (AS) curve slopes upward in the short-run
+) Sticky-price theory
Prices of some goods & services slow to adjust to changing economic
conditions due to for example menu costs (Costs to adjusting prices) →
sticky price firms besides flexible price firms
When price level increases, flexible price firms tend to increase price.
However sticky price firms keep price unchanged → output of sticky
price firms increases
+) Misperceptions theory
Changes in the overall price level Can temporarily mislead suppliers
about changes in individual markets (Changes in relative prices) or
changes in all markets (changes in common prices)
Suppliers - respond in the wisest way to changes in level of prices by
Change - quantity supplied of goods and services (price
increase/decrease by output increase/decrease)
The short-run aggregate-supply curve: summary (a)
Why Does the Short-Run Aggregate-Supply Curve Slope
Upward?
1. The Sticky-Wage Theory: An unexpectedly low price
level raises the real wage, which causes firms to hire fewer
workers and produce a smaller quantity of goods and
services.
2. The Sticky-Price Theory: An unexpectedly low price
level leaves some firms with higher-than desired prices,
which depresses their sales and leads them to cut back
production.
3. The Misperceptions Theory: An unexpectedly low price
level leads some suppliers to think their relative prices have
fallen, which induces a fall in production.
The short-run aggregate-supply curve: summary (b)
Why Might the Short-Run Aggregate-Supply Curve Shift?
1. Shifts Arising from Labor: An increase in the quantity of labor available
(perhaps due to a fall in the natural rate of unemployment) shifts the aggregate-
supply curve to the right. A decrease in the quantity of labor available (perhaps
due to a rise in the natural rate of unemployment) shifts the aggregate-supply
curve to the left.
2. Shifts Arising from Capital: An increase in physical or human capital shifts the
aggregate-supply curve to the right. A decrease in physical or human capital shifts
the aggregate-supply curve to the left.
3. Shifts Arising from Natural Resources: An increase in the availability of natural
resources shifts the aggregate-supply curve to the right. A decrease in the
availability of natural resources shifts the aggregate-supply curve to the left.
4. Shifts Arising from Technology: An advance in technological knowledge shifts
the aggregate-supply curve to the right. A decrease in the available technology
(perhaps due to government regulation) shifts the aggregate-supply curve to the
left.
5. Shifts Arising from the Expected Price Level: A decrease in the expected price
level shifts the short-run aggregate-supply curve to the right. An increase in the
expected price level shifts the short-run aggregate-supply curve to the left.
II AD – AS model
Using AD and SRAS to depict short run fluctuation of
the economy

a) Economy in normal b) Economy in recession

 III Explain behaviors of the economy via
AD – AS model
Two causes of economic fluctuations: shift of the AD
curve and shift of the SRAS curve
We begin short run examination with
Assumption: Economy begins in long-run equilibrium
Long-run equilibrium: Intersection of AD and LRAS
curve (Output - natural rate ; Actual price level) and
Intersection of AD and short-run AS curve (Expected
price level = Actual price level)
SR: quantity and quality of input (K, L, N, T)
Production tax VAT
Production cost (oil, water, electricity)
Business environment
Expected price (in the future) of
 The long-run equilibrium
Price
Level

Equilibrium A
price

Quantity of Output

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.
III Explain behaviors of the economy via
AD – AS model
Four steps for analyzing macroeconomic fluctuations
1. Decide whether the event shifts the aggregate demand
curve or the aggregate supply curve (or perhaps both).
2. Decide in which direction the curve shifts.
3. Use the diagram of aggregate demand and aggregate
supply to determine the impact on output and the price
level in the short run.
4. Use the diagram of aggregate demand and aggregate
supply to analyze how the economy moves from its
new short-run equilibrium to its long-run equilibrium.
 III Explain behaviors of the economy via
AD – AS model
1 The effects of a shift in aggregate demand: expansionary
demand shock and contractionary demand shock
Contractionary demand shock
Factor: Wave of pessimism affects aggregate demand →
Aggregate demand – shifts left
Short-run: Output falls & Price level falls
Long-run: Short-run aggregate supply curve – shifts right →
Output – natural rate and Price level – falls
 A contraction in aggregate demand

