PowerPoint Slides prepared by:

Andreea CHIRITESCU
Eastern Illinois University
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33
Aggregate Demand
and Aggregate Supply

PowerPoint Slides prepared by:

Andreea CHIRITESCU
Eastern Illinois University

© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 2
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

1
Economic Fluctuations
• Economic activity
– Fluctuates from year to year
• Recession
– Economic contraction
– Period of declining real “You’re fired.
incomes and rising Pass it on.”
unemployment
• Depression
– Severe recession
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Economic Fluctuations
• Three key facts about economic
fluctuations
1. Economic fluctuations are irregular and
unpredictable
• The business cycle
2. Most macroeconomic quantities fluctuate
together
• Recessions: economy-wide phenomena
3. As output falls, unemployment rises

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2
Figure 1
A Look at Short-Run Economic Fluctuations (a)

This figure shows real

GDP in panel (a),
investment spending
in panel (b), and
unemployment in
panel (c) for the U.S.
economy using
quarterly data since
1965. Recessions are
shown as the shaded
areas. Notice that real
GDP and investment
spending decline
during recessions,
while unemployment
rises.

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Figure 1
A Look at Short-Run Economic Fluctuations (b)

This figure shows real

GDP in panel (a),
investment spending in
panel (b), and
unemployment in panel
(c) for the U.S. economy
using quarterly data
since 1965. Recessions
are shown as the
shaded areas. Notice
that real GDP and
investment spending
decline during
recessions, while
unemployment rises.

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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

3
Figure 1
A Look at Short-Run Economic Fluctuations (c)

This figure shows real GDP in panel (a), investment spending in panel (b), and unemployment in
panel (c) for the U.S. economy using quarterly data since 1965. Recessions are shown as the
shaded areas. Notice that real GDP and investment spending decline during recessions, while
unemployment rises.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Short-Run Economic Fluctuations

• Classical dichotomy
– Separation of variables into:
• Real variables
• Nominal variables
• Monetary neutrality
– Changes in the money supply
• Affect nominal variables
• Do not affect real variables

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4
Short-Run Economic Fluctuations
• Classical theory holds in the long-run
– Changes in money supply
• Affect prices, and other nominal variables
• Do not affect real GDP, unemployment, or
other real variables

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Short-Run Economic Fluctuations

• Short-run
– Assumption of monetary neutrality: no
longer appropriate
– Real and nominal variables are highly
intertwined
– Changes in the money supply
• Can temporarily push real GDP away from its
long-run trend

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5
Short-Run Economic Fluctuations
• AD-AS model
– Model of aggregate demand (AD) and
aggregate supply (AS)
– Most economists use it to explain short-
run fluctuations in economic activity
• Around its long-run trend

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Short-Run Economic Fluctuations

• Aggregate-demand curve
– Shows the quantity of goods and services
– That households, firms, the government,
and customers abroad
– Want to buy at each price level
– Downward sloping

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6
Short-Run Economic Fluctuations
• Aggregate-supply curve
– Shows the quantity of goods and services
– That firms choose to produce and sell
– At each price level
– Upward sloping

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Figure 2
Aggregate Demand and Aggregate Supply
P
AS

Equilibrium
price level

AD

Equilibrium Y
output

Economists use the model of aggregate demand and aggregate supply to analyze
economic fluctuations. On the vertical axis is the overall level of prices. On the
horizontal axis is the economy’s total output of goods and services. Output and the
price level adjust to the point at which the aggregate-supply and aggregate-demand
curves intersect.
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7
The Aggregate-Demand Curve
Y = C + I + G + NX
• Three effects explain why AD curve
slopes downward:
– Wealth effect (C )
– Interest-rate effect (I)
– Exchange-rate effect (NX)
• Assumption: government spending (G)
– Fixed by policy

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The Aggregate-Demand Curve

• Price level and consumption (C): the
wealth effect
– Decrease in price level
• Increase in the real value of money
• Consumers are wealthier
• Increase in consumer spending
• Increase in quantity demanded of goods and
services

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8
The Aggregate-Demand Curve
• Price level and investment (I): the
interest-rate effect
– Decrease in price level
• Decrease in the interest rate
• Increase spending on investment goods
• Increase in quantity demanded of goods and
services

