The Business Cycles

Chapter 9

Macroeconomic Equilibrium: Aggregate Demand and Supply

Macroeconomic Principles Instructor: El-hadj Bah Fall, 2007

Aggregate demand = total spending in the economy at alternative price levels. Aggregate supply = total output of the economy at alternative price levels. Changes in aggregate demand and supply cause the equilibrium price level and real GDP to change resulting in business cycles.

Aggregate Demand, Aggregate Supply, and Business Cycles

Demand Pull Inflation-Cost Push Inflation

Demand-pull inflation: inflation caused by increasing demand for output Cost-push inflation: inflation caused by rising cost of production Examples:
Home prices Oil prices

Aggregate Demand and Business Cycles

Aggregate Supply and Business Cycles

Factors that Affect AD AD = C + I + G + NX

Consumption
Income Wealth Expectations Demographics Taxes Interest Rates Technology Cost of Capital Goods Capacity Utilization
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Why the Aggregate Demand Curve Slopes Downward

The reasons for its downward slope are price-level effects:
Wealth Effect (Real Wealth/Real Balances) Interest Rate Effect International Trade Effect (Substitution)

Government Spending Net Exports

Domestic & Foreign Income Domestic & Foreign Prices Exchange Rates Government Policy

Investment

Wealth Effect

Interest Rate Effect

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Aggregate demand curve

International Effect

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Nonprice Determinants: Changes in Aggregate Demand

Nonprice Determinants: Changes in Aggregate Demand

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Nonprice Determinants: Changes in Aggregate Demand

Shifting the Aggregate Demand Curve

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Effects of a Change in Aggregate Demand

Test question
A decrease in the foreign price level relative to the domestic price level will result in
A leftward shift of the domestic aggregate demand curve. A rightward shift of the domestic aggregate demand curve.

Demand-pull inflation: rapid increases in AD outpace the growth of AS, causing price level increases (inflation).

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Aggregate Supply
Aggregate Supply (AS) is the total of all the firm (market) supply curves. It shows the quantity of real GDP produced at different price levels. Short-run AS slopes upward because an increase in the price level (while production costs and capital are held constant on the short-run), means higher profit marginsfirms will want to produce more.
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Aggregate Supply

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Shape of Short-run AS (SRAS)

In the short-run, the capital stock (the number of factories and machines, etc.) are held constant. Increasing the number of workers increases output, but at a diminishing rate. Diminishing returns manifest as an eversteeper SRAS curve.
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The Shape of the Short-Run Aggregate Supply Curve

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The Shape of Long-run AS (LRAS)

Resource costs are NOT fixed.
As prices rises, workers will want higher wages and will eventually get them.

The Shape of the Long-Run Aggregate Supply Curve

The amount of capital is not fixedfirms can build new plants and buy new equipment over the long-run. In the long-run, AS is set by the production possibilities curvethe capacity of the economy, and is not affected by prices, hence is vertical.
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Determinants of Aggregate Supply: Resource Prices

Determinants of Aggregate Supply: Technology

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Determinants of Aggregate Supply: Expectations

Shifting the Long-Run Aggregate Supply Curve

Growth occurs as the labor force and the capital stock grow, as technological innovation improves production efficiency.

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Changes in Aggregate Supply

Aggregate Demand and Supply Equilibrium

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