ECON 22 – MACROECONOMICS

CHAPTER 8: Aggregate Demand and Aggregate Supply

The Economy

- Consists of two major activities: buying and producing

o Aggregate Demand (AD) – buying side of the economy
o Aggregate Supply – producing side of the economy
 Relevant time periods:
 Production in the short run  Short-run Aggregate Supply
 Production in the long run  Long-run Aggregate Supply

Aggregate Demand

- Definition: is the quantity demanded of all goods and services (Real GDP) at different price levels, ceteris paribus
- Aggregate Demand Curve
o Is the graphical representation of aggregate demand
o Is downward sloping
 There is an inverse relationship between the price level (P) and the quantity demanded
 As the price level rises, the quantity demand of Real GDP falls; as the price level falls, the quantity
demanded of Real GDP rises, ceteris paribus
o Why does the Aggregate Demand Curve slope downwards?
a. Real Balance Effect
 States that the inverse relationship between the price level and the quantity demanded of Real
GDP is established through changes in the value of monetary wealth/ assets  changes in the
purchasing power (quantity of goods and services that can be purchased with a unit of money)
 When price level falls,
o purchasing power rises  increase in monetary wealth  increase in QD
 When price level rises,
o purchasing power falls  decrease in monetary wealth  decrease in QD
b. Interest Rate Effect
 States that the inverse relationship between the price level and the quantity demand of Real GDP
is established through changes in the part of household and business spending that is sensitive to
changes in interest rates
 When price level falls:
 Purchasing power rises  Savings rise  Supply of credit rises  Interest rates fall 
Borrowing rises  Household and Business can buy more  Quantity demanded rises
 When price level rises:
 Purchasing power falls  Savings fall  Supply of credit falls  Interest rates rise 
Borrowing falls  Household and Business can buy less  Quantity demanded falls
c. International Trade Effect
 Inverse relationship from change in foreign sector spending as the price level changes
 When price level falls relative to foreign price levels,
 Local goods become cheaper  both local and foreigners buy more local goods 
Quantity demanded rises
 When price level rises relative to foreign price levels,
 Local goods become expensive  both local and foreigners buy less local goods 
Quantity demanded falls
- Change in Quantity Demanded vs Change in Aggregate Demand
o Change in Quantity Demanded
 Movement from one point to another point on the AD curve
 Brought about by changes in price levels which can be explained through the real balance effect,
interest effect, and international trade effect
o Change in Aggregate Demand
 Represented by a shift in the AD curve
 The QD changes although price level remains the same
- Changes in Aggregate Demand
o Caused by a change of spending at a given price level
 Spending increases at a given price level  AD rises  AD curve shifts to the right
 Spending decreases at a given price level  AD falls  AD curve shifts to the left
o How Spending Components Affect Aggregate Demand:
 𝑇𝑜𝑡𝑎𝑙 𝑒𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒 = 𝐶 + 𝐼 + 𝐺 + 𝑁𝑋
 NX = EX – IM
 C↑, I↑, G↑, NX↑  AD↑
 C↓, I↓, G↓, NX↓  AD↓
o Factors Affecting C, I, G, NX
a. Consumption
 Wealth – the value of all assets owned, both monetary and nonmonetary
 Increase in wealth  Increase in Consumption  AD increases
 Decrease in wealth  Decrease in Consumption  AD decreases
 Expectations about future prices and income
 Expect higher prices in future  Increase current consumption  AD increases
 Expect lower prices in future  Decrease current consumption  AD decreases
 Expect higher income in future  Increase current consumption  AD increases
 Expect lower income in future  Decrease current consumption  AD decreases
 Interest Rate – buyers often pay for items by borrowing
 Interest rate increases  Increase in monthly payments  Decrease consumption  AD
decreases
 Interest rate decreases  Decrease in monthly payments  Increase consumption  AD
decreases
 Income Taxes
 Income tax rises  Disposable Income decreases  Consumption decreases  AD
decreases
 Income tax falls  Disposable Income increases  Consumption increases  AD
increases
b. Investment
 Interest rate
 Interest rate rises  cost of investment project rises  businesses invest less  AD
decreases
 Interest rate falls  cost of investment project falls  businesses invest more  AD
increases
 Expectations about future sales
 Optimistic about future sales  investment spending increases  AD increases
 Pessimistic about future sales  investment spending decreases  AD decreases
 Business taxes
 Increase in business taxes  lowers expected profitability  less investment  AD
decreases
 Decrease in business taxes  increases expected profitability  more investment  AD
increases
c. Net Exports
 Foreign real national income – the foreign national income adjusted for price changes
 Foreign real national income rises  Foreigners buy more local goods  Exports increase
 Net exports increase  AD increases
 Foreign real national income falls  Foreigners buy less local goods  Exports decrease
 Net exports decrease  AD decreases
 Exchange Rate – the price of one currency in terms of another currency
 Appreciation – an increase in the value of one currency relative to other currencies
o Foreign goods become cheaper  imports increases  net exports decrease 
AD decreases
 Depreciation – a decrease in the value of one currency relative to other currencies
o Foreign goods become more expensive  imports decrease  net exports
increase  AD increases
 o Change in Money Supply
 Affects aggregate demand
 A change in money supply:
1. Affects interest
2. Interest rates affect consumption and investment
3. Consumption and investment affects aggregate demand
o Velocity – the average number of times a dollar is spent to buy final goods and services in a year
 Total Spending = Money supply x Velocity
o If both money supply and velocity are constant, a rise in one spending component (such as consumption)
necessitates a decline in one or more other spending components
o If either the money supply or velocity rises, one spending component can rise without requiring other
spending components to decline