Price Long-run Short-run

Level aggregate aggregate
supply, AS1 3. . . . but over time, the
supply
short-run aggregate-supply
curve shifts . . .
AS2
P1 A
B 4. . . . and output returns
P2 to its natural rate.
C
P3
1. A decrease in
aggregate demand . . .
AD2 Aggregate demand, AD1
Y2 Y1 Quantity of Output
2. . . . causes output to fall in the short run . . .
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 AS 1 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 P , and output returns to its natural rate, Y .
Policy of government to respond contractionary demand shock
Price Long-run Short-run
Level aggregate aggregate
supply supply, AS1

(2)

(1)

AD2 Aggregate demand, AD1

Y1 Quantity of Output

The government will implement policy such as

increasing government spending to affect AD so that
the AD curve shifts to the right. As a result, recession
could be constrained
 III Explain behaviors of the economy via
AD – AS model
1 The effects of a shift in aggregate demand: expansionary
demand shock and contractionary demand shock
Expansionary demand shock
Factor: Decrease of interest rate affects aggregate demand →
Aggregate demand – shifts left
Short-run: Output rises & Price level increases
Long-run: Short-run aggregate supply curve – shifts left →
Output – natural rate and Price level – rises
 A expansionary in aggregate demand
Price Long-run
Level aggregate AS2
3. . . . but over time, the
supply
Short-run short-run aggregate-supply
C aggregate curve shifts . . .
P3 supply, AS1
4. . . . and output returns
P2 B
A to its natural rate.
P1
1. A increase in
aggregate demand . . .
Aggregate demand, AD1 AD2

Y1 Y2 Quantity of Output
2. . . . causes output to rise in the short run . . .
A rise in aggregate demand is represented with a rightward shift in the aggregate-demand curve
from AD1 to AD2. In the short run, the economy moves from point A to point B. Output rises from Y 1
to Y2, and the price level increases from P1 to P2. Over time, as the expected price level adjusts, the
short-run aggregate-supply curve shifts to the left from AS 1 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 P , and output returns to its natural rate, Y .
Policy of government to respond expansionary demand shock
Price Long-run
Level aggregate
supply
Short-run
aggregate
supply, AS1

(1)
(2)
AD2

Y1 Aggregate demand, AD1 of Output

Quantity

The government will implement policy such as

decreasing government spending to affect AD so that
the AD curve shifts to the left. As a result, booming
could be constrained
 III Explain behaviors of the economy via
AD – AS model
1 The effects of a shift in aggregate demand: expansionary
demand shock and contractionary demand shock
Summary
AD curve Output Price level Policy of
shift to (inflation) government
Contractio Left Decline (short Fall Shift AD to the
n run) (short run) right
Unchanged Fall further
(long run) (long run)
Expansion Right Rise (short run) Increase (short Shift AD to the
Unchanged run) left
(long run) Increase further
(long run)
III Explain behaviors of the economy via
AD – AS model
2 The effects of a shift in aggregate supply: adverse
supply shock and beneficial supply shock
Adverse supply shock
Factor: Firms – increase in production costs (oil price
increases) → Aggregate supply curve – shifts left
Short-run: Output falls & Price level rises
(Stagflation)
Long-run, (if AD is held constant) SR AS shifts back
to right: Output – natural rate and Price level - falls
 An adverse shift in aggregate supply
Price
Long-run 1. An adverse shift in the short-run
Level AS2
aggregate aggregate-supply curve . . .
supply
Short-run aggregate
supply, AS1
B
3. . . . and P2
the price P1 A
level to rise

4. Long run, AS shifts back

Aggregate demand

Y2 Y1 Quantity of Output
2. . . . causes output to fall . . .

