AGGREGATE DEMAND & AGGREGATE SUPPLY K. Adjei-Mantey Department of Economics kadjei-mantey@ug.edu.gh

The Aggregate Demand Curve and its Slope Shocks to the Aggregate Demand Curve Fiscal Policy and Shifts in the Aggregate Demand Curve Monetary Policy and Shifts in the Aggregate Demand Curve The Aggregate Supply Curve and its Slope Shifts in the Aggregate Supply Curve Macroeconomic equilibrium Policy and stabilization of the economy

Economic fluctuations occur in every economy They are irregular and unpredictable Variables fluctuate together Real GDP most common variable used but fluctuates with other variables As output falls, unemployment rises and vice versa The AD and AS model used to analyze short run fluctuations in economic activity (around its long run trend)

The AD curve The AD curve shows the quantity of goods and services that households, firms, the government, and customers abroad want to buy at each price level. It relates the general price level in the economy to total quantities of goods and services demanded Caution: This is not simply a ‘macro’ version of the market demand curve studied under microeconomics AD curve tells us the equilibrium real output at each price level. This is the output level at which total spending equates total output.

Slope of the AD curve Slopes downwards Negative relationship between overall price level and total quantity of goods and services demanded Why?? Why does the market demand curve studied under microeconomics show a negative relationship between price and quantity demanded???

The substitution effect under microeconomics in response to price changes cannot occur for the economy as a whole

Slope of the AD curve Slopes downwards Negative relationship between overall price level and total quantity of goods and services demanded Why?? Recall: Y = C+I+G+NX Assume fixed G, Y is determined by C, I, NX Each determined by the price level and other economic factors

The Wealth Effect (C) A fall in price increases the real value of money holdings Individuals become wealthier Subsequently, the individual is able to afford more goods and services, hence a downward slope.

The interest rate effect (I, C) A fall in the price level reduces the interest rate Through reduced money holdings Low interest rate encourages borrowing by firms and households for investment purposes and for consumption on durables respectively. This increases demand for goods and services An increase in the price level shifts money demand outwards and this raises the equilibrium interest rate Investment induced spending falls Borrowing for consumption falls AD falls

The exchange rate effect (NX) When the price level falls, interest rate falls and it leads to a depreciation of the cedi Falling interest rates make it more attractive to invest outside the economy Increased demand for foreign currency to invest depreciates domestic currency This makes local goods less expensive compared with foreign goods This increases demand for locally produced goods and services Note: All other things held constant. Money supply is assumed to be fixed

AE and the AD curve [i]. Aggregate expenditure [ii]. Aggregate Demand AE = Y AE0 (P0) E0 AE1(P1) E1 AE2(P2) Desired Expenditure E2 [i]. Aggregate expenditure 45o Y2 Y1 Y0 Real National Income [GDP] [ii]. Aggregate Demand E2 Price Level P2 E1 P1 E0 AD P0 Real National Income [GDP]

AD Shocks Apart from the price level, other factors can lead to changes in aggregate demand i.e shifting the AD curve either outwards or inwards What causes the AD curve to shift? Changes in Consumption (a or Yd) Increase in consumption shifts AD to the right, vv. Could result from tax cuts, high stock performances Changes in Investment Tax rebates to investing firms could increase AD Fall in interest rate resulting from increase in money supply Shift AD outwards Changes in government purchases Changes in net exports

changes in price level, movement along the AD curve Note: When autonomous consumption or investment spending changes, AD curve shifts changes in price level, movement along the AD curve But autonomous C and I also change when the price changes Through changes in the interest rate Hence a change in autonomous C or I shifts the AD curve iff those changes were not the result of a price change

The AS curve and its slope The AS curve shows the quantity of goods and services that firms produce and sell at each price level. The AS curve has different slopes depending on the time horizon under consideration In the long run, the AS curve is vertical In the short run, the AS curve has a positive slope. Actually, the AS curve summarizes what happens when output changes affect the price level.