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The Aggregate-Demand Curve

• Price level and net exports (NX): the
exchange-rate effect
– Decrease in U.S. price level
• Decrease in the interest rate
• U.S. dollar depreciates
• Stimulates U.S. net exports
• Increase in quantity demanded of goods and
services

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9
The Aggregate-Demand Curve
• A fall in price level
– Increases quantity of goods and services
demanded
– Because:
1. Consumers are wealthier: stimulates the
demand for consumption goods
2. Interest rates fall: stimulates the demand for
investment goods
3. Currency depreciates: stimulates the
demand for net exports
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The Aggregate-Demand Curve

• A rise in price level
– Decreases the quantity of goods and
services demanded
– Because:
1. Consumers are poorer: depress consumer
spending
2. Higher interest rates fall: depress
investment spending
3. Currency appreciates: depress net exports

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10
Figure 3
The Aggregate-Demand Curve
P
1. A decrease in
the price level . . .

P1
2. . . . increases the quantity of
P2 goods and services demanded

AD

Y1 Y2 Y

A fall in the price level from P1 to P2 increases the quantity of goods and services demanded from
Y1 to Y2. There are three reasons for this negative relationship. As the price level falls, real wealth
rises, interest rates fall, and the exchange rate depreciates. These effects stimulate spending on
consumption, investment, and net exports. Increased spending on any or all of these components
of output means a larger quantity of goods and services demanded.

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The Aggregate-Demand Curve

• The AD curve might shift:
– Changes in consumption, C
– Changes in investment, I
– Changes in government purchases, G
– Changes in net exports, NX

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11
The Aggregate-Demand Curve
• Changes in consumption, C
– Events that change how much people
want to consume at a given price level
• Changes in taxes, wealth
– Increase in consumer spending
• Aggregate-demand curve: shift right

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The Aggregate-Demand Curve

• Changes in investment, I
– Events that change how much firms want
to invest at a given price level
• Better technology
• Tax policy
• Money supply
– Increase in investment
• Aggregate-demand curve: shift right

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12
The Aggregate-Demand Curve
• Changes in government purchases, G
– Policy makers – change government
spending at a given price level
• Build new roads
– Increase in government purchases
• Aggregate-demand curve: shift right

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The Aggregate-Demand Curve

• Changes in net exports, NX
– Events that change net exports for a given
price level
• Recession in Europe
• International speculators – change in
exchange rate
– Increase in net exports
• Aggregate-demand curve: shift right

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13
Table 1
The Aggregate-Demand Curve: Summary

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Table 1
The Aggregate-Demand Curve: Summary

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14
The Aggregate-Supply Curve
• Long run aggregate-supply curve, LRAS
– Aggregate-supply curve is vertical
• Price level does not affect the long-run
determinants of GDP:
– Supplies of labor, capital, and natural resources
– Available technology
• Short run
– Aggregate-supply curve is upward sloping

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Figure 4
The Long-Run Aggregate-Supply Curve
P LRAS

P1
1. A change in
the price
level . . . P2 2. . . . does not affect the
quantity of goods and services
supplied in the long run

YN Y

In the long run, the quantity of output supplied depends on the economy’s quantities of labor,
capital, and natural resources and on the technology for turning these inputs into output.
Because the quantity supplied does not depend on the overall price level, the long-run
aggregate-supply curve is vertical at the natural level of output.

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15
The Aggregate-Supply Curve
• Natural level of output
– Production of goods and services
– That an economy achieves in the long run
• When unemployment is at its normal rate
– Potential output
– Full-employment output

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The Aggregate-Supply Curve

• The LRAS curve might shift
– Any change in natural level of output
– Changes in labor
– Changes in capital
– Changes in natural resources
– Changes in technological knowledge

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16
The Aggregate-Supply Curve
• Changes in labor
– Quantity of labor – increases
• Aggregate-supply curve: shifts right
– Natural rate of unemployment – increases
• Aggregate-supply curve: shifts left
• Changes in capital
– Capital stock – increase
• Aggregate-supply curve: shifts left
– Physical and human capital
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The Aggregate-Supply Curve

• Changes in natural resources
– New discovery of natural resource
• Aggregate-supply curve: shifts right
– Weather
– Availability of natural resources

