Aggregate Demand and Aggregate Supply

GT01003 Macroeconomics

Learning Objectives

1. Define the aggregate demand and aggregate supply curves

2. Show how aggregate supply and demand determine short-run output and inflation Show how aggregate demand, aggregate

supply, and the long-run aggregate supply curve determine long-run output and inflation

Learning Objectives

4. Using the AD-AS model to study business cycles

5. Analyze how the economy adjusts to expansionary and recessionary gaps Relate this to the idea of a self-correcting

economy The role of stabilization policy

Introduction

The aggregate demand - aggregate supply (AD-AS) model has two distinct advantages over the basic Keynesian model:

i. It applies to both the short run and the long run

ii. It shows both inflation and output Effective for analyzing macroeconomic

policies

The Aggregate Demand Curve Aggregate demand (AD) curve shows the

relationship between short-run equilibrium output, Y, and the rate of inflation, Holds all other factors constant

AD has a negative slope ↑ → ↓ PAE → ↓ Y Along the AD curve, short-run Y

equals planned spending

Output (Y)

ADInfla

tion

()

Shifts in Aggregate Demand Curve At a given inflation rate, aggregate demand

shifts when Demand Shocks Stabilization Policy

Demand shocks are changes other than those caused by changes in output or the real interest rate Consumer wealth Business confidence Foreign demand for

US goodsOutput (Y)

ADAD'

Infla

tion

()

Shifts in Aggregate Demand Curve

Stabilization Policy:

A rightward shift of the AD curve: Increase government spending (expansionary

fiscal policy) Cut taxes (expansionary fiscal policy) Increase the money supply (expansionary

monetary policy)

A leftward shift of the AD curve: Decrease government spending (contractionary

fiscal policy) Raise taxes (contractionary fiscal policy) Decrease the money supply (contractionary

monetary policy)

Aggregate Supply

Aggregate supply curve (AS) shows the relationship between the rate of inflation and the short-run equilibrium level of output Holds all other factors constant

Aggregate supply curve has a positive slope When output is below potential, actual inflation

is above expected inflation When output is above potential, actual inflation

is below expected inflation

The Aggregate Supply Curve If the economy is operating at potential

output, then = e = 1 at A

If Y > Y* and 2 > e at B

If Y < Y* and 3

< e at C The AS curve slope up In

flatio

n (

)

Output (Y)

AggregateSupply (AS)

2

Y1

B

Y2

3C

Y*

1

A

Shifts in the AS Curve What causes the AS curve to shift?

Changes in available resources & technology

Changes in the expected inflation Inflation shocks

Infla

tion

()

Output (Y)

AS1

Y*

1

2

AS2 If actual inflation

exceeds expectations, expected inflation increases AS curve shifts to

the left At each level of

output, inflation is higher

Shifts in the AS Curve

An inflation shock is a sudden change in the normal behavior of inflation A shock is not related to an output gap

A sudden rise in the price of oil increases prices of Gasoline, diesel fuel, jet fuel, heating oil Goods made with oil (synthetic rubber,

plastics, etc.) Transportation of most goods

OPEC reduced supplies in 1973; price of oil quadrupled Food shortages occurred at the same time Sharp increase in inflation in 1974

Shifts in the AS Curve

An adverse inflation shock shifts the aggregate supply curve to the left Increases inflation at each output level Oil price increases in 1973

A favorable inflation shock shifts the aggregate supply curve to the right Lower inflation at each output level Oil price decrease in 1986

Long-Run Equilibrium

In the long run, Actual output equals potential output Actual inflation equals expected inflation

Long-run equilibrium occurs at the intersection of Aggregate demand Aggregate supply and Long-run aggregate

supplyIn

flatio

n (

)

Output (Y)

AggregateDemand (AD)

AggregateSupply (AS)

Y*

Long-Run AggregateSupply (LRAS)

Short-Run Equilibrium

Short-run equilibrium occurs when there is either an expansionary gap or a recessionary gap Intersection of AD and AS curves at a level

of output different from Y* Point A in the graph

Short-run equilibrium is temporary In

flatio

n (

)

Output (Y)

AD

AS1

LRAS

Y* Y1

1

A

Y*

LRAS

Using the AD-AS Model to Study Business Cycles

Five Steps for Using the AD-AS Model to Study Business Cycles

Example Event: Great Recession 2007-2009

Step 1: Draw a diagram to show the long run equilibrium

Infla

tion

()

Output (Y)

AggregateDemand (AD)

AggregateSupply (AS)

Y*

Long-Run AggregateSupply (LRAS)

Five Steps for Using the AD-AS Model to Study Business Cycles Step 2: Ask whether the event affects the

AD curve, AS curve or both. The Great Recession caused worldwide

financial panic and the sharp decrease in house prices.

Worldwide financial panic and the decrease in house prices were negative demand shocks

Five Steps for Using the AD-AS Model to Study Business Cycles

Infla

tion

()

Output (Y)

AS

Y*

LRAS

A

AD1

1

AD2

Y1

2 B

Step 3: Shift the curve(s) in the appropriate direction(s).

Step 4: Find the new short-run equilibrium

The new short-run equilibrium is at B

Five Steps for Using the AD-AS Model to Study Business Cycles Step 5: Compare the new short-run

equilibrium to the original long-run equilibrium.

We find that the actual output Y1 < the potential output Y* and the 2 is below the expected 1

Thus, there is a recessionary gap.

Can active use of stabilization policy help to eliminate output gap?

Self-Correcting Economy

In the long-run the economy tends to be self-correcting Missing from Keynesian model Concentrates on the short-run; no price

adjustments Given time, output gaps disappear

without any changes in monetary or fiscal policy

Whether stabilization policies are needed depends on the speed of the self-correction

process the nature of the shock that created

the output gap

The Role of Stabilization PolicySpeed of Self-Correction Process:

The greater the gap, the longer the adjustment period

A slow self-correcting mechanism (Large output gap) Fiscal and monetary policy can help stabilize

the economy A fast self-correcting mechanism (Small

output gap) Fiscal and monetary policy are not effective

and may destabilize the economy

The Role of Stabilization PolicyThe Nature of the Shocks:

Active fiscal policy and monetary policy are helpful when a recession is caused by negative demand shocks

Active fiscal policy and monetary policy can be costly when a recession is caused by negative price shocks

The Role of Stabilization PolicyNegative Demand

Shocks: AD shifts to AD2

Output falls to Y1

An expansionary fiscal policy or monetary policy shifts the AD curve back toward AD1

The inflation returns back to the initial level 1

Infla

tion

()

Output (Y)

AS

Y*

LRAS

A

AD1

1

AD2

Y1

2 B

The Role of Stabilization Policy

Negative Price Shocks:

A negative price shock shifts the AS curve to AS2.

Output falls to Y1 and inflation rises to 2

An Expansionary fiscal policy or monetary policy shifts the AD to AD2

Inflation rises to 3

Infla

tion

()

Output (Y)

AD1

AS1

Y*

LRAS

1

Y1

2

AS2

AD2

3

Short-Run

Long-Run

Aggregate

Demand

Aggregate Supply

Equilibrium

Self-Correcting Economy

LRAS

AS

Conclusion