MAC 15&16

Aggregate Demand and Supply

Define and derive AD curve in P-Y plane
The slope and position of the AD curve
Impact of Fiscal Policy on AD curve
Impact of Monetary Policy on AD curve

Equilibrium in case of Classical and Keynesian Supply

Curve; Impact of Fiscal and Monetary Policy on such
equilibrium

1
• Macroeconomics is concerned with behaviour of
economy: inflation, recession, growth, boom ,
depression, etc.
• The AD/AS model is the basic macroeconomic tool for
studying output fluctuations and the determination of
the price level and the inflation rate
• Aggregate supply and demand each describe a
relation between overall price level(GDP deflator) and
output(GDP)
5-2
 Deriving the AD Schedule
• Aggregate demand curve shows
combinations of price level and
output at which the goods and
[Insert Figure 10-13 here]
money markets are
simultaneously in equilibrium
• AD schedule maps out the IS-LM
equilibrium holding autonomous
spending and the nominal money
supply constant and allowing
prices to vary
– Suppose prices increase from P1 to P2
• M/P decreases from M/P1 to
M/P2  LM curve shifts from
LM1 to LM2
• Interest rates increase from i1 to
i2, and decreases output from Y1
to Y2
• Corresponds to lower AD
10-3
 AD Relationship Between
Output and Prices
• Key to the AD relationship between output and prices is the dependency of AD on real money
supply
– Real money supply = value of money provided by the central bank and the banking system
– Real money supply is written as M
where is the nominal money supply, and P is the
price level
M
P
–
M
P    i   I   AD 
P
• and
M
P     i   I   AD 
P
M
• For a given level of ,Mhigh prices result in low OR
P
• High prices mean that the value of the number of available rupees is low and thus a high P = low
level of AD

Inverse relationship between P and Y  downward sloping AD curve

 AD and the Money Market
• If we ignore the goods market and focus on the money
market downward sloping AD curve can be easily
determined
• The quantity theory of money offers a simple explanation
of the link between the money market and AD
– The total number of rupees spent in a year, is the Nominal GDP,
which is P*Y
– The total number of times the average rupee changes hands in a
year is the velocity of money, V
– The central bank (i.e., the RBI) provides M rupees
M V  P  Y
®The fundamental equation underlying the quantity
theory of money is the quantity equation: (2)
 AD and the Money Market
M V  P  Y
(2)
Misassumed
(A) If the velocity of money V  P constant,
Y then
equation (2) becomes , and if Y too is a constant at the
full-employment level of Yf , then equation (2) is the ‘Quantity Theory
Equation’ which alleges neutrality of money – i.e. , changes in money supply
will change the nominal variables in a proportionate manner, but leave the real
variables unchanged. Interpretation (A) is by Classicals.
(B) However, if only the velocity of money, V, is a constant, and Y is not a constant,
then for a given level of M, an increase in Y must be offset by a decrease in P, and
vice versa, i.e. , equation (2) defines the AD curve
– Inverse relationship between Y and P as illustrated by downward sloping AD
curve . Interpretation (B) is by Keynesians.
• An increase in M shifts the AD curve upward for any value of Y
 AD and AS
• Aggregate demand curve shows the combinations of the
price level and the level of output at which the goods
and money markets are simultaneously in equilibrium
– Downward sloping since higher prices reduce the value of the
money supply, which reduces the demand for output
• Aggregate supply curve describes, for each given price
level, the quantity of output firms are willing to supply
– Upward sloping since firms are willing to supply more output
at higher prices
– Can also be derived using Phillip’s curve
 The Phillips Curve
• In 1958 A.W. Phillips published a
study of wage behavior in the [Insert Figure 6.2 here]
U.K. between 1861 and 1957
– The main findings are summarized
in Figure
® There is an inverse relationship
between the rate of unemployment
and the rate of increase in money
wages
® From a policymaker’s perspective,
there is a tradeoff between wage
inflation and unemployment
® Choose between low inflation high
unemployment, or high inflation
low unemployment
® Inflation zero at natural rate of
unemployment
• Short run AS derived from Phillip’s curve in four steps
• Output assumed proportional to employment
• Prices set up as a mark-up over costs
• Wage is the main element of cost and adjusts
according to Phillips curve
• Phillips curve relation between wage and
unemployment transformed into relationship between
price level and output
– Less unemployment, high wage
– Means high output, high wage
– Means high output, high price level
– Therefore upward sloping supply curve

