Aggregate Supply and Aggregate Demand Module 3: National Income, Price Determination, and Economic Growth D. McKee, 01.09.2013 Source: Economics, Krugman and Wells, Worth Publishing, 2006

Key Points How the aggregate supply curve illustrates the relationship between the aggregate price level and the quantity of aggregate output supplied in the economy Why the aggregate supply curve different in the short run compared to the long run How the aggregate demand curve illustrates the relationship between the aggregate price level and the quantity of aggregate output demanded in the economy How the AS–AD model is used to analyze economic fluctuations How monetary policy and fiscal policy can stabilize the economy

The Short-Run Aggregate Supply Curve The Great Depression, from 1929 to 1933: when deflation occurred and the aggregate price level fell from 11.9 (in 1929) to 8.9 (in 1933), firms responded by reducing the quantity of aggregate output supplied from $865 billion to $636 billion in 2000 dollars. Total investment spending is assumed to be $500 billion, $400 billion of which is financed by private savings. The remaining $100 billion comes from the budget surplus.

Shifts of the Short-Run Aggregate Supply Curve A decrease in short-run aggregate supply: the short-run aggregate supply curve shifts leftward from SRAS1 to SRAS2, and the quantity of aggregate output supplied at any given aggregate price level falls. An increase in short-run aggregate supply: the short-run aggregate supply curve shifts rightward from SSRA1 to SRAS2,and the quantity of aggregate output supplied at any given aggregate price level rises.

Shifts of the Short-Run Aggregate Supply Curve Changes in Commodity prices Nominal wages Productivity

From the Short Run to the Long Run The initial short-run aggregate supply curve is SRAS1. At the aggregate price level, P1, the quantity of aggregate output supplied, Y1, exceeds potential output, YP. Eventually, low unemployment will cause nominal wages to rise, leading to a leftward shift of the short-run aggregate supply curve from SRAS1 to SRAS2. In panel (b), at the aggregate price level, P1, the quantity of aggregate output supplied is less than potential output. This reflects the fact that the short-run aggregate supply curve has shifted to the right, due to both the short-run adjustment process in the economy and to a rightward shift of the long-run aggregate supply curve.

The Aggregate Demand Curve The aggregate demand curve shows the relationship between the aggregate price level and the quantity of aggregate output demanded. The curve is downward sloping due to the wealth effect of a change in the aggregate price level and the interest rate effect of a change in the aggregate price level. Here, the total quantity of goods and services demanded at an aggregate price level of 8.9, the actual number for 1933, is $636 billion in 2000 dollars, the actual quantity of aggregate output demanded in 1933. According to our hypothetical curve, however, if the aggregate price level had been only 5.0, the quantity of aggregate output demanded would have been $950 billio

Classical Versus Keynesian Macroeconomics One important difference between classical and Keynesian economics involves the short-run aggregate supply curve. Panel (a) shows the classical view: the SRAS curve is vertical, so shifts in aggregate demand affect the aggregate price level but not aggregate output. Panel (b) shows the Keynesian view: in the short run the SRAS curve slopes upward, so shifts in aggregate demand affect aggregate output as well as aggregate prices.

Fiscal Policy with a Fixed Money Supply In panel (a) an expansionary fiscal policy shifts the AD curve rightward, driving up both the aggregate price level and aggregate output. However, this leads to an increase in the demand for money. If the money supply is held fixed, as in panel (b), the increase in money demand drives up the interest rate, reducing investment spending and offsetting part of the fiscal expansion. So the shift of the AD curve is less than it would otherwise be: fiscal policy becomes less effective when the money supply is held fixed.

Rational Expectations, Real Business Cycles, and New Classical Macroeconomics New classical macroeconomics is an approach to the business cycle that returns to the classical view that shifts in the aggregate demand curve affect only the aggregate price level, not aggregate output. Rational expectations is the view that individuals and firms make decisions optimally, using all available information.

