1 copyright 2002 mcgraw-hill australia pty ltd ppts t/a macroeconomics by dornbusch, bodman,...

Copyright 2002 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Dornbusch, Bodman, Crosby, Fischer and Startz 1

Chapter 5

Aggregate Supply and Demand


The aggregate supply–aggregate demand (AS–AD) model is the basic tool for studying output fluctuations and the determination of price levels

The model describes the relationship between overall prices (GDP deflator) and output (real GDP)

Aggregate Supply and Aggregate Demand


Chapter Organisation5.1 The Aggregate Supply Curve

5.2 The Aggregate Demand Curve

5.3 Aggregate Demand Under Alternative Supply Assumptions

5.4 Supply-side Economics


The AS curve describes, for each given price level, the quantity of output firms are willing to supply

The AS curve is upward sloping since firms are willing to supply more at higher prices

In the short run the AS curve is horizontal (the Keynesian AS curve)

In the long run the AS curve is vertical (the classical AS curve)

5.1 The Aggregate Supply Curve


The Aggregate Supply Curve


The classical AS curve Is vertical, indicating that the same amount of

goods will be supplied whatever the price level

AssumptionThe labour market is in equilibrium at full

employment and all factors of production are fully utilised

Implication Increases in AD do not increase output but

merely raises prices

The Classical AS Curve


The level of output corresponding to full employment is called potential GDP

Potential GDP grows over time as the economy accumulates resources and new technologies

This shifts the AS curve to the right over time

The Classical AS Curve


The Keynesian AS curve Is horizontal, indicating firms will supply

whatever amount of goods is demanded at the existing price

AssumptionThere is unemployment, so firms may obtain

as much labour as they want at the current wage

ImplicationAD determines the level of output, with prices

‘sticky’ in the short run

The Keynesian AS Curve


Vertical or Horizontal?


At levels of output below potential, the AS is quite flat, as there is little tendency for prices of goods and factors to fall

At levels of output above potential, the AS curve is steep and prices tend to rise continuously

Hence, the effect of changes in AD on output and prices depends on the level of actual output relative to potential output

Vertical or Horizontal?


Frictional unemploymentUnemployment due to individuals shifting

between jobs and looking for new jobs

Structural unemploymentUnemployment due to a mismatch

between the skills of the labour force and the skills demanded by firms

Unemployment is a consequence of technological improvements

Types of Unemployment


The natural rate of unemployment (NRU)The frictional and structural

unemployment associated with the full employment level of output

Current estimates of the NRU in Australia are about 6.5%

Types of Unemployment


The AD curve Shows the combinations of the price and

output level at which the goods and money markets are in equilibrium

Is downward sloping because for a given level of nominal money, higher prices reduce the value of the real money supply, which reduces the demand for output

Increases in autonomous AD shifts the AD curve to the right



The AD relationship between price and output Is dependent upon the real money supply

Real money supply is nominal money supply () deflated by the price level (P)

That is: /P

When P falls, the real money supply rises, interest rates fall and investment rises, causing AD to increase

The Aggregate Demand Curve


The quantity theory of money provides a simple analysis of the AD curve

M V = P Y

Where M is the nominal money supply and V is the velocity of money

If we assume that V and M are constant then an increase in output Y must be offset by a decrease in prices P

The Aggregate Demand Curve


5.3 AD Under Alternative Supply Assumptions


Initial equilibrium is at E where AD and AS intersect (goods and money market equilibrium)

Assume an increase in AD, which shifts AD to AD’

The new equilibrium point is E’ where output has increased

Firms are willing to supply any amount of output at that level of price

The Keynesian Case


The Classical Case


Assume an increase in AD

At the initial level of prices, spending has increased and the economy would tend to move towards point E’

However, firms cannot obtain more labour as the economy is at full employment

Wages are bid up which increases the costs of production

The increase in costs is passed on as higher prices

The Classical Case


The increase in prices reduces real money stock and decreases spending

The economy moves up along AD’ until spending has decreased to the level consistent with full employment output at E”

Increases in AD only lead to higher prices, not increases in output

The Classical Case




5.3 The Aggregate Demand Under Alternative Supply Assumptions



Shifting the AS to the right is preferred as it increases potential GDP

There is debate about how best to achieve this increase in AS

Supply-side economics (advocated by George Bush Senior) argue Cutting taxes will significantly increase AS

This increase will be so large that total tax revenue will rise



Supply-side Economics


The initial tax cut shifts AD to the right

The AS also shifts to the right over time because lower tax rates increase the incentive to work

However, the AD curve shifts by more than the AS curve, since consumer spending increases by more than the increase in potential GDP



In the short runGDP has increased substantially (from E to E’)

This is primarily due to the AD effect

In the long runThe economy moves to E”

GDP has only increased by a small amount, total tax collection falls, the government’s budget deficit rises, and prices are permanently higher


1 copyright 2002 mcgraw-hill australia pty ltd ppts t/a macroeconomics by dornbusch, bodman,...

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