9
 AD, AS, and Equilibrium
• Intersection of AD and AS
curves determines the
equilibrium level of output and [Insert Figure 5-1 here]
price level
• AD and AS intersect at point E
in Figure (in the adjacent window)
 Equilibrium: AD = AS
– Equilibrium output is Y0
• Observed level of output in
the economy at particular
point in time
– Equilibrium price level is P0
• Observed price level in the
economy at particular point
in time
 AD, AS, and Equilibrium
• Shifts in either the AS or AD [Insert Figure 5-2 here]
schedule results in a change in
the equilibrium level of prices
and output
– Increase in AD  increase in P
and Y
– Decrease in AD  decrease in P
and Y
– Increase in AS  decrease in P
and increase in Y
– Decrease in AS  increase in P
and decrease in Y
Figure illustrates an increase
in AD (i.e., rightward shift in AD)
resulting from an increase
in money supply.
 AD, AS, and Equilibrium
 The amount of the
increase/decrease in P and Y [Insert Figure 5-3 here]
after a shift in either
aggregate supply or aggregate
demand depends on:
1. The slope of the AS curve
2. The slope of the AD curve
3. The extent of the shift of AS/AD

Figure shows the result of an

adverse AS shock(1973 oil
embargo , for example):
AS  Y, P
 Classical Supply Curve
• The classical supply curve is [Insert Figure 5-4 here]
vertical, indicating that the
same amount of goods will be
supplied, regardless of price
[Figure (b)]
– Based upon the assumption
that the labor market is in
equilibrium with full
employment of the labor force
– The level of output
corresponding to full
employment of the labor force
= potential GDP, Y*
Long run version of the AS curve
 Classical Supply Curve
• Y* grows over time as the [Insert Figure 5-5 here]
economy accumulates
resources and technology
improves  AS curve moves
to the right
– The growth theory models
explain the level of Y* in a
particular period
• Y* is “exogenous with respect
to the price level”
 illustrated as a vertical line
since graphed in terms of the
price level
 AS and the Price Adjustment Mechanism
• AS curve describes the price adjustment mechanism within
the economy
*
• The AS curve is defined by the equation: Pt 1  Pt [1   (Y  Y )]
(1) where Pt+1 is the price level next period, Pt is the price
level today, and Y* is potential output
 AS and the Price Adjustment Mechanism
Pt 1  Pt [1   (Y  Y * )]
• If output is above potential (Y>Y*), prices increase, higher
next period
• If output is below potential (Y<Y*), prices fall, lower next
period
• Prices continue to rise/fall over time until Y=Y*
 AS and the Price Adjustment Mechanism
Pt 1  Pt [1   (Y  Y * )]
• Upward shifting horizontal lines in Figure 5-6 (b) correspond
to successive snapshots of equation (1)
• Process continues until Y=Y*
 AS and the Price Adjustment Mechanism
Pt 1  Pt [1   (Y  Y * )]
• Speed of the price adjustment mechanism controlled by 
• Policy implication: If  is large, the AS mechanism will return
the economy to Y* relatively quickly; if  is small, might want to
use AD policy to speed up the adjustment process
 Keynesian Supply Curve
• The Keynesian supply curve is [Insert Figure 5-4 here, again]
horizontal, indicating firms will
supply whatever amount of
goods is demanded at the
existing price level [Figure (a)]
– Since unemployment exists,
firms can obtain any amount of
labor at the going wage rate
– Since average cost of production
does not change as output
changes, firms willing to supply
as much as is demanded at the
existing price level
 Keynesian Supply Curve
• Intellectual genesis of the horizontal Keynesian AS curve is found in
the Great Depression, when it seemed firms could increase
production without increasing P by putting idle K (i.e., capital) and N
(i.e., labor) to work
• Additionally, wages and prices are viewed as sticky (in fact,
completely rigid !) in the short run, as firms are not required to offer
higher wages when they increase employment to produce more and,
therefore, reluctant to charge higher prices from consumers when
demand shifts
– Instead firms readily increase/decrease output in response to
shifts in demand, i.e., there is a flat AS curve in the short run

Short run version of the AS curve

 Frictional Unemployment and the Natural
Rate of Unemployment
• Taken literally, the classical model implies that there is no
involuntary unemployment  everyone who wants to work
is employed
– In reality there is always some unemployment due to frictions in
the labor market (Ex. Someone is always moving and looking for a
new job)
• The unemployment rate associated with the full
employment level of output is the natural rate of
unemployment
– Natural rate of unemployment is the rate of unemployment
arising from normal labor market frictions that exist when the
labor market is in equilibrium
 AD Curve and Shifts in AD
• AD shows the combination of [Insert Figure 5-8 here]
the price level and level of
output at which the goods and
money markets are
simultaneously in equilibrium
• Shifts in AD due to:
1. Policy measures, such as,
Changes in G, t, and MS
2. Consumer and investor
confidence