The Modern Consensus

Why is the aggregate demand curve downward-sloping? Wealth effect of a change in the aggregate price level Interest rate effect of a change in aggregate the price level

Shifts of the Aggregate Demand Curve Changes in Expectations Wealth Stock of physical capital

Shifts of the Aggregate Demand Curve The effect of events that increase the quantity of aggregate output demanded at any given aggregate price level, such as improvements in business and consumer expectations or increased government spending. Such changes shift the aggregate demand curve to the right, from AD1 to AD2. In panel (b), the effect of events that decrease the quantity of aggregate output demanded at any given price level, such as a fall in wealth caused by a stock market decline. This shifts the aggregate demand curve leftward from AD1 to AD2.

The Multiplier The size of the multiplier, 1/1 – MPC, depends on the marginal propensity to consume, MPC: the larger the MPC, the larger the change in real GDP for any given autonomous increase in aggregate spending.

The Multiplier A change in expectations that leads to a rise in investment spending shifts the AD curve to the right for two reasons. Holding the aggregate price level constant, there is an initial increase in GDP from the rise in I. Then there are subsequent increases in GDP as rising disposable income leads to higher consumer spending. Panel (a) shows how the rise in GDP at a given aggregate price level takes place. Panel (b) shows how this shifts the AD curve.

The AS–AD Model The AS–AD model combines the short-run aggregate supply curve and the aggregate demand curve. Their point of intersection, ESR, is the point of short-run macroeconomic equilibrium where the quantity of aggregate output demanded is equal to the quantity of aggregate output supplied. PE is the short-run equilibrium aggregate price level, and YE is the short-run equilibrium level of aggregate output.

Shifts of the SRAS Curve A supply shock shifts the short-run aggregate supply curve, moving the aggregate price level and aggregate output in opposite directions. Panel (a) shows a negative supply shock, which shifts the short-run aggregate supply curve leftward, causing stagflation—lower aggregate output and a higher aggregate price level. Here the short-run aggregate supply curve shifts from SRAS1 to SRAS2 , and the economy moves from E1 to E2. The aggregate price level rises from P1 to P2 , and aggregate output falls from Y1 to Y2. Panel (b) shows a positive supply shock, which shifts the short-run aggregate supply curve rightward, generating higher aggregate output and a lower aggregate price level. The short-run aggregate supply curve shifts from SRAS1 to SRAS2 , and the economy moves from E1 to E2. The aggregate price level falls from P1 to P2 , and aggregate output rises from Y1 to Y2. An event that shifts the short-run aggregate supply curve is a supply shock.

Shifts of Aggregate Demand: Short-Run Effects A demand shock shifts the aggregate demand curve, moving the aggregate price level and aggregate output in the same direction. In panel (a) a negative demand shock shifts the aggregate demand curve leftward from AD1 to AD2, reducing the aggregate price level from P1 to P2 and aggregate output from Y1 to Y2. In panel (b) a positive demand shock shifts the AD curve to the right, increasing the aggregate price level from P1 to P2 and aggregate output from Y1 to Y2.

Long-Run Macroeconomic Equilibrium Here the point of short-run macroeconomic equilibrium also lies on the long-run aggregate supply curve, LRAS. As a result, actual aggregate output is equal to potential output. The economy is in long-run macroeconomic equilibrium at ELR.

Short-Run Versus Long-Run Effects of a Positive Demand Shock Starting at E1 a positive demand shock shifts AD1 rightward to AD2, and the economy moves to E2 in the short run. This results in an inflationary gap as aggregate output rises from Y1 to Y2, the aggregate price level rises from P1 to 2, and unemployment falls to a low level. In the long run, SRAS1 shifts leftward to SRAS2 Pas nominal wages rise in response to low unemployment. Aggregate output falls back to Y1, the aggregate price level rises again to P3, and the economy returns to long-run macroeconomic equilibrium at E3.

Negative Supply Shocks

Macroeconomic Policy Fiscal policy affects aggregate demand directly through government purchases and indirectly through changes in taxes or government transfers that affect consumer spending. Monetary policy affects aggregate demand indirectly through changes in the interest rate that affect consumer and investment spending.