7
CHAPTER
AGGREGATE DEMAND
&
AGGREGATE SUPPLY
10:27 PM 1
Objectives
After studying this chapter, you will able to
Explain what determines aggregate supply
Explain what determines aggregate demand
Explain macroeconomic equilibrium
Explain the effects of changes in aggregate supply
and aggregate demand on economic growth,
inflation, and business cycles
Explain U.S. economic growth, inflation, and
business cycles by using the AS-AD model.
10:27 PM 2
Production and Prices
What forces bring persistent and rapid expansion
of real GDP?
What causes inflation?
Why do we have business cycles?
How do policy actions by the government and the
Federal Reserve affect output and prices?
10:27 PM 3
Aggregate Supply
Aggregate Supply Fundamentals
The aggregate quantity of goods and services
supplied depends on three factors:
The quantity of labor (L )
The quantity of capital (K )
The state of technology (T )
The aggregate production function shows how
quantity of real GDP supplied, Y, depends on
labor, capital, and technology.
10:27 PM 4
Aggregate Supply
Aggregate Supply Fundamentals
The aggregate production function is written as
the equation:
Y = F(L, K, T ).
In words, the quantity of real GDP supplied
depends on (is a function of) the quantity of labor
employed, the quantity of capital, and the state of
technology.
The larger is L, K, or T, the greater is Y.
10:27 PM 5
Aggregate Supply
Aggregate Supply Fundamentals
At any given time, the quantity of capital and the
state of technology are fixed but the quantity of
labor can vary.
The higher the real wage rate, the smaller is the
quantity of labor demanded and the greater is the
quantity of labor supplied.
The wage rate that makes the quantity of labor
demanded equal to the quantity supplied is the
equilibrium wage rate and at that wage the level of
employment is the natural rate of unemployment.
10:27 PM 6
Aggregate Supply
Aggregate Supply Fundamentals
We distinguish two time frames associated with
different states of the labor market:
Long-run aggregate supply
Short-run aggregate supply
10:27 PM 7
Aggregate Supply
Long-Run Aggregate Supply
The macroeconomic long run is a time frame that
is sufficiently long for all adjustments to be made
so that real GDP equals potential GDP and there is
full employment.
The long-run aggregate supply curve (LAS) is the
relationship between the quantity of real GDP
supplied and the price level when real GDP equals
potential GDP.
10:27 PM 8
Aggregate Supply
Figure 7.1 shows an LAS curve
with potential GDP of $10
trillion.
The LAS curve is vertical
because potential GDP is
independent of the price level.
Along the LAS curve all prices
and wage rates vary by the
same percentage so that
relative prices and the real
wage rate remain constant.
10:27 PM 9
Aggregate Supply
Short-Run Aggregate Supply
The macroeconomic short run is a period during
which real GDP has fallen below or risen above
potential GDP.
At the same time, the unemployment rate has risen
above or fallen below the natural unemployment rate.
The short-run aggregate supply curve (SAS) is the
relationship between the quantity of real GDP
supplied and the price level in the short-run when the
money wage rate, the prices of other resources, and
potential GDP remain constant.
10:27 PM 10
Aggregate Supply
Figure 7.2 shows a short-
run aggregate supply
curve.
Along the SAS curve, rise
in the price level with no
change in the money
wage rate and other
input prices increases the
quantity of real GDP
supplied—the SAS curve
is upward sloping.
10:27 PM 11
Aggregate Supply
The SAS curve is upward
sloping because:
A rise in the price level
with no change in costs
induces firms to bear a
higher marginal cost and
increase production.
A fall in the price level
with no change in costs
induces firms to
decrease production to
lower marginal cost.
10:27 PM 12
Aggregate Supply
Along the SAS curve,
real GDP might be
above potential GDP…
… or below potential
GDP.
10:27 PM 13
Aggregate Supply
Movement along the
LAS and SAS Curves
Figure 7.3 summarizes
what you’ve just learned
about the LAS and SAS
curves.
A change in the price level
with an equal percentage
change in the money
wage causes a movement
along the LAS curve.
10:27 PM 14
Aggregate Supply
Movement along the
LAS and SAS Curves
Figure 7.3 summarizes
what you’ve just
learned about the LAS
and SAS curves.
A change in the price
level with no change in
the money wage
causes a movement
along the SAS curve.
10:27 PM 15
Aggregate Supply
Changes in Aggregate Supply
When potential GDP increases, both the LAS and
SAS curves shift rightward.
Potential GDP changes, for three reasons
Change in the full-employment quantity of labor.
Change in the quantity of capital (physical or
human).
Advance in technology.
10:27 PM 16
Aggregate Supply
Figure 7.4 shows
how these factors
shift the LAS
curve and have
the same effect
on the SAS curve.
10:27 PM 17
Aggregate Supply
Figure 7.5 shows the effect
of a change in the money
wage rate on aggregate
supply.
