Co9 - Ch27 - Lec15 - ECN 3010 - AS - AD - NAM Naseem PDF

N.A.
M Naseem, Department of Economics, UPM

ECN 3100 – PRINCIPLES OF ECONOMICS
27
N.A.M Naseem, Department of Economics, UPM
ECN 3010- PRINCIPLES OF ECONOMICS
AGGREGATE SUPPLY &
AGGREGATE DEMAND
Aggregate Supply
Quantity Supplied and Supply
The quantity of real GDP supplied is the total quantity

that firms plan to produce during a given period.
Aggregate supply is the relationship between the

quantity of real GDP supplied and the price level.
We distinguish two time frames associated with different

states of the labor market:
 Long-run aggregate supply (LAS)

 Short-run aggregate supply (SAS)
© 2014
ECN 3010- Pearson Education
PRINCIPLES OF ECONOMICS
Aggregate Supply
Long-Run Aggregate Supply (LAS)

Long-run aggregate supply is the relationship between:
 the quantity of real GDP supplied and the price level

when real GDP equals potential GDP.
Potential GDP is independent of the price level.
So the long-run aggregate supply curve (LAS) is vertical

at potential GDP.

© 2014
Aggregate Supply
Figure 27.1 shows the LAS

curve.
In the long run, the quantity
of real GDP supplied is
potential GDP.
As the price level rises
and the money wage rate
changes by the same
percentage, the quantity of
real GDP supplied remains
at potential GDP
∆%P = ∆%w => RGDP = PGDP
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Aggregate Supply
Short-Run Aggregate Supply

Short-run aggregate supply is the relationship between
the quantity of real GDP supplied and the price level when
the money wage rate, the prices of other resources,
and potential GDP remain constant.
A rise in the price level with no change in the money

wage rate and other factor prices increases the quantity
of real GDP supplied.
The short-run aggregate supply curve (SAS) is upward

sloping.

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Aggregate Supply
In the short run, the
quantity of real GDP
supplied increases if the
price level rises.
The SAS curve slopes

upward.
A rise in the price level

with no change in the
money wage rate induces
firms to increase
production.
∆%P ≠ 𝑊 => RGDP
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Aggregate Supply
With the given money

wage rate, as the price
level rises above 110 …
the quantity of real GDP

supplied increases along
the SAS curve.
Real GDP exceeds

potential GDP.

© 2014
Aggregate Supply
With a given money wage

rate, the SAS curve cuts
the LAS curve at potential
GDP.
The price level is 110.
With the given money

wage rate, as the price
level falls below 110 ...
the quantity of real GDP

supplied decreases
along the SAS curve.
© 2014
Aggregate Supply
Changes in Aggregate Supply

Aggregate supply changes if an influence on production
plans other than the price level changes.
These influences include
 Changes in potential GDP

 Changes in money wage rate (and other factor prices)

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Aggregate Supply: ∆ in Potential GDP
∆ in potential GDP:
 An increase in the full-
employment quantity of
labor
 An increase in the quantity
of capital (physical or
human)
 An advance in technology
When potential GDP increases: the LAS & SAS curves

shift rightward.
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Aggregate Supply: ∆ in the Money Wage Rate
A rise in the money

wage rate.
 SAS decreases and

shifts upward to the
leftward.
 LAS does not

change.

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Aggregate Demand
The Aggregate Demand Curve

Aggregate demand is the relationship between the
quantity of real GDP demanded and the price level.
The aggregate demand curve (AD) plots the quantity of

real GDP demanded against the price level.
The quantity of real GDP demanded, Y, is the total

amount of final goods and services produced in one
particular country
Y = C + I + G + X – M.
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Aggregate Demand
Figure 27.4 shows an

AD curve.
The AD curve slopes
downward for two
reasons:
 Wealth effect
 Substitution effects

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Aggregate Demand
Wealth Effect = purchasing power
A rise in the price level, other things remaining the same,

decreases the quantity of real wealth (money, stocks, etc.).
To restore their real wealth, people increase saving and

decrease spending.
The quantity of real GDP demanded decreases.
Similarly, a fall in the price level, other things remaining the

same, increases the quantity of real wealth, which increases
the quantity of real GDP demanded.

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Aggregate Demand
Substitution Effects
Intertemporal substitution effect:
decreases the real value of money and raises the interest
rate. -> Inflation (opportunity cost of holding money increase)
When the interest rate rises, people borrow and spend less,
so the quantity of real GDP demanded decreases.
Similarly, a fall in the price level increases the real value of
money and lowers the interest rate.
When the interest rate falls, people borrow and spend more,
so the quantity of real GDP demanded increases.
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Aggregate Demand
International substitution effect:

increases the price of domestic goods relative to foreign
goods.
So imports increase and exports decrease, which
decreases the quantity of real GDP demanded.
Similarly, a fall in the price level, other things remaining
the same, increases the quantity of real GDP demanded.

