Economics
Chapter 10
Aggregate Demand and
Aggregate Supply
AS - AD model
Examine the changes in price level and real GDP with

AD: Aggregate demand (總需求)

AS: Aggregate supply (總供應)
Aggregate demand (AD)

Factors affecting the demand of local computers:

Household income   Demand  ( Private consumption [ C ] )

Companies computers renewal  Demand  ( Investment [ I ] )

Government e-service  Demand  ( Gov’t expenditure [ G ] )

Economic growth overseas  Demand  ( Export [ NX ] )

Price of foreign computer   Demand  ( Import [ NX ] )
Aggregate demand (AD)

The quantity of domestic output (i.e. goods and services)
demanded at different price level.
Aggregate demand (AD)
In a closed economy
 No foreign trade
 AD = C + I + G




Private consumption expenditure (C)
Investment expenditure (I)
Government expenditure (G)
Remarks:

GDP



Investment = Private investment + Public investment
Government expenditure = Gov’t / Public expenditure
Aggregate demand


Investment = Private investment
Government expenditure = Public investment + Gov’t / Public expenditure
Aggregate demand (AD)
In an open economy

Net export = Export – Import
( NX = X – M )

AD = C + I + G + NX
Aggregate demand curve

AD curve shows the quantity of domestic
output demanded at different price level.

Relationship bet.

Aggregate output (Y), i.e. real GDP

Price level (P), i.e. GDP deflator
Aggregate demand curve
The downward sloping AD curve
Price level

PY
P2
P1
AD
0

PY
Y2
Y1
Aggregate
output
Price level
P1
P2
AD
0
Y1
Y2
Aggregate
output
Reasons for downward sloping AD curve
Change in “Price level” will lead to :
1.
Wealth effect
2.
Interest rate effect
3.
Exchange rate effect
* These effects show the movement along AD curve.
Reasons for downward sloping AD curve
1. Wealth effect

Wealth = Money + Financial asset (e.g. bonds)

Take “money” for explanation

Price level   Purchasing power of money   Real wealth 
 Holder of money is richer  Buy more goods and services
 Quantity of output demanded 
Price level
P1
P2
AD
0
Y1
Y2
Aggregate
output
Reasons for downward sloping AD curve
1. Wealth effect

Wealth = Money + Financial asset (e.g. bonds)

Take “financial asset” for explanation

Price level   Value of bond   Real value of assets 
 Holder of financial asset is poorer  Buy less goods and services
 Quantity of output demanded 
Price level
P2
P1
AD
0
Y2
Y1
Aggregate
output
Reasons for downward sloping AD curve
1. Wealth effect

Increase in price level
Price level   Wealth 
 Consumption 
 Quantity of output demanded 

Decrease in price level
Price level   Wealth 
 Consumption 
 Quantity of output demanded 
Reasons for downward sloping AD curve
2. Interest rate effect

Money market related

Take “money” for explanation

Price level   Purchasing power of money 
 Real money supply  (∵ buying same goods needs less money)
 Interest rate   Present Consumption & Investment 
 Quantity of output demanded 
Ms1
Ms2
Price level
Interest rate (%)
r1
P1
r2
P2
Md
0
Quantity of
money
AD
0
Y1
Y2
Aggregate
output
Reasons for downward sloping AD curve
2. Interest rate effect

Money market related

Take “money” for explanation

Price level   Purchasing power of money 
 Real money supply  (∵ buying same goods needs more money)
 Interest rate   Present Consumption & Investment 
 Quantity of output demanded 
Ms2
Ms1
Price level
Interest rate (%)
r2
P2
r1
P1
Md
0
Quantity of
money
AD
0
Y2
Y1
Aggregate
output
Reasons for downward sloping AD curve
2. Interest rate effect

Increase in price level
Price level   Real money supply 
 Real interest rate   Consumption & Investment 
 Quantity of output demanded 

Decrease in price level
Price level   Real money supply 
 Real interest rate   Consumption & Investment 
 Quantity of output demanded 
Reasons for downward sloping AD curve
3. Exchange rate effect

Real exchange rate related

i.e. price of domestic goods in terms of foreign goods
Real exchange rate = Nominal exchange rate x

𝐷𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝑝𝑟𝑖𝑐𝑒 𝑙𝑒𝑣𝑒𝑙
𝐹𝑜𝑟𝑒𝑖𝑔𝑛 𝑝𝑟𝑖𝑐𝑒 𝑙𝑒𝑣𝑒𝑙
Take “local goods” for explanation

Price level of local goods 
 Local goods can exchange for more foreign goods
 Real exchange rate 
 Less demand of local goods from foreigners
 Net export 
 Quantity of output demanded 
Reasons for downward sloping AD curve
2. Exchange rate effect

Real exchange rate related

i.e. price of domestic goods in terms of foreign goods
Real exchange rate = Nominal exchange rate x

𝐷𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝑝𝑟𝑖𝑐𝑒 𝑙𝑒𝑣𝑒𝑙
𝐹𝑜𝑟𝑒𝑖𝑔𝑛 𝑝𝑟𝑖𝑐𝑒 𝑙𝑒𝑣𝑒𝑙
Take “local goods” for explanation

Price level of local goods 
 Local goods can exchange for fewer foreign goods
 Real exchange rate 
 More demand of local goods from foreigners
 Net export 
 Quantity of output demanded 
Reasons for downward sloping AD curve
3. Exchange rate effect

Increase in price level
Price level   Real exchange rate 
 Net export 
 Quantity of output demanded 

