Aggregate Demand and
Aggregate Supply
Short-Run Economic
Fluctuations
• Economic activity fluctuates from year to year.
– In most years production of goods and services rises.
– On average over the past 50 years, production in the U.S. economy
has grown by about 3 percent per year.
– In some years normal growth does not occur, causing a recession.
• A recession is a period of declining real incomes, and
rising unemployment. Since 1965, the U.S. economy has
suffered six recessions.
• A depression is a severe recession. The Great Depression
occurred in 1929-1941 when output fell by about 30
percent and unemployment rose to 25 percent.
THREE KEY FACTS ABOUT ECONOMIC
FLUCTUATIONS
• Economic fluctuations are irregular and
unpredictable.
– Fluctuations in the economy are often called the
business cycle. Stylized model of the business
cycle.
• Most macroeconomic variables fluctuate
together.
• As output falls, unemployment rises.
Figure 1 A Look At Short-Run Economic
Fluctuations
(a) Real GDP
Billions of
1996 Dollars
$10,000
9,000
Real GDP
8,000
7,000
6,000
5,000
4,000
3,000
2,000
1965
1970
1975
1980
1985
1990
1995
2000
Copyright © 2004 South-Western
THREE KEY FACTS ABOUT
ECONOMIC FLUCTUATIONS
• Most macroeconomic variables fluctuate
together.
– Most macroeconomic variables that measure
some type of income or production fluctuate
closely together.
– Although many macroeconomic variables
fluctuate together, they fluctuate by different
amounts.
Figure 1 A Look At Short-Run Economic
Fluctuations
(b) Investment Spending
Billions of
1996 Dollars
$1,800
1,600
1,400
Investment spending
1,200
1,000
800
600
400
200
1965
1970
1975
1980
1985
1990
1995
2000
Copyright © 2004 South-Western
THREE KEY FACTS ABOUT
ECONOMIC FLUCTUATIONS
• As output falls, unemployment rises.
– Changes in real GDP are inversely related to
changes in the unemployment rate.
– During times of recession, unemployment rises
substantially.
Figure 1 A Look At Short-Run Economic
Fluctuations
(c) Unemployment Rate
Percent of
Labor Force
12
10
Unemployment rate
8
6
4
2
0
1965
1970
1975
1980
1985
1990
1995
2000
Copyright © 2004 South-Western
EXPLAINING SHORT-RUN ECONOMIC
FLUCTUATIONS
• Short-run versus the long-run: Price Flexibility
– LR: Most economists believe that classical theory describes the
world in the long run but not in the short run.
• Changes in the money supply affect nominal variables but not real
variables = Monetary is neutral.
• The aggregate supply curve is vertical and prices adjust fully.
– SR: Most economists believe that prices do not adjust fully in the
short-run and therefore output will change.
• Changes in the money supply can affect real variables in the short-run
= Money is not neutral.
• Aggregate supply is upward sloping.
• Therefore, aggregate demand as well as aggregate supply
are important in determining output and prices in the shortrun.
The Basic Model of Economic
Fluctuations
• Two variables are used to develop a model to
analyze the short-run fluctuations.
– The economy’s output of goods and services measured
by real GDP.
– The overall price level measured by the CPI or the GDP
deflator.
• The Basic Model of Aggregate Demand and
Aggregate Supply
– Economist use the model of aggregate demand and
aggregate supply to explain short-run fluctuations in
economic activity around its long-run trend.
• The Basic Model of Aggregate Demand and
Aggregate Supply
– The aggregate-demand curve shows the quantity of
goods and services that households, firms, and the
government want to buy at each price level.
• The Basic Model of Aggregate Demand and
Aggregate Supply
– The aggregate-supply curve shows the quantity of
goods and services that firms choose to produce and
sell at each price level.
Figure 2 Aggregate Demand and Aggregate
Supply...
Price
Level
Aggregate
supply
Equilibrium
price level
Aggregate
demand
0
Equilibrium
output
Quantity of
Output
Copyright © 2004 South-Western
THE AGGREGATE-DEMAND
CURVE
• The four components of GDP (Y) contribute
to the aggregate demand for goods and
services.
Y = C + I + G + NX
Figure 3 The Aggregate-Demand Curve...
Price
Level
P
P2
1. A decrease
in the price
level . . .
0
Aggregate
demand
Y
Y2
Quantity of
Output
2. . . . increases the quantity of
goods and services demanded.