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.
Policy of government to respond adverse supply shock
Price
Long-run
Level AS2
aggregate
supply
Short-run aggregate
Economy supply, AS1

Gov(2
)
Gov(1 Aggregate demand
)
Y1 Quantity of Output

Government has 2 choices:

+ gov(1) decrease AD → shift AD to the left → keep P unchanged
but Y declines further
+ gov(2) increase AD → shift AD to the right → keep Y
unchanged but Y rises further
III Explain behaviors of the economy via
AD – AS model
2 The effects of a shift in aggregate supply: adverse
supply shock and beneficial supply shock
Benefitcial supply shock
Factor: Firms – decrease in production costs (oil price
decreases) → Aggregate supply curve – shifts right
Short-run: Output rises & Price level falls
Long-run, (if AD is held constant and factor shifting
AS has temporary effect) SR AS shifts back to left:
Output – natural rate and Price level - rises
 An beneficial shift in aggregate supply
Price 1. An benefitcial shift in the short-run
Long-run
Level aggregate-supply curve . . .
aggregate
supply Short-run aggregate
supply, AS1
AS2

3. . . . and
the price P1 A
level to fall 4. Long run, AS shifts back
P2 B

Aggregate demand

Y1 Y2 Quantity of Output
2. . . . causes output to increase . . .

When some event decreases firms’ costs, the short-run aggregate-supply curve shifts to the
right from AS1 to AS2. The economy moves from point A to point B. The result : Output rises from
Y1 to Y2, and the price level falls from P1 to P2.
Policy of government to respond beneficial supply shock
Price
Long-run
Level
aggregate
Short-run aggregate
supply
supply, AS1
AS2
Economy

Gov(1)
Gov(2)
Aggregate demand

Y1 Quantity of Output

Government has 2 choices (if it thinks adjusting economy is

necessary):
+ gov(1) decrease AD → shift AD to the left → keep Y
unchanged but P declines further
+ gov(2) increase AD → shift AD to the right → keep P
 III Explain behaviors of the economy via
AD – AS model
Summary
2 The effects of a shift in aggregate supply: adverse
supply shock and beneficial supply shock

SRAS Output Price level Policy of government

curve (inflation)
shift to
Adverse left Decline Rise (1) Increase AD so that Y unchanged but
(short run) (short run) P increases further
Unchanged Unchanged (2) Decrease AD so that P unchanged
(long run) (long run) but Y decreases further
Beneficia right Rise Decline (1) Increase AD so that P unchanged but
l (short run) (short run) Y increases further
(temporar Unchanged Unchanged (2) Decrease AD so that Y unchanged
y effects) (long run) (long run) but P decreases further
 Appendix 1 Closer look to supply shock
1) Adverse supply shock
Long-run AS2
aggregate
Price
supply
Level AS3

Short-run aggregate
supply, AS1
B

Aggregate demand

Y2 Y1 Quantity of Output

In the long run, the economy will not come back point A, initial long
run equilibrium. Because, adverse supply shock potentially harms
natural level of output then LRAS shift to the left. Eventually, in long
run, the economy will move to the new equilibrium at point B (higher
price, lower output) compared with point A
 Appendix 1 Closer look to supply shock
2) Beneficial supply shock
Long-run
Price aggregate
Level supply Short-run aggregate
supply, AS1
AS2
AS3
A

Aggregate demand

Y1 Y2 Quantity of Output

In the long run, the economy will not come back point A, initial long
run equilibrium. Because, beneficial supply shock usually accompanied
with permanent effects potentially accelerates natural level of output
then LRAS shift to the right. Eventually, in long run, the economy will
move to the new equilibrium at point B (lower price, higher output)
 Appendix 2 Using vertical axis of inflation rate
in AD – AS model
Mathematical transformations for formula of AS curve (follows Phillips
curve equation) and AD curve (follow dynamic AD equation under
Mundell – Fleming model), we both arrive at conclusion that:
- In terms of aggregate supply, inflation rate and output have positive
relationship
- In terms of aggregate demand, inflation rate and output have negative
relationship lnflation
Short-run aggregate
supply

∏e

Aggregate demand

Y* Quantity of Output
Key concepts
- Aggregate demand
- Aggregate supply
- Wealth effect
- Interest-rate effect
- Exchange-rate effect
- Sticky wage theory
- Sticky price theory
- Misperception theory
- Potential output
- Expansionary/Contractionary demand shock
- Beneficial/Adverse supply shock