Decrease in price level
Price level   Real exchange rate 
 Net exports 
 Quantity of output demanded 
Reasons for downward sloping AD curve
Conclusion

Change of price level  Change of quantity of output demand

Movement along the AD curve

Opposite direction
1. Wealth effect
- Wealth 
- purchasing power 
Price level

2. Interest effect
- real interest rate 
- consumption 
- Investment 
3. Exchange rate effect
- Real exchange rate 
- net export 
Quantity of
output demanded

Changes in AD caused by other factors
Change in other factors (not “price level”):
1.
Consumption (C)
2.
Investment (I)
3.
Government expenditure (G)
4.
Net exports (NX)
* These effects show the shifting of AD curve.
Change in AD caused by other factors

Increase in AD


Price level
At any price level, the
quantity of output demanded
will rise.
AD curve shifts rightward
AD1
Aggregate
output
0

Decrease in AD


AD2
Price level
At any price level, the
quantity of output demanded
will fall.
AD curve shifts leftward
AD2
0
AD1
Aggregate
output
Shifting of AD curve caused by Consumption

Private consumption   AD 

*Disposable income 




More able to earn higher salary
Expected more future income
Interest rate 



Price level
Economic prospects (growth)


Income tax rate 
Tax allowance 
More current consumption
Less saving
Desire to spend 

Saving rate 
AD1
0
AD2
Aggregate
output
Shifting of AD curve caused by Investment

Investment expenditure   AD 

*Interest rate 


Economic prospects (growth)


Lower cost to make loan for investment
More willing to invest
Price level
Profit tax 


Increase firms’ net profit
Higher incentive to invest more
AD1
0
AD2
Aggregate
output
Shifting of AD curve caused by Government Exp.

Government expenditure   AD 

Government expenditure 




*Infrastructure, e.g. highways and new airport runway
Medical services, e.g. medical coupons for elderly
Education, e.g. small class teaching
Cultural, e.g. Art Festival
Price level
AD1
0
AD2
Aggregate
output
Shifting of AD curve caused by Net Export

Net export   AD 

Income of foreign countries 


Demand of domestic goods 
 Domestic export 
Exchange rate of domestic currency 


Price of domestic goods in terms
of foreign currency 
Remarks:


Change in exchange rate lead to price change
Not price change lead to change in exchange rate
Conclusion: Aggregate demand

Price level   Quantity of output demand




Consumption
Investment
Net exports
Other factors  Change in AD




Consumption
Investment
Government expenditure
Net exports
Aggregate supply


The quantity of output supplied (or the real national
income) at different price levels.
It shows the relationship between the output supplied
and the price level.
Two classifications of aggregate supply
 Long run aggregate supply ( LAS or LRAS )
 Short run aggregate supply ( SAS or SRAS )
Assumptions in macroeconomic

Similarity in short run and long run




Production resources
Technology
Productivity
Differences


Market prices
 Short run: can’t fully adjust to clear the market.
 Long run: fully adjust to clear the market.
Price level
 Short run: misconception about price level
 Long run: correct all mistakes after gathering all information
Assumptions in macroeconomic
Short run
Price
Misconceptions about price level
Production resources and
technology
Can’t adjust freely
to clear the market.
Long run
Can adjust freely.
Yes
No
Constant
Constant
Assumptions in macroeconomic
Explanation to the differences

If there is an economic recession, employers cut the wages of the
workers
 Short run:




Workers refuses a pay cut.
Employers can’t find workers  Employment level 
Aggregate supply 
Long run:




Workers know reason (i.e. recession) of the cutting of wages
Workers finally agree to a pay cut.
Employers can hire worker to full employment
Aggregate supply increases to the full employment level.
Long Run Aggregate Supply
1. Potential output
 The output of an economy at full employment
i. Labour


Labour supply   Potential output 
Productivity   Potential output 
ii. Capital


More advanced equipment  Potential output 
Capital accumulation  Potential output 
Long Run Aggregate Supply
1. Potential output
 The output of an economy at full employment
iii. Natural resources


Richer natural resources  Potential output 
E.g. fertile soil  more crops
iv. Technology


Advanced technology  higher productivity  Potential output 
e.g. Internet help speed up international trading
Long Run Aggregate Supply
2. Aggregate output in long run = Potential output

Price can be adjusted freely to reach equilibrium

Labour market is at equilibrium wage




No surplus labour
No labour shortage
i.e. Full employment
 The economy can achieve potential output.

Example:
 Equilibrium wage = W*
 Qs of labour = Qd of labour = 500
 Assume that average productivity of labour =10 units
 Then, Potential output = 500 x 10 = 5000 units
Long-run Aggregate Supply (LAS)
3. LAS curve
 Relationship between



the price level (P)
the potential output (YF) which is determined by
 Labour
Price level
 Capital
 Natural resources
P2
 Technology
Market price can be adjusted to achieve
full employment


At each price level, the economy reaches
potential output.
LAS curve is vertical at potential output.
LAS
P1
P3
0
YF
Aggregate
output
Long-run Aggregate Supply (LAS)
Why is LAS curve vertical?
Suppose the real GDP = Potential output and you have a shop in this economy.
If the gov’t double the money supply:
According to the QTM in long-run, %MS = %P
  Price level will be doubled
2. Inflation ( Price level)  Purchasing power 
  Market price of products will be doubled so as to offset the reduction of purchasing power
 i.e. you will sell your goods at a doubled price in order to gain the same purchasing power
3. Wages to workers will be doubled then.
 ∵Workers have less purchasing power under inflation.
 They will ask for higher wages to offset the decrease in purchasing power.
 If no wages increases, they will quit and your shop will close down.
Result of your shop:
Revenue : Ms   Price level   Market price   Revenue  (double)
Cost : Price level   Purchasing power   Wage   Cost  (double)
Output : Same amount of workers to sell same amount of goods (potential output)
No change in real price / real wage / Qd of labour / Qs of labour /
level of full employment / Aggregate supply
1.
Long-run Aggregate Supply (LAS)
Why is LAS curve vertical?
Conclusion
 In long-run, all prices are fully flexible.
 Change in price level will not change the relative price because

All money prices change in the same proportion



Change in price level will not affect the production decision of the
firms and workers



Product prices
Cost of production factors, e.g. wage rate
∵ they know there’s no change in relative price
Therefore, output will not be affected by the price level.
LAS curve is vertical.
Long-run equilibrium
1.