Copyright © 2004 South-Western
Why the Aggregate-Demand Curve Is
Downward Sloping
• The AD is not downward sloping for the reasons a demand
curve in microeconomics is downward sloping
(substitution and income effects)
• Remember our analysis of the Wealth Portfolio – If P falls
the value of money increases, people are then holding
excess cash balances so they either spend it or lend it:
– Spend it : The Price Level and Consumption: The Wealth Effect
– Lend it: The Price Level and Investment: The Interest Rate Effect
– The result of lend it: The Price Level and Net Exports: The
Exchange-Rate Effect
• The Price Level and Consumption: The Wealth
Effect
– A decrease in the price level increases the value of
money in one’s portfolio and makes consumers feel
more wealthy, which in turn encourages them to spend
more.
– This increase in consumer spending means larger
quantities of goods and services demanded.
– P↓ → VofM↑ → wealth↑ → spend it → C↑ →AD↑
• The Price Level and Investment: The Interest Rate
Effect
– A lower price level increases the value of cash holdings
and wealth, people lend more, this reduces the interest
rate, which encourages greater spending on investment
goods.
– This increase in investment spending means a larger
quantity of goods and services demanded.
– P↓ → VofM↑ → wealth↑ → lend it → SLF↑ → r↓ → I↑
→ AD↑
• The Price Level and Net Exports: The ExchangeRate Effect
– A lower price level increases the value of cash holdings
and wealth, people lend more, this reduces the interest
rate, NCO increases the supply of dollars increases, the
real exchange rate depreciates, which stimulates U.S.
net exports.
– The increase in net export spending means a larger
quantity of goods and services demanded.
– P↓ → VofM↑ → wealth↑ → lend it → SLF↑ → r↓ → S$
↑ → eP/P*↓ → NX↑ → AD↑
Shifts in the Aggregate-Demand Curve
• The downward slope of the aggregate demand curve shows
that a fall in the price level raises the overall quantity of
goods and services demanded.
• Many other factors, however, affect the quantity of goods
and services demanded at any given price level. When one
of these other factors changes, the aggregate demand curve
shifts.
• Shifts arise from autonomous (not related to P or Q in US)
– Consumption – consumer confidence
– Investment – business confidence
– Government Purchases – Military, Medicare
– Net Exports – ROW incomes↑
Shifts in the Aggregate Demand
Curve
Price
Level
P1
D2
Aggregate
demand, D1
0
Y1
Y2
Quantity of
Output
THE AGGREGATE-SUPPLY CURVE
• In the long-run, aggregate-supply curve is vertical.
This is the Classical view.
• In the short run, the aggregate-supply curve is
upward sloping. This a modification of the
Keynesian view.
• The Long-Run Aggregate-Supply Curve
– In the long run, an economy’s production of goods and
services depends on its supplies of labor, capital, and
natural resources and on the available technology used
to turn these factors of production into goods and
services. Q= A F(K/L, H/L, NR/L)
– The price level does not affect these variables in the
long run.
Figure 4 The Long-Run Aggregate-Supply Curve
Price
Level
Long-run
aggregate
supply
P
P2
2. . . . does not affect
the quantity of goods
and services supplied
in the long run.
1. A change
in the price
level . . .
0
Natural rate
of output
Quantity of
Output
Copyright © 2004 South-Western
THE AGGREGATE-SUPPLY
CURVE
• The Long-Run Aggregate-Supply Curve
– The long-run aggregate-supply curve is vertical
at the natural rate of output.
– This level of production is also referred to as
potential output or full-employment output.
Why the Long-Run Aggregate-Supply
Curve Might Shift
• Any change in the economy that alters the natural
rate of output shifts the long-run aggregate-supply
curve.
• The shifts may be categorized according to the
various factors in the classical model that affect
output.
• Shifts arising
–
–
–
–
Labor
Capital
Natural Resources
Technological Knowledge
Figure 5 Long-Run Growth and Inflation
2. . . . and growth in the
money supply shifts
aggregate demand . . .
Long-run
aggregate
supply,
LRAS1980 LRAS1990 LRAS2000
Price
Level
1. In the long run,
technological
progress shifts
long-run aggregate
supply . . .
P2000
4. . . . and
ongoing inflation.
P1990
Aggregate
Demand, AD2000
P1980
AD1990
AD1980
0
Y1980
Y1990
Quantity of
Output
3. . . . leading to growth
in output . . .