A rise in the money wage
rate decreases short-run
aggregate supply and
shifts the SAS curve
leftward.
But it has no effect on
long-run aggregate supply.
10:27 PM 18
Aggregate Demand
The quantity of real GDP demanded, Y, is the total
amount of final goods and services produced in
the United States that people, businesses,
governments, and foreigners plan to buy.
This quantity is the sum of consumption
expenditures, C, investment, I, government
purchases, G, and net exports, X – M. That is:
Y = C + I + G + X – M.
10:27 PM 19
Aggregate Demand
Buying plans depend on many factors and some of
the main ones are:
The price level
Expectations
Fiscal and monetary policy
The world economy
10:27 PM 20
Aggregate Demand
The Aggregate Demand Curve
Aggregate demand is the relationship between
the quantity of real GDP demanded and the price
level.
The aggregate demand (AD) curve plots the
quantity of real GDP demanded against the price
level.
10:27 PM 21
Aggregate Demand
Figure 7.6 shows an
AD curve.
The AD curve slopes
downward for two
reasons
A wealth effect
Substitution effects
10:27 PM 22
Aggregate Demand
Wealth effect A rise in the price level, other things
remaining the same, decreases the quantity of real
wealth (money, bonds, stocks, etc.).
To restore their real wealth, people increase saving and
decrease spending, so the quantity of real GDP
demanded decreases.
Similarly, a fall in the price level, other things remaining
the same, increases the quantity of real wealth.
With more real wealth, people decrease saving and
increase spending, so the quantity of real GDP
demanded increases.
10:27 PM 23
Aggregate Demand
Intertemporal substitution effect A rise in the price
level, other things remaining the same, decreases
the real value of money and raises the interest rate.
Faced with a higher interest rate, people try to
borrow and spend less so the quantity of real GDP
demanded decreases.
Similarly, a fall in the price level increases the real
value of money and lowers the interest rate.
Faced with a lower interest rate, people borrow and
spend more so the quantity of real GDP demanded
increases.
10:27 PM 24
Aggregate Demand
International substitution effect A rise in the
price level, other things remaining the same,
increases the price of domestic goods relative to
foreign goods, so imports increase and exports
decrease, which decreases the quantity of real
GDP demanded.
Similarly, a fall in the price level, other things
remaining the same, decreases the price of
domestic goods relative to foreign goods, so
imports decrease and exports increase, which
increases the quantity of real GDP demanded.
10:27 PM 25
Aggregate Demand
Changes in Aggregate Demand
A change in any influence on buying plans other
than the price level changes aggregate demand.
The main influences on aggregate demand are
Expectations
Fiscal and monetary policy
The world economy.
10:27 PM 26
Aggregate Demand
Changes in Aggregate Demand
Expectations about future income, future inflation, and
future profits change aggregate demand.
Increases in expected future income increase people’s
consumption today, and increases aggregate demand.
A rise in the expected inflation rate makes buying goods
cheaper today and increases aggregate demand.
An increase in expected future profits boosts firms’
investment, which increases aggregate demand.
10:27 PM 27
Aggregate Demand
Changes in Aggregate Demand
Fiscal policy is the government’s attempt to
influence economic activity by changing its taxes,
spending, deficit, and debt policies.
A tax cut or an increase in transfer payments
increases households’ disposable income—
aggregate income minus taxes plus transfer
payments.
An increase in disposable income increases
consumption expenditure and increases aggregate
demand.
10:27 PM 28
Aggregate Demand
Changes in Aggregate Demand
Because government purchases of goods and
services are one component of aggregate demand,
an increase in government purchases increases
aggregate demand.
Monetary policy is changes in the interest rate and
quantity of money.
An increase in the quantity of money increases
buying power and increases aggregate demand.
A cut in the interest rate increases expenditure and
increases aggregate demand.
10:27 PM 29
Aggregate Demand
Changes in Aggregate Demand
The world economy influences aggregate demand in
two ways:
A fall in the foreign exchange rate lowers the price
of domestic goods and services relative to foreign
goods and services, increases exports, decreases
imports, and increases aggregate demand.
An increase in foreign income increases the
demand for U.S. exports and increases aggregate
demand.
10:27 PM 30
Aggregate Demand
Figure 7.7 illustrates
changes in aggregate
demand.
When aggregate
demand increases, the
AD curve shifts
rightward…
… and when aggregate
demand decreases, the
AD curve shifts leftward.
10:27 PM 31
Macroeconomic Equilibrium
Short-Run Macroeconomic Equilibrium
Short-run macroeconomic equilibrium occurs
when the quantity of real GDP demanded equals
the quantity of real GDP supplied at the point of
intersection of the AD curve and the SAS curve.
10:27 PM 32
Macroeconomic Equilibrium
Figure 7.8 illustrates a
short-run equilibrium.
