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MACROECONOMICS
Lecturer: Doan Ngoc Thang

Chapter 4
Aggregate Demand and Aggregate Supply

+
Reading materials

• Gregory Mankiw, Cengage

learning, Principle of
macroeconomics, 9th edition,
chapter 20

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IN THIS CHAPTER 4

n What are economic fluctuations? What are their characteristics?

n How does the model of aggregate demand and aggregate

supply explain economic fluctuations?
n Why does the Aggregate-Demand curve slope downward? What
shifts the AD curve?

n What is the slope of the Aggregate-Supply curve in the short

run? In the long run?
What shifts the AS curve(s)?

+
Outline

1. Economic Fluctuations
2. AD-AS model
3. Two Causes of Economic Fluctuations

SHORT-RUN ECONOMIC
FLUCTUATIONS

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Revisiting the Assumptions of Classical Economics 7

n The Classical Dichotomy: separation of variables into two

groups:
n Real – quantities, relative prices
n Nominal – measured in terms of money

n The neutrality of money: Changes in the money supply affect

nominal but not real variables

Introduction 8

Economic activity fluctuates from year to year. In some years, the production

of goods and services rises. In other years normal growth does not occur,

leading to recession.

And, as Output Falls, Unemployment Rises

n Real GDP over the long run, U.S.

Grows about 3% per year on average

n GDP in the short run

Fluctuates around its trend

n Recessions
Periods of falling real incomes and rising unemployment

n Depressions
Severe recessions (very rare)

+ A Look at Short-Run Economic Fluctuations

n This figure shows real GDP in panel (a), investment spending in panel (b), and unemployment in
panel (c) for the U.S. economy. Recessions are shown as the shaded areas. Notice that real GDP and
investment spending decline during recessions, while unemployment rises.
9

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A Look at Short-Run Economic Fluctuations

+

n This figure shows real GDP in panel (a), investment spending in panel (b), and unemployment in panel
(c) for the U.S. economy. Recessions are shown as the shaded areas. Notice that real GDP and
investment spending decline during recessions, while unemployment rises.

10

10

+ A Look at Short-Run Economic Fluctuations

n This figure shows real GDP in panel (a), investment spending in panel (b), and unemployment in panel
(c) for the U.S. economy. Recessions are shown as the shaded areas. Notice that real GDP and
investment spending decline during recessions, while unemployment rises.

11

11

The Reality of Short-Run Fluctuations 12

Classical theory Describes the world in the long run, but not
the short run

n In the short run:

n Changes in nominal variables (like the money supply or P ) can
affect real variables (like Y or the u-rate).
n We use a new model to explain short run movements

Most economists use the model of aggregate demand (AD)

and aggregate supply (AS) to analyze short – run economic
fluctuations

12

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The AD – AS model

13

+ The AD – AS Model

Price Short-run Aggregate

Supply - SRAS
Level

E
PE

The
equilibrium Aggregate
price level, Demand - AD
The overall
price level, Output
measured by
the CPI or
YE The equilibrium output;
GDP Deflator economy’s output,
measured by real GDP

14

The Aggregate Demand Curve

+
The Aggregate Demand Curve shows the quantity of goods and
services that households, firms and the government are willing to
buy at different prices (shows the quantity of all g&s demanded)

The Aggregate Demand may be

referred to as:

YAD = C + I + G + NX

• consumption, C
• investment, I
• government spending, G
• net exports, NX

15

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The Aggregate Demand Curve

+

an
A decrease in the
increase in
quantity of goods and
the overall
services demanded
level of
(AD)
prices (P)

16

The AD curve
+ • Why is the AD curve downward
sloping?
1. Pigou’s Wealth Effect
Price 2. Keynes’ Interest Rate Effect
Aggregate
Level 3. Real Exchange Rate
Supply Effect
- AS

P1 The AD curve is downward sloping:

when Price increase -> Aggregate
P0 demand decrease

AD

Output
Y1 Y0

17

Reasons for the Downward Slope of the AD curve

+ level and consumption (C)
Price

If price decrease
10%

You’ll have 1.2

millions more to buy
things
4m
6m 2m

• Pigou’s Wealth Effect: when price decrease, consumers feel wealthier,

which stimulates the demand for consumption goods.

