Aggregate Demand and Supply
AD
• What is AD?
Determinants of AD
• Change in Consumer Spending
–
–
–
–
Consumer Wealth
Consumer Expectatitons
Household Borrowing
Taxes
• Change in Investment Spending
– Interest Rates
– Expected Returns
•
•
•
•
Expected future business conditions
Technology
Degree of excess capacity
Business taxes
• Change in government spending
• Change in net export spending
– National Income Abroad
– Exchange Rates
Aggregate Supply
• What is AS?
• 1st : Immediate Short run:
• 2nd : Short Run:
• 3rd : Long Run:
AS-Immediate Short Run
AS- Short Run
AS- Long Run
Changes in Aggregate Supply
• Change in Input Prices
– Domestic Resource prices
– Prices of imported resources
• Change in productivity
• Change in Legal-Institutional Enviroment
– Business Taxes and subsidies
– Government Regulations
• Factors that change LRAS:
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An increase (decrease) in the supply of resources.
An improvement (deterioration) in technology and productivity.
Institutional changes that increase (reduce) the efficiency of
resource use.
Factors that change SRAS:
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
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A decrease (increase) in resource prices
— that is, production costs.
A reduction (increase) in the expected rate of inflation.
Favorable (unfavorable) supply shocks, such as good (bad)
weather or a reduction (increase) in the world price of a key
imported resource.
Questions for Thought:
1. Indicate how each of the following would
influence U.S. aggregate supply in the short run:
(a) An increase in real wage rates.
(b) A severe freeze that destroys half the
orange crop in Florida.
(c) An increase in the expected rate of
inflation in the future.
(d) An increase in the world price of oil,
a key import.
(e) Abundant rainfall during the growing
season of agricultural states.
Equilibrium
• Changes in equilibrium?
– Demand pull and Cost Push
Unanticipated Changes
in Aggregate Demand
• In the short-run, output will deviate from full
employment capacity as prices in the goods & services
market deviate from the price level that people
expected.

Impact of unanticipated increases in AD:
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Initially, the strong demand and higher price level in the
goods & services market will temporarily improve profit
margins.
Output will increase, the rate of unemployment will drop
below the natural rate, and output will temporarily
exceed the economy's long-run potential.
With time, however, contracts will be modified and
resource prices will rise and return to their competitive
relation with product prices.
Once this happens, output will recede to the economy's
long-run potential.
Unanticipated Increase
in Aggregate Demand
Price
level
LRAS
SRAS1
Short-run effects of an
unanticipated increase in AD
P105
P 100
AD1
YF

Y2
AD2
Goods & Services
(real GDP)
In response to an unanticipated increase in AD for goods & services (shift from AD1
to AD2), prices will rise to P105 and output will temporarily exceed full-employment
capacity (increases to Y2).
Unanticipated Increase
in Aggregate Demand
Price
level
LRAS
SRAS2
SRAS1
P110
Long-run effects of an
unanticipated increase in AD
P105
P100
AD1
YF Y2



AD2
Goods & Services
(real GDP)
With the passage of time, prices in resource markets, including the labor
market, will rise due to the strong demand. As a result, higher costs reduce
aggregate supply to SRAS2.
In the long-run, a new equilibrium at a higher price level (P110) and an output
consistent with the economy’s sustainable potential will occur.
Thus, the increase in demand will expand output only temporarily.
Unanticipated Changes
in Aggregate Demand
• Impact of unanticipated reductions in AD:
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Weak demand and lower prices in the goods &
services market will reduce profit margins. Many
firms will incur losses.
Firms will reduce output, the rate of unemployment
will rise above the natural rate, and output will
temporarily fall short of the economy's long-run
potential.
With time, long-term contracts will be modified.
Eventually, lower resource prices and a lower real
interest rate will direct the economy back to longrun equilibrium, but this may be a lengthy and
painful process.
Unanticipated Reduction
in Aggregate Demand
Price
level
LRAS
SRAS1
Short-run effects of an
unanticipated reduction in AD
P 100
P95
AD
AD2 1
YF


