11th IB Economics

Chapter 8: Aggregate Demand and Aggregate Supply

  • 8.1 The business (trade) cycle: economic fluctuations

Understanding the business (trade) cycle
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Business trade cycles: consist of growth of real output, consisting of alternating periods of expansion and contractions. Business cycles are commonly denominated as trade cycles, or economic fluctuations.
*Expansion: Increasing real output.
*Contraction: Decreasing real output.

The phases of the business(trade) cycle:
  1. Expansion: this phase occurs when a positive growth occurs in the real GDP. During this phase employment of resources increases and the general price level of the economy usually begins to rise more rapidly than in previous periods.
  2. Inflation refers to an increase in the general price level.
  3. Peak: This is the period in the cycle where maximum level of GDP is reached. This marks the end of expansion. In this period unemployment of resource fall substantially, and the general price level might rise quite rapidly. In simple word the economy might be experiencing inflation.
  4. Contraction: Right after the peak phase the economy faces the falling of real GDP. If this contraction lasts more than six moths it is called a recession. The increase in the price level may slow down, and eventually some sectors might begin o fall. (Might no always happen; contractions are frequently accompanied by increasing price levels or inflation)
  5. Trough: This phase represents the minimum or borderline level of GDP. Meaning contraction has reached its end. Unemployment might be widespread, after trough comes expansion once again; this is the beginning of a new cycle.
*As real GDP increases, unemployment falls, and as real GDP falls, unemployment increases.
*Each cycle last several years.
Even though the terms ‘’business cycle’’ seems to state that is its predictable and regular. They are the total opposite, since they do not occur in regular time intervals, and are very unpredictable. This is why the term economic fluctuations is preferred. In a cycle cannot be generalized, because the intensity and time can widely vary.

  • 8.2 The aggregate demand and aggregate supply model in the short run

  • The AD-AS model in some ways resembles the microeconomic “supply and demand” curves; though when it comes to this model appearances are indeed deceiving. The point of controversy in the area of macroeconomics arises during its interpretation. This is due to the different theoretical perspectives that exist:

Neoclassical & Keynesian
  • Which may come to no surprise; that they reach different conclusions as to what policies the government must pursue to achieve the three macroeconomic goals.

Aggregate Demand and the Aggregate Demand Curve
  • Aggregate Demand: Is the total quantity of real GDP that the consumers, government, firms, and foreigners are willing to buy at different price levels; during a particular time period ceteris paribus.
  • Curve: Depicts the negative relationship between the total amount of real GDP demanded in the economy by the 4 components; during a certain period of time, ceteris paribus.
  • Demand of:
Consumers (C)
Businesses (I)
Government (G)
Foreigners (X- M)
C+ I + G+ (X-M)
• GDP= spending by 4 components, for a particular price level.
• Yet as price levels change, so does the spending. Due to this the aggregate curve displays the amount of real GDP the components are willing to buy at different price levels.
Downward Slope
  • The Wealth Effect: A higher price level reduces the purchasing power of financial wealth. Assets such as stocks, bonds, cash, which shrinks the amounts you can buy. Thus, higher average prices reduce the amount of domestic production sold along an Aggregate Demand curve.
  • Interest Rate Effect: changes in price level affect levels of interest .
Meaning the amount of borrowing required to finance a major purchase rises; if the price level rises. Higher price levels increase the demand for more money (loan able funds); which consequently increases the interest rate. This in turn reduces consumer investments.; since no one wants to spend more money than necessary.
§ International Trade Effect: An increase in price levels increase in the domestic economy, while other countries remain the same. Export will be more expensive, hence the demand will fall.
  • Shifts to the right {AD1 to AD2} when Aggregate Demand increases. Larger amount of GDP is demanded, for any particular price.
  • Shifts to the Left {AD1 to AD3} When Aggregate Demand decreases. Less real GDP is demanded; at any price level.
  • Is mainly caused by any factor that produces a chain in one of the 4 components.

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Aggregate Supply and the Short-run A-S curve
  • Short- Run: period in which nominal prices of resources (wages); do not change in response to a changes in price level. {resource prices are constant}
  • Long-Run: In this case even resources, change to reflect the change in price level.
  • Aggregate Supply: The amount of total goods and services supplied at a given price level.
  • There is a difference in the decision of how much firms produce in the long and short run.
  • “SRAS” Curve: displays the positive relationship between price level and quantity of real GDP, produced by firms when resource prices do not change.

Changes in short-run aggregate supply (shifts in the SRAS curve)

A movement on the SRAS curve occurs when there is a change in the price level.

Shifts from SRAS1 to SRAS2:
  • Rightward shift: short-run aggregate supply increases (this happens when the firms produce a LARGER quantity of real GPD).