Long-run equilibrium price level and aggregate output
Long-run equilibrium refers to


Quantity of output demanded = Quantity of output supplied = Potential output
Price level at which AD curve cuts LAS curve
Price level
Price level
LAS
LAS
P
P1
P1
AD
0

YF
AD
Aggregate
output
0
YF
If price level in above P1



Quantity of output demanded < Quantity of output supplied
Market price will be adjusted freely
Price level will fall until P1
Aggregate
output
Long-run equilibrium
2.



Aggregate demand only affects the price level
Price level
LAS curve is vertical
AD does not affect aggregate output
P2
Shift of AD curve affects the price level only

P1
0
Increase in aggregate demand: AD curve shifts
rightward from AD1 to AD2


Price level increases from P1 to P2
Aggregate output remains unchanged at YF
LAS
Price level
AD2
AD1
Aggregate
output
YF
LAS
P1

Decrease in aggregate demand: AD curve shifts
leftward from AD1 to AD3


Price level decreases from P1 to P3
Aggregate output remains unchanged at YF
P3
AD1
AD3
0
YF
Aggregate
output
Shift of the LAS curve
In AS-AD model,
 Potential output is constant at YF
 LAS curve is vertical
Factors leading to the change in YF:
Price level
Increase in YF ( LAS1  LAS2 ),
[ LAS curve shifts rightward]
 Increase in population  labour supply *
 Economic growth * over time by


Capital accumulation *
Technology advancement *
0
LAS1
Y1
LAS2
Y2
Aggregate
output
Shift of the LAS curve
Factors leading to the change in YF:
Decrease in YF ( LAS1  LAS3 )
[LAS curve shifts leftward]
 War / Mass emigration  labour supply  *
 Major incidents


Price level
LAS3 LAS1
911 horror attack
Financial crisis in 1998 / Financial tsunami in 2008
0
Y3
Y1
Aggregate
output
Economic growth
LAS curve shifts rightward ( LAS1  LAS2 )
 Increase in YF



Labour supply  (∵ population )
Productivity  (∵ capital accumulation and higher technology level)
Assume AD does not change  Price level 
Price level
LAS1
LAS2
P1
P2
AD
0
Y1
Y2
Aggregate
output
Economic growth
AD curve shifts rightward ( AD1  AD2 )
 Increase in population  Consumption 
 Continual economic development  Higher AD
Price level
LAS1
LAS2
P1
AD1
0

Price level 
Price level
remains unchanged
Y1
Y2
AD2
Aggregate
output
Change in price level is determined
by the extent of the rightward shifting
of AD curve and LAS curve
Aggregate
output
Price level
Price level 
Aggregate output
Aging problem = Negative economic growth?
Hong Kong
 Low birth rate
 Forecasted 26% of population aged 65 or above
 Labour supply   YF 
Argument: YF will increase because of
 Advancement in technology
 Capital accumulation
 Import of foreign labour
Question: Is it possible that the long-run aggregate
supply (LAS) curve is not vertical in shape? Explain. (5)

No. (1)

In the long run, an economy’s total output is determined by its
productive capacity, which depends on the quantity and/or
quality of its factors of production. It is independent of the
price level. The output level will remain at the full-employment
level, no matter how the price level changes. (2)

The full-employment output level is also called the potential
output level or the natural rate of output level because this is
the production level at which the economy’s resources are
fully employed and unemployment is at its natural rate. The
LAS curve is vertical at the full-employment level of output or
the natural rate of output. (2)
Question:
Suppose a new kind of natural resources is discovered for
the production of computer.
a. How will the long-run aggregate supply be affected? (2)
b. Assume there is no change in AD, how will the long-run
equilibrium be changed? Explain with an aid of a diagram. (4)
c. What is the possible reason for the change in the long-run
equilibrium? Give any one. (3)
Question:
Suppose a new kind of natural resources is discovered
for the production of computer.
a. How will the long-run aggregate supply be affect? (2)
Answer:
 Discovery of a new kind of natural resources for production
helps increase the productive capacity. (1)

Assume that the resources are fully employed, the long-run
aggregate supply will be increased to a higher potential output
level. (1)
Question:
Suppose a new kind of natural resources is discovered
for the production of computer.
b. Assume there is no change in AD, how will the long-run
equilibrium be changed? Explain with an aid of a diagram. (3)
Answer:
 As the long-run aggregate supply increases, the LAS curve
shifts rightward from LAS1 to LAS2, (1)
where aggregate output level will be increased to a new
potential output level, YF. (1)
 Price level will drops from P1 to P2. (1)
 Correct diagram (2)
Question:
Suppose a new kind of natural resources is discovered
for the production of computer.
What is the possible reason for the change in the long-run
equilibrium? Give any one. (3)
Answer:
 Increase in long-run aggregate supply will lead to a fall in
price level, which lead to an increase in real wealth. As people
are richer, they will increase their private consumption.
Therefore the equilibrium aggregate output will increase
because of this wealth effect.
or
 Increase in long-run aggregate supply will lead to a fall in
price level, which lead to an increase in real money supply and
hence lower the interest rate. Since there is lower cost in loan
making, investment will be increased. Therefore the
equilibrium aggregate output will increase because of this
interest rate effect.
Short-run Aggregate Supply (SAS)
SAS curve
 Relationship between




the price level (P)
the quantity of output supplied (or real national income)
in the short run
Upward sloping
Positive relationship


