Aggregate supply and demand

• The aggregate supply, aggregate demand model is the basic macroeconomic tool for studying output fluctuations and the determination of price-level and the inflation rate. Here we deal with short-run study.

• Aggregate supply: curve describes, for each given price level, the quantity of output, firms are willing to supply.
• The aggregate supply curve is upward sloping because the firms are willing to supply more output at higher prices.
• Aggregate demand: curve shows the combinations of the price level and level of output at which goods and money markets are simultaneously in equilibrium.
• The aggregate demand curve is downward sloping because higher prices reduce the value of the money supply, which reduces the demand for output.

• The intersection of the aggregate demand and aggregate supply curve denotes the equilibrium level of output and equilibrium price level.

Aggregate supply curve

• In the short run, the AS curve is horizontal (the Keynesian aggregate supply curve); in the long run the AS curve is vertical (the classical aggregate supply curve).
• Classical aggregate supply curve is vertical, indicating that the same amount of goods will be supplied whatever the price level.

• This is based on the assumption that the labor market is in equilibrium with full employment of labor force.

• We call the level corresponding to full employment of labor force as potential GDP, \(Y^{*}\). The potential GDP changes every year, but does not depend on the price level. We say that potential GDP is “exogenous with respect to the price level”.
• The potential GDP grows over time as the economy accumulates resources adn technology improvements. Hence the position of the classical aggregate supply curve moves to the right over time.
• Keynesian aggregate supply curve: is horizontal; indicating that the firms will supply whatever amount of goods is demanded at the existing price level.
• One way to explain is that, because there is unemployment, firms can obtain as much labour as they want at the current wage; their average cost of production therefore are not to change as their output levels change. They, accordingly, are willing to supply as much as is demanded at the existing price level
• Short-term price stickiness: In short term, the firms are reluctant to change prices (or wages) when demand shifts. Instead, at least for a while, they increase or decrease the output.

• On a Keynesian aggregate supply curve, the price level does not depend on GDP.

• The classical model implies that there is no unemployment. In equilibrium, everyone who wants to work is working. Because it takes time for an individual to find the right new job, there will always be some frictional unemployment as people search for jobs.

• There is some unemployment associated with the full-employment level of employment and the corresponding full-employment (or potential) level of output, \(Y^{*}\). The amount of unemployment is called natural rate. The natural rate of unemployment is the rate of unemployment arising from normal labor market frictions that exist when the labor market is in equilibrium.

Aggregate demand curve

• Expansionary policies such as increases in government spending, cuts in taxes, and increases in money supply, etc, moves the aggregate demand curve to the right. Consumer and investor confidence also affects the aggregate demand. When the confidence increases, the curve goes towards the right.
• Real value money supply is the value of money provided by central bank and the banking system.
• If the number of dollars in money supply is \(\bar{M}\) and the price level be \(P\), then the real money supply is \(\bar{M}/P\). When \(\bar{M}/P\) rises, interest rates fall and the investment rises, leading to an overall increase in aggregate demand. Analogously, the lowering of \(\bar{M}/P\) lowers investment and overall aggregate demand.
• For given price level, as \(P\) increases, \(\bar{M}/P\) decreases and thus the aggregate demand decreases. For convenience, we show it as a straight line.