Short-Run Aggregate Supply

- Definition: Is the quantity supplied of all goods and services (Real GDP) at various price levels, ceteris paribus
- Includes short-run aggregate supply (SRAS) and long-run aggregate supply (LRAS)

A. Short-Run Aggregate Supply

o Shows the quantity supplied of all goods and services at different price levels, ceteris paribus
o Is upward sloping
 As price level rises, firms increase quantity supplied of goods and services
 As price level drops, firms decrease the quantity supplied of goods and services
o Why is it upward sloping?
a. Sticky Wages
 Wages are sticky or inflexible – locked in for a few years due to labor contracts that workers and
management enter into
 Firms pay nominal wages but decide on how many workers to hire based on real wages
 Real wages – are nominal wages divided by the price level
o 𝑅𝑒𝑎𝑙 𝑊𝑎𝑔𝑒 = 𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝑊𝑎𝑔𝑒/ 𝑃𝑟𝑖𝑐𝑒 𝐿𝑒𝑣𝑒𝑙
o Inverse relationship between price level and real wages
 On quantity of labor demanded:
 Real Wage rises  Quantity supplied of labor increases
 Real Wage falls  Quantity supplied of labor decreases
 On quantity of labor supplied:
 Real Wage rises  Quantity demanded of labor decreases  less output produced
 Real Wage falls  Quantity demanded of labor increases  more output produced
 Put together:
 Price level declines  Real wage rises  Firms hire fewer workers  Decline in quantity
supplied of Real GDP
b. Worker Misconceptions
 Nominal wages and price level decline by equal percentage  Real wage remains constant 
workers mistakenly think real wage has fallen  workers reduce quantity supplied of labor 
less output is produced
o SRAS is relevant only to a period of time when sticky wages and misconceived real wages are relevant
o Shifts in the SRAS curve:
 Wage Rates
 Profit per unit = Price per unit – Cost per unit
o Higher wages  Higher costs  Lower profits  Lower production
o Lower rages  Lower costs  Higher profits  Increases production
 Price of Non-Labor Inputs (same effect as of wage rates)
 Productivity – is the output produced per unit of input employed over some period of time
 Increase in productivity  produce more products with same number of inputs
 Decrease in productivity  produce less products with same number of inputs
 Supply Shock – natural or institutional changes that affect aggregate supply
 Adverse Supply Shocks – shift SRAS curve left; decreases production
 Beneficial Supply Shocks – shift SRAS curve right; increases production
 Expected price level
o Short-Run Equilibrium
 The condition in the economy when the quantity demanded of Real GDP equals the (short-run)
quantity supplied of Real GDP
 This condition is met when the aggregate demand curve intersects the short-run aggregate supply
curve

o How Factors Affect the Price Level and Real GDP in the Short Run
 B. Long-Run Aggregate Supply
o Identifies the Real GDP that the economy produces when wages become unstuck and misperceptions turn
into accurate perceptions; when economy is said to be in the long run
o In the long run, economy produces full-employment Real GDP or the Natural Real GDP
 Natural Real GDP – Real GDP produced at the natural unemployment rate and when the economy
is in long-run equilibrium
o Long-run Aggregate Supply (LRAS) curve – is a vertical line at the level of Natural Real GDP
 Represents the output the economy produces when wages and prices have adjusted to their final
equilibrium levels and when workers and when workers have no relevant misperceptions
o Long-run Equilibrium - Identifies the level of Real GDP the economy produces when wages and prices
have adjusted to their final equilibrium levels and when workers have no relevant misperceptions