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  • Leftward shift: short-run aggregate supply decreases (this happens when the firms produce a SMALLER quantity of real GPD).

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There are 5 factors that can cause these shifts:

1. Changes in wages:
- Changes in minimum wage legislation
- Changes brought about by labour union bargaining with employers

Nominal wages increases ---> firms' cost of production rises ---> leftward shift
Wages decrease ---> firms' cost drop ---> rightward shift

2. Changes in non-labour resource prices:
- Price of oil
- Price of equipment
- Price of capital goods
- Price of land inputs

Increase in the price ---> leftward shift
Decrease in the price ----> rightward shift

3. Changes in business taxes - firm profits

Higher taxes profits ---> increases in production costs ---> leftward shift
Lower taxes profits ---> lower production costs ---> rightward shift

4. Changes in subsidies offered to businesses:

What does subsidy mean?
Subsidy is a sum paid by one government to another to secure some service in return. In this case, it involves money transferred to firms from the government.

Increase in subsidy ---> rightward shift
Decrease in subsidy ---> leftward shift

5. Supply shocks:

What are supply shocks?
These are events that have a strong and abrupt impact on short-run aggregate supply.

Adverse supply shocks ---> leftward shift (e.g. war or violent conflict)
Beneficial supply shocks ---> rightward shift (e.g. major oil discovery)

  • E- intersection between SRAS (short-run aggregate supply) curve and AD (aggregate demand).
  • The P at the middle is Pe, which is the equilibrium price level.
  • Ye is the equilibrium level of real GPD.
  • When this intersection occurs, there is equilibrium of real GPD.
  • This determines the price level (the level of real GPD & the level of employment)

Increase in real GPD ---> firms hire more labour ---> unemployment decreases
Decrease in real GPD ---> firms need fewer labour resources ---> unemployment increases

The P closest to the origin (P1) - excess quantity of real GPD being supplied ---> downward pressure on the price level
The P farthest to the origin (P2) - excess quantity of real GPD demanded ---> upward pressure on the price level
The P at the middle (Pe) ---> quantity of real GPD supplied = quantity of real GPD demanded


Short-run equilibrium level of prices and output

· Equilibrium level of real GDP- The intersection between AD and SRAS.
· GDP increases ---> firms hire more labor ---> Unemployment decreases
· GDP decreases ---> firms hire less labor ---> Unemployment increases

Changes in short-run equilibrium
· Whenever there is a change in AD or SRAS, it changes.
· Increase in AD ---> Rise in price level & in real GDP ---> Fall in unemployment
· Decrease in AD ---> Fall in price level & in real GDP ---> Rise in unemployment
· Rightward shift in SRAS ---> Rise to a lower price level, a higher level of real GDP & a lower unemployment
· Leftward shift in SRAS ---> Increase in price level, fall in real output & a higher unemployment

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Recessionary (deflationary) gaps, inflationary gaps and short-run full employment equilibrium

1. Recessionary (deflationary) gap:
a. Real GDP < Potential GDP
b. Unemployment > the natural rate of unemployment
c. There isn’t enough total demand
2. Inflationary gap:
a. Real GDP > potential GDP
b. Unemployment < the natural rate of unemployment
c. There is too much total demand
3. Full employment level of real GDP:
a. In equilibrium; real GDP = potential GDP
b. Unemployment = the natural rate of unemployment

Shifts in AD or SRAS: possible causes of the business cycle

1. Recessionary gap:
a. Fall in AD; AD shifts leftward; Real GDP < Potential GDP; Unemployment increases
b. Rise in AD; AD shifts rightward; Real GDP > Potential GDP; Unemployment decreases
2. Fall in SRAS ---> Rightward shift à Rise in economic contraction ---> Rise in unemployment
3. Rise in SRAS ---> Leftward shift à Rise in economic expansion ---> Fall in unemployment
4. Stagflation: a combination of the words “stagnation” with “inflation”
a. Undesirable events:
o Economic contraction with unemployment
o A rising price level
b. Desirable developments:
o Economic expansion and increasing employment
o A falling price level

  • 8.3 Macroeconomic controversies: the neoclassical perspective

· Key points:
o Importance of the price mechanism in coordinating economic activities
o The concept of perfectly competitive market equilibrium
o The conceptualization of the economy as a harmonious system


Defining the long-run aggregate supply curve and long-run macroeconomic equilibrium
· The long-run aggregate supply (LRAS) curve is vertical at potential GDP
· When is the economy in long-run equilibrium?
o When the AD curve and LRAS curve intersect

Why is the LRAS curve vertical?
It’s vertical, because costs of production remain constant; therefore firms’ profits are also constant

