Aggregate Demand and Aggregate Supply

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

Figure 1: Deriving the Aggregate Demand Curve

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

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

Figure 2: A Spending Shock Shifts the AD Curve

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

Figure 3: The Aggregate Supply Curve

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

Figure 4: Shifts of the Aggregate Supply Curve Price Level Real GDP ($ Trillions) 100 AS 1 10 A AS 2 140 L

Figure 5: Short-Run Macroeconomic Equilibrium

Figure 6: The Effect of a Demand Shock Price Level Real GDP ($ Trillions) AS 10 E AD 1 H 12 130 13.5 100 J AD 2

An Increase in Government Purchases When G , AD curve shifts rightward. As a result, real GDP , given price level is fixed However, when real GDP , unit cost , so price level Furthermore, as price level , Md and interest rate , which causes aggregate expenditure to decrease In the end, real GDP increases by less than horizontal shift in AD curve

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

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

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

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

Figure 7: The Long-Run Adjustment Process After A Positive Demand Shock Price Level Long-Run AS Curve Real GDP P 1 Y FE E AS AD AS 2 P 4 K 2 AD Y P H Y 3 P J

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

Figure 9: The Effect of a Supply Shock

More examples 1990-91 recession 2001 recession Oil supplies and price of oil 2001 recession Money supply and interest rate

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 Price Level Real Domestic Output AS P3 P2 AD3 P1 Q0 Q1 Q2 Q3 Real Domestic Output

The Phillips Curve Demonstrates short-run tradeoff between inflation and unemployment Concept Empirical Data Data for the 1960s Annual Rate of Inflation (Percent) Unemployment Rate (Percent) Unemployment Rate (Percent) Annual Rate of Inflation (Percent) 69 68 66 67 65 63 62 64 61

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 PCLR 3 6 9 12 15 PC3 b3 PC2 a3 Annual Rate of Inflation (Percent) b2 PC1 a2 c3 b1 a1 c2 3 4 5 6 Unemployment Rate (Percent)