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17
The Aggregate-Supply Curve
• Changes in technology
– New technology, for given labor, capital
and natural resources
• Aggregate-supply curve: shifts right
– International trade
– Government regulation

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Long-Run Growth and Inflation

• In long run: both AD and LRAS curve shift
– Continual shifts of LRAS curve to right
• Technological progress
– AD curve shifts to right
• Monetary policy
• The Fed increases money supply over time
– Result:
• Continuing growth in output
• Continuing inflation

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18
Figure 5
Long-Run Growth and Inflation in the AS - AD Model

P
LRAS1990 LRAS2000 LRAS2010
2. . . . and growth in the 1. In the long run,
money supply shifts technological progress shifts
aggregate demand . . . long-run aggregate supply…
P2010
3. . . . leading to
P2000 growth in output . . .

P1990
AD2010
4. . . . and AD1990 AD2000
ongoing inflation
Y1990 Y2000 Y2010 Y
As the economy becomes better able to produce goods and services over time, primarily because
of technological progress, the long-run aggregate-supply curve shifts to the right. At the same
time, as the Fed increases the money supply, the aggregate-demand curve also shifts to the right.
In this figure, output grows from Y1990 to Y2000 and then to Y2010, and the price level rises from P1990
to P2000 and then to P2010. Thus, the model of aggregate demand and aggregate supply offers a
new way to describe the classical analysis of growth and inflation.
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The Aggregate-Supply Curve

• In the short-run:
– Increase in overall level of prices in
economy
• Tends to raise the quantity of goods and
services supplied
– Decrease in level of prices
• Tends to reduce quantity of goods and
services supplied

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19
Figure 6
The Short-Run Aggregate-Supply Curve

P
SRAS
1. A decrease in the
price level . . .

P1

P2 2. . . . reduces the quantity of

goods and services supplied in
the short run

Y2 Y1 Y

In the short run, a fall in the price level from P1 to P2 reduces the quantity of output supplied from
Y1 to Y2. This positive relationship could be due to sticky wages, sticky prices, or misperceptions.
Over time, wages, prices, and perceptions adjust, so this positive relationship is only temporary.

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The Aggregate-Supply Curve

• Theories that explain why the AS curve
slopes upward in short-run:
– Sticky-wage theory
– Sticky-price theory
– Misperceptions theory

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20
The Aggregate-Supply Curve
• Sticky-wage theory
– Nominal wages - slow to adjust to
changing economic conditions
• Long-term contracts: workers and firms
• Slowly changing social norms
• Notions of fairness - influence wage setting
– Nominal wages - based on expected
prices
• Don’t respond immediately when actual price
level – different from what was expected
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The Aggregate-Supply Curve

• Sticky-wage theory
– If price level < expected
• Firms – incentive to produce less output
– If price level > expected
• Firms – incentive to produce more output

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21
The Aggregate-Supply Curve
• Sticky-price theory
– Prices of some goods and services
• Slow to adjust to changing economic
conditions
• Menu costs
– Costs to adjusting prices

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The Aggregate-Supply Curve

• Misperceptions theory
– Changes in the overall price level
• Can temporarily mislead suppliers
– About changes in individual markets
– Changes in relative prices
• Suppliers - respond to changes in level of
prices
– Change - quantity supplied of goods and services

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22
The Aggregate-Supply Curve
• Quantity of output supplied =
= Natural level of output +
+ a(Actual price level – Expected price
level)
• Where a - number that determines how much
output responds to unexpected changes in
the price level

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The Aggregate-Supply Curve

• The short-run AS curve might shift:
– Changes in labor, capital, natural
resources, or technological knowledge
– Expected price level increases
• Aggregate-supply curve: shifts left

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23
Table 2
The Short-Run Aggregate-Supply Curve: Summary

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Table 2
The Short-Run Aggregate-Supply Curve: Summary

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24
Causes of Economic Fluctuations
• Assumption
– Economy begins in long-run equilibrium
• Long-run equilibrium:
– Intersection of AD and LRAS curves
• Natural level of output
• Actual price level
– Intersection of AD and short-run AS curve
• Expected price level = Actual price level

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Figure 7
The Long-Run Equilibrium
P
LRAS

SRAS

Equilibrium A
price

AD

YN Y

The long-run equilibrium of the economy is found where the aggregate-demand curve crosses
the long-run aggregate-supply curve (point A). When the economy reaches this long-run
equilibrium, the expected price level will have adjusted to equal the actual price level. As a
result, the short-run aggregate-supply curve crosses this point as well.