The AS curve: long run In the long run, real GDP is not determined by the price level. Real GDP determined by land (plus natural resources), labour, capital and technology The price level is inconsequential as far as long run real output is concerned The long run AS curve is vertical Independent of the price level The output produced in the long run is referred to as the full employment output/the natural rate of output

Shifts in AS curve: long run Changes that alters the natural rate of output Changes in economy’s labour Changes in economy’s stock of capital Changes in the state of technology New discoveries of natural resources

The AS curve: short run In the short run, prices influence AS and hence a positive slope Driven mainly by expectations Sticky wages Wages are sluggish in responding to price changes Sticky prices Prices are slow to adjust to changing economic conditions Menu costs P falls below expectations, goods become expensive, lower sales, lower output; vv Misperceptions Misguided thoughts that changes in prices are relative rather than absolute

As real GDP increases Input requirements per unit of output increases Prices of non labour inputs increases Nominal wages increase All of these increase unit costs Price level increases

Increase in output leads to increased prices Note: Increase in output leads to increased prices Assumption of fixed input prices behind the market supply curve in microeconomics not realistic in the case of the AS Output of all firms increasing Raises demand for inputs Input prices cannot be fixed

AS curve shocks: short run Factors that shift the long run AS curve equally shifts the curve in the short run Expected price level A decrease in the expected price level shifts the short-run aggregate-supply curve to the right; vv expected price level falls, wages fall, lower production costs, firms increase output at any given actual price level. short run AS curve shifts to the right. expected price level rises, wages rise, higher production costs, firms output declines at any given actual price level. short-run AS curve shifts to the left

Macroeconomic Equilibrium Intersection of AD and AS yields equilibrium

Effects of shifts in AD

A fall in AD Output falls in the short run Price level falls Unemployment rises Price level falls Deviating from the expected price level Time allows for adjustment of price expectations Price of labour falls eventually and hence firms are able to hire more AS curve shifts outwards New intersection of AD and L-R AS Output returns to natural rate in the long run Effect: A shift in aggregate demand in the long run leads to a fall in the general price level but output remains the same.

Effects of shifts in AS

A fall in AS Output falls, given AD Price rises Stagflation occurs: stagnation (falling output) plus inflation Wage price spiral: higher prices leading to higher wage demands and even higher prices Reduces output further Unemployment becomes high and that drives down wages Lower wages increases output gradually Natural rate of output restored

The Keynesian AS curve When real NY < Potential NY Firms operating at less than full capacity Prices set at profit max price at full capacity Then, supply is demand determined Firms will supply any output at the existing price so long as there is demand. NB: they must be producing below their capacity The amount produced depends on the AD curve This gives a horizontal AS curve P Keynesian SRAS AD Y

Increases in demand eventually causes firms to produce beyond their current production Unit costs rise Prices rise An upward sloping AS curve The Keynesian SRAS curve is only applicable to an economy iff its national income is below its potential income

The multiplier under varying prices Recall: the simple multiplier assumes constant prices Tells the extent of the shift in AD following a change in autonomous spending. Shows the increase in equilibrium NY But… When AD rises NY rises Price rises

AD falls and hence NY falls There is a reverse effect Recall: Wealth effect foreign exchange effect interest rate effect. AD falls and hence NY falls There is a reverse effect The change in NY as a result of a change in autonomous spending is less than the change in AD resulting from the spending change.

Thus the multiplier when prices are changing is less than the simple multiplier This occurs when the SRAS is positively sloped.

AD can be enhanced through policy to accommodate shifts in AS Policy can use fiscal or monetary means to minimize the effects of shifts in AS AD can be enhanced through policy to accommodate shifts in AS This prevents short run fall in output and hence employment Price level increases as a result Inflation but not stagflation results Added benefit of no fall in output

Fiscal policy and AD curve shifts Fiscal policy refers to government spending and taxation Increase in Government purchases Directly shifts AD outwards Multiplier (1/(1-MPC)) Crowding out Taxes Tax cuts shifts the AD curve outwards Fiscal policy could also affect AS Lower taxes incentivize labour supply Increase in government spending on capital goods make the economy more productive

Monetary policy and AD shifts Changes in the money supply Increase in MS Reduces interest rates IR must fall to induce people to hold the excess money created by the increase in money supply. Reduced IR leads to increase in demand for goods and services AD shifts outwards

Fiscal & Monetary policy and stabilization When fiscal policy raises taxes AD falls Unemployment rises Monetary policy can increase MS, Interest rate falls AD rises The economy is stabilized.

Fiscal & Monetary policy and stabilization Criticized, however, due to the lag effect Legislation Bureaucracy Response time by other economic variables Accuracy of estimated multiplier value No guarantee of future behaviour following previous behaviour Yet the best way to predict the future is from the past

Automatic stabilizers Fiscal policy change that stimulates AD when the economy slows down without deliberate policy action Built in tax and government spending policies that are triggered into effect when the economy fluctuates Eg. Progressive tax system Government spending on unemployment benefits etc. Automatic stabilizers usually would not completely deal with the effect of economic fluctuation but can mitigate it

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