Agg+Demand+and+Supply+by+Amit+Bhandari

8/6/2019 Agg+Demand+and+Supply+by+Amit+Bhandari

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Aggregate Demand Aggregate Demand Aggregate Supply Aggregate Supply



The questions we take up nowThe questions we take up now

What causes t he short term fluctuation inWhat causes t he short term fluctuation ineconomic activity?economic activity?

What can public policy do to prevent What can public policy do to prevent periods of falling income and risingperiods of falling income and risingunemployment?unemployment?

When recession and depression occur,When recession and depression occur,how can policymakers reduce t heir lengt h how can policymakers reduce t heir lengt h and severity?and severity?



Three key facts about economicThree key facts about economic

fluctuationsfluctuationsFact 1:Fact 1: Economic fluctuations areEconomic fluctuations are

irregular and unpredictable.irregular and unpredictable.

Fact 2:Fact 2: Most macroeconomicMost macroeconomicquantities fluctuate toget her.quantities fluctuate toget her.

Fact 3:Fact 3: As output falls, As output falls,

unemployment rises.unemployment rises.



The Basic Model of EconomicThe Basic Model of Economic

FluctuationFluctuationThe model of aggregate demand andThe model of aggregate demand and

aggregate supplyaggregate supply

Two variablesTwo variables

Economy's output of goods and servicesEconomy's output of goods and services

(GDP).(GDP). Overall price level (WPI, CPI etc)Overall price level (WPI, CPI etc)



The Aggregate Demand CurveThe Aggregate Demand Curve

The aggregate demand curve tells usThe aggregate demand curve tells ust he quantity of goods and servicest he quantity of goods and services

demanded in t he economy at anydemanded in t he economy at anygiven price level.given price level.

Ot her t hings equal, a fall in t heOt her t hings equal, a fall in t he

economys overall level of priceseconomys overall level of pricestends to raise t he quantity of goodstends to raise t he quantity of goodsand services demanded.and services demanded.



The Aggregate Demand CurveThe Aggregate Demand Curve

Quantity of output

PriceLevel

AggregateDemand

P1

Y 1

P2

Y 2



Why t he Aggregate Demand CurveWhy t he Aggregate Demand CurveSlopes Downward?Slopes Downward?



The Price Level and Consumption:The Price Level and Consumption:

The Wealth EffectThe Wealth EffectWhen the general price level rises, the When the general price level rises, the

value of money falls.value of money falls.

Price Level

ConsumerWealthier Consumption

Value of Money

Quantity of goods& services demanded



The Price Level and Investment:The Price Level and Investment:The Interest Rate EffectThe Interest Rate Effect

Fall in Price Level

Increase in value of money

Money used to buy interest bearing asset

Interest rate fall

Investment rises

Aggregate Demand Rises



The Price Level and Investment:The Price Level and Investment:The Interest Rate EffectThe Interest Rate Effect

Rise in Price Level

Decrease in value of money

Sell interest bearing asset to acquire money

Interest rate rise

Investment falls

Aggregate Demand Falls



The Price Level and Net Exports:The Price Level and Net Exports:

The Exchange Rate EffectThe Exchange Rate EffectFall in Price level in U.S.

Lower interest rate in U.S.

Mutual funds might sell U.S. govt. bonds to buy Indian bonds

Convert U. S. Dollar into Indian rupee

Increase supply of Dollar

Dollar depreciate relative to Indian Rupee



Increase in Net Export (Export Import)

Increase in quantity of goods and services demanded

Import of Indian goods falls

Export of U.S. goods increases

Indian goods become more expensive relative to U.S. goods

The Exchange Rate Effect Contd.



Shifts in Aggregate DemandShifts in Aggregate Demand

Quantity of output

PriceLevel

AD

AD2

AD1

Increase in aggregate demand

Decrease inaggregatedemand



Why Aggregate Demand Curve Might Why Aggregate Demand Curve Might Shift Shift

Shifts arising from consumptionShifts arising from consumption

Shifts arising from investment Shifts arising from investment

Shifts arising from government purchaseShifts arising from government purchase

Shifts arising from net exportsShifts arising from net exports



Aggregate Supply Curve Aggregate Supply Curve

The aggregate supply curve tells us t heThe aggregate supply curve tells us t hetotal quantity of goods and services t hat total quantity of goods and services t hat firms produce and sell at any given pricefirms produce and sell at any given pricelevel.level.

Long Run:Long Run: Aggregate supply curve in Aggregate supply curve invertical.vertical.

Short Run:Short Run: Aggregate supply curve is Aggregate supply curve isupward sloping.upward sloping.



Why aggregate supply curve isWhy aggregate supply curve isvertical in t he long run?vertical in t he long run?

In t he long run, t he economys total labour,In t he long run, t he economys total labour,capital, natural resources, and technologycapital, natural resources, and technologydetermine t he total quantity of goods anddetermine t he total quantity of goods andservices supplied.services supplied.

This quantity supplied is t he sameThis quantity supplied is t he sameregardless of what t he price level happensregardless of what t he price level happens

to be.to be.



The Aggregate Supply CurveThe Aggregate Supply Curve

Quantity of output

PriceLevel Long run

aggregatesupply

P1

Natural rateof output

P2does not affect the quantity of goods and services



Why t he Aggregate Supply CurveWhy t he Aggregate Supply CurveSlopes Upward in t he Short Run?Slopes Upward in t he Short Run?

Quantity of output

PriceLevel

Short runaggregatesupply

P1

Y 1

P2

Y 2



Why t he Aggregate Supply CurveWhy t he Aggregate Supply CurveSlopes Upward in t he Short Run?Slopes Upward in t he Short Run?

The StickyThe Sticky--Wage TheoryWage Theory

The StickyThe Sticky--Price TheoryPrice Theory

Th

eM

isperceptionTh

eoryTh

eM

isperceptionTh

eory



The Sticky Wage TheoryThe Sticky Wage Theory

Nominal wages are slow to adjust or Sticky in the short run.

Fall in Price Level Nominal wage remain fixed

Real wage rises

Rise in firmsreal cost

Less employmentLess production

Reduction in quantity of goods and services



The Sticky Price TheoryThe Sticky Price Theory

Sticky price theory emphasizes that the prices of some goods andservices Adjust sluggishly in response to changing economic condition.

Sluggish housing market in India

Higher than desired prices in Kolkata

Depress sales

Stop new projects



The Misperception TheoryThe Misperception Theory

Changes in t he overall price level canChanges in t he overall price level cantemporarily mislead suppliers about what temporarily mislead suppliers about what is happening in t he individual market t heyis happening in t he individual market t heysell t heir output.sell t heir output.



Why Might t he Short Run AggregateWhy Might t he Short Run AggregateSupply Curve Shift?Supply Curve Shift?

1.1. Shifts arising from labourShifts arising from labour

2.2. Shifts arising from capitalShifts arising from capital3.3. Shifts arising from natural resourcesShifts arising from natural resources

4.4. Shifts arising from technologyShifts arising from technology

5.5. Shifts arising from t he expected priceShifts arising from t he expected pricelevellevel



The Long Run EquilibriumThe Long Run Equilibrium

Quantity of output

PriceLevel

AggregateDemand

EquilibriumPrice (P0)

Short runaggregate supply

Long runaggregate supply

Natural rateof output (Y 0)




Quantity of output

PriceLevel

AggregateDemand

P0



Y0 Y1

P1




Quantity of output

PriceLevel

AggregateDemand

P0



Y0 Y1

P1

P2

Agg+Demand+and+Supply+by+Amit+Bhandari

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