PY
PY
Price level
SAS
P2
P1
P3
0
Y3
Y1
Y2
Aggregate
output
Short-run Aggregate Supply (SAS)
Why is SAS curve sloping upward?
1.
Sticky-price theory
2.
Sticky-wage theory
3.
Misperceptions theory
a.
Misperceptions of firms
b.
Misperceptions of workers
Short-run Aggregate Supply (SAS)
1. Sticky-price theory
In the short-run, price are not fully adjusted because there is


cost of price changing
insufficient information

Economic recession  Demand of good   Price level 

Firms may not lower the price of goods

Cost of price adjustment
Price level

(Below full-employment level)

SAS
Therefore, firms will produce less.
Conclusion: P   Y 
P1
P2
0
Y2
Y1 = YF
Aggregate
output
Short-run Aggregate Supply (SAS)
2. Sticky-wage theory
In the short-run, wages are not fully flexible


Long term contracts and pressure from labour unions
Therefore, impossible for instant wage cut.

Economic recession  Demand of good   Price level 

Decrease in price level means increase in real wage

Real wage   Production cost 

To lower the production cost  Fire workers  Reduce the output

Therefore, firms will produce less. (Below full-employment level)

Conclusion: P   Y 
Short-run Aggregate Supply (SAS)
3. Misperception theory
Misperception of change in price level:
Monetary price level vs. Relative price level

Economic recession  Demand of good   Price level 

General price level  = Money prices of all goods 

The truth is




all money prices change by the same proportion
i.e. Relative prices remain unchanged
if people realize no change in relative prices, then production decision
will be unchanged also.
However, in reality, due to imperfect competition,

people make decision by studying money prices
Short-run Aggregate Supply (SAS)
3. Misperceptions theory
a. Misperceptions of firms

Economic boom  Demand of good   Price level 





Economic recession  Demand of good   Price level 





Firms notice that money prices rise
Mistakenly believe it to be a rise in the relative prices
Increase production
Hire more workers (beyond full employment level)
Firms notice that money prices fall
Mistakenly believe it to be a reducton in the relative prices
Decrease production
Cut workers (below full employment level)
Conclusion: P   Y 
or
PY
Short-run Aggregate Supply (SAS)
3. Misperceptions theory
b. Misperceptions of workers

Economic boom  Demand of good   Price level 




Economic recession  Demand of good   Price level 




Workers notice that money wages rise
Mistakenly regard as a rise in real wages
Supply more labour (beyond full employment level)
Workers notice that money wages fall
Mistakenly regard as a fall in real wages
Supply less labour (below full employment level)
Conclusion: P   Y 
or
PY
From SAS to LAS (graphical presentation)

Economic boom  Price level 

In the short-run, misperceptions lead to


In the long-run, prices will fully adjust to clear the market, or
misperceptions are corrected


P  [from P1 to P2]  Y  [from YF to Y2]
Y return to the potential output [from Y2 to YF]
Economic recession  Price level 

LAS
In the short-run,

P  [from P1 to P3]
 Y [from YF to Y3]

Price level
SAS
P2
P1
In the long-run,
P3

Y return to the potential output
[from Y3 to YF]
0
Y3
YF
Y2
Aggregate
output
Short-run AS vs. Long-run AS
In the short run
 Decision of production is misled by price level changes
 Upward sloping SAS curve
In the long run



Misperceptions about the price level are corrected
Production should not be affected by the price level
Vertical LAS curve
Shift of the SAS curve
Factors leading to the change in the short-run aggregate supply:
1. Money prices of factors of production
(assume the quantity of resources and technology
remain constant)
a.



Price level
Cost of production 
MC   Output  at any price level
SAS curve shifts leftward (from SAS1 to SAS2)
At P1, output decreases from YF to Y2
P1
0
Y2
Price level
b.



SAS2 SAS1
LAS
Cost of production 
MC   Output  at any price level
SAS curve shifts rightward (from SAS1 to SAS3)
At P1, output increases from YF to Y3
Aggregate
output
YF
SAS1 SAS3
LAS
P1
0
YF
Y3
Aggregate
output
Shift of the SAS curve
Factors leading to the change in the short-run aggregate supply:
2. Expected price level (in the future)
(assume the actual price level remains unchanged)
a.
Expected price level 

Labour side



Firm side






Price level LAS
Same wage earned at the moment means
lower purchasing power in the future
Real wage   Workers are less willing to work
Labour supply   SAS 
Same return earned at the moment means
lower purchasing power in the future
Real return   Firm will produce less at current
price level
Production   SAS 
SAS curve shifts leftward (from SAS1 to SAS2)
At P1, output decreases from YF to Y2
SAS2 SAS1
P1
0
Y2
YF
Aggregate
output
Shift of the SAS curve
Factors leading to the change in the short-run aggregate supply:
2. Expected price level (in the future)
(assume the actual price level remains unchanged)
b.
Expected price level 

