Topic 9 Aggregate Demand and Aggregate Supply 1

2 The Aggregate Demand Curve When price level rises, money demand curve shifts rightward Consequently, interest rate is higher, given money supply is fixed Then, aggregate expenditure decreases (AE line shifts downward) As a result, the equilibrium GDP becomes lower So, a rise in price level causes a decrease in equilibrium GDP. The aggregate demand curve shows the negative relationship between price levels and equilibrium real GDP

3 Figure 1: Deriving the Aggregate Demand Curve

4 Understanding the AD Curve Each point on the AD curve represents a short-run equilibrium in economy The AD curve is different from a demand curve for one particular product

5 Movements of the AD Curve Moving along the AD curve whenever price level changes When anything other than price level cause equilibrium GDP to change, the AD curve shifts –Government purchasing –Taxes –Autonomous consumption spending –Investment spending –Net exports –Money supply –Expectations

6 Figure 2: A Spending Shock Shifts the AD Curve

7 Costs and Prices To understand how macroeconomic events affect the price level, we assume –A firm sets price of its products as a markup over cost per unit –So, in the short-run, price level rises when there is an economy- wide increase in unit costs Labor costs Costs of natural resources How an increase in output level raises the price level? –As output increases, demand for inputs rises –As unit cost increases, price level ( assumed as a markup over unit cost) rises

8 Figure 3: The Aggregate Supply Curve

9 Movements of the AS Curve When price level changes due to a change in real GDP, the change happens along the AS curve When the change of price level is caused by any factor other than real GDP, the AS curve shifts –Oil prices –Weather –Technological change –Nominal wage

10 Figure 4: Shifts of the Aggregate Supply Curve

11 Figure 5: Short-Run Macroeconomic Equilibrium

12 Figure 6: The Effect of a Demand Shock

13 An Increase in Government Purchases –When G rises, AD curve shifts rightward. As a result, real GDP rises, given price level is fixed. –However, when real GDP rises, unit cost goes up, so does price level. –Furthermore, as price level goes up, M d and interest rate increase too, which causes aggregate expenditure to fall. –In the end, real GDP increases by less than horizontal shift in AD curve.

14 An Increase in the Money Supply Can you demonstrate how an increase in the money supply affects the real equilibrium GDP?

15 Demand Shocks A positive demand shock—shifts AD curve rightward –Increases both real GDP and price level in short-run A negative demand shock—shifts AD curve leftward –Reduces both real GDP and price level in short- run

16 Examples The Great Depression 1929 – 1933 –Negative demand shocks Oil Crisis 1973 (began on October 17) –Negative supply shocks

17 Demand Shocks: Adjusting to the Long-Run In short-run, wage rate is treated as given But in long-run, wage rate can change –When output is above full employment, wage rate will rise, shifting AS curve upward –When output is below full employment, wage rate will fall, shifting AS curve downward

18 Figure 7: The Long-Run Adjustment Process After A Positive Demand Shock

19 Figure 8: Long-Run Adjustment After A Negative Demand Shock

20 Figure 9: The Effect of a Supply Shock

21 More examples recession –Oil supplies drop and price of oil goes up recession –Money supply decreases and interest rate increases.

Inflation and Unemployment Low inflation and unemployment – Fed’s major goals – Compatible or conflicting? Short-run tradeoff Supply shocks cause both rates to rise No long-run tradeoff

The Phillips Curve

The Phillips Curve (cont’) Demonstrates short-run tradeoff between inflation and unemployment

The Phillips Curve No long-run tradeoff between inflation and unemployment Short-run Phillips curve – Role of expected inflation Long-run vertical Phillips curve Disinflation vs. Reflation

The Long Run Phillips Curve