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25
Causes of Economic Fluctuations
• Shift in aggregate demand
– Wave of pessimism: AD shifts left
– Short-run
• Output falls
• Price level falls
– Long-run
• Short-run aggregate-supply curve shifts right
• Output – natural level
• Price level – falls

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Table 3
Four Steps for Analyzing Macroeconomic Fluctuations

1. Decide whether the event shifts the aggregate-demand curve or the

aggregate-supply curve (or perhaps both).
2. Decide the direction in which the curve shifts.
3. Use the diagram of aggregate demand and aggregate supply to
determine the impact on output and the price level in the short run.
4. Use the diagram of aggregate demand and aggregate supply to
analyze how the economy moves from its new short-run equilibrium to its
long-run equilibrium.

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26
Figure 8
A Contraction in Aggregate Demand
P
LRAS SRAS1
3. . . . but over time, the
short-run aggregate-supply
curve shifts . . .
SRAS2
P1 A
B 4. . . . and output returns to its
P2 natural level.
C
P3
1. A decrease in aggregate
demand . . .

AD2 AD1
Y2 Y1 Y
2. . . . causes output to fall in the short run . . .
A fall in aggregate demand is represented with a leftward shift in the aggregate-demand curve
from AD1 to AD2. In the short run, the economy moves from point A to point B. Output falls from Y1
to Y2, and the price level falls from P1 to P2. Over time, as the expected price level adjusts, the
short-run aggregate-supply curve shifts to the right from AS1 to AS2, and the economy reaches
point C, where the new aggregate-demand curve crosses the long-run aggregate-supply curve.
In the long run, the price level falls to P3, and output returns to its natural level, Y1.
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Two Big Shifts in Aggregate Demand: The Great

Depression and World War II
• Early 1930s: large drop in real GDP
– The Great Depression
• Largest economic downturn in U.S. history
– From 1929 to 1933
• Real GDP fell by 27%
• Unemployment rose from 3 to 25%
• Price level fell by 22%

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27
Two Big Shifts in Aggregate Demand: The Great
Depression and World War II
• Early 1930s: large drop in real GDP
– Cause: decrease in aggregate demand
• Decline in money supply (by 28%)
• Decreasing: C and I

The outcome of a massive

decrease in aggregate
demand

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Two Big Shifts in Aggregate Demand: The Great

Depression and World War II
• Early 1940s: large increase in real GDP
– Economic boom
– World War II
• More resources to the military
• Government purchases increased
• Aggregate demand – increased 1939 to 1944
• Doubled the economy’s production of goods
and services
• 20% increase in the price level
• Unemployment fell from 17 to 1%
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28
Figure 9
U.S. Real GDP Growth since 1900

Over the course of U.S. economic history, two fluctuations stand out as especially large. During
the early 1930s, the economy went through the Great Depression, when the production of goods
and services plummeted. During the early 1940s, the United States entered World War II, and the
economy experienced rapidly rising production. Both of these events are usually explained by
large shifts in aggregate demand.
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The Recession of 2008–2009

• 2008-2009, financial crisis, severe
downturn in economic activity
– Worst macroeconomic event in more than
half a century
• A few years earlier: a substantial boom in
the housing market
– Fueled by low interest rates
• Rise in housing prices
– Developments in the mortgage market
– Other issues
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29
The Recession of 2008–2009
• Developments in the mortgage market
– Easier for subprime borrowers to get
loans
• Borrowers with a higher risk of default
(income and credit history)
– Securitization
• Process by which a financial institution
(mortgage originator) makes loan
• Then (investment bank) bundles them
together mortgage-backed securities

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The Recession of 2008–2009

• Developments in the mortgage market
– Mortgage-backed securities
• Sold to other institutions, which may not have
fully appreciated the risks in these securities
• Other issues
– Inadequate regulation for these high-risk
loans
– Misguided government policy
• Encouraged this high-risk lending