Short-Run Equilibrium, Long-Run Equilibrium, and Disequilibrium

- Disequilibrium
o Is the state of the economy as it moves from one short-run equilibrium to another or from short-run
equilibrium to long-run equilibrium
o Quantity supplied and quantity demanded of Real GDP are not equal
 CHAPTER 9: Classical Macroeconomics and the Self-Regulating Economy

Classical Economics

- Often used to refer to an era in the history of economic thought that stretched from about 1750 to the early 1900s

Say’s Law

- Supply creates its own demand

- Production creates enough demand to purchase all the goods and services produced
- In a Barter Economy
o A baker bakes bread because he wants to use it to demand other things
o Implications of Say’s Law
 There cannot be:
1. A general overproduction of goods – where supply in the economy is greater than demand
2. A general underproduction of goods – where demand in the economy is greater than supply
- In a Money Economy
o A baker bakes bread to earn income to
buy goods and services, but he may not
spend everything to buy goods and
services, and instead saves
o Say’s Law still holds because of the
assumption on Interest Rate Flexibility
 Funds saved must give rise to
an equal mound of funds
invested
 C↓ S↑  I↑
 TE = C + I + G + (EX-IM)
 S = Disposable Inc. -
Consumption
o Implication of an increase in savings on
Aggregate Demand
 As long as total spending does
not increase, aggregate
demand will remain the same
- On Prices and Wages
o Classical economists believe that prices
and wages are flexible
 Markets are competitive and that supply and demand operate in all markets
 Prices adjust quickly to any surpluses and shortages, and equilibrium will be quickly reestablished

Three States of the Economy

Common Misconceptions about the Unemployment Rate and Natural Unemployment Rate

- An economy’s employment rate can be higher than the natural employment rate because natural unemployment
rate lies on the institutional PPF and sometimes it can be ineffective (e.g. inflation which reduces purchasing
power of minimum wage)
The Self-Regulating Economy

- Some economists believe that the economy is self-regulating

o If the economy is not at the natural unemployment rate (full employment), or if it is not producing the
Natural Real GDP, then it can move on its own to this position

- If a Self-Regulating Economy is in a Recessionary Gap

o Recessionary Gap  Unemployment Rate > Natural Unemployment Rate  Surplus in Labor Market 
Wages falls  SRAS shifts to the right  Economy moves into long-run equilibrium

- If a Self-Regulating Economy is in an Inflationary Gap

o Inflationary Gap  Unemployment Rate < Natural Unemployment Rate  Shortage in Labor Market 
Wages rise  SRAS shifts to the left  Economy moves into long-run equilibrium

- Policy Implication of Believing the Economy is Self-Regulating

o Full employment is the norm
o The economy always moves back to Natural Real GDP
o Macroeconomic policy of laissez-faire
 Non-interference
 Government does not have an economic management role to play
 - Changes in a Self-Regulating Economy: Short Run and Long Run

- Main thoughts on Classical Macroeconomics and a Self-Regulating Economy

1. Say’s Law holds
2. Interest rates change such that savings equals investment
3. The economy is self-regulating, making full employment and an economy producing Natural Real GDP the
norm
4. Prices and wages are flexible – if the economy is in a recessionary gap, wages fall and the economy soon
moves itself toward producing Natural Real GDP (at a lower price level than in the recessionary gap). If the
economy is in an inflationary gap, wages rise and the economy moves itself toward producing Natural Real
GDP (at a higher price level than in the inflationary gap)
5. Because the economy is self-regulating, laissez-faire is the policy prescription

Business-Cycle Macroeconomics

- Deals with changes in Real GDP (up and down)

around a fixed LRAS curve

Economic-Growth Macroeconomics

- Increases in Real GDP due to a rightward-shifting

LRAS curve
 CHAPTER 10: Keynesian Macroeconomics and Economic Instability

John Maynard Keynes

- Published “The General Theory of Employment, Interest and Money” in 1936

- Challenged four classical beliefs:
1. Say’s law holds, so that insufficient demand in the economy is unlikely
2. Wages, prices, and interest rates are flexible
3. The economy is self-regulating
4. Laissez-faire is the right and sensible economic policy