Figure shows an outward shift in

AD resulting from an increase in G (or Note : The shift in AD in case of an
expansionary monetary policy (EMP)
a decrease in t) or an increase in the will NOT be a paralell shift.
money supply. WHY? Instead, AD will shift to the right,
but will be tapering downwards
 Changes in the Money Stock and AD
• An increase in the nominal
money stock shifts the AD [Insert Figure 5-8 here, again]
schedule up exactly in
proportion to the increase in
nominal money
– Suppose M 0 corresponds to AD
and the economy is operating at
P0 and Y0
– If money stock increases by 10%
to M   1.1M 0 , AD shifts to AD’ 
the value of P corresponding to Y0
must be P’ = 1.1P0
– Therefore M   1.1M 0  M 0  real
P 1.1P0 P0
Note : The shift in AD in case of an EMP
money balances and Y are will NOT be a paralell shift.
unchanged Instead, AD will shift to the right,
but will be tapering downwards.
 Fiscal and Monetary Policy with the
Keynesian Supply Curve
• Figure 5-9 shows the AD schedule and [Insert Figure 5-9 here]
the Keynesian supply schedule
– Initial equilibrium is at point E (AS
= AD, goods and money markets
are in equilibrium )
– Suppose there is an expansionary
fiscal policy (EFP) / expansionary
monetary policy (EMP)

• GAD shifts to

, and/or , and/or  M 
 TAD’ S

• The new equilibrium point, E’,

corresponds to the same price
Note that in case of EFP , output rises,
level, and a higher level of interest rate rises,
output (employment is also but prices remain unchanged.
likely to increase) However, in case of EMP, output rises, real
balance increases, interest rate declines,
but prices remain unchanged.
 AD Policy & the Classical Supply Curve
• In the classical case, AS
schedule is vertical at FE
level of output
• The price level is not given,
but depends upon the
interaction between AS and
AD
• If AD increases to AD’,
spending increases to E’
BUT firms can not obtain
the N required to meet the
increased demand
 AD Policy & the Classical Supply Curve
• Firms hire more workers &
wages and costs of
production rise  firms
must charge higher price
• Move up AS and AD curves
to E’’ where AS = AD’
• Prices increase and real
money stock and spending
decrease
• Economy moves up AD until
price and M/P adjustments
reduce total spending to a
level consistent with full
employment
 Fiscal and Monetary Policy with the
Classical Supply Curve
• In the classical case, AS schedule is [Insert Figure 5-10 here]
vertical at FE(full employment ) level of
output
– Unlike the Keynesian case, the price
level is not given, but depends upon the
interaction between AS and AD
• Suppose AD increases to AD’:
– At the original price level, spending
would increase to E’ BUT firms can not
obtain the N required to meet the
increased demand
– As firms hire more workers, wages and
costs of production increase, and firms Note that in case of EFP , output cannot
must charge higher price increase, the impact of increase in AD is
– Increase in demand for goods leads only completely transmitted to a rise in prices.
The real balance then falls, causing a leftward
to higher prices, and not higher output shift in the LM curve. Hence , interest rate
– Move up AS and AD curves to E’’ where rises, which pulls down private investment.
AS = AD’ The increase in government expenditure is
RESULT: Increase in AD results thus completely crowded out.
 Fiscal and Monetary policy with the
Classical Supply Curve
• The increase in price from the [Insert Figure 5-10 here]
increase in AD reduces the real
money stock,   MP  , and
 
leads to a reduction in
spending
– The economy only moves up AD’
schedule until prices have risen
enough, and M/P has fallen
enough, to reduce total spending
to a level consistent with full
employment  this is to E’’, Note that in case of EMP , output
cannot increase, the impact of
where increase in AD is completely
AD = AS transmitted to a rise in prices. The
real balance, however, remains
unchanged. Hence , interest rate
also remains unchanged.
Fiscal and Monetary Policy with Keynesian and
Classical Supply Conditions
The Effects of a Fiscal Expansion
Aggregate output Interest rate prices Real
Supply Balance

Keynesian + + 0
(horizontal AS
curve)
Classical 0 + +
(vertical AS
curve)

The Effects of a Monetary Expansion

Keynesian + - 0 +
Classical 0 0 + 0