1. AGGREGATE DEMAND & AGGREGATE SUPPLY
K. Adjei-Mantey
Department of Economics

2. 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

3. 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)

4. 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.

6. 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???

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

8. 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

9. 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.

10. 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

11. 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

12. 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]

13. 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

14. 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

15. 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.

16. 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

17. 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

18. 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

19. 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

20. 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

21. 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

22. Macroeconomic Equilibrium
Intersection of AD and AS yields equilibrium

23. Effects of shifts in AD

24. 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.

25. Effects of shifts in AS

26. 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

27. 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

28. 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

29. 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

30. 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.

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

32. 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

34. 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

35. 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

36. 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.

37. 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

38. 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

39. IA
15th April
8am
Venue to be confirmed next week