Rittenberg Macroeconomics
Chapter 7
Aggregate Demand and Supply
Why the Aggregate Demand Curve Slopes
Downward (1)
• Aggregate demand (AD) is the economy-wide
demand for goods and services.
• Like the market demand curve, the aggregate
demand curve slopes downward, but for different
reasons.
• The reasons for its downward slope are price-level
effects:
– Wealth Effect (Real Wealth/Real Balances)
– Interest Rate Effect
– International Trade Effect (Substitution)
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1.1 The Slope of the Aggregate
Demand Curve
•
•
•
Aggregate demand is the relationship
between the total quantity of goods and
services demanded (from all the four
sources of demand) and the price level,
ceteris paribus.
The aggregate demand curve is a
graphical representation of aggregate
demand.
The wealth effect is the tendency for a
change in the price level to affect real
wealth and thus alter consumption.
1.1 The Slope of the Aggregate
Demand Curve
•
•
•
The interest rate effect is the tendency
for a change in the price level to affect the
interest rate and thus to affect the quantity
of investment demanded.
The international trade effect is the
tendency for a change in the price level to
affect net exports.
The change in the aggregate quantity of
goods and services demanded refers to
a movement along an aggregate demand
curve in response to a change in price level,
ceteris paribus.
1.2 Changes in Aggregate
Demand
•
A Change in aggregate demand is a change in
the aggregate quantity of goods and services
demanded at every price level. This can be caused
by changes in…
– Consumption,
– Investment,
– Government purchases,
– Net exports.
•
The exchange rate is the price of a currency
in terms of another currency or currencies.
Why the Aggregate Demand Curve Slopes
Downward (2)
6
The Interest Rate Effect
7
Why the Aggregate Demand Curve Slopes
Downward (4)
8
The
Aggregate
Demand
Curve
Note that changes
in price level result
in changes in the
aggregate quantity
demanded.
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9
Factors that Affect AD
AD = C + I + G + XN
• Consumption
–
–
–
–
–
Income
Wealth
Expectations
Demographics
Taxes
• Investment
–
–
–
–

Government purchases

Net Exports
–
–
–
–
Domestic & Foreign
Income
Domestic & Foreign Prices
Exchange Rates
Government Policy
Interest Rates
Technology
Cost of Capital Goods
Capacity Utilization
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Non-price Determinants: Changes in
Aggregate Demand (1)
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Nonprice Determinants: Changes in
Aggregate Demand (2)
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12
Non-price Determinants: Changes in Aggregate
Demand (3)
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13
Shifting the
Aggregate
Demand Curve
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The Multiplier
•
The multiplier is the ratio of the change in the
quantity of real GDP demanded at each price
level to the initial change in one or more
components of aggregate demand that
produced it.
EQUATION 1.1
Multiplier = Δ (real GDP demanded at each price level)
initial Δ (component of AD)
EQUATION 1.2
Δ (real GDP demanded at each price level) = Multiplier
× initial Δ (component of AD)
The Multiplier
Effect of initial increase in
net exports without
multiplier effect
AD1
AD2
The Multiplier
Effect of initial decrease in
net exports without
multiplier effect
AD2
AD1
Effects of a
Change in
Aggregate
Demand
Demand-pull
inflation: rapid
increases in AD
outpace the
growth of AS,
causing price level
increases
(inflation).
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18
2. AGGREGATE DEMAND AND AGGREGATE
SUPPLY: THE LONG RUN AND THE SHORT
RUN
Learning Objectives
1. Distinguish between the short run and the long run, as these
terms are used in macroeconomics.
2. Draw a hypothetical long-run aggregate supply curve and
explain what it shows about the natural levels of employment
and output at various price levels, given changes in aggregate
demand.
3. Draw a hypothetical short-run aggregate supply curve,
explain why it slopes upward, and explain why it may shift;
that is, distinguish between a change in the aggregate
quantity of goods and services supplied and a change in
short-run aggregate supply.