18

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Reasons for the Downward Slope of the AD curve

+ level and investment (I)
Price

• Keynes’ Interest-Rate Effect: The lower the price level, the less
money households need to hold to buy the goods and services they
want. The household can save more, therefore, investment will
increases

19

Reasons for the Downward Slope of the AD curve

+ level and net export (Nx)
Price

When prices of
domestic goods
decrease 10%
VN: 0,99 m vnd = 45 usd

More the US consumers

VN: 1,1 m vnd will buy VN’s coat; and
US: 50usd less VN consumers will
buy the US Cost

With the globalization, goods

are purchased internationally
• Real Exchange-Rate Effect: When prices of domestic
goods go down, foreigners buy more of our goods
and we purchase less of their goods.

This stimulates net exports, thereby increasing the

quantity of goods and services demanded.

20

+
Summary

nA fall in price level will increases quantity of AD

Because:

1.The Wealth Effect: A lower price level increases real wealth, which stimulates spending on consumption.

2.The Interest-Rate Effect: A lower price level reduces the interest rate, which stimulates spending on
investment.

3.The Exchange-Rate Effect: A lower price level causes the real exchange rate to depreciate, which stimulates
spending on net exports

nA rise in price level decreases the quantity of goods and services demanded
Because:

1.The Wealth Effect: A higher price level decreases real wealth, which reduces spending on consumption.

2.The Interest-Rate Effect: A higher price level increase the interest rate, which reduces spending on
investment.

3.The Exchange-Rate Effect: A higher price level causes the real exchange rate to appreciate, which decreases
spending on net exports

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Why the AD curve slopes downward 22

An increase in P reduces
P
the quantity of goods and
services demanded
because: P2

• the wealth effect (C

falls)
P1
• the interest-rate effect
(I falls) AD

• the exchange-rate Y
effect (NX falls) Y2 Y1

22

Factors that might shift the AD Curve

+

AD = C + I +G+ Nx

Anything that quantity demanded more or less than

before at the same price will cause the AD curve
schedule to shift.

• Shifts in the aggregate demand curve may arise

because of: any event that changes in C, I, G, Nx

23

Shifts in the Aggregate Demand Curve

+

Price
Level
An increase in C, I, G,
Nx at the same price
level

A
decreas
e in C, I,
G, Nx at
the same
price
level
AD

Quantity of Output

24

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EXAMPLE 1: A shift in the AD curve 25

What is the effect of a

stock market boom on P
the AD curve?

A stock market boom

makes households feel P1
wealthier, C rises,
the AD curve shifts right. AD2
AD1
Y
Y1 Y2

25

Why the AD Curve Might Shift – 1 26

n Changes in consumption (C): Events that change how

much people want to consume at a given price level:
n Stock market boom/crash
n Preferences re: consumption/saving tradeoff
n Tax hikes/cuts

n Changes in investment (I)- Events that change how much

firms want to invest at a given price level:
n Firms buy new computers, equipment, factories
n Expectations, optimism/pessimism
n Interest rates,
n Monetary policy,
n Investment Tax Credit or other tax incentives

26

Why the AD Curve Might Shift – 2 27

n Changes in government purchases (G): Policy makers –

change government spending at a given price level:
n State & local Government spending, e.g., roads, schools

n Changes in net exports (NX): Events that change net

exports for a given price level:
n Booms/recessions in countries that buy our exports
n Appreciation/depreciation resulting from international
speculation in foreign exchange market

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+
Active learning 1

28

The
+ Aggregate Supply Curve

• The Aggregate Demand Curve shows the quantity of

goods and services that households, firms and the
government are willing to buy at different prices.

• The Aggregate Supply Curve shows the quantity of

goods and services that firms would be willing to
produce and sell at different prices.

29

The Long-Run Aggregate-Supply Curve (LRAS)

+
Price Long-run
Level Because the quantity
aggregate
supplied does not
supply depend on the overall
price level, the LRAS
P1
curve is vertical at
the natural level of
output.
P2

Natural level Quantity of Output

Natural level of
of output
output is the
Production of goods
and services that an The LRAS cur ve might shift:
economy achieves in
Any change in natural level of output
the long run when
unemployment is at Changes in labor
its normal rate (so Changes in capital
called Potential
output/ Full- Changes in natural resources
employment output) Changes in technological knowledge

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Long-Run Growth and Inflation

+
in the Model of Aggregate Demand and Aggregate Supply
Price
Level LRAS1990 LRAS2010
2. . . . and growth in the 1. In the long run,
money supply shifts technological progress
aggregate demand . . . shifts long-run aggregate
supply…
P2010
3. . . . leading to
growth in output . . .
P1990
AD2010
4. . . . and
AD1990
ongoing inflation
Y1990 Y2010 Quantity of Output

n As the econom y becom es better able to produce goods and services over tim e, prim arily because
of technological progress, the long-run aggregate-supply curve shifts to the right. At the same time,
as the Central bank increases the money supply, the aggregate-demand curve also shifts to the
right.

n In this figure, output grows from Y 1990 to Y 2010, and the price level rises from P 1990 to P 2010. Thus,
the model of aggregate demand and aggregate supply offers a way to describe the classical
analysis of growth and inflation.

