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