Revision 2 - AD&AS

Deriving the aggregate demand curve

Aggregate demand shows a negative relationship between price level and real GDP

Aggregate Demand

• We ask what happens to AE as we change the price level

• A fall in the price level shifts AE curve upwards

• A rise in the price level shifts the AE curve downwards

• A new equilibrium level of GDP results in each case

• The reason is

• A rise in the price level lowers exports because it raises the relative price of domestic goods

• A rise in the price level lowers private consumption spending because it decreases the real value of consumers wealth

• Both of these changes lower equilibrium GDP and cause the aggregate demand curve to have a negative slope

• The AD curve plots the equilibrium level of real GDP that corresponds to each possible price level

• A change in equilibrium real GDP following a change in the price level I shown by a movement along the AD curve

Shifts of aggregate demand

• The AD curve shifted when any element of exogenous expenditure changes

• The same multiplier (1/(1-b)(1-t)+m) times the shift in exogenous spending measures the magnitude of the shift

Short run aggregate supply curve

• The short run aggregate supply curve is drawn for given input prices, given technology and fixed capital stock

• It is positively sloped because unit costs rise with increasing output and because rising product prices make it profitable to increase output

• An increase in productivity or a decrease in input prices shifts the SRAS curve to the right and vice versa.

A short run aggregate supply curve

Macroeconomic equilibrium happens when AD and AS intercept each other

Supply shocks

• An aggregate supply shock moves equilibrium real GDP along the AD curve, causing the price level and output to move in opposite directions

• A leftward shift in the SRAS curve causes a stagflation - rising prices and falling output

• A rightward shift causes an increase in real GDP and a fall in the price level

• The division of the effects of a shift in SRAS between a change in real GDP and a change in the price level depends on the shape of the AD curve

An inflationary gap means that actual GDP,Y, is greater than Y and hence excess demand in the labour market

As a result wages rise faster than productivity, causing unit labour cost to rise

The SRAS curve shifts leftward and the price level rises

A recessionary gap means that Y is less than y and hence demand in the labour market is relatively low.

Although the is some resulting tendency for wages to fall relative to productivity, asymmetric behaviour means that this force will be much weaker than in the case of inflationary gap

Unit labour costs will fall only slowly, so the output gap will persist for some time.