Labour side







Price level
SAS1 SAS3
LAS
P1
Firm side


Same wage earned at the moment means
higher purchasing power in the future
Real wage   Worker is more willing to work
Labour supply   SAS 
Same return earned at the moment means
higher purchasing power in the future
Real return   Firm will produce more at current
price level
Production   SAS 
SAS curve shifts rightward (from SAS1 to SAS3)
At P1, output increases from YF to Y3
0
YF
Y3
Aggregate
output
Shift of the SAS curve
Factors leading to the change in the short-run aggregate supply:
3. Long-run factor:
Change in quantity of resources
Productivity
Population
Technology




e.g. Unstable political conditions / Wars
 Mass emigration
 Labour supply 


LAS2 LAS1 SAS2
LAS curve shifts leftward (from LAS1 to LAS2)
SAS1
P1
SAS curve shifts leftward (from SAS1 to SAS2)
Potential output (YF) 

Price level
0
Y2
Y1
Aggregate
output
Short-run equilibrium
Short-run equilibrium price level and aggregate output
 Short-run equilibrium refers to


Equilibrium where AD intersect SAS




At P1, AD = SAS
i.e. quantity of output demand equals
quantity of output supplied
P1 = the short-run equilibrium price level
Y1 = the short-run equilibrium aggregate output
At P2, AS > AD



Quantity of output demanded = Quantity of output supplied
Price level
SAS
P2
P1
P3
0
Firms will produce less and cut price
Aggregate output and price level will achieve equilibrium
At P3, AS < AD


Firms will produce more and raise price
Aggregate output and price level will achieve equilibrium
AD
Y1
Aggregate
output
Short-run equilibrium
Changes in short-run equilibrium
Price level

SAS
Increase in aggregate demand



AD curve shifts rightward (from AD1 to AD2)
Price level  (from P1 to P2)
Aggregate output  (from Y1 to Y2)
P2
P1
AD2
AD1
0
Y1 Y2
Aggregate
output
Price level

Decrease in aggregate demand



AD curve shifts leftward (from AD1 to AD3)
Price level  (from P1 to P3)
Aggregate output  (from Y1 to Y3)
SAS
P1
P3
AD1
AD3
0
Y3 Y1
Aggregate
output
Short-run equilibrium
Changes in short-run equilibrium
Price level

SAS1
SAS2
Increase in short-run aggregate supply



SAS curve shifts rightward (from SAS1 to SAS2)
Price level  (from P1 to P2)
Aggregate output  (from Y1 to Y2)
P1
P2
AD
0
Price level

Decrease in short-run aggregate supply



SAS curve shifts leftward (from SAS1 to SAS3)
Price level  (from P1 to P3)
Aggregate output  (from Y1 to Y3)
Y1 Y2
Aggregate
output
SAS3
SAS1
P3
P1
AD
0
Y3 Y1
Aggregate
output
Short-run and long-run economic adjustments
Assumption
 The economy is as full employment level
 Long-run AS is fixed. Constant (vertical) LAS curve
Basic concepts
1. Long-run equilibrium implies short-run equilibrium
2. Deviation from long-run equilibrium
Short-run and long-run economic adjustments
Basic concepts
1. Long-run equilibrium implies short-run equilibrium
 Long-run equilibrium:
Quantity of output demanded = Quantity of output supplied = Potential output
Short-run equilibrium
Price level

Equil. price level = P1

Aggregate output = Y1 = YF
LAS
SAS
P1
AD
0
Y 1 = YF
Aggregate
output
Short-run and long-run economic adjustments
Basic concepts
2.
Deviation from long-run equilibrium

The short-run equilibrium aggregate output is lower or higher than
the potential output.

Short-run aggregate output deviates from long-run potential output
Short-run and long-run economic adjustments
Basic concepts
2. Deviation form long-run equilibrium
a. Deflationary gap



Short-run aggregate output (Y2) < Potential output (YF)
Amount of YF in excess of Y2 is called a deflationary gap
Price level tends to fall later
Price level
LAS
SAS
P1
Deflationary gap
AD
0
Y2
YF
Aggregate
output
Short-run and long-run economic adjustments
Basic concepts
2. Deviation form long-run equilibrium
b. Inflationary gap



Short-run aggregate output (Y3) > Potential output (YF)
Amount of Y3 in excess of YF is called a inflationary gap
Price level tends to rise later
Price level
LAS
SAS
P1
Inflationary gap
AD
0
YF
Y3
Aggregate
output
Short-run and long-run economic adjustments
Fluctuations caused by changes in AD
(Suppose the economic starts at point A)
1. The effects of a fall in AD


If people feel pessimistic, cut investment
Price level
AD  ( from AD1 to AD2)
LAS

In the short run




economy will adjust to point B
P  (from P1 to P2)
Y  (from YF to Y2)
deflationary gap
P1
SAS
A
P2
B
AD1
AD2
0
**Remarks: Reasons for P   Y 



Sticky-price theory
Sticky-wage theory
Misperceptions theory
Y2
YF
Aggregate
output
Short-run and long-run economic adjustments
Fluctuations caused by changes in AD
(Suppose the economic starts at point A)
1. The effects of a fall in AD (con’t)

In the long run, price level will be corrected.


expected price level will fall
SAS  (from SAS1 to SAS2)
Price level
LAS
SAS1
SAS2