Criticism on Say’s Law in a Money Economy

- Added savings do not necessarily stimulate an equal amount of added investment spending
- Both saving and investment depend on a number of factors that may be far more influential than the interest rate
o Savings is more responsive to changes in income than to changes in interest rate
o Investment is more responsive to technological changes, business expectations, and innovations than to
changes in interest rate
- Savings may not always directly relate to interest (it can have an inverse effect sometimes)
o Suppose individuals are saving for a certain goal—say, a retirement fund of $100,000. They might save
less per period at an interest rate of 10 percent than at an interest rate of 5 percent because a higher
interest rate means that they can save less per period and still meet their goal by retirement. For example,
if the interest rate is 5 percent, they need $50,000 in savings to earn $2,500 in interest income per year.
If the interest rate is 10 percent, they need only $25,000 in savings to earn $2,500 in interest.

On Wage Rates

- Unemployment Rate > Natural Unemployment  Surplus Exists  Employers try to cut wages  Labor Unions
will resist the wage cuts  Wage rates may be inflexible
o If wage rates do not fall, the economy will not be able to get itself out of an inflationary gap
- Keynes believed that the economy is inherently unstable and that it may not automatically cure itself of a
recessionary gap
o It may not be self-regulating
- Labor markets do not adjust the same way or as quickly as the stock market
o Wage rate is likely to be inflexible downward – it isn’t likely to decline at least for some time
 Why?
 Long-term Labor Contracts
o Employers enter it because (1) fewer labor negotiations; (2) fewer worker strikes
o Employees enter it because (1) wage security; (2) fewer worker strikes
 Efficiency Wage Models
o Models holding that it is sometimes in the best interest of business firms to pay
their employees higher-than-equilibrium wage rates
o Workers are more productive when they are paid a higher wage
o Workers become less productive when paid a lower wage – less productive, shirk
more, or perhaps stela from the employer
o A lower demand for labor may not be met with a declining wage rate

On Prices

- Prices may not always be flexible

- Anticompetitive or monopolistic elements in the economy sometimes prevent price from falling
Classical Economics vs Keynesian Economics

The Simple Keynesian Model

- In the simple Keynesian Model, certain simplifying assumptions hold

o First, the price level is assumed to be constant until the economy reaches its full-employment or Natural
Real GDP level
o Second, there is no foreign sector; the model represents only a closed economy, not an open economy
 Total Spending = Consumption + Investment + Government Purchases
o Third, the monetary side of the economy is excluded

The Consumption Function

- Three basic points:

1. Consumption depends on disposable income (income minus taxes)
2. Consumption and disposable income move in the same direction
3. When disposable income changes, consumption may change by less
𝐶 = 𝐶0 + (𝑀𝑃𝐶)(𝑌𝑑 )
o C is consumption
o Yd is disposable income
o MPC is Marginal Propensity to Consume
 Consumption is made of 2 parts:
 Autonomous Consumption (C0) – independent of disposable income
o Changes not as disposable income changes, but rather due to other factors (e.g.
illness)
 Induced Consumption [MPC(YD)] – depends on disposable income
 Marginal Propensity to consume is the ratio of change in consumption to the change in disposable
income
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐶𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛 ∆𝐶
𝑀𝑃𝐶 = =
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐷𝑖𝑠𝑝𝑜𝑠𝑎𝑏𝑙𝑒 𝐼𝑛𝑐𝑜𝑚𝑒 ∆𝑌𝐷
o Consumption can be increased in 3 ways:
1. Raise autonomous consumption
2. Raise disposable income
3. Raise the MPC

Consumption and Saving

𝑆𝑎𝑣𝑖𝑛𝑔 = 𝐷𝑖𝑠𝑝𝑜𝑠𝑎𝑏𝑙𝑒 𝐼𝑛𝑐𝑜𝑚𝑒 – 𝐶𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛

= 𝑌𝑑 − [𝐶0 + (𝑀𝑃𝐶)(𝑌𝑑 )]
- Marginal Propensity to Save – is the ratio of the change in saving to the change in disposable income
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑆𝑎𝑣𝑖𝑛𝑔 ∆𝑆
𝑀𝑃𝐶 = =
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐷𝑖𝑠𝑝𝑜𝑠𝑎𝑏𝑙𝑒 𝐼𝑛𝑐𝑜𝑚𝑒 ∆𝑌𝐷
𝑀𝑃𝐶 + 𝑀𝑃𝑆 = 1
The Multiplier