4. Discuss various explanations for wage and price stickiness.
5. Explain and illustrate what is meant by equilibrium in the
short run and relate the equilibrium to potential output.
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2. AGGREGATE DEMAND AND AGGREGATE
SUPPLY: THE LONG RUN AND THE SHORT RUN
•
•
•
The short run in macroeconomic analysis,
is a period in which wages and some other
prices are sticky and do not respond to
changes in economic conditions.
A sticky price is a price that is slow to
adjust to its equilibrium level, creating
sustained periods of shortage or surplus.
The long run in macroeconomic analysis, is
a period in which wages and prices are
flexible.
Short-run Aggregate Supply
• Aggregate Supply (AS) is the total of all the
firm (market) supply curves.
• It shows the quantity of real GDP produced at
different price levels.
• Like Supply at the microeconomic level, it is a
positive, upward-sloping curve
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Short-run Aggregate Supply
• Short-run AS slopes upward because an increase
in the price level (while production costs (wages)
and capital are held constant on the short-run),
means higher profit margins—firms will want to
produce more.
– The reverse is true when price level falls….
• Sticky Prices: esp. Sticky Wages: Changes in
Nominal Wages tend to lag behind changes in
price level. This leads to a short term effective
change in REAL WAGE.
22
Aggregate
Supply
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Shape of Short-run AS (SRAS)
• In the short-run, the capital stock (the number of
factories and machines, etc.) are held constant.
• Increasing the number of workers increases output,
but at a diminishing rate.
• Diminishing returns manifest as an ever-steeper
SRAS curve.
• In the short-run, some prices do not adjust quickly;
they are “sticky”:
– Labor Costs (wages)
– Contracted supplies
– “Sticky” prices effect the short-run equillibrium
24
The Shape of
the Short-Run
Aggregate
Supply Curve
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The Shape of Long-run AS (LRAS)
• Resource costs are NOT fixed.
– As prices rise, workers will want higher wages and will
eventually get them.
• The amount of capital is not fixed—firms can build
new plants and buy new equipment over the longrun.
• In the long-run, AS is set by the production
possibilities curve—the capacity of the economy, and
is not affected by prices, hence is vertical.
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2.1 The Long Run
•
The long run aggregate supply (LRAS) curve is
a graphical representation that relates the level of
output produced by firms to the price level in the
long run.
The Shape of the
Long-Run
Aggregate Supply
Curve
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Long-Run Equilibrium
Determinants of Aggregate Supply (1)
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Determinants of Aggregate Supply (2)
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Determinants of Aggregate Supply (3)
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2.2 The Short Run
•
•
•
The short run aggregate supply (SRAS)
curve is a graphical representation of the
relationship between production and the price
level in the short run.
A change in the aggregate quantity of
goods and services supplied is characterized
by movement along the short-run aggregate
supply curve.
A change in short-run aggregate supply is
characterized by a change in the aggregate
quantity of goods and services supplied at
every price level in the short-run.
Shifting the
Long-Run
Aggregate
Supply Curve
Growth occurs as the
labor force and the
capital stock grow, as
technological
innovation improves
production efficiency.
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Changes in
Short-Run
Aggregate
Supply
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Changes in Short-Run
Aggregate Supply
Shift caused by
increase in
price of natural
resources.
SRAS3 SRAS1 SRAS2
Shift caused by
decrease in
price of natural
resources.
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Short-Run Equilibrium
SRAS2 SRAS1
P2
Shift caused by increase in
health insurance premium
paid by firms
P1
AD1
Y2
Y1
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Short-Run Equilibrium
SRAS1
Shift caused by
increase in
government
purchases.
P2
P1
AD1
Y1
Y2
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AD2
Effects of a
Change in
Aggregate
Supply
Cost-push
inflation: cost
increases push
AS to the left
(relative to AD),
causing price
level increases
(inflation).
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Aggregate
Demand and
Aggregate
Supply
Equilibrium
40
Aggregate
Demand and
Supply
Equilibrium
41
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Economic Insight:
OPEC and
Aggregate Supply
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