31

The Short-Run Aggregate Supply Curve

+

an an increase in
increase in the quantity of
the overall goods and
level of services Increase in
the quantity
prices supplied of AS

32

+ Long-Run Growth and Inflation

In long run: both AD and LRAS
curves shift (normally) right,
therefore,
The Results:
n Growth in output
n Continuing inflation

33

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+ The SRAS curve

Price Aggregate
Level Supply - AS

• Why is the AS curve upward

P1 sloping?
This positive relationship could
P2 be due to sticky wages, sticky
prices, or misperceptions.
Over time, wages, prices, and
perceptions adjust, so this
positive relationship is only
temporary (short run).

Output
Y2 Y1

In the short run, a fall in the price level from P1 to P 2 reduces the quantity of output supplied
from Y 1 to Y 2.

34

+Reasons for the Upward Slope of the short run AS Curve

• There are three alternative explanations for the upward slope of the
short-run aggregate supply curve.

– The Keynesian Sticky-Wage Theory

– The New Keynesian Sticky-Price Theory

– New Classical Misperceptions Theory

35

+
n Why Does the Short-Run Aggregate-Supply Curve
Slope Upward - summary
n 1. The Sticky-Wage Theory: An unexpectedly low price
level raises the real wage, which causes firms to hire
fewer workers and produce a smaller quantity of goods
and services.
n 2. The Sticky-Price Theory: An unexpectedly low price
level leaves some firms with higher than desired prices,
which depresses their sales and leads them to cut back
production.
n 3. The Misperceptions Theory: An unexpectedly low
price level leads some suppliers to think their relative
prices have fallen, which induces a fall in production.

36

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+ The SRAS curve

Price
AS
Level

In the short-run,

- an increase in the
P1 overall level of prices in

P2 the economy tends to

raise the quantity of AS.
- a decrease in the level
of prices tends to reduce

the quantity of AS.

Y2 Y1
Output

37

What the 3 theories have in common – 1 38

nInall 3 theories, Y deviates from YN when

P deviates from PE (expected price).
Y = YN + a(P – PE)
Quantity of Expected
price level
output
supplied a > 0, measures how
much Y responds to Actual
Natural rate unexpected changes price level
in P
of output
(long-run)

38

What the 3 theories have in common – 2 39

Y = YN + a (P – PE)
P

SRAS
When P > PE

the expected
PE
price level

When P < PE
This slide illustrates these concepts
using a graph. Y
YN
When P = PE, Y = YN
Y < YN Y > YN
When P < PE, Y < YN

When P > PE, Y > YN

39

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SRAS and LRAS 40

n The imperfections in these theories are temporary. Over

time,
n Sticky wages and sticky prices become flexible
n Misperceptions are corrected

n In the LR,
n PE = P
n AS curve is vertical

40

SRAS and LRAS 41

Y = YN + a (P – PE)

P LRAS

SRAS
In the long run,
PE = P
PE
and
Y = YN.

Y
YN

41

Shifts
+ in the Aggregate Supply Curve

Price AS Aggregate Supply

Level
AS

Aggregate
Demand
Quantity of Output

42

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Why the SRAS curve might shift 43

Everything that
shifts LRAS shifts
SRAS, too. P LRAS
SRAS2
Also, P E shifts SRAS: SRAS1
If P E rises, PE
workers & firms set
higher wages. PE

At each P,
production is less
Y
profitable, Y falls, YN
SRAS shifts left.

43

+ The short-run AS curve’s shift

n The short-run AS curve might shift:

n Changes in labor, capital, natural resources, or technological
knowledge
n Expected price level increases: AS decrease -> AS curve shifts left

44

+
What might cause the Short-Run Aggregate-Supply Curve to Shift - summary

n1. Changes in Labor and human resource: An increase in the quantity of labor
available (perhaps due to a fall in the natural rate of unemployment) shifts the AS curve
to the right. A decrease in the quantity of labor available (perhaps due to a rise in the
natural rate of unemployment) shifts the AS curve to the left.

n2. Changes in Capital: An increase in physical or human capital shifts the AS curve to
the right. A decrease in physical or human capital shifts the AS curve to the left.