The short-run equilibrium will shift
to point C





P  (from P2 to P3)
Y  (from Y2 to YF)
Return to potential output
The long-run equilibrium is attained
Finally, YF remains unchanged, P 
P1
A
P2
B
P3
C
AD1
AD2
0
Y2
YF
Aggregate
output
Short-run and long-run economic adjustments
Fluctuations caused by changes in AD
(Suppose the economic starts at point A)
2. The effects of a rise in AD

If NX increases caused by overseas economic prosperity
Price level
LAS

AD  ( from AD1 to AD2)

In the short run




economy will adjust to point B
P  (from P1 to P2)
Y  (from YF to Y2)
inflationary gap
SAS
P2
B
P1
A
AD2
AD1
0
YF
Y2
Aggregate
output
Short-run and long-run economic adjustments
Fluctuations caused by changes in AD
(Suppose the economic starts at point A)
2. The effects of a rise in AD (con’t)

In the long run, price level will be corrected.


expected price level will rise
SAS  (from SAS1 to SAS2)
Price level
LAS
SAS2
C
SAS1
P3

The short-run equilibrium will shift
to point C





P  (from P2 to P3)
Y  (from Y2 to YF)
Return to potential output
The long-run equilibrium is attained
Finally, YF remains unchanged, P 
P2
B
P1
A
AD2
AD1
0
YF
Y2
Aggregate
output
Short-run and long-run economic adjustments
Fluctuations caused by changes in AD
Fill in the table below:
Short-run effects
Long-run effects
Price level
Aggregate output
Price level
Aggregate output
AD falls



Remains constant
AD rises



Remains constant
Short-run and long-run economic adjustments
Fluctuations caused by changes in AD
Conclusion:
Changes in AD

In the short run

Change in price level


or
AD   P 
Change in aggregate output


AD   P 
AD   Y 
or
AD   Y 
In the long run

Further change in price level only


AD   P 
or
AD   P 
No change in aggregate output
Short-run and long-run economic adjustments
Fluctuations caused by changes in SAS
(Suppose the economic starts at point A)
1. The effects of a fall in SAS


If cost of production increases, e.g. higher wages
Price level
SAS  ( from SAS1 to SAS2)
LAS

SAS1
In the short run




economy will adjust to point B
P  (from P1 to P2)
Y  (from YF to Y2)
deflationary gap
B
P2
P1



Wealth effect
Interest rate effect
Exchange rate effect
A
AD
0
**Remarks: Reasons for P   Y 
SAS2
Y2
YF
Aggregate
output
Short-run and long-run economic adjustments
Fluctuations caused by changes in SAS
(Suppose the economic starts at point A)
1. The effects of a fall in SAS (con’t)
 Since Y2 < YF





In the long run






factors are not fully employed
surplus in factor market
 factor price 
SAS  (from SAS2 to SAS1)
economy will adjust to point A
P  (from P2 to P1)
Y  (from Y2 to YF)
Return to potential output
The long-run equilibrium is attained
Finally, YF and P remain unchanged
Price level
LAS
SAS2
SAS1
B
P2
P1
A
AD
0
Y2
YF
Aggregate
output
Short-run and long-run economic adjustments
Fluctuations caused by changes in SAS
(Suppose the economic starts at point A)
2. The effects of a rise in SAS


If the actual price level remains unchanged but the expected price level falls
Price level
SAS  ( from SAS1 to SAS2)
LAS

SAS2
In the short run




economy will adjust to point B
P  (from P1 to P2)
Y  (from YF to Y2)
inflationary gap
SAS1
A
P1
P2
B
AD
0
YF
Y2
Aggregate
output
Short-run and long-run economic adjustments
Fluctuations caused by changes in SAS
(Suppose the economic starts at point A)
2. The effects of a rise in SAS (con’t)


People correct their expected price level
Price level
 factor price 
 SAS  (from SAS2 to SAS1)
In the long run






economy will adjust to point A
P  (from P2 to P1)
Y  (from Y2 to YF)
Return to potential output
The long-run equilibrium is attained
Finally, YF and P remain unchanged
LAS
SAS1
SAS2
A
P1
P2
B
AD
0
YF
Y2
Aggregate
output
Short-run and long-run economic adjustments
Fluctuations caused by changes in SAS
Fill in the table below:
Short-run effects
Long-run effects
Price level
Aggregate
output
Price level
Aggregate output
SAS falls


Remains constant
Remains constant
SAS rises


Remains constant
Remains constant
Short-run and long-run economic adjustments
Changes in LAS
(Suppose the economic starts at point A)
1. The effects of a rise in LAS

If the technology improves
LAS  ( from LAS1 to LAS2)

In the short run







LAS1 LAS2 SAS1
SAS2
deflationary gap
Economic adjustments

Price level
economy will adjust to point B
SAS  ( from SAS1 to SAS2)
P  (from P1 to P2)
Y  (from Y1 to Y2)
A
P1
P2
It’s beneficial to improve technology.
B
AD
0
Y1
Y2
Aggregate
output
Short-run and long-run economic adjustments
Changes in LAS
(Suppose the economic starts at point A)
2. The effects of a fall in LAS

If there is mass emigration
LAS  ( from LAS1 to LAS2)

In the short run






LAS2 LAS1
SAS2
inflationary gap
Economic adjustments

Price level
economy will adjust to point B
SAS  ( from SAS1 to SAS2)
P  (from P1 to P2)
Y  (from Y1 to Y2)
SAS1
B
P2
P1
A
AD
0
Y2
Y1
Aggregate
output
Stagflation (滯漲)
It comes from two words:
 Stagnation: High unemployment rate
 Inflation: High inflation rate
Case: Sharp rise in oil prices in the 1970s
The effects of a fall in SAS