Y2000
Copyright © 2004 South-Western
A New Way to Depict Long-Run Growth
and Inflation
• Short-run fluctuations in output and price
level should be viewed as deviations from
the continuing long-run trends.
Why the Aggregate-Supply Curve Slopes
Upward in the Short Run
• In the short run, an increase in the overall
level of prices in the economy tends to raise
the quantity of goods and services supplied.
• A decrease in the level of prices tends to
reduce the quantity of goods and services
supplied.
Figure 6 The Short-Run Aggregate-Supply Curve
Price
Level
Short-run
aggregate
supply
P
P2
2. . . . reduces the quantity
of goods and services
supplied in the short run.
1. A decrease
in the price
level . . .
0
Y2
Y
Quantity of
Output
Copyright © 2004 South-Western
Why the Aggregate-Supply Curve Slopes
Upward in the Short Run
To understand an upward sloping short-run supply
curve we need to understand expectations.
Specifically, expectations about prices.
– Remember nominal interest rates equals the real rate of
interest plus the rate of inflation: i=r+%ΔP
– Borrowers and lenders must form expectations about
what prices will be in the future before they agree to
lend and borrow.
– In the macroeconomy, individuals form expectations
about the price level (inflation later on).
• Workers form Pe when negotiating form nominal wages (W).
• Business form Pe ,especially about inputs, when setting prices.
• The expected price level Pe is the link between
aggregate supply in the short-run and in the longrun.
• In the long-run P=Pe, people can’t be “fooled”,
but in the short-run P can be less than, equal to, or
more than Pe.
• Three theories of upward-sloping short-run
aggregate supply:
– The Misperceptions Theory
– The Sticky-Wage Theory
– The Sticky-Price Theory
• The Misperceptions Theory
– Changes in the overall price level temporarily
mislead suppliers about what is happening in
the markets in which they sell their output:
– A lower price level causes misperceptions about
relative prices.
• These misperceptions induce suppliers to decrease
the quantity of goods and services supplied.
The Sticky-Wage Theory
• The Sticky-Wage Theory
– Nominal wages are slow to adjust, or are
“sticky” in the short run:
• Wages do not adjust immediately to a fall in the
price level.
• A lower price level makes employment and
production less profitable.
• This induces firms to reduce the quantity of goods
and services supplied.
The Sticky-Price Theory
– Prices of some goods and services adjust
sluggishly in response to changing economic
conditions:
• An unexpected fall in the price level leaves some
firms with higher-than-desired prices.
• This depresses sales, which induces firms to reduce
the quantity of goods and services they produce.
Why the Short-Run Aggregate-Supply Curve
Might Shift
• Shifts arising
–
–
–
–
–
Labor
Capital
Natural Resources.
Technology.
Expected Price Level.
• An increase in the expected price level reduces the
quantity of goods and services supplied and shifts
the short-run aggregate supply curve to the left.
• A decrease in the expected price level raises the
quantity of goods and services supplied and shifts
the short-run aggregate supply curve to the right.
Figure 7 The Long-Run Equilibrium
Price
Level
Long-run
aggregate
supply
Short-run
aggregate
supply
A
Equilibrium
price
Aggregate
demand
0
Natural rate
of output
Quantity of
Output
Copyright © 2004 South-Western
Figure 8 A Contraction in Aggregate Demand
2. . . . causes output to fall in the short run . . .
Price
Level
Long-run
aggregate
supply
Short-run aggregate
supply, AS
AS2
3. . . . but over
time, the short-run
aggregate-supply
curve shifts . . .
A
P
B
P2
P3
1. A decrease in
aggregate demand . . .
C
Aggregate
demand, AD
AD2
0
Y2
Y
4. . . . and output returns
to its natural rate.
Quantity of
Output
Copyright © 2004 South-Western
TWO CAUSES OF ECONOMIC
FLUCTUATIONS
• Shifts in Aggregate Demand
– In the short run, shifts in aggregate demand cause
fluctuations in the economy’s output of goods and
services.
– In the long run, shifts in aggregate demand affect the
overall price level but do not affect output.
• An Adverse Shift in Aggregate Supply
– A decrease in one of the determinants of aggregate
supply shifts the curve to the left:
• Output falls below the natural rate of employment.
• Unemployment rises.
• The price level rises.
Figure 10 An Adverse Shift in Aggregate Supply
1. An adverse shift in the shortrun aggregate-supply curve . . .
Price
Level
Long-run
aggregate
supply
AS2
Short-run
aggregate
supply, AS
B
P2
A
P
3. . . . and
the price
level to rise.
