Aggregate Demand

and Aggregate Supply

GT01003 Macroeconomics
Learning Objectives
1. Define the aggregate demand and aggregate
supply curves

2. Show how aggregate supply and demand
determine short-run output and inflation
Show how aggregate demand, aggregate supply, and
the long-run aggregate supply curve determine long-
run output and inflation
Learning Objectives
4. Using the AD-AS model to study business
cycles

5. Analyze how the economy adjusts to
expansionary and recessionary gaps
Relate this to the idea of a self-correcting
economy
The role of stabilization policy

Introduction
The aggregate demand - aggregate supply
(AD-AS) model has two distinct advantages
over the basic Keynesian model:
i. It applies to both the short run and the long
run
ii. It shows both inflation and output
Effective for analyzing macroeconomic policies
The Aggregate Demand Curve
Aggregate demand (AD) curve shows the
relationship between short-run equilibrium output,
Y, and the rate of inflation,
Holds all other factors constant
AD has a negative slope
PAE Y
Along the AD curve, short-run Y
equals planned spending
Output (Y)
AD
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Shifts in Aggregate Demand
Curve
At a given inflation rate, aggregate demand shifts
when
Demand Shocks
Stabilization Policy
Demand shocks are changes
other than those caused
by changes in output or
the real interest rate
Consumer wealth
Business confidence
Foreign demand for
US goods
Output (Y)
AD
AD'
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Shifts in Aggregate Demand
Curve
Stabilization Policy:

A rightward shift of the AD curve:
Increase government spending (expansionary fiscal
policy)
Cut taxes (expansionary fiscal policy)
Increase the money supply (expansionary monetary
policy)

A leftward shift of the AD curve:
Decrease government spending (contractionary fiscal
policy)
Raise taxes (contractionary fiscal policy)
Decrease the money supply (contractionary monetary
policy)

Aggregate Supply
Aggregate supply curve (AS) shows the
relationship between the rate of inflation and the
short-run equilibrium level of output
Holds all other factors constant
Aggregate supply curve has a positive slope
When output is below potential, actual inflation is
above expected inflation
When output is above potential, actual inflation is
below expected inflation
The Aggregate Supply Curve
If the economy is operating at potential output,
then


=
e =

1
at A
If Y > Y*
and
2


>
e
at B
If Y < Y*
and
3

<
e
at C
The AS curve slope up

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Output (Y)
Aggregate
Supply (AS)

2
Y
1
B
Y
2

3
C
Y*

1
A
Shifts in the AS Curve
What causes the AS curve to shift?
Changes in available resources & technology
Changes in the expected inflation
Inflation shocks

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Output (Y)
AS
1
Y*

2
AS
2
If actual inflation
exceeds expectations,
expected inflation
increases
AS curve shifts to
the left
At each level of output,
inflation is higher

Shifts in the AS Curve
An inflation shock is a sudden change in the
normal behavior of inflation
A shock is not related to an output gap
A sudden rise in the price of oil increases prices of
Gasoline, diesel fuel, jet fuel, heating oil
Goods made with oil (synthetic rubber, plastics,
etc.)
Transportation of most goods
OPEC reduced supplies in 1973; price of oil
quadrupled
Food shortages occurred at the same time
Sharp increase in inflation in 1974
Shifts in the AS Curve
An adverse inflation shock shifts the aggregate
supply curve to the left
Increases inflation at each output level
Oil price increases in 1973
A favorable inflation shock shifts the aggregate
supply curve to the right
Lower inflation at each output level
Oil price decrease in 1986
Long-Run Equilibrium
In the long run,
Actual output equals potential output
Actual inflation equals expected inflation
Long-run equilibrium
occurs at the intersection of
Aggregate demand
Aggregate supply and

Long-run aggregate
supply
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Output (Y)
Aggregate
Demand (AD)
Aggregate
Supply (AS)
Y*
Long-Run Aggregate
Supply (LRAS)
Short-Run Equilibrium
Short-run equilibrium occurs when there is
either an expansionary gap or a recessionary
gap
Intersection of AD and AS curves at a level of
output different from Y*
Point A in the graph
Short-run equilibrium is
temporary I
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Output (Y)
AD
AS
1
LRAS
Y* Y
1

1
A
Y*
LRAS
Using the AD-AS Model to
Study Business Cycles
Five Steps for Using the AD-AS
Model to Study Business Cycles
Example Event: Great Recession 2007-2009

Step 1: Draw a diagram to show the long run
equilibrium
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Output (Y)
Aggregate
Demand (AD)
Aggregate
Supply (AS)
Y*
Long-Run Aggregate
Supply (LRAS)
Five Steps for Using the AD-AS
Model to Study Business Cycles
Step 2: Ask whether the event affects the AD
curve, AS curve or both.
The Great Recession caused worldwide financial
panic and the sharp decrease in house prices.
Worldwide financial panic and the decrease in
house prices were negative demand shocks
Five Steps for Using the AD-AS
Model to Study Business Cycles
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Output (Y)
AS

Y*
LRAS
A
AD
1

1
AD
2

Y
1

2
B
Step 3: Shift the
curve(s) in the
appropriate direction(s).

Step 4: Find the new
short-run equilibrium
The new short-run
equilibrium is at B
Five Steps for Using the AD-AS
Model to Study Business Cycles
Step 5: Compare the new short-run
equilibrium to the original long-run equilibrium.
We find that the actual output Y
1
< the
potential output Y* and the
2
is below the
expected
1

Thus, there is a recessionary gap.

Can active use of stabilization
policy help to eliminate output
gap?
Self-Correcting Economy
In the long-run the economy tends to be self-
correcting
Missing from Keynesian model
Concentrates on the short-run; no price
adjustments
Given time, output gaps disappear without any
changes in monetary or fiscal policy
Whether stabilization policies are needed
depends on
the speed of the self-correction process
the nature of the shock that created the output
gap
The Role of Stabilization Policy
Speed of Self-Correction Process:

The greater the gap, the longer the adjustment
period
A slow self-correcting mechanism (Large output
gap)
Fiscal and monetary policy can help stabilize the
economy
A fast self-correcting mechanism (Small output
gap)
Fiscal and monetary policy are not effective and
may destabilize the economy
The Role of Stabilization Policy
The Nature of the Shocks:

Active fiscal policy and monetary policy are
helpful when a recession is caused by
negative demand shocks
Active fiscal policy and monetary policy can be
costly when a recession is caused by negative
price shocks
The Role of Stabilization Policy
Negative Demand
Shocks:
AD shifts to AD
2

Output falls to Y
1

An expansionary fiscal
policy or monetary
policy shifts the AD
curve back toward AD
1

The inflation returns
back to the initial level
1

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Output (Y)
AS

Y*
LRAS
A
AD
1

1
AD
2

Y
1

2
B
The Role of Stabilization Policy
Negative Price Shocks:
A negative price shock
shifts the AS curve to AS
2.
Output falls to Y
1
and
inflation rises to
2
An Expansionary fiscal
policy or monetary policy
shifts the AD to AD
2
Inflation rises to
3




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Output (Y)
AD
1
AS
1
Y*
LRAS

1
Y
1

2
AS
2
AD
2

3
Conclusion