n3. Changes in Natural Resources: An increase in the availability of natural resources

shifts the AS curve to the right. A decrease in the availability of natural resources shifts
the AS curve to the left.

n4. Changes in Technology: An advance in technological knowledge shifts the AS curve

to the right. A decrease in the available technology (perhaps due to government
regulation) shifts the AS curve to the left.

n5. Changes in the Expected Price Level: A decrease in the expected price level shifts
the short-run AS curve to the right. An increase in the expected price level shifts the
short-run AS curve to the left.
45

45

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The long-run equilibrium 46

In the long-run
P LRAS
equilibrium:
n PE = P, SRAS

nY = YN ,
n and
PE
unemployment is
at its natural rate.
AD
Y
YN

© 2021 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for
classroom use.

46

Analyzing Economic Fluctuations

47

Analyzing Economic Fluctuations 48

n Four steps to analyzing economic fluctuations:

1. Determine whether the event shifts AD
or AS.
2. Determine whether curve shifts left or
right.
3. Use AD–AS diagram to see how the shift
changes Y and P in the short run.
4. Use AD–AS diagram to see how
economy moves from new SR
equilibrium to new LR equilibrium .

48

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EXAMPLE 3: The effects of a shift in AD

Use the AD–AS diagram to show the
effect of a stock market crash.
P LRAS
1. Affects C, AD curve
SRAS1
2. C falls, so AD shifts left
3. SR equilibrium at B.
P and Y lower, P1 A SRAS2
unemployment higher P2 B
4. Over time, in medium-run, AD1
PE falls, P3 C
SRAS shifts right, AD2
until LR equilibrium at C.
Y2 YN Y
Y and unemployment back at
initial levels.
49

49

Two big AD shifts: 1.The Great Depression 50

U.S. Real GDP,

From 1929–1933, money supply fell billions of 2000 dollars
28% due to problems in banking
system

n stock prices fell 90%, reducing C

and I

nY fell 26%

nP fell 22%

n Unemployment rate rose from 3%

to 25%

50

Two big AD shifts: 2.The World War II 51

boom
U.S. Real GDP,
billions of 2000 dollars
From 1939–1944,

n government outlays rose from $9.1

billion
to $91.3 billion

nY rose 90%

nP rose 20%

n unemployment fell
from 17% to 1%

51

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+
Sources of
recession

52

Sources of Recession
+

n Two sources from which a recession in the economy may

occur:
n A decrease in aggregate demand
n A decrease in aggregate supply

n Shifts in the aggregate demand or the aggregate supply

curves result in fluctuations in the economy’s output of
goods and services.

53

Source of Recession
+
A Decrease in Aggregate Demand

? What are the effect of the decrease in one component of the AD

function to price and output.

54

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A Decrease in Aggregate Demand - It will cause

+ the AD to shift

leftward
Price - Output AND
Level
Aggregate Price will fall

Supply -
Unemployment

will rise
PE

Aggregate
Demand

YE Quantity of Output

55

Source of Recession
+
A Decrease in Aggregate Supply

n A decrease in short-run aggregate supply will result in a new

equilibrium along the aggregate demand curve below full
employment.

n A fall in total output below full output

n An increase in unemployment

56

Source of Recession
+
A Decrease in Aggregate Supply

? What are the effect of the decrease in Aggregate supply to price and
output.

57

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A+ Decrease in Aggregate Supply

- The AS will
Price shift leftward.
Level - A Fall in total
Aggregate output
- An increase
Supply in
unemployme
nt
PE - An increase
in price level

Aggregate
Demand

YE Quantity of Output

58

A+Decrease in Aggregate Supply

When the economy falls due to a decrease in the aggregate

supply, the price level rises and output decreases. This is
called Stagflation.

59

+
Now you try

n Apply AD – AS model to analyse how does each case below affect to

price and out put of the economy

n 1. The Government increases their expenditure for the Army force

n 2. Net export decreases because of the global crisis

n 3. The input price of all production increase

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+
- It will cause

Price the AD to shift

Level rightward
Aggregate
Supply - Output AND

Price will be

higher-
PE
Unemployment

will be lower
Aggregate
Demand

YE Quantity of Output

61

- It will cause
+ the AD to shift

leftward
Price - Output AND
Level
Aggregate Price will be

Supply lower-
Unemployment

will be higher
PE

Aggregate
Demand

YE Quantity of Output

62

+
- The AS will
Price shift leftward.
Level - A Fall in total
Aggregate output
- An increase
Supply in
unemployme
nt
PE - An increase
in price level

Aggregate
Demand

YE Quantity of Output

63

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