SAS  ( from SAS1 to SAS2)
In the short run
 economy will adjust to point B
 P  (from P1 to P2)
 Y  (from YF to Y2)
If increase in oil prices is temporary,

In the long run
 Price will return to P1
 Aggregate output will return to YF
However, the case was not as expected!!!
Stagflation (滯漲)
Case: Sharp rise in oil prices in the 1970s
The oil prices continued to increase



Firms
 avoid using too much oil
 change production method
 Lower productivity
In the long run
 LAS  ( from LAS1 to LAS2)
Economy further adjusted to point C
 SAS ( from SAS2 to SAS3)
 P  (from P2 to P3)
 Y  (from Y2 to Y3)
SAS3
Price level
SAS2
C
P3
SAS1
B
P2
P1
A
AD
0

LAS1
LAS2
Y3
Y2
Y1
Aggregate
output
As a result
 Price level increased (inflation)
 Aggregate output decreased (stagnation = far away from full employment)
Case study (p.128)
Country A
1.
2.
3.
4.
Short-run equilibrium
 Point B
Possible reasons for short-run changes
Price level
 AD 
 Interest rates 
 Exchange rates 
 Profit tax rates 
 SAS 
 Production costs 
 Expected price level 
0
Adjustment
 SAS  (SAS curve shifts rightward)
Long-run equilibrium
 Point C
LAS
SAS
A
B
C
AD
Aggregate
output
Case study (p.128)
Country B
1.
2.
3.
4.
Short-run equilibrium
 Point R
Possible reasons for short-run changes
Price level
 AD 
 Interest rates 
 Exchange rates 
 Profit tax rates 
 SAS 
 Production costs 
 Expected price level 
0
Adjustment
 SAS  (SAS curve shifts leftward)
Long-run equilibrium
 Point Q
LAS
SAS
Q
R
S
AD Aggregate
output
Short question, Q5 p.135
With the aid of a diagram, use the AS-AD model to explain why, in
the long rum, aggregate output is solely determined by aggregate supply,
and the price is determined by aggregate demand. (7 marks)
Answer
The long-run aggregate supply is the potential output, which is determined
by resources and technology, independent of the price level. The long-run
aggregate supply curve is vertical at the potential output. (3)
Suppose the long-run aggregate supply curve
remains constant. A rise in aggregate demand
will lead to a rise in the price level. A fall in
aggregate demand will lead to a fall in the price
level, but aggregate output does not change. (2)
Correct diagram (2)
87
Structured question, Q3 p.136
Suppose there is a major breakthrough in the use of renewable
energy. How does this affect the long-term economic growth and the
price level? Explain with the AS-AD model. (5 marks)
Technological advances and more production resources push up
potential output. The price level falls and real GDP rises. (3)
Diagram: a rightward shift of the long-run aggregate supply curve, a
fall in the price level and a rise in real GDP. (2)
88
Structured question, Q4 p.136
Suppose Country A was initially in long-run equilibrium. If large-scale
enterprises of Country A expect the profits of the coming quarters to fall,
answer the following questions with the AS-AD model, and explain the
adjustment process with aid of a diagram.
In the short run, how do real GDP and the price level of Country A
change? (6 marks)
b. In the long run, how do real GDP and the price level of Country A
change? (6 marks)
a.
89
Structured question, Q4 p.136
a. In the short run, how do real GDP and the price level of Country A
change? (6 marks)
The economy is initially at point A.
Short run: Aggregate demand falls to AD2. (1)
Due to sticky prices and sticky wages (or misperceptions about the price level), (1)
both the price level and aggregate output move along SAS1 and fall toP2 andY2
respectively. (2)
Correct diagram (2)
90
Structured question, Q4 p.136
b. In the long run, how do real GDP and the price level of Country A
change? (6 marks)
Long run: Prices and wages fully adjust downward to clear the market (or the
expected price level falls). (1)
The short-run aggregate supply curve shifts rightward to SAS2. (1)
The price level falls further to P3, (1)
aggregate output returns to the potential
output at YF. (1)
Correct diagram (2)
91
Revision Ex.10.3 Q.1









The economy is originally at point A.
AD curve shifts rightward from AD1 to AD2.
In the short-run, equilibrium moves from point A to B.
Price level rises from P1 to P2.
Aggregate output rises from YF to Y2.
There is an inflationary gap.
In the long-run, prices are fully adjusted to clear the market.
Misperception of prices are corrected and the short-run aggregate
supply decreases. SAS curve shifts leftward from SAS1 to SAS2.
Equilibrium moves from point B to C.
Price level rises further from P2 to P3.
Aggregate output returns to the potential
output from Y2 to YF.
Revision Ex.10.3 Q.2









The economy is originally at point A.
AD curve shifts leftward from AD1 to AD2.
In the short-run, equilibrium moves from point A to B.
Price level falls from P1 to P2.
Aggregate output falls from YF to Y2.
There is a deflationary gap.
In the long-run, prices are fully adjusted to clear the market. Misperception
of prices are corrected and the short-run aggregate supply increases. SAS
curve shifts rightward from SAS1 to SAS2. Equilibrium moves from point
B to C.
Price level falls further from P2 to P3.
Aggregate output returns to the potential
output from Y2 to YF.
Revision Ex.10.3 Q.3