Aggregate demand
0
Y2
2. . . . causes output to fall . . .
Y
Quantity of
Output
Copyright © 2004 South-Western
The Effects of a Shift in Aggregate
Supply
• Stagflation
– Adverse shifts in aggregate supply cause stagflation—a
period of recession and inflation.
• Output falls and prices rise.
• Policymakers who can influence aggregate demand cannot
offset both of these adverse effects simultaneously.
• Policy Responses to Recession
– Policymakers may respond to a recession in one of the
following ways:
• Do nothing and wait for prices and wages to adjust.
• Take action to increase aggregate demand by using monetary
and fiscal policy.
Figure 11 Accommodating an Adverse Shift in
Aggregate Supply
1. When short-run aggregate
supply falls . . .
Price
Level
Long-run
aggregate
supply
P3
C
P2
A
3. . . . which P
causes the
price level
to rise
further . . .
0
4. . . . but keeps output
at its natural rate.
Natural rate
of output
Short-run
aggregate
supply, AS
AS2
2. . . . policymakers can
accommodate the shift
by expanding aggregate
demand . . .
AD2
Aggregate demand, AD
Quantity of
Output
Copyright © 2004 South-Western
Short-run vs. Long-run Adjustment
• The economy may contract or expand in the short-run, but
it will return to the long-run level of output and the natural
rate of unemployment (full-employment or YFE).
• Aggregate supply is the curve that shifts to return the
economy to full employment.
• Given that we have emphasized sticky wages, over other
theories of the slope of the AS curve, lets use wage
flexibility in the long-run to explain how the AS shifts and
returns the economy to YFE
• The basic idea is that wages will adjust upwards when
Yactual> YFE or the unemployment rate is below the natural
rate and downwards if Yactual<YFE.
• If Yactual> YFE, Uactual<UNR, this will cause nominal
wages (W) to rise in the long-run and the AS will
decrease or shift up and to the left.
• If Yactual< YFE, Uactual>UNR, this will cause nominal
wages (W) to fall in the long-run and the AS will
increase or shift down and to the right.
• In both cases, nominal wages will continue to
adjust until we return to the UNR and YFE is
restored.
Adjustment to Shifts in AD and AS
• Positive AD shock, AD↑, P↑, Y↑, Yactual> YFE, Uactual<UNR,
W↑, AS↓, until Yactual=YFE, Uactual=UNR (Figure 7 above)
• Negative AD shock, AD↓, P↓, Y↓, Yactual<YFE, Uactual>UNR,
W↓, AS↑, until Yactual=YFE, Uactual=UNR (Figure 7 above)
• Positive AS shock, AS↑, P↓, Y↑, Yactual> YFE, Uactual<UNR,
W↑, AS↓, until Yactual=YFE, Uactual=UNR (Figure 8 above)
• Negative AS shock, AS↓, P↑, Y↓, Yactual<YFE, Uactual >UNR,
W↓, AS↑, until Yactual=YFE, Uactual=UNR(Figure 8 above)
Summary
• All societies experience short-run economic
fluctuations around long-run trends.
• These fluctuations are irregular and largely
unpredictable.
• When recessions occur, real GDP and other
measures of income, spending, and
production fall, and unemployment rises.
Summary
• Economists analyze short-run economic
fluctuations using the aggregate demand
and aggregate supply model.
• According to the model of aggregate
demand and aggregate supply, the output of
goods and services and the overall level of
prices adjust to balance aggregate demand
and aggregate supply.
Summary
• The aggregate-demand curve slopes
downward for three reasons: a wealth
effect, an interest rate effect, and an
exchange rate effect.
• Any event or policy that changes
consumption, investment, government
purchases, or net exports at a given price
level will shift the aggregate-demand curve.
Summary
• In the long run, the aggregate supply curve
is vertical.
• The short-run, the aggregate supply curve is
upward sloping.
• The are three theories explaining the
upward slope of short-run aggregate supply:
the misperceptions theory, the sticky-wage
theory, and the sticky-price theory.
Summary
• Events that alter the economy’s ability to
produce output will shift the short-run
aggregate-supply curve.
• Also, the position of the short-run
aggregate-supply curve depends on the
expected price level.
• One possible cause of economic
fluctuations is a shift in aggregate demand.
Summary
• A second possible cause of economic
fluctuations is a shift in aggregate supply.
• Stagflation is a period of falling output and
rising prices.