- The number that is multiplied by the change in autonomous spending to obtain the overall change in total
spending
- If the economy is operating below Natural GDP, then the multiplier is the number that is multiplied by the change
in autonomous spending to obtain the change in Real GDP
- Multiplier process – an initial rise in autonomous consumption leads to a rise in consumption for one person,
generating additional income for another person, and leading to additional consumption spending by that person,
and so on and so on
1
𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 (𝑚) =
1 − 𝑀𝑃𝐶
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑡𝑜𝑡𝑎𝑙 𝑠𝑝𝑒𝑛𝑑𝑖𝑛𝑔 = 𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑒𝑟 × 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑎𝑢𝑡𝑜𝑛𝑜𝑚𝑜𝑢𝑠 𝑠𝑝𝑒𝑛𝑑𝑖𝑛𝑔
- In Reality:
o A change in autonomous spending leads to a greater change in total spending
o Change in total spending is equal to the change in Real GDP (assuming the economy is operating below
the Natural GDP)
 Reason: prices are assumed to remain constant until Natural GDP is reached
 So any change in nominal spending is equal to change in real total spending
o 2 Reality Checks necessary:
1. Multiplier takes time to have an effect
2. For the multiplier to increase Real GDP, idle resources must exist at each spending round
 Idle resources must be available to be brought into production
 If not available, increased spending will simply result in higher prices without an increase in Real
GDP (GDP will increase but not Real GDP)

Simple Keynesian Model in the AD-AS Framework

- Shift in the Aggregate Demand Curve

o Changes in consumption (C),
investment (I), and government
purchases (G) shifts the AD curve
- Keynesian Aggregate Supply Curve
o Price level is assumed to be
constant until it reaches its full-
employment or Natural Real GDP
level

The Economy in a Recessionary Gap

- Keynes believed neither

household/business sectors may be able to
move the economy out of a recessionary gap
- A fall in interest rate is also not enough
to get businesses to invest more
o Businesses won’t invest more if they feel
pessimistic even if interest rates drop
- Government’s has a role to play in the
economy
o If the private sector cannot self-regulate,
the government must play a role to shift the AD
curve rightward so that it goes to point B
Summary of the Simple Keynesian Model

1. The price level is constant until

Natural Real GDP is reached
2. The AD curve shifts if there are
changes in C,I, or G
3. The economy could be in
equilibrium and in a recessionary
gap too
4. The private sector may not be able
to get the economy out of a
recessionary gap. In other words,
the private sector may not be able
to increase C or I enough
5. The government may have a
management role to play in the
economy. According to Keynes,
government may have to raise
aggregate demand enough to
stimulate the economy to move it
out of the recessionary gap and to
its Natural Real GDP Level

The Simple Keynesian Model in the TE-TP Framework

- Deriving a Total Expenditures Curve

o Total Expenditures are the sum of its parts: consumption, investment, and government purchases
o To derive a TE curve, first derive a diagrammatic representation of C, I, G
 Consumption – as disposable income rises, so does consumption; Consumption also rises as Real
GDP rises, but by a smaller percentage
 Investment – constant
 Government purchases – constant
- What will shift the TE curve?
o Change in C, I, G
- Comparing Total Expenditure (TE) and Total Production
o 3 possible states:
 TE < TP
 TE > TP
 TE = TP
o If the economy is currently operating where TE < TP or TE > TP (both states are described as
disequilibrium), it will eventually move to where TE = TP (where the economy is in equilibrium)
o Moving from Disequilibrium to Equilibrium
 Business firms hold an inventory of their goods to guard against unexpected changes in the
demand for their product
 We know that all business firms have some optimum inventory, which is just-the-right-amount of
inventory (not too much or not too little)
 3 Cases:
 TE < TP
o Surplus in production  Inventory levels rise beyond optimal inventory 
inventory level signals firm that they have overproduced  firm cuts back on
production  cutback causes Real GDP to fall
 TE > TP
o Inventory levels fall because of higher demand  fall in inventory signals firm
that they have under produced  firm increases quantity of goods produced 
rise in production causes Real GDP to rise