Aggregate demand and aggregate supply model
A model that explains short-run fluctuations in real
GDP and the price level.
Aggregate Demand GDP has four components: consumption (C),
investment (I), government purchases (G), and net exports (NX).
If we let Y stand for GDP, we can write the following:
Y = C + I + G + NX
Why Is the Aggregate Demand Curve Downward Sloping?
The International-Trade Effect (substitution of foreign stuff
for our stuff): When our price level rises, foreigners buy less of
our exports and we import more things from abroad.
When our price level rises, the real value of our monetary wealth
declines. We feel poorer.
The Wealth Effect: When our monetary wealth declines, we
feel poorer and buy less.
When our price level rises, real money balances (M/P)
become scarcer and the interest rate rises.
The Interest-Rate Effect: A higher interest rate discourages
spending, investment spending in particular.
The wealth effect refers to the fact that:
a. When the price level falls, the real value of
household wealth rises, and so will consumption.
b. When income rises, consumption rises.
c. When the price level falls, the nominal value of
assets rises, while the real value of assets
remains the same.
d. All of the above.
What Shifts the Aggregate Demand Curve?
Changes in Government Policies intended to achieve macroeconomic
objectives: high employment, price stability, steady economic
growth.
•Monetary policy Actions the Federal Reserve takes to manage
the money supply and interest rates.
•Fiscal policy Changes in federal taxes and purchases.
Changes in Expectations of Households and Firms
•If households become more optimistic about their future
incomes, they are likely to increase their current consumption.
Changes in Foreign Variables
•If foreign economies expand, foreign firms and households
will buy more U.S. goods.
•If the dollar depreciates, foreign firms and households will
buy more U.S. goods and U.S. firms and households will
buy fewer foreign goods.
Net exports will rise and the aggregate demand curve will
shift to the right.
Movements along the Aggregate Demand Curve
versus Shifts of the Aggregate Demand Curve
When price rises, less domestic
output is demanded owing to the
international-trade effect, the wealth
effect and the interest rate effect.
When taxes increase or government
spending decreases, when the
money supply is reduced or when
people lose confidence, aggregate
demand shifts to the left
Variables That Shift the Aggregate Demand Curve
aggregate demand
Variables That Shift the Aggregate Demand Curve
Shifts the demand curve to the left
The Long-Run Aggregate Supply Curve
LRAS reflects the economy’s output capacity at full employment of
available resources using the best available technology.
LRAS shifts outward as capital accumulates, the labor force grows
and as technology improves.
Which of the following factors does not cause the
aggregate demand curve to shift?
a. A change in the price level.
b. A change in government policies.
c. A change in the expectations of households and
firms.
d. A change in foreign factors.
Aggregate demand and aggregate supply
Aggregate Supply
The Short-Run Aggregate Supply Curve slopes upward
Why does the short-run aggregate supply curve slope
upward?
1 Contracts make some wages and prices “sticky.”
2 Firms are often slow to adjust wages.
3 Menu costs make some prices sticky.
Variables That Shift the Short-Run Aggregate Supply Curve
Expected Changes in the Future Price Level
Aggregate Supply
Variables That Shift the Short-Run Aggregate Supply Curve
Recall: Supply Relation Reflects COSTS
Adjustments of Workers and Firms to Errors in Past
Expectations about the Price Level:
• Wage Adjustments
Unexpected Changes in the Price of an Important
Natural Resource
Supply shock An unexpected event that changes costs
causes the short-run aggregate supply curve to shift.
Variables That Shift the Short-Run Aggregate Supply Curve
Variables That Shift the Short-Run Aggregate Supply Curve
An increase in productivity results in:
a. An increase in aggregate demand.
b. An increase in short-run aggregate supply.
c. A decrease in aggregate demand.
d. A decrease in short-run aggregate supply.
Macroeconomic Equilibrium
in the Long Run and the Short Run
Long-Run Macroeconomic
Equilibrium
Macroeconomic Equilibrium
in the Long Run and the Short Run
Recessions, Expansions, and Supply Shocks
Because the full analysis of the aggregate demand and
aggregate supply model can be complicated, we begin with a
simplified case, using two assumptions:
1 The economy has not been experiencing any inflation.
The price level is currently 100, and workers and firms
expect it to remain at 100
in the future.
2 The economy is not experiencing any long-run
growth. Potential real GDP is $10.0 trillion and will
remain at that level in the future.
Expansion...and restoration of full employment
The Short-Run and Long- run
Effects of an Increase in
Aggregate Demand:
• Prices rise along SRAS as
the economy expands
• Costs increase as less
productive resources
are used to produce
more output
• Firms increase prices
to cover higher costs
• Rising wages and prices
shift SRAS inward
• Workers demand and
get higher wages to
offset higher prices
• Costs of production
increase
• Firms increase prices
to cover higher costs
How can government policies shift the aggregate
demand curve to the right?
a. By increasing personal income taxes.
b. By increasing business taxes.
c. By increasing government purchases.
d. All of the above.
