CHAPTER
13
Aggregate Demand
and Aggregate Supply
Prepared by: Jamal Husein
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
O’Sullivan & Sheffrin
Economic Fluctuations

Economic fluctuations are irregular,
recurring movements of GDP away from
potential output, also called business cycles.

Aggregate supply and aggregate
demand curves are tools of analysis used
for understanding key aspects of economic
fluctuations in both the short run and the
long run.
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Economic Fluctuations



The short run in macroeconomics refers
to a period of time during which prices
change very little, or do not adjust fully to
changes in demand.
The idea that demand determines output in
the short-run will be examined.
In the long-run, underlying economic
forces push the economy back towards full
employment.

The level of output in the economy when it
operates at full employment is called
Potential output.
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Economic Fluctuations

A recession is a period when real GDP falls for
two consecutive quarters. It starts at the peak of
an increase in output, and ends at a trough.

A depression is a prolonged period of decline in
output, or a severe recession. During the Great
Depression, 1929 through 1933, real GDP fell by
over 33%, and unemployment rose to 25%.

In the U.S., there were 20 recessions prior to
World War II, including two severe episodes in
1893 and 1929. After WWII the U.S. has had
nine recessions.
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Business Cycles & Economic Fluctuations
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Ten Postwar Recessions
Peak
Trough
November 1948
October 1949
1.5
July 1953
May 1954
3.2
August 1957
April 1958
3.3
April 1960
February 1961
1.2
December 1969
November 1970
1.0
November 1973
March 1975
4.9
January 1980
July 1980
2.5
July 1981
November 1982
3.0
July 1990
March 1991
1.4
March 2001
--------
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Percent Decline in
Real GDP
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Okun’s Law

The relationship between changes in real
GDP and the corresponding changes in
unemployment is called Okun’s Law.

According to Okun’s law, for every
percentage point that real GDP grows
faster than the normal rate of increase in
potential output, the unemployment rate
falls by one-half of a percentage point.
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Okun’s Law: Example

If the trend rate of real GDP growth
is 3% per year and the
unemployment rate is 5%, then ;
If real GDP grows by 4% a year (1%
point above its trend), then the
unemployment rate will decline by
0.5% to 4.5%.
 If real GDP grows at only 2% per year
(1% point below its trend), then the
unemployment rate would rise 5.5%.

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The Unemployment Rate During
Recessions

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During periods of
recession, marked
by the shaded
bars,
unemployment
rises sharply.
9
Procyclical and Countercyclical Measures

Procyclical economic measures move in
conjunction with real GDP. Investment
spending, consumption spending and prices of
stocks are all procyclical. The stock market
always plunges sharply during recessions.
Economic measures that fall as real GDP rises
are countercyclical. Unemployment is
countercyclical.
 Recessions are unpredictable and can arise as
a result of external shocks or changes in
economic policy.

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Sticky Prices & Demand-side Economics

Prices give the correct signals to all
producers in the economy so that
resources are used efficiently.


If consumers decide to consume fresh
fruit rather than chocolate, the price
of fruit will rise and the price of
chocolate will fall.
The economy will produce more fresh
fruit and less chocolate on the basis of
these price signals.
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Sticky Prices & Demand-side Economics


If prices are slow to adjust, then the
proper signals are not given quickly
enough to producers and consumers.
Arthur Okun classifies prices as:

Auction prices, or prices that adjust
nearly on a daily basis, such as food
products.
 Custom prices, or prices that adjust
slowly, or “sticky prices,” such as wages
and some industrial commodities.
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Sticky Prices & Demand-side Economics


Wages are sticky because workers often
have long-term contracts or are protected
from wage decreases by minimum wage
laws.
If wages are sticky, then firms’ costs and
their prices will be sticky as well. Sticky
prices get in the way of the economy’s
ability to coordinate economic activity,
and to bring demand and supply into
balance.
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Sticky Prices & Demand-side Economics



Typically, firms let demand determine the
level of output in the short run. In the long
run, prices fully adjust to changes in demand.
In the short run, firms have negotiated
contracts that keep input prices fixed.
Sudden changes in demand will be met by
changes in production with only small
changes in prices.
Keynesian economics refers to the
determination of output in the short run
based strictly on changes in demand.
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Aggregate Demand (AD)


The aggregate
demand curve plots
the total demand
for GDP as a
function of the
price level.
The price level refers to the average of all
prices in the economy, as measured by a price
index.
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Components of Aggregate Demand

Demand for GDP comprises the
demand for goods and services by all
sectors of the economy:
the household sector (consumption),
the business sector (investment),
the government sector (government
spending), and
the foreign sector (net exports)
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Aggregate Demand Slopes Downward

Aggregate demand slopes downward for
several reasons. Among them are:

