Aggregate demand

Aggregate Supply & Demand

AD and AS
intersection at point E
determines the level
of output Yo and price
level, Po.

The Derivation of the Aggregate

An increase in the price
Demand
Curve
level leads to a decrease
in output

M
P i d em a n d Y
P

An Increase in the Nominal Money Stock Shifts

Aggregate Demand to the Right
An increase in money
stock shifts the
aggregate demand
curve from AD to AD.
The equilibrium
moves from E to E
resulting in higher
prices rather than
entirely in higher
output.

Aggregate supply

The Aggregate Supply Curve

Aggregate

supply is the total supply of all

goods and services in the economy.
The aggregate supply (AS) curve is a
graph that shows the relationship between
the aggregate quantity of output supplied
by all firms in an economy and the overall
price level.

Aggregate supply

The aggregate supply curve is built up from the

links among wages ,prices, employment and
output.

The Aggregate Supply Curve

The

AS curve describes, for each given price

level, the quantity of output firms are willing to
supply

The

AS curve is upward sloping since firms

are willing to supply more at higher prices

In

the short run the AS curve is horizontal (the

Keynesian AS curve)

In

the long run the AS curve is vertical (the

classical AS curve)

Keynesian & Classical Aggregate

Supply Functions

The Classical AS Curve

The

classical AS curve

Is vertical, indicating that the same amount of

goods will be supplied whatever the price level

Assumption

The labour market is in equilibrium at full

employment and all factors of production are fully
utilised

Implication

Increases in AD do not increase output but merely

raises prices

The Keynesian AS Curve

The

Keynesian AS curve

Is horizontal, indicating firms will supply whatever

amount of goods is demanded at the existing price

Assumption

There is unemployment, so firms may obtain as

much labour as they want at the current wage

Implication

AD determines the level of output, with prices

sticky in the short run.

Fiscal and monetary policy

under alternative supply
assumptions.

Aggregate Demand Expansion:

The Keynesian Case

A fiscal expansion in
Keynesian case
output is perfectly
elastic supply at a
given price level, a
fiscal expansion
increases equilibrium
income from y to y.

Aggregate Demand Expansion:

The Classical Case

The supply of output is

perfectly inelastic at the full
employment level of output Y*.
A fiscal expansion raises
spending, excess demand ,
firms are willing to supply that
much output.
Prices increase lower real
balances, higher interest rate
and reduced private spending.
Full Crowding out in classical
case.

Why wages and prices sticky ?

Wages move slowly over time rather than
being fully and immediately flexible so as
to ensure full employment.
Why wages and prices are adjust slowly to
changes in aggregate demand.
Why output increases when price rises?

Models of aggregate supply

Aggregate supply shows relationship between

price level and output.
Short run Aggregate supply curve is upward
sloping.
Long run Aggregate supply curve is vertical.
Why aggregate supply curve is upward sloping
in short run? various models explain this

Sticky
wage model
The sticky model of upward sloping short run aggregate

supply is based on labor market

Short run wages are set by contracts.
When economy changes, the wages the workers receive
cannot adjust immediately.(wages are sticky)
When price level rises, nominal wage is fixed ,but real
wages fall.
When real wages that firms pay employees falls, labor
becomes cheap, since the amount of output produced
for each unit of labor is still the same, firms choose to
hire more workers and increase revenues and profits.
Firms employs more labors, output increases.

Rational expectations
According
to
rational
expectations,
economic agents such as workers and
firms do not know future with uncertainty
and therefore base their decisions on the
expectations of future.
According to Lucas people can be confused
temporarily by monetary surprises, an
expansion of price level may temporarily
fool workers.

Workers misconception model(Lucas rational

expectations model )

Based on labor market

Price level increases, nominal wages of labor
increases.
Workers in short run are in misconception that
their real wages has increased, but only nominal
wage has increased.
Workers are induced to work more
Output increases.
Thus when price increase output increases
because of workers misperception.

Imperfect
information

Neither the worker nor the firm has complete

information.
In this model producers are concerned to be aware of
the price of the goods and services they produce. They
believe that prices of only their goods and services
increase.
Whereas there is overall price rise, producers mistake
for it for a relative increase in price level.
So it producers more output.

Sticky
price
model

Firms do not adjust their prices instantly to

changes in the economy.
Reasons :

First ,Prices like wages are set in relatively long term

contracts.
Second, firms hold prices stable to keep from annoying
customers .
Third , firms hold prices stable due to menu costs ( printed
catalogues and menus)

Inside outside model

Firms negotiate with the workers who
have jobs, not with the people who are
unemployed.
It is costly for firms to turn over their labor
force-firing cost, hiring costs, training
costs, as a result the insiders have a
advantage over outsiders.

Threatening insiders with unemployment unless they accept wage

cuts is not very effective for two reasons.
People who are threatened may have to give in but they will
respond poorly in terms of morale effort and productivity.
If the firms actually fired high wage workers and brought in
unemployed at low wages, the unemployed would now become
insiders and present exactly the same resistance to wages cuts.
Thus firms would face many costly rounds of labor turnover before
getting labor force.
Far better to deal with insiders than outsiders who are eager to work
for low wages.
Thus this explanation of inside outside model predicts that wages
will not quickly respond to unemployment and this offers a reason
why we do not quickly return to full employment once economy
experiences recession.

Aggregate supply

The theory of aggregate supply is one of the

least settled in macroeconomics, with competing
schools of thought each offering their own
explanations.
Economists
widely
agree
that
wages,
employment, and output adjust only slowly to
changes in aggregate demand, but there are
several explanations for the reasons for the slow
wage and price adjustment.