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30
The Recession of 2008–2009
• 1995-2006
– Increase in housing demand
– Increase in housing prices
• More than doubled
• 2006-2009, housing prices fell 30%
– Substantial rise in mortgage defaults and
home foreclosures
– Financial institutions that owned
mortgage-backed securities
• Huge losses
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The Recession of 2008–2009

• Large contractionary shift in AD
– Real GDP fell sharply
• By 4% between the forth quarter of 2007 and
the second quarter of 2009
– Employment fell sharply
• Unemployment rate rose from 4.4% in May
2007 to 10.1% in October 2009

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31
The Recession of 2008–2009
• Three policy actions aimed in part at
returning AD to its previous level
– The Fed
• Cut its target for the federal funds rate
– From 5.25% in September 2007 to about zero in
December 2008
• Started buying mortgage-backed securities
and other private loans
– In open-market operations
– Provided banks with additional funds

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The Recession of 2008–2009

• Three policy actions
– October 2008, Congress appropriated
$700 billion
• For the Treasury to use to rescue the
financial system
• To stem the financial crisis on Wall Street
• To make loans easier to obtain
• Equity injections into banks
• U.S. government – temporarily became a
part owner of these banks

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32
The Recession of 2008–2009
• Three policy actions
– January 2009, Barack Obama
• Large increase in government spending
• $787 billion stimulus bill, February 17, 2009
• June 2009, the meager recovery began
– From 2010 through 2012
• Real GDP growth averaged 2.1% per year
– Unemployment fell, but remained high
• 7.5% in April 2013

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Causes of Economic Fluctuations

• Shift in aggregate supply
– Firms – increase in production costs
• Aggregate-supply curve: shifts left
– Short-run - stagflation
• Output falls
• Price level rises
– Long-run, if AD is held constant
• Short-run AS shifts back to right
• Output – natural level
• Price level - falls
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33
Figure 10
An Adverse Shift in Aggregate Supply
P 1. An adverse shift in the
LRAS SRAS2 short-run aggregate-
supply curve . . .
SRAS1

B
3. . . . and P2
the price P1 A
level to rise

AD

Y2 Y1 Y
2. . . . causes output to fall . . .

When some event increases firms’ costs, the short-run aggregate-supply curve shifts to the left
from AS1 to AS2. The economy moves from point A to point B. The result is stagflation: Output
falls from Y1 to Y2, and the price level rises from P1 to P2.

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Causes of Economic Fluctuations

• Shift in aggregate supply
– Firms – increase in production costs
• Aggregate-supply curve: shifts left
– Short-run
• Output falls
• Price level rises
– Long-run, policymakers – shift AD to right
• Output – natural level
• Price level – rises

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34
Figure 11
Accommodating an Adverse Shift in Aggregate Supply
1. When short-run
P LRAS aggregate supply
SRAS2
falls . . .
SR AS1
3. . . . which
causes the P C
3
price level
P2 2. . . . policymakers can
to rise
A accommodate the shift by
further . . . P1
expanding aggregate
demand . . .
AD2
AD1
YN Y
4. . . . but keeps output
at its natural level.

Faced with an adverse shift in aggregate supply from AS1 to AS2, policymakers who can influence
aggregate demand might try to shift the aggregate-demand curve to the right from AD1 to AD2.
The economy would move from point A to point C. This policy would prevent the supply shift from
reducing output in the short run, but the price level would permanently rise from P1 to P3.

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Oil and the Economy

• Economic fluctuations in the U.S.
– Since 1970, originated in the oil fields of
the Middle East
• Some event - reduces the supply of
crude oil flowing from Middle East
– Price of oil rises around the world
– Aggregate-supply curve shifts left
– Stagflation
• Mid-1970s
• Late-1970s
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35
Oil and the economy
• Some event – increases the supply of
crude oil from Middle East, 1986
– Price of oil decreases
– Aggregate-supply curve – shifts right
• Output – rapid growth
• Unemployment – falls
• Inflation rate – falls

Changes in Middle East oil

production are one source of U.S.
economic fluctuations.
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Oil and the economy

• Recent years
– World market for oil – not an important
source of economic fluctuations
– Conservation efforts
– Changes in technology
• Amount of oil used to produce a unit of
real GDP
– Declined 40% since the OPEC shocks of
the 1970s

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36