The economy is originally at point A.
SAS curve shifts rightward from SAS1 to SAS2.
In the short-run, equilibrium moves from point A to B.
Price level falls from P1 to P2.
Aggregate output rises from YF to Y2.
There is an inflationary gap.
In the long-run, prices are fully adjusted to clear the market. Misperception of
prices are corrected and the short-run aggregate supply decreases. SAS curve
shifts leftward from SAS2 to SAS1. Equilibrium moves from point B back to A.
Price level rises from P2 to P1.
Aggregate output returns to the potential
output from Y2 to YF.
Revision Ex.10.3 Q.4









The economy is originally at point A.
SAS curve shifts leftward from SAS1 to SAS2.
In the short-run, equilibrium moves from point A to B.
Price level rises from P1 to P2.
Aggregate output falls from YF to Y2.
There is a deflationary gap.
In the long-run, prices are fully adjusted to clear the market. Misperception of
prices are corrected and the short-run aggregate supply increases. SAS curve
shifts rightward from SAS2 to SAS1. Equilibrium moves from point B back to
A.
Price level falls form P2 to P1.
Aggregate output returns to the potential
output from Y2 to YF.
Revision Ex.10.3 Q.5
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The economy is originally at point A.
LAS curve shifts rightward from LAS1 to LAS2.
In the short-run, equilibrium is at point A.
There is a deflationary gap.
In the long-run, prices are fully adjusted to clear the market. Misperception of
prices are corrected and the short-run aggregate supply increases. SAS curve
shifts rightward from SAS1 to SAS2. Equilibrium moves from point A to B.
Price level falls from P1 to P2.
Aggregate output rises to the potential
output from Y1 to Y2.
Revision Ex.10.3 Q.6
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The economy is originally at point A.
LAS curve shifts leftward from LAS1 to LAS2.
In the short-run, equilibrium is at point A.
There is a inflationary gap.
In the long-run, prices are fully adjusted to clear the market. Misperception of
prices are corrected and the short-run aggregate supply decreases. SAS curve
shifts leftward from SAS1 to SAS2. Equilibrium moves from point A to B.
Price level rises from P1 to P2.
Aggregate output falls to the potential
output from Y1 to Y2.
Revision Ex.10.3 Q.7a
Revision Ex.10.3 Q.7a
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Aggregate demand increases as the government expenditure
increases.
AD curve shifts rightward from AD1 to AD2.
In the short-run, due to misperceptions about the price level,
both the price level and aggregate output move along SAS1.
Price level rises from P1 to P2.
Aggregate output rises from Y1 to Y2.
In the long-run, prices and wages fully adjust upward to clear
the market. The short-run aggregate supply curve shifts
leftward from SAS1 to SAS2.
Price level rises further from P2 to P3.
Aggregate output returns to the potential output from Y2 to YF.
Revision Ex 10.4 Q.1
Wealth effect:
 A lower price level implies greater purchasing power of
money, so private consumption rises, the quantity of
output demanded rises. (2)
Interest rate effect:
 As the price level falls, real money supply rises, real
interest rate falls, both consumption and investments rise,
leading to a larger quantity of output demanded. (2)
Exchange rate effect:
 As the price level falls, real exchange rate falls, net
exports rises, leading to a larger quantity of output
demanded. (2)
Revision Ex 10.4 Q.2
Possible reasons for an upward sloping short-run aggregate supply
curve include:
Sticky-price theory:
 As the price level falls, some firms choose to cut production instead
of price, leading to lower quantity of output supplied. (2)
Sticky-wage theory:
 As the price level falls, wages are not fully flexible. Firms produce
less due to higher real wage costs, leading to a lower quantity of
output supplied. (2)
Revision Ex 10.4 Q.2 (con’t)
Possible reasons for an upward sloping short-run aggregate supply
curve include:
The misperceptions theory:
 As the price level falls, firms mistakenly believe that the relative
prices of their goods are lower and thus produce less. Workers
mistakenly believe they have lower real wage and supply less
labour. These bring a lower quantity of output supplied. (2)
Reasons for a vertical long-run aggregate supply curve:
 In the long run, both prices and wages can fully adjust, and the
misperceptions about the price level are corrected. Aggregate output
equals potential output. (2)
Revision Ex 10.4 Q.3
The tax rebate will increase disposable income and
private consumption. (1)
Aggregate demand increases. (1)
Aggregate output and the price level increase. (1)
Correct diagram:
The aggregate demand curve
shifts to the right. (1)
Aggregate output and the
price level increase. (1)
Revision Ex 10.4 Q.4
The discovery of a new natural resource will increase
potential output. (1)
Long-run aggregate supply will increase. (1)
Aggregate output will increase and the price level will
decrease. (1)
Correct diagram:
The long-run aggregate supply
curve shifts to the right. (1)
Aggregate output increases and
the price level falls. (1)
Revision Ex 10.4 Q.5
An inflationary gap exists when the short-run
equilibrium aggregate output is higher than the
potential output. (1)
In the long-run, all prices are flexible and the price
level is fully anticipated by the public. As a result, all
markets are cleared and all resources are efficiently
employed. Aggregate output equals potential output
and there is no inflationary gap. (3)
Correct diagram (2) + (2)
Revision Ex 10.4 Q.6
a.
The economy is initially at point A.
 Short run: Aggregate demand falls to AD2. (1)
 Due to sticky prices and sticky wages (or misperceptions
about the price level), (1)
 both the price level and aggregate output move along
SAS1 and fall to P2 andY2 respectively. (2)
Revision Ex 10.4 Q.6
b.
Long run:
 Prices and wages fully adjust downward to
clear the market (or the expected price level
falls). (1)
 The short-run aggregate supply curve shifts
rightward to SAS2. (1)
 The price level falls further to P3, (1)
 aggregate output returns to the potential
output at YF. (1)