Business Economics (ECO 341)Fall: 2012 Semester

Khurrum S. Mughal

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Aggregate Demand and Supply

3

PriceLevel

RealGDP

Aggregate Demand Curve

Aggregate Supply Curve

The Two-Way Relationship Between Output and the Price Level

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There exist a two-way relationship between price level and output

Changes in price level cause changes in

real GDP – illustrated by Aggregate Demand curve

Changes in real GDP cause changes in price level – illustrated by Aggregate Supply curve

AD and AS

Aggregate Demand

Define aggregate demand as the total demand for an economy’s output (production of goods and services) over a given period of time.

Demand may come from households (consumption), firms (investment), the public sector (government spending) or foreign households, firms, or governments (net exports).◦ YAD = C + I + G + NX

We assume an inverse relationship between price and aggregate demand

Aggregate Demand

Suppose aggregate prices in the economy fell

This would cause the demand for money to decrease, causing interest rates to decline◦ Alternatively, the real money supply (M/P) rises, causing

interest rates to fall.

With lower interest rates, the opportunity cost of consumption is lower: ◦ P↓ Md↓ i↓ C↑

With lower interest rates, the direct cost of investment falls: ◦ P↓ Md↓ i↓ I↑

With lower interest rates a country’s currency will depreciate. A weaker currency makes exports cheaper and imports more expensive◦ P↓ Md↓ i↓ Exchange Rate↓ NX↑

Aggregate Demand Rises as Price Falls

P

Y

AD

2

1

100 180

The Aggregate Demand Curve

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A variety of events can cause the price level to change, and move us along the AD curve

◦It’s important to understand what happens in the economy as we make such a move

Movements Along The AD Curve

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Movements Along The AD Curve

Opposite sequence of events will occur if the price level falls, moving us rightward along the AD curve

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(a)

Real GDP

Price Level

P3

Q3 Q1 Q2

AD

P1

P2

Price level ↑ moves us leftward along the AD curve

Price level ↓ moves us rightward along the AD curve

Effects of Key Changes on the Aggregate Demand Curve

Anything (other than price!) that causes C, I, G, or NX to increase will shift the AD curve to the right.

C increases when…◦ There is an increase in consumer confidence, leading to

more current consumption and less current savings◦ Taxes are cut leaving consumers with more income to

spend

I increases when…◦ Business confidence rises, prompting firms to invest more

for the future.

Factors that Shift the AD Curve

G increases when…◦ Government spending increases

NX increases when…◦ There is increased preference for domestically produced

goods.

An increase in the money supply will cause AD to shift right◦ Interest rates are lower, so C and I rise. The currency

weakens, so NX increases.

Factors that Shift the AD Curve

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Entire AD curve shifts rightward if:• a, IP, G, or NX increases• Net taxes decrease• The money supply increases

AD2

AD1

(b)

Real GDP

Price Level

Effects of Key Changes on the Aggregate Demand Curve

Aggregate Supply

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Price Level

Real GDP ($ Trillions)

130

100

80C

AS

13.5106

A

B

Starting at point A, an increase in output raises unit costs. Firms raise prices, and the overall price level rises.

Starting at point A, a decrease in output lowers unit costs. Firms cut prices, and the overall price level falls.

Short Run Aggregate Supply Curve

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Figure in last slide assumed that a number of important variables remained unchanged◦ Unit costs sometimes change for reasons other than a

change in output

In general, we distinguish between a movement along AS curve, and a shift of curve itself, as follows◦ When a change in real GDP causes the price level to change,

we move along AS curve When anything other than a change in real GDP causes price level

to change, AS curve itself shifts

What can cause unit costs to change at any given level of output?◦ Changes in world oil prices◦ Changes in the weather◦ Technological change◦ Nominal wage, etc.

Shifts of the AS Curve

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When a change in output causes price level to change, we move along economy’s AS curve

◦ What happens in economy as we make such a move?◦ As we move upward along AS curve, we can represent

what happens as follows

Movements Along the AS Curve

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(a)

Real GDP

Price Level

P3

Q2 Q1 Q3

P1

P2

ASReal GDP ↑ moves us rightward along the AS curve

Real GDP ↓ moves us leftward along the AS curve

Movements Along the AS Curve

Tightness in the labor market.◦ Suppose that because of a big economic expansion, the economy is

producing at an output level Y that is greater than YP. ◦ This suggests that the economy is using more labor than it normally does.◦ To get people to work longer hours, you have to pay them more.◦ This increase in labor costs will shift the SRAS curve left, as profit per output

falls when labor costs rise.

Expectations about inflation◦ If workers expect inflation to be higher in the future, they will demand higher

wages in anticipation of this increase in the cost of living.◦ Higher wages reduce firm profit and shift SRAS left

Supply shocks to critical raw materials◦ Suppose a war broke out between the US and Iran. Oil prices would rise

dramatically◦ Since oil is such a pervasive part of nearly everything we produce,

production costs would rise significantly.◦ The SRAS curve would shift left as the return on production fell.

Short Run Aggregate Supply Curve

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Real GDP

Price Level(b)

AS1

AS2

Entire AS curve shifts upward if unit costs ↑ for any reason besides an increase in real GDP

Shifts of the AS Curve

P

Y

P*

SRAS

Y*

AD

PH

PL

Surplus

Shortage

Short Run Equilibrium

In the long run, money is neutral◦ Any changes in the money supply will be met by a

proportionate change in prices◦ Increasing the money supply will not affect the economy’s

output in the long run.

Long run output is determined entirely by an economy’s productive capacity◦ Production Function: YP = A*F(K,L,H,N)

Only changes in real variables can affect potential output.◦ Price does not have any effect on YP

In the long run, all resources are being efficiently utilized such that unemployment equals the natural rate

Long Run Aggregate Supply

P

Y

2

1

LRAS

YP = 140

Long Run Aggregate Supply