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Aggregate Demand
Changes in Aggregate Demand
A change in any influence on buying plans other than the

price level changes aggregate demand.
The main influences (or shift) on aggregate demand are
 Expectations
 Fiscal policy and monetary policy
 The world economy
N.A.M Naseem, Department of Economics, UPM N.A.M Naseem, Department of Economics, UPM
© 2014
PRINCIPLES OF ECONOMICS ECN 3100 – PRINCIPLES OF ECONOMICS
Aggregate Demand
Expectations
Expectations about future income, future inflation, and

future profits change aggregate demand.
Increases in expected future income increase people’s

consumption today and increases aggregate demand.
A rise in the expected inflation rate makes buying goods

cheaper today and increases aggregate demand.
An increase in expected future profits boosts firms’

investment, which increases aggregate demand.

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Aggregate Demand
Fiscal Policy – is the government’s attempt to influence the

economy by setting and changing taxes, making transfer
payments, and purchasing goods and services.
A tax cut (T) or an increase in transfer payments increases
households’ disposable income—aggregate income minus
taxes plus transfer payments.
An increase in disposable income increases consumption

expenditure and increases aggregate demand.
Because government expenditure on goods and services (G)

is one component of AD, an increase in G increases AD.

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Aggregate Demand
Shifts of the Aggregate Demand Curve from Policy Variables
 FIGURE 12.8 The Effect of an Increase in

Government Purchases or a Decrease in Net
Taxes on the AD Curve
An increase in government purchases (G)
or a decrease in net taxes (T) causes the
aggregate demand curve to shift to the
right, from AD0 to AD1.
The increase in G increases planned
aggregate expenditure, which leads to an
increase in output at each possible price
level.
A decrease in T causes consumption to
rise.
The higher consumption then increases
planned aggregate expenditure, which
leads to an increase in output at each
possible price level.

© 2014
Aggregate Demand
Monetary Policy
The Fed’s attempt to influence the economy by changing

the interest rate and adjusting the quantity of money is
called monetary policy.
An increase in the quantity of money increases buying

power and increases AD.
A cut in interest rates increases expenditure and increases

AD.

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Aggregate Demand
Shifts of the Aggregate Demand Curve from Monetary Policy Variables
 FIGURE 12.7 The Effect of an Increase in

Money Supply on the AD Curve
An increase in the money supply (Ms)

causes the aggregate demand curve to shift
to the right, from AD0 to AD1.
This shift occurs because the increase in Ms
lowers the interest rate, which increases
planned investment (and thus planned
aggregate expenditure).
The final result is an increase in output at
each possible price level.

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Aggregate Demand
Shifts of the Aggregate Demand Curve from Policy Variables
 FIGURE 12.9 Factors That Shift the Aggregate Demand Curve

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Aggregate Demand
The World Economy

The world economy influences aggregate demand in two
ways:
A fall in the foreign exchange rate (depreciation of RM)

lowers the price of domestic goods and services relative to
foreign goods and services, which increases exports,
decreases imports, and increases AD.
An increase in foreign income increases the demand for

Malaysia exports and increases AD.

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Aggregate Demand
Figure 27.5 illustrates

changes in aggregate
demand.
When aggregate demand
increases, the AD curve
shifts rightward…
… and when aggregate
demand decreases, the AD
curve shifts leftward.

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Explaining Macroeconomic Trends
and Fluctuations
Short-Run Macroeconomic Equilibrium
Short-run macroeconomic equilibrium occurs when the

quantity of real GDP demanded equals the quantity of
real GDP supplied
 at the point of intersection of the AD curve and the

SAS curve.

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and Fluctuations
Figure 27.6 illustrates a

short-run equilibrium.
If real GDP < equilibrium
GDP, firms increase
production and raise
prices…
… and if real GDP >
equilibrium GDP, firms
decrease production and
lower prices.

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and Fluctuations
Long-Run Macroeconomic Equilibrium
 real GDP equals potential GDP— when the economy is

on its LAS curve.
 Long-run equilibrium occurs at the intersection of the AD

and LAS curves.

