Understanding Aggregate Demand and Aggregate Supply in Macroeconomics

Part III: Macroeconomics

Economic Fluctuations

• Unit 17: Business Cycles
• Unit 18: The ISLM Model and Aggregate Demand
• Unit 19: Aggregate Demand and Aggregate Supply
• Unit 20: Aggregate Demand Policies
• Unit 21: Inflation and Unemployment

Unit 19 Aggregate Demand and Aggregate Supply

(Mankiw & Taylor, Ch 28)

Preview of Unit 19

1. The aggregate demand and aggregate supply framework is the
   basic macromodel for the analysis of output determination: the business
   cycle can then be looked at as resulting from changes in AD and/or AS.
2. After a brief recap of some basic facts about the business cycle, we
   look again at the basic model of AD, and discuss its slope.
3. We then look at AS, the slope of which distinguishes the long run from
   the short run model of the macroeconomy.
4. The AD/AS framework can then be used to account for short run
   economic fluctuations

Basic facts about the business cycle

Real GDP is the variable that is most often used to examine short-run changes in the
economy. Fluctuations in gdp are irregular, but some regularities can be uncovered:

• The two main components of aggregate spending (consumption and investment)
  exhibit markedly different behaviour: aggregate investment is much more variable
  than GDP, aggregate consumption is much less variable than gdp;
• As output falls, unemployment rises. According to most estimates, a 1% increase in
  unemployment is associated with a 3% drop in GDP (this is an estimate of the
  original Okun's law, according to which a 2% GDP growth implies a 1% drop in
  unemployment). However, there is a time-lag between any downturn in economic
  activity and a rise in unemployment and vice versa: unemployment is a lagged
  indicator.

Aggregate Demand and Aggregate Supply

The basic model of aggregate demand and aggregate supply is key to explaining
short-run fluctuations in economic activity around its long-run trend.

• The aggregate demand curve shows the quantity of goods and services that
  households, firms, and the government (plus the foreign sector) would be willing to
  purchase at any price level, if firms were willing to produce them at that price level.
• The aggregate-supply curve shows the quantity of goods and services that firms
  choose to produce and sell at each price level.
• Equilibrium determines the economy's output of goods and services (measured by
  real GDP) and the overall price level (measured by the CPI or the GDP deflator).

Aggregate Demand and Aggregate Supply Model

Equilibrium output and
equilibrium price level in
a standard basic AD/AS
model (blue curve).
Shifts in AD or AS (or
both) will affect gdp and
the general price level,
depending also on their
slopes.
E.g., if AS is vertical, AD
has no effect on gdp (red
curves)
Shifts in AD
A vertical AS
Price
Level
Aggregate
supply
Equilibrium
price level
Aggregate
demand
0
Equilibrium
output
Quantity of
Output
FROM MANKIW AND TAYLOR, ECONOMICS 5TH EDITION 9781473768543 @ CENGAGE EMEA 2020

Slopes of AD and AS Curves

In order to use the AD/AS model to interpret economic activity, a crucial information is
that concerning the slopes of the two curves:
The slope of the AD curve is usually supposed to be negative, though according
to some economists it may be vertical.
The slope of the AS curve is usually supposed to be positive in the short run and
vertical in the long run, though some economists argue that in some circumstance it
may be zero.

Aggregate Demand

The AD curve is supposed to be decreasing due to three main effects.

1. The Price Level and Investment: The Interest Rate Effect

Recall our money market equilibrium condition:
M
P
= L(Y, i)
A lower price level amounts to an increase in the supply of real money,
which reduces the interest rate, which in turn encourages greater
spending on investment goods.
This is the effect we relied on to derive a downward sloping AD curve in
unit 22. Two additional effects can be identified.

2. The Price Level and Consumption: The Wealth Effect

A decrease in the price level raises the value of nominal assets (e.g.,
bonds, nominal money balances): for any given level of income, this is
likely to raise the demand for consumption goods as consumers feel
wealthier, which encourages them to spend more.

3. The Price Level and Net Exports: The Exchange Rate Effect

When a fall in the price level occurs the interest rate goes down (effect
no 1). This is likely to stimulate net exports, as lower interest rates lead
to a sale of domestic currency (as people buy higher interest-rate
bearing foreign assets), which in turn lowers the real exchange rate
and domestically produced commodities are cheaper to foreigners.
The increase in net export spending means a larger quantity of goods
and services demanded.