Y2
Goods & Services
(real GDP)
The short-run impact of an unanticipated reduction in AD (shift from AD1
to AD2) will be a decline in output (decreases to Y2), and a lower price
level (P95).
Temporarily, profit margins decline, output falls, and unemployment rises
below its natural rate.
Unanticipated Reduction
in Aggregate Demand
Price
level
LRAS
SRAS1
SRAS2
P100
Long-run effects of an
unanticipated reduction in AD
P95
P90
AD2
Y2 YF
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
AD1
Goods & Services
(real GDP)
In the long-run, weak demand and excess supply in the resource market will
lead to lower wage rates and resource prices resulting
in an expansion in short-run aggregate supply to SRAS2.
In the long-run, a new equilibrium at a lower price level (P90) and an output
consistent with the economy’s sustainable potential will result.
This method of restoring equilibrium may be both long and painful.
Impact of Changes
in Aggregate Supply
• Economic growth and anticipated shifts in longrun aggregate supply.
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Increases in LRAS will make it possible to
produce and sustain a larger rate of
output.
Both LRAS and SRAS will shift to the right
and output will increase.
These changes generally take place
slowly and therefore they need not
disrupt long-run equilibrium.
Shifts in Aggregate Supply
Price
Price
level
LRAS1
YF,1


level
LRAS2
YF,2
SRAS1
Goods & Services
(real GDP)
SRAS2
Goods & Services
(real GDP)
Such factors as an increase in the stock of capital or an improvement in
technology will expand the economy’s potential output and shift the
LRAS to the right (note that SRAS will also shift to the right).
Such factors as a reduction in resource prices, favorable weather, or a
temporary decrease in the world price of an important imported resource
would shift SRAS to the right (note that LRAS will remain constant).
Growth in Aggregate Supply
Price
level
LRAS1
LRAS2
SRAS1
SRAS2
P1
P2
AD
YFF1
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

YF2
Goods & Services
(real GDP)
Here we illustrate the impact of economic growth due to capital
formation or a technological advancement, for example.
Both LRAS and SRAS increase (to LRAS2 and SRAS2); the full
employment output of the economy expands from YF1 to YF2.
A sustainable, higher level of real output and real income is the result.
If the money supply is held constant, a new long-run equilibrium will
emerge at a larger output rate (YF2) and lower price level (P2).
Impact of Changes
in Aggregate Supply
• The impact of changes in short-run aggregate supply
(SRAS):
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SRAS shifts to the right – output will temporarily exceed
the economy's long-run potential.
Since the temporarily favorable supply conditions cannot
be counted on in the future, the economy’s long-term
production capacity will not be altered.
Recognizing that they will be unable to maintain their
current high level of income, individuals will generally save
a substantial portion of it for use at a future time that is not
nearly so prosperous.
The increased saving will reduce interest rates, which
encourages investment (capital formation).
Unanticipated, Temporary Increase
in Aggregate Supply
Price
level
LRAS
SRAS1
SRAS2
P1
P2
AD
YF
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

Y2
Goods & Services
(real GDP)
Here we illustrate an unanticipated, but temporary, increase in aggregate supply,
such as may result from a bumper crop caused by good weather.
The increase in aggregate supply (shift to SRAS2) would lead to a lower price level
(P95) and an increase in current GDP to Y2.
Since the favorable supply conditions cannot be counted on in the future,
the economy’s long-run aggregate supply will not increase.
Growth in Aggregate Supply
Loanable Funds
Market
Real Interest
Rate
S1
S2
r1
r2
D
Q1 Q2

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Quantity of
Loanable Funds
Predictably, decision makers will save a large proportion of their
temporary higher real income, spreading the benefits into the future.
Thus, the supply of loanable funds will increase (from S1 to S2).
The real interest rate will fall to r2, encouraging expenditures on interestsensitive capital goods and consumer durables.
Impact of Changes
in Aggregate Supply
• The impact of unanticipated reductions in short-run
aggregate supply (SRAS):
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
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If an unfavorable supply shock is expected to be
temporary, long-run aggregate supply will be
unaffected.
Households will reduce their current saving level (and
dip into past savings) to maintain a current
consumption level more consistent with their longerterm perceived opportunities.
The reduction in saving will lead to higher real
interest rates and retard current investment.
Reduction in Resources: A Supply Shock
Resource
Market
Price
Level
S2
S1
Pr2
P r1
D
Q1 Q
2


Quantity of
Resources
Suppose there is an unanticipated reduction in the supply of
resources, perhaps as the result of a crop failure or a sharp increase
in the world price of a major imported resource, such as oil.
Resource prices would rise from P1 to P2.
Effects of Adverse Supply Shock
Price
LRAS
level
SRAS2 (Pr2)
SRAS1 (Pr1)
P110
P 100
B
A
AD
YF Y
2




Goods & Services
(real GDP)
The higher resource prices shift the SRAS curve to the left; in the short-run,
the price level rises to P110 and output falls to Y2.
What happens in the long-run depends on whether the reduction in the
supply of resources is temporary or permanent.
If temporary, resource prices fall in the future, permitting the economy to
return to its original equilibrium (A).
If permanent, the productive potential of the economy will shrink (LRAS
shifts to the left) and (B) will become the long-run equilibrium.