Why the LRAS curve is situated at the level of potential GDP (or why inflationary and deflationary gaps cannot persist in the long run)
· Recessionary and inflationary gaps are only short-run phenomena, because the LRAS curve is vertical
· This is also the reason why recessionary and inflationary gaps cannot persist in the long run
· They eventually disappear, which leads the economy towards full employment equilibrium

Why in the long run aggregate demand influences only the price level, leaving real GDP unchanged
· Another principle of the neoclassical interpretation of the AD-AS model:
o “Changes in AD can have an influence on real GDP ONLY in the short run; in the long run, they only result in increases in the price level, having no impact on real GDP, as this remains constant at the level of potential output and the LRAS curve.” (Pg. 239)
· AD falls à Price level falls à Real GDP remains unchanged
· AD rises à Price level rises à Real GDP remains unchanged


Economic growth in the AD-AS model
---> A rightward LRAS curve shift indicates an increase in real GDP ---> Positive economic growth
---> A leftward LRAS curve shift indicates a decrease in real GDP ---> Negative economic growth
Shifts to the right factors:
· Increases in efficiency
· Reductions in the natural rate of unemployment
Shifts to the left factors:
· Increases in the quantities of the factors of production
· Improvements in the quality of factors of production (resources)
· Improvements in technology

The relationship between the SRAS and LRAS curve
· Economic growth:
o LRAS curve shifts rightward ---> Increase in potential output
o SRAS curve shifts rightward
· Any factors that shift the LRAS curve will also shift the SRAS curve

  • 8.4 Macroeconomic controversies: the Keynesian perspective

It is based on the work of John Maynard Keynes, who was one of the most famous economists of the 20th century.


Wage and price downward inflexibility
· Principle: All resource prices are fully flexible and respond to the forces of supply & demand
· According to the Keynesian perspective:
o In an economic expansion: Unemployment lower than the natural rate + a rising price level à Wages move upward
o In a recessionary gap: Unemployment greater than the natural rate ---> Wages don’t fall easily
o Price levels are also inflexible in downward directions

The inability of the economy to move into the long run
Inflexible wages and price levels lead to inability to eliminate recessionary gap, which means that the economy is unable to move in the long run.

The shape of the Keynesian aggregate supply curve
Three segments:
· Segment I (Keynesian Range):
o Real GDP is low
o Price level is constant, while real GDP increases
o Significant amount of unemployment resources
· Segment II (Intermediate Range):
o While real GDP increases, AS curve rises
o Increases in real GDP are accompanied by increases in price level
o Output increases, while the employment of resources increases
o Growing output gives rise to an increasing price level
· Segment III (Classical Range):

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o GDP cannot increase anymore
o Price level increases in a very rapid rate
o Firms use max. amount of labor and other resources, which is the reason why price level can increase

  • 8.5 Some final observations.

Policy implications of the Neoclassical and Keynesian perspectives

The business cycle and government policy in the Neoclassical Perspective
    • The economy is viewed as a stable system that is inclined towards long-run equilibrium where there is full employment (at the natural rate of unemployment). Reason as to why the system is viewed to possess a fixed tendency to revert to long-run equilibrium on its own.
    • Due to the fact that short-term fluctuations {Recessionary/ Inflationary gaps} are viewed to correct themselves; the government feels no need to intervene and fix them. For if they were to apply policies intended to reduce the fluctuations of the business cycle, they believe the results would eventually backfire.
    • Thus the government believes that they in-turn should:
- Promote competition between the markets, so that resources and output prices respond to forces of supply demand (change in price level); which will allow the economy to settle at its point of long-run equilibrium.
- Implement policies that influence the supply side of the economy, to promote the right-shift of the LRAS curve. To achieve increases in real GDP without causing inflation.

The business cycle and government policy in the Keynesian Perspective
    • The economy; in this perspective is viewed as an unstable system that does not possess the ability for short-term fluctuations to auto-correct themselves.
    • These fluctuations are viewed to be resultant of changes in investment spending (a shift in Aggregate Demand curve), due to spontaneous actions of the consumers in terms of their expectations of the future.
    • The government must intervene particularly when there is a recessionary gap by:
- Focus on policies that promote an increase in aggregate demand (right shift of AD); to avoid long periods of high unemployment and low levels of GDP.
The mainstream perspective
Now-a-days it is impossible to accurately label economists as neoclassical or Keynesian since both perspectives have valued argument, and as workers in the field it is necessary for them to grasp another view of things. Yet; these two perspectives may differ in shape of their aggregate supply curve, the movement of the economy in the long-run, and the implementations of policies; yet the debate behind them goes farther beyond these qualities. Since; in some ways both are needed to reach the goal of efficiently reducing short-term fluctuations in the business cycle.
To be continued....