Standard Representation of the AD Curve

The standard
representation of the AD
curve.
1
It is downward sloping
due to three effects:
1. The 'interest rate'
effect
2. The wealth effect
3. The exchange rate
effect
Price
Level
P1
P2
1. A decrease
in the price
level . . .
Aggregate
demand
0
Y1
Y2
Quantity
of output
2. .. . increases the quantity of
goods and services demanded.
FROM MANKIW AND TAYLOR, ECONOMICS 5TH EDITION 9781473768543 @ CENGAGE EMEA 2020

Liquidity Trap and AD Sensitivity

According to some economists, AD might not be sensitive to changes in the general
price level, as the money market may prevent the first effect from working. This is the
so-called liquidity trap.
If at some point the
demand for liquidity
becomes flat (infinitely
elastic to the interest
rate), changes in the real
money supply (red line)
M/P have no effect on the
interest rate (and hence
on investment).
Rate of
interest
A change in
M/P affects i
L(Y,i)
A change in
M/P does not
affect i
Quantity of money

Liquidity Trap and Monetary Policy

If a liquidity trap sets in, expansionary monetary policy by the Central Bank
is ineffective and the interest rate cannot fall. As a result the first
mechanism outlined above does not work - if the other channels are weak,
the aggregate demand curve is vertical.
Within the ISLM model, that would mean a horizontal LM curve: output is
entirely determined by the position of the IS curve, and no crowding out
effect operates: we are back in the world of the Keynesian cross.

Investment Trap and Price Insensitive AD

A similar effect with price insensitive AD would be observed if the
'investment trap' occurs: the interest elasticity of investment is low and
investment is driven by the entrepreneurs' expectations: the IS curve
would be vertical, no crowding out effect operates and we are again in the
world of the Keynesian cross.
This is consistent with some interpretations of JM Keynes's work,
according to which prime mover of investment is not the interest rate, but
the entrepreneurs' "animal spirits".

Shifts in Aggregate Demand

The downward slope of the aggregate demand curve shows that a fall in the
price level raises the overall quantity of goods and services demanded.
At any given the price level, any exogenous increase in the quantity of
goods and services demanded, i.e.
Consumption (e.g., higher consumers' confidence, lower taxation, ... )
Investment (e.g., higher business confidence, lower taxation ..
Government Purchases (e.g., expansionary fiscal policy)
Net Exports (e.g., larger demand from abroad) ....
... imply and outward shift of the aggregate demand curve.

Aggregate Demand Curve Shifts

Shifts in aggregate
demand can be driven
by increases in any of
its components (C, I, G,
NX).
The overall effect on
equilibrium output will
depend on the slope of
the aggregate supply
curve.
Price
Level
P.
........
D2
Aggregate
demand, D1
0
Y1
Y2
Quantity of
Output
FROM MANKIW AND TAYLOR, ECONOMICS 5TH EDITION 9781473768543 @ CENGAGE EMEA 2020

Aggregate Supply

The effects of changes in AD on equilibrium output is conditional on the slope of the
AS curve. Start from equilibrium levels Yo and Po (point A), and let & be the AD shift.
If the AS curve is vertical (red),
an AD change (from ADo to AD1) has
no effect on output, and has a big
impact on price (classical case:
long run).
If the AS curve is upward sloping
(green) an AD change affects both
output (Yo to YB) and price (Po to PB)
(short run).
If the AS curve is horizontal
(blue), AD affects only output (Yo to
YD): the 'extreme Keynesian' case,
where gdp is determined entirely by
AD.
AD1
ADO
∆
C
Pc
B
PB
A
0
D
Po
Yo
YB
YD

Vertical Supply Curve in Classical Theory

Most economists believe that classical theory describes the world in the long-run but
not in the short-run. In this 'classical' framework ...
(A) wages and prices are perfectly flexible: the labour markets adjust quickly
to the full employment level (recall Unit 16 on unemployment) ...
Labor
Real wage per hour
Labor demand
Labor supply
supply
$20
$20
10
Labor
demand
0
5,000 10,000
0
5,000 10,000
0
7,500
Labor
Labor
Labor
(A) Demand for Labor
(B) Supply of Labor
(C) Demand and Supply
Real wage per hour
$15
10

GDP and Money Neutrality

... which means gdp is always close to its maximum full employment level (basic idea:
in the long run the impact of nominal sluggishness wears out): for any given P there is
a level of the nominal wage W such that the equilibrium real wage rate ensures full
employment, and perfect competition drives the economy there. Hence real gdp is
independent of P and the AS curve is vertical.
(B) "money neutrality" holds: changes in the money supply affect only nominal
variables. The classical theory of the money market is the quantity theory of money,
such that M = kPY: the demand for money depends on real output Y (no effect of the
interest rate): the amount of money people hold depends only the prices of goods and
services. Increasing M lowers the value of money in terms of commodities (1/P) which
is consistent with what happens in the AD-AS framework with a vertical AS curve.

Long-Run Aggregate Supply Curve

In the long run, an economy's
production of goods and
services depends on its stock
of labour, capital, and natural
resources, and on technology:
the price level has no effect on
these.
This long run AS curve is
vertical at the natural rate of
output (all factors are fully
employed, and unemployment
is at its natural rate: also
referred to as potential- or full-
employment output).
Price
Level
1. A change
in the price
level . . .
Long-run
aggregate
supply
P
-
I
P2
2. . . . does not affect
the quantity of goods
and services supplied
in the long run.
0
Natural rate
of output
Quantity of
output
FROM MANKIW AND TAYLOR, ECONOMICS 5TH EDITION 9781473768543 @ CENGAGE EMEA 2020