Recession...and textbook restoration of full employment
The Short-Run and
Long-Run Effects of a
Decrease in Aggregate
Demand:
• Declining wages
and prices shift
SRAS outward
Why does the short run aggregate supply curve slope
upward?
a. Because profits rise when the prices of the goods
and services firms sell rise more rapidly than the
prices they pay for inputs.
b. Because an increase in market price results in an
increase in quantity supplied, as stated by the law of
supply.
c. Because, as the number of workers, machinery,
equipment, and technological change increase,
quantity supplied increases.
d. All of the above.
Does It Matter What Causes a Decline in Aggregate Demand?
The collapse in spending on housing
added to the severity of the 2007–2009
recession.
It’s the financial
Spending on residential construction has
declined prior to every recession since 1955
crisis and deleveraging by households, businesses, governments,
and foreigners that make the current downturn so ugly.
• Deleveraging: Cutting back spending in effort to reduce debt.
Which Components of Aggregate Demand Changed
the Most during the 2007–2009 Recession?
Which Components of Aggregate Demand Changed
the Most during the 2007–2009 Recession?
The following graphs illustrate the components of aggregate demand that
showed the largest movements relative to potential GDP during the 2007-2009 recession,
which is represented by the red bar.
Which Components of Aggregate Demand Changed
the Most during the 2007–2009 Recession?
Macroeconomic Equilibrium
in the Long Run and the Short Run
Supply Shock
 Stagflation
..in short run
The Short-Run and Long-Run Effects of a Supply Shock
Stagflation:
falling output
and rising prices
at the same time
Which of the following statements is true?
a. In the long run, increases in the price level
result in an increase in real GDP.
b. In the long run, increases in the price level
result in a decrease in real GDP.
c. In the long run, increases in the price level
do not affect real GDP.
d. In the long run, increases in the price level
may increase or decrease real GDP.
A Dynamic Aggregate Demand and Aggregate Supply Model
We can create a dynamic aggregate demand and aggregate supply
model by making three changes to the basic model...but we won’t
Realistically,
• Potential real GDP increases continually, shifting
the long-run aggregate supply curve to the right.
• During most years, the aggregate demand curve
will be shifting to the right.
• Except during periods when workers and firms
expect high rates of inflation, the short-run
aggregate supply curve will be shifting to the
right as productivity increases.
Macroeconomic Schools of Thought
Keynesian revolution The name given to the widespread acceptance
during the 1930s and 1940s of John Maynard Keynes’s macroeconomic
model and activist policy prescriptions...and use of demand management
tools during the post-WWII “Golden Age.”
Alternative schools of thought use models that differ
significantly from the standard aggregate demand and
aggregate supply model. We can briefly consider each of
three major alternative models that caution against Keynesian,
activist policies:
1 The monetarist model
2 The new classical model
3 The real business cycle model
Macroeconomic Schools of Thought
The Monetarist Model
The monetarist model—also known as the neo-Quantity Theory of
Money model—was developed beginning in the 1940s by Milton
Friedman, an economist at the University of Chicago who was
awarded the Nobel Prize in Economics in 1976.
Monetary growth rule A plan for increasing the quantity of
money at a steady, predictable rate that does not respond to
changes in economic conditions.
• Steady monetary growth can serve as an automatic stabilizer.
Monetarism The macroeconomic theories of Milton Friedman
and his followers; particularly the idea that the quantity of money
should be increased at a constant rate.
• Unintended consequences of Keynesian intervention will only
make matters worse...So don’t mess with the economy!
Macroeconomic Schools of Thought
The New Classical Model
The new classical model was developed in the mid-1970s by a
group of economists including Nobel laureate Robert Lucas of
the University of Chicago, Thomas Sargent of New York
University, and Robert Barro of Harvard University.
New classical macroeconomics The macroeconomic
theories of Robert Lucas and others, particularly the idea
that workers and firms have rational expectations.
• People anticipate what government will do to try to
hype the economy ... and will act in ways that makes
demand management polices ineffective.
• So don’t mess with the economy!!
Macroeconomic Schools of Thought
The Real Business Cycle Model
Beginning in the 1980s, some economists, including Nobel laureates
Finn Kydland of Carnegie Mellon University and Edward Prescott of
Arizona State University, argued that Lucas was correct in assuming
that workers and firms formed their expectations rationally and that
wages and prices adjust quickly to supply and demand but wrong
about the source of fluctuations in real GDP.
Real business cycle model A macroeconomic model that
focuses on real, rather than monetary, causes of the
business cycle.
• Instability is from the supply-side.
• So don’t mess with Keynesian demand-side policies!!!
Karl Marx: Capitalism’s Severest Critic
… or most perceptive analyst?
Karl Marx predicted that a final
economic crisis would lead to
the collapse of the market system.
Key Terms
Aggregate demand and aggregate supply model
Aggregate demand curve
Fiscal policy
Long-run aggregate supply curve
Menu costs
Monetary policy
Short-run aggregate supply curve
Stagflation
Supply shock