The wealth effect: as the price level falls, the real
value of money increases and people find that they
are wealthier. This concept is associated with the
reality principle.
Reality PRINCIPLE
What matters to people is the real value or
purchasing power of money or income, not
its face value.
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Aggregate Demand Slopes Downward

Aggregate demand slopes downward
for several reasons. Among them
are:

The interest rate effect: with a given
money supply, a lower price level will
lead to lower interest rates and higher
consumption and investment
spending.
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Aggregate Demand Slopes Downward

Aggregate demand slopes downward
for several reasons. Among them
are:

The impact of international trade: a lower
price level makes domestic goods cheaper
relative to foreign goods; and a lower U.S.
interest rate leads to a lower U.S. exchange
rate which also makes domestic goods
relatively cheaper than foreign goods.
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Factors That Shift Aggregate Demand
Factors That
Increase
Aggregate
Demand
Factors That
Decrease
Aggregate
Demand
Decrease in
taxes
Increase in
taxes
Increase in
government
spending
Decrease in
government
spending
Increase in the Decrease in
money supply the money
supply
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Aggregate Supply


The aggregate supply curve depicts
the relationship between the level
of prices and real GDP.
We will consider two aggregate
supply curves, one corresponding
to the long run (the long run
aggregate supply curve), and one to
the short run (the short run
aggregate supply curve).
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The Long Run Aggregate Supply Curve

The classical aggregate
supply curve is the supply
curve for the long run—
when the economy is at full
employment.

The level of fullemployment output does
not depend on the level of
prices, but on supply
factors—capital, labor and
technology. This is why
the classical AS curve is
vertical.
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Long Run
AS
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The Long Run Aggregate Supply Curve


Combined with the
aggregate demand curve,
the intersection of the
classical AS curve and the
AD curve determines the
price level and the fullemployment level of
output.
The position of the AD
curve depends on the level
of taxes, government
spending, and the supply
of money.
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Long Run
AS
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The Long Run Aggregate Supply Curve

An increase in aggregate
demand does not change
the level of output in the
economy but only the level
of prices.

The main result from the
classical model is that, in
the long run, output is
determined solely by the
supply of capital and
labor—not by changes in
demand.
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Long Run
AS
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Crowding Out

As we have seen, higher aggregate
demand (i.e. higher government
spending) in the classical model does not
change the level of output.

If the level of output remains the same
but government spending increases,
some other component of demand
(consumption, investment, or net
exports) must decrease.
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Crowding Out

Increased government spending
“crowds out” other demands for GDP.
PRINCIPLE of Opportunity Cost
The opportunity cost of something is what you
sacrifice to get it.

At full employment, the opportunity
cost of increased government
spending is some other component of
GDP.
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Competing Shares of GDP
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The Short Run Aggregate Supply Curve

The Keynesian AS curve is
relatively flat because, in
the short run, firms adjust
output more than they
adjust prices.

Since an increase in
demand is met mostly by
an increase in output, we
say that aggregate demand
primarily determines the
level of output in the short
run.
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The Short Run Aggregate Supply Curve

The level of output where
the Keynesian AS curve
intersects the aggregate
demand curve need not be
the full-employment level
of output.

Output may exceed the
level of full employment
when demand is very high,
and fall short of full
employment when demand
is very low.
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The Short Run Aggregate Supply Curve



Because prices do not adjust fully over short
periods of time, the economy need not always
remain at full employment, or potential
output.
Changes in demand will lead to economic
fluctuations, away from full employment, with
sticky prices and a Keynesian aggregate
supply curve.
Only in the long run, when prices fully adjust,
will the economy operate at full employment.
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Adverse Supply Shocks


Supply shocks are
external events that
shift the Keynesian
aggregate supply
curve.
Adverse supply
shocks result in lower
output, lower
employment, and
higher prices.
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Favorable Supply Shocks


Favorable supply
shocks are also
possible. They lead to
the best of both
worlds: higher
output and lower
prices.
Favorable supply
shocks allow the
economy to grow
rapidly without
incurring the risk of
higher inflation.
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From Short-run to Long-run Equilibrium

As firms compete for labor
and raw materials, wages
and prices will tend to rise
over time.

This will cause the
Keynesian aggregate
supply curve to shift
upward.

This situation will continue
as long as output exceeds
potential.
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Long
LongRun
Run
Long
Run
Long
AS
AS Run
AS
AS
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From Short-run to Long-run Equilibrium

The Keynesian aggregate
supply will keep rising
upward until it intersects
the aggregate demand
curve at full employment.

Adjustments in wages and
prices eventually take the
economy from short-run
Keynesian equilibrium to
long-run classical
equilibrium.
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Long Run
AS
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