Lecture 13 - Aggregate Demand and Supply

Represents the combinations of price levels and real GDP that clear both the money and goods markets.
Points on the aggregate demand curve correspond to intersections of IS and LM curves at various price levels.
The model begins with fixed interest rates, prices, and wages, transitioning to price flexibility in the short run.
In the long run, wages also become flexible.

The aggregate demand curve is derived by examining how changes in the price level affect the intersection of the IS and LM curves.
If the price level increases, the LM curve shifts left (due to a decrease in real money supply) leading to a decrease in real GDP.
For instance, if the price level is at $p0$ , the corresponding output is $y0$ .
As prices change from $p0$ to $p1$ , real GDP alters to $y_1$ due to the leftward shift of the LM curve, establishing another point on the AD curve.
If prices decrease (e.g. drops to $p_2$ ), the LM curve shifts right, leading to a higher output level.

The aggregate demand curve shifts in response to changes other than the price level.
Increase in Money Supply:
- An increase in money supply (e.g., from $m$ to $m'$ ) causes the LM curve to shift right, resulting in a higher equilibrium output ( $y0'$ ) with the same initial price level $p0$ , shifting the aggregate demand curve to the right.
Increase in Spending:
- Rising consumption, investment, or government spending shifts the IS curve to the right, altering the equilibrium output at the same price level.

The short-run aggregate supply (SRAS) reflects how much output firms are willing to produce at given price levels while nominal wages remain fixed.
In the long run, the aggregate supply curve becomes flexible, indicating adjustments in output as wages change.

Firms determine output based on the labor hired, maximizing profits where the marginal product of labor equals the real wage ( $w/P$ ).
Example: For a pizza shop, the output increases with hiring, indicating diminishing marginal productivity.
To derive the SRAS, consider how output changes with various price levels, keeping wages fixed. As price increases, the real wage decreases, allowing firms to hire more labor and produce more output, resulting in a movement along the SRAS curve.

An increase in productivity shifts the production function upward, leading to higher outputs at every level of input, meaning firms are incentivized to hire more labor.
Worker productivity can increase due to technology advancements, improved processes, or enhanced capital.

Shifts occur due to factors such as changes in productivity, input costs, and wages.
Rightward Shifts: Increased productivity, decreased input costs, or a decrease in wage rates can shift the AS curve right.
Leftward Shifts: Increased wages, increased energy prices, or decreased technological advancements shift the AS curve left.

Aggregate supply is influenced by changes in labor costs, energy prices, productivity, and technology.
Aggregate demand responds to changes in consumption, investment, government expenditure, imports/exports, and overall economic sentiment.
The value of the dollar affects both curves: a depreciation shifts AD to the right (increased exports) but shifts AS to the left (higher import costs).

Understanding these dynamics helps in predicting how policy changes or external factors will influence overall economic activity.