Chapter

Aggregate Demand and

Aggregate Supply

Hồ Thị Hoài Thương

Email: thuonght@ftu.edu.vn
 Chapter objectives
• The model of aggregate demand and aggregate supply
• How does the model of aggregate demand and
aggregate supply explain economic fluctuations?

2
1. Introduction
• Economic activity fluctuates from year to year
– Expansion: period of rising production of goods and
services and falling unemployment
– Recession: period of falling production of goods and
services and rising unemployment

• Short-run economic fluctuations are often called

business cycles. Business
Economic cycle
activity

Time 3
1. Introduction
• Most economists use the model of
aggregate demand and aggregate supply
to study fluctuations.

4
2. The Model of Aggregate Demand and Aggregate
Supply
P

SRAS
“Short-Run
The model P1 Aggregate
determines the Supply”
...
AD “Aggregate
Demand”
and eq’m ... Y
Y1

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2.1 Aggregate Demand curve (AD)
• Recall, AD curve shows the ...
in the economy at any given price level.

• The AD curve slopes downward for three

reasons:
–
–
–

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The AD Curve
P

P2

P1
AD

Y
Y2 Y1

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 The AD Curve
Any event that changes C,
I, G, or NX P
– except a change in P –
will ... the AD
curve.
P1

AD2
AD1
Y
Y1 Y2

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2.2 Aggregate-Supply curve (AS)
AS curve shows the P
total quantity of g&s
firms produce and sell
at any given price level.

AS curve is:
▪ ...
in short run
▪ ...
in long run Y

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a. The Long-Run Aggregate-Supply Curve (LRAS)

The natural rate of P LRAS

output (YN) is the
amount of output
that an economy
achieves ...

YN is also called
potential output or
full-employment output. Y
YN

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 Why LRAS Is Vertical
YN determined by the P
economy’s stocks of
labor, capital, natural
resources, and on the
level of technology. P2
An increase in P
P1
....
any of these, so
it ... YN
Y
YN

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 Why the LRAS Curve Might Shift
Any event that changes P
any of the determinants
of YN will shift LRAS.
Example: Immigration
… L,
causing YN to …, the
LRAS curve shifts…

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b. Short Run Aggregate Supply (SRAS) curve
The SRAS curve P
is ...
an increase in P SRAS
causes an increase P2
in the quantity of
g & s supplied.
P1

Y
Y1 Y2

13
Why the Aggregate-Supply Curve Slopes Upward in the
Short Run
• Three Theories:
– The Sticky-Wage Theory
– The Sticky-Price Theory
– The Misperceptions Theory

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 The Sticky-Wage Theory
– Nominal wages are slow to adjust to changing
economic conditions, or are “sticky” in the short run
– Firms and workers set the nominal wage in
advance based on PE, the price level they
expect to prevail.
– If P > PE,
– Hence, higher P causes ... Y, so the SRAS curve
...

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 The Sticky-Wage Theory
• The theory suggests that output deviates in
the short run from the natural rate when the
actual price level deviates from the price
level that people had expected to prevail.

Quantity
of output =
supplied

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 Why the SRAS Curve Might Shift
1. Factors of production that shifts LRAS shifts
SRAS, too.
2. PE shifts SRAS
If PE rises, workers & firms set … wages,
cost of production … , Y …, SRAS shifts ...

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 Question
Explain whether each of the following events
shifts SRAS curve, LRAS curve or AD curve.
a.

b.

c.

d.

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18
2.3 Equilibrium in the AS-AD model
a. The Short-Run Equilibrium
P
SRAS

P1
The model
determines the
eq’m AD

Y
Y1
and eq’m

19 19
2.3 Equilibrium in the AS-AD model
b. The Long-Run Equilibrium
LRAS
P
SRAS

P1

AD
Y
Y=YN

20 19
3. How the AS–AD model is used to analyze economic fluctuations

•Two causes of economic fluctuations: shifts in AD

curve and shifts in SRAS curve.
•To keep things simple, we assume that the
economy begins in the long run equilibrium.

21 19
3. How the AS–AD model is used to analyze economic fluctuations

• Four steps for analyzing economic fluctuations:

1. Determine whether the event shifts AD or SRAS (left or
right)
2. Use AD-AS diagram to see how the shift changes Y and P in
the short run.
3. Use AD-AS diagram to see how policymakers take actions to
stabilize the economy
4. Use AD-AS diagram to see how economy moves from new
SR eq’m to new LR eq’m if policymakers do nothing

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3.1 The Effects of a Shift in AD (Demand shock)

• Negative demand shock – AD curve shifts

to the ...
• Positive demand shock – AD curve shifts
to the ...

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a. Negative demand shock
Event: Stock market crash
Step 1: Affects ..., P LRAS

C …, so … shifts … SRAS1

P1 A

Step 2: SR eq’m at .... AD1

P and Y are …,
… is higher Y
YN

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a. Negative demand shock
Step 3: Policymakers respond to a negative demand shock
P LRAS
SRAS1

P1 A

AD1

Y
YN

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a. Negative demand shock
Step 4: Over time, …
unemployment causes wages
to …, P LRAS
SRAS shifts …,
until LR eq’m at .... SRAS1
Y and unemp back
at initial levels.
P1 A

AD1

Y
YN

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b. Positive demand shock
Event: Stock market boom
Step 1:

Step 2:

Step 3:

Step 4:
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 Summary
Demand AD curve Output Price level Policy of
shock shift to (inflation) government

Negative Left Decline (short Fall Shift AD to the

run) (short run) right
Unchanged (long Fall further
run) (long run)

Positive Right Rise (short run) Increase (short Shift AD to the

Unchanged (long run) left
run) Increase further
(long run)

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3.2 The Effects of a Shift in AS (Supply shock)
• Negative supply shock – SRAS curve shifts to the
left
• Positive supply shock – SRAS curve shifts to the
right

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a. Negative supply shock
Event: Oil price rises
Step 1: Increases ...., P LRAS
shifts …
(assume LRAS
constant) SRAS1

P1 A
Step 2: SR eq’m at ....
P is …, Y is …,
unemp is …(stagflation) AD1
Y
YN

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 a. Negative supply shock
Step3: Policymakers respond to a negative supply shock
P
LRAS

SRAS1

P1

AD1

YN Y

Policymakers have 2 choices:

(1) decrease AD → shift AD to the left → keep P unchanged but Y
declines further
(2) increase AD (accommodate the AS shift) → shift AD to the
right → keep Y unchanged but P rises further 31
a. Negative supply shock

Step 4:........unemployment P LRAS

causes wages to …, SRAS
shifts …,
until LR eq’m at ….
SRAS1

P1 A

AD1
Y
YN

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b. Positive supply shock
•Event: Oil price falls
Step 1:

Step 2:

Step 3:

Step 4:
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 Summary

Supply SRAS Output Price level Policy of government

shock curve (inflation)
shift to

Negative left Decline Rise (1) Increase AD so that Y unchanged but

(short run) (short run) P increases further
Unchanged Unchanged (2) Decrease AD so that P unchanged but
(long run) (long run) Y decreases further

Positive right Rise Decline (1) Increase AD so that P unchanged but

(short run) (short run) Y increases further
Unchanged Unchanged (2) Decrease AD so that Y unchanged but
(long run) (long run) P decreases further

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 CHAPTER SUMMARY
• This chapter has introduced the model of
aggregate demand and aggregate supply,
which helps explain economic fluctuations.
• According to this model, the output of goods
and services and the overall level of prices
adjust to balance aggregate demand and
aggregate supply

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