Aggregate Demand and Aggregate Supply

Learning Objectives Upon completing the assignment, students will: Understand the aggregate demand and aggregate supply model Recognize why the short-run aggregate demand curve shifts Recognize why the short and long-run aggregate supply curves shift Learn how macroeconomic events impact output and price level

AD/AS Model The Aggregate Demand (AD) / Aggregate Supply (AS) model is a simplified illustration used to explain macroeconomic dynamics using two variables: Average level of prices The economy’s output of goods and services as measured by real GDP

AD/AS Model (cont.) The three curves on the AD/AS model are the: Aggregate-demand curve (AD) Short-run aggregate- supply curve (SRAS) Long-run aggregate- supply curve (LRAS)

Equilibrium on the AD/AS Model The equilibrium point is where the aggregate- demand and aggregate- supply curves intersect. This point indicates where the economy has adjusted at a certain price level and quantity of output: matching aggregate demand to aggregate supply.

Equilibrium on the AD/AS Model (cont.) If this equilibrium point also intersects with the long-run aggregate-supply curve, this is known as long-run equilibrium. When economists use the AD/AS model to illustrate fluctuations in economic activity, long-run equilibrium is typically the starting point.

What is Aggregate Demand? Aggregate demand is the total demand for final goods and services in an economy at a point in time. In other words, demand for gross domestic product (GDP). An economy’s GDP (signified as “Y”) is a sum of four components: Y = C + I + G + NX Consumption Investment Government purchases Net exports

Why Does the AD Curve Slope Downward? As the average price level goes down there is an increase in the quantity of goods and services demanded, due to the: Wealth effect Interest-rate effect Exchange-rate effect

What Can Shift the AD Curve? Any of the following can shift the AD curve, either increasing or decreasing total output: Changes in consumption Changes in investment Changes in government purchases Changes in net exports Increases (at any price level) shift the AD curve to the right; decreases move the AD curve to the left.

What is Aggregate Supply? Aggregate supply is the total quantity of goods and services produced by an economy in a given time period. Two aggregate supply curves are used in the model: An upward sloping short-run aggregate supply curve (SRAS) A vertical long-run aggregate supply curve (SRAS)

Why Short and Long-Run AS Curves? As explained by Gregory Mankiw, in Principles of Macroeconomics, classical economic theory is based on the assumption that nominal variables such as the money supply and price level do not influence real variables such as output and employment. In other words, an economy’s “natural level of output” is not affected by how much money is in the economy. Economists believe this idea is accurate in the long run, but not in the short run.

Why is the LRAS Curve Vertical? In the long-run, the total quantity of goods and services supplied depends on availability of real economic factors such as labor, capital, natural resources and technology. Output is not determined by price level, so the LRAS curve is vertical. Natural (also known as “potential”) level of output

What Can Shift the LRAS Curve? Changes to any of the following sources of output can shift the LRAS curve: Labor Capital Natural resources Technological knowledge Increases shift the LRAS to the right; decreases shift the LRAS to the left.

Why Does the SRAS Curve Slope Upward? Most economists believe price level affects an economy’s ability to produce goods and services in the short-run. As the level of overall prices rise, output also rises. .

Why Does the SRAS Curve Slope Upward? (cont.) There are three theories proposed for the assumed upward slope to the short-run supply curve: Sticky-wage theory Sticky-price theory Misperceptions theory

Why Does the SRAS Curve Slope Upward? (cont.) In all three theories, the implication is that output deviates from its natural rate when the actual price level deviates from the expected price level. These short-run fluctuations in output are seen as deviations from the long-run trends of output.

What Can Shift the SRAS Curve? All the same variables that shift the long-run supply curve also shift the short-run supply curve. Both curves shift to the right or left.

What Can Shift the SRAS Curve? (cont.) However, changing expectations in price level will shift only the short-run aggregate supply curve. For example, three variables that only shift short-run aggregate supply are: Temporary supply shocks Changes in expected future prices Adjustments to mistakes made regarding past price expectations

Assignment Link to assignment: https://wrds-classroom.wharton.upenn.edu/aggsupdem/ Using the interactive AD/AS model, select each event and note whether the described scenario shifts the aggregate-demand or aggregate-supply curves, and in which direction.

Assignment (cont.) Remember to click Reset between the selection of each event.

Assignment (cont.) Note the new equilibrium point. What effect did the event have on price level and output? Did price levels rise or fall? Did GDP increase or decrease?

Conclusion The AD/AS model is a tool used to explain fluctuations in economic activity. Changes in consumption, investment, government purchases, and net exports can shift the aggregate-demand curve. Changes in labor, capital, natural resources, and technology can shift both the short and long-run aggregate-supply curves. Changes in expectations regarding price levels can also shift the short-run aggregate-supply curve.