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and Fluctuations
Economic Growth
& Inflation
in the AS-AD
Model
Since, the quantity of labor grows, capital is accumulated, and technology

advances, potential GDP increases the LAS curve shifts rightward.
Thus, the quantity of money grows faster than potential GDP, AD
increases by more than LAS – the AD curve shifts rightward faster than the
rightward shift of the LAS curve.
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and Fluctuations
 the economy is at an above-full  the economy is at below-full

employment equilibrium. employment equilibrium.
 the money wage rate rises until the SAS  the money wage falls until the SAS
curve passes through the long-run curve passes through the long-run
equilibrium point. equilibrium point.
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and Fluctuations
The Business Cycle in the AS-AD Model
The business cycle occurs because AD and SAS fluctuate,
but the money wage does not change rapidly enough to
keep real GDP at potential GDP.
 An above full-employment equilibrium is an equilibrium

in which real GDP exceeds potential GDP.
 A full-employment equilibrium is an equilibrium in which

real GDP equals potential GDP.
 A below full-employment equilibrium is an equilibrium

in which real GDP below potential GDP.
N.A.M Naseem, Department of Economics, UPM N.A.M Naseem, Department of Economics, UPM
© 2014
PRINCIPLES OF ECONOMICS ECN 3100 – PRINCIPLES OF ECONOMICS
and Fluctuations
This figure shows short-run equilibrium – real GDP fluctuates around

potential GDP in a business cycle.
If real GDP < potential GDP – below full-employment equilibrium =
recessionary gap.
If potential GDP > real GDP = an inflationary gap
© 2014
and Fluctuations
Fluctuations in AD
Figure 27.10 shows the

effects of an increase in
AD.
An increase in AD shifts
the AD curve rightward.
Firms increase production
and the price level rises in
the short run.

© 2014
and Fluctuations
At the short-run equilibrium,
there is an inflationary
gap.
The money wage rate
begins to rise and the SAS
curve starts to shift leftward.
 The price level continues
to rise
 real GDP continues to
decrease: until it equals
potential GDP.
© 2014
and Fluctuations
Fluctuations in Aggregate
Supply
Figure 27.11 shows the
effects of a rise in the price of
oil.
The SAS curve shifts leftward.
Real GDP decreases and the
price level rises.
The economy experiences
stagflation.
© 2014

Co9 - Ch27 - Lec15 - ECN 3010 - AS - AD - NAM Naseem PDF

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N.A.

M Naseem, Department of Economics, UPM

Quantity Supplied and Supply

The quantity of real GDP supplied is the total quantity

Aggregate supply is the relationship between the

We distinguish two time frames associated with different

 Long-run aggregate supply (LAS)

Long-Run Aggregate Supply (LAS)

 the quantity of real GDP supplied and the price level

Potential GDP is independent of the price level.

So the long-run aggregate supply curve (LAS) is vertical

N.A.M Naseem, Department of Economics, UPM

Figure 27.1 shows the LAS

Short-Run Aggregate Supply

A rise in the price level with no change in the money

The short-run aggregate supply curve (SAS) is upward

N.A.M Naseem, Department of Economics, UPM

The SAS curve slopes

A rise in the price level

With the given money

the quantity of real GDP

Real GDP exceeds

N.A.M Naseem, Department of Economics, UPM

With a given money wage

The price level is 110.

With the given money

the quantity of real GDP

Changes in Aggregate Supply

These influences include

 Changes in potential GDP

N.A.M Naseem, Department of Economics, UPM

When potential GDP increases: the LAS & SAS curves

A rise in the money

 SAS decreases and

 LAS does not

N.A.M Naseem, Department of Economics, UPM

The Aggregate Demand Curve

The aggregate demand curve (AD) plots the quantity of

The quantity of real GDP demanded, Y, is the total

Figure 27.4 shows an

N.A.M Naseem, Department of Economics, UPM

Wealth Effect = purchasing power

A rise in the price level, other things remaining the same,

To restore their real wealth, people increase saving and

The quantity of real GDP demanded decreases.

Similarly, a fall in the price level, other things remaining the

N.A.M Naseem, Department of Economics, UPM

International substitution effect:

N.A.M Naseem, Department of Economics, UPM

Changes in Aggregate Demand

A change in any influence on buying plans other than the

Expectations about future income, future inflation, and

Increases in expected future income increase people’s

A rise in the expected inflation rate makes buying goods

An increase in expected future profits boosts firms’

N.A.M Naseem, Department of Economics, UPM

Fiscal Policy – is the government’s attempt to influence the

An increase in disposable income increases consumption

Because government expenditure on goods and services (G)

N.A.M Naseem, Department of Economics, UPM

 FIGURE 12.8 The Effect of an Increase in

N.A.M Naseem, Department of Economics, UPM

The Fed’s attempt to influence the economy by changing