11 Aggregate Demand and Aggregate Supply

Lecture from: 25.11.2025 | Video: Video ETHZ

From IS-LM to Aggregate Demand

The previous lecture established the IS-LM model under the assumption of a fixed price level. This assumption is now relaxed to handle inflation and price dynamics.

The Aggregate Demand (AD) and Aggregate Supply (AS) model is derived from this extension. It serves as the workhorse for analyzing short-run fluctuations in both output ($Y$) and the price level ($P$).

Transition Logic: In the IS-LM framework, a change in price ($P$) alters the real money supply ($M/P$).

1. Price Rises ($P\uparrow$): Real money supply falls ($M/P\downarrow$).
2. LM Shift: LM curve shifts Left.
3. Result: Interest rate rises, Output ($Y$) falls.
4. Conclusion: A higher price level causes lower aggregate demand. This inverse relationship forms the downward-sloping AD curve.

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Explaining Short-Run Economic Fluctuations

The Classical Dichotomy (monetary neutrality) holds in the long run: money affects prices, but not real output.

In the short run, this breaks down. Prices and wages are sticky, meaning nominal shocks have real effects. The AD-AS model captures these dynamics.

• AD Curve: Quantity of goods demanded by all agents at each price level.
• AS Curve: Quantity of goods supplied by firms at each price level.

Equilibrium: Intersection determines short-run $P$ and $Y$.

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The Aggregate Demand (AD) Curve

Shows the inverse relationship between Price Level ($P$) and Output Demanded ($Y$).

Three Reasons for the Downward Slope

Effect	Channel	Logic
1. Wealth Effect	Consumption ($C$)	Lower $P$ makes cash holdings more valuable. Consumers feel wealthier $\to$ Spend more.
2. Interest-Rate Effect	Investment ($I$)	Lower $P$ reduces money demand. Households buy bonds $\to$ Interest rates fall $\to$ Investment rises.
3. Exchange-Rate Effect	Net Exports ($NX$)	Lower interest rates cause capital outflow. Currency depreciates $\to$ Exports rise.

Country Context

• USA (Closed-ish): Interest-Rate effect dominates.
• Switzerland (Open): Exchange-Rate effect is likely dominant.

Shifts in the AD Curve

Any non-price factor changing $C,I,G,$ or $NX$ shifts the curve.

• Right Shift: Optimism, Tax cuts, Govt spending increase, Money supply increase.
• Left Shift: Pessimism, Tax hikes, Spending cuts, Money supply decrease.

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The Aggregate Supply (AS) Curve

Unlike demand, supply behaves differently in the short vs. long run.

The Long-Run Aggregate Supply (LRAS)

In the long run, output is determined by real factors (Capital, Labor, Technology). It is not affected by the price level.

• Shape: Vertical at the Natural Rate of Output ($\hat{Y}$).
• Shifts: Only when factors of production change (Growth).

The Short-Run Aggregate Supply (SRAS)

In the short run, a higher price level encourages more production.

• Shape: Upward Sloping.

Equation: $Y=\hat{Y}+a(P-P^e)$ Current Output = Natural Output + response to (Actual Price - Expected Price).

Three Theories for the Upward Slope:

1. Sticky-Wage Theory: Nominal wages are fixed. If $P$ is lower than expected, real wages ($W/P$) are effectively too high. Firms hire less $\to$ Output falls.
2. Sticky-Price Theory: Menu costs keep some prices fixed. If $P$ falls, firms with sticky (high) prices sell less $\to$ Production falls.
3. Misperceptions Theory: Firms mistake a general price drop for a relative price drop in their own product $\to$ Cut production.

Shifts in SRAS:

• Changes in Labor/Capital/Tech.
• Crucial: Changes in Expected Price Level ($P^e$). If people expect higher inflation, they negotiate higher wages $\to$ Costs rise $\to$ SRAS shifts Left.

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Analyzing Economic Fluctuations: A Four-Step Process

Method:

1. Is it an AD or AS shock?
2. Which way does it shift?
3. Find Short-Run Equilibrium (intersection with SRAS).
4. Analyze Transition to Long-Run (SRAS shifts as expectations adjust).

Case Study: A Negative Demand Shock (Recession)

(e.g., Export demand falls)

1. Shift: AD shifts Left ($A{D}_1\to A{D}_2$).
2. Short-Run: Economy moves to Point B. Output falls (Recession), Prices fall.
3. Self-Correction: At Point B, prices are lower than expected. Expectations ($P^e$) eventually adjust downward.
4. Transition: Lower expectations make wages cheaper. SRAS shifts Right.
5. Long-Run: Economy reaches Point C. Output returns to natural rate ($\hat{Y}$), but at a permanently lower Price Level.

The Policy Choice

• Do Nothing: Wait for self-correction (Points A $\to$ B $\to$ C). Requires enduring a recession.
• Intervene: Use Fiscal/Monetary policy to shift AD back (Points A $\to$ B $\to$ A). Avoids recession but keeps prices high.

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Continue here: 12 Monetary and Fiscal Policy