If real GDP is below
equilibrium GDP, firms
increase production
and raise prices…
… and if real GDP is
above equilibrium GDP,
firms decrease
production and lower
prices.
10:27 PM 33
Macroeconomic Equilibrium
These changes bring a
movement along the
SAS curve toward
equilibrium.
In short-run
equilibrium, real GDP
can be greater than or
less than potential
GDP.
10:27 PM 34
Macroeconomic Equilibrium
Long-Run Macroeconomic Equilibrium
Long-run macroeconomic equilibrium occurs
when real GDP equals potential GDP—when the
economy is on its LAS curve.
10:27 PM 35
Macroeconomic Equilibrium
Figure 7.9 illustrates long-
run equilibrium.
Long-run equilibrium
occurs where the AD and
LAS curves intersect and
results when the money
wage has adjusted to put
the SAS curve through the
long-run equilibrium point.
10:27 PM 36
Macroeconomic Equilibrium
Economic Growth
and Inflation
Figure 7.10 illustrates
economic growth and
inflation.
10:27 PM 37
Macroeconomic Equilibrium
Economic Growth and
Inflation
Economic growth
occurs because the
quantity of labor grows,
capital is accumulated,
and technology
advances, all of which
increase potential GDP
and bring a rightward
shift of the LAS curve.
10:27 PM 38
Macroeconomic Equilibrium
Economic Growth and
Inflation
Inflation occurs because the
quantity of money grows
faster than potential GDP,
which increases aggregate
demand by more than long-
run aggregate supply.
The AD curve shifts
rightward faster than the
rightward shift of the LAS
curve.
10:27 PM 39
Macroeconomic Equilibrium
The Business Cycle
The business cycle occurs because aggregate
demand and the short-run aggregate supply
fluctuate but the money wage does not change
rapidly enough to keep real GDP at potential GDP.
10:27 PM 40
Macroeconomic Equilibrium
A below full-employment
equilibrium is an
equilibrium in which
potential GDP exceeds
real GDP.
Figures 21.11(a) and (d)
illustrate below full-
employment equilibrium.
The amount by which
potential GDP exceeds
real GDP is called a
recessionary gap.
10:27 PM 41
Macroeconomic Equilibrium
A long-run equilibrium is
an equilibrium in which
potential GDP equals
real GDP.
Figures 21.11(b) and (d)
illustrate long-run
equilibrium.
10:27 PM 42
Macroeconomic Equilibrium
An above full-employment
equilibrium is an
equilibrium in which real
GDP exceeds potential GDP.
Figures 21.11(c) and (d)
illustrate above full-
employment equilibrium.
The amount by which real
GDP exceeds potential GDP
is called an inflationary
gap.
10:27 PM 43
Macroeconomic Equilibrium
Figure 7.11(d) shows
how, as the
economy moves
from one type of
short-run
equilibrium to
another, real GDP
fluctuates around
potential GDP in a
business cycle.
10:27 PM 44
Macroeconomic Equilibrium
Fluctuations in
Aggregate Demand
Figure 7.12 shows the
effects of an increase in
aggregate demand.
Part (a) shows the short-
run effects.
Starting at long-run
equilibrium, an increase in
aggregate demand shifts
the AD curve rightward.
10:27 PM 45
Macroeconomic Equilibrium
Fluctuations in
Aggregate Demand
Firms increase
production and rise
prices—a movement
along the SAS curve.
10:27 PM 46
Macroeconomic Equilibrium
Fluctuations in
Aggregate Demand
Figure 7.12(b) shows
the long-run effects.
Real GDP increases,
the price level rises,
and in the new short-
run equilibrium, there
is an inflationary gap.
10:27 PM 47
Macroeconomic Equilibrium
Fluctuations in Aggregate
Demand
The money wage rate
begins to rise and short-run
aggregate supply begins to
decrease.
The SAS curve shifts
leftward.
The price level rises and real
GDP decreases until it has
returned to potential GDP.
10:27 PM 48
Macroeconomic Equilibrium
Fluctuations in
Aggregate Supply
Figure 7.13 shows the
effects of a decrease in
aggregate supply.
Starting at long-run
equilibrium, a rise in the
price of oil decreases
short-run aggregate
supply and the SAS
curve shifts leftward.
10:27 PM 49
Macroeconomic Equilibrium
Fluctuations in
Aggregate Supply
Real GDP decreases and
the price level rises.
The combination of
recession combined with
inflation is called
stagflation.
10:27 PM 50
U.S. Economic Growth,
Inflation, and Cycles
Figure 7.14
interprets the
changes in real
GDP and the
price level each
year from 1963
to 2003 in terms
of shifting AD,
SAS, and LAS
curves.
10:27 PM 51
U.S. Economic Growth,
Inflation, and Cycles
The figure shows
the business
cycle,
… long-term
economic
growth,…
…. and inflation
10:27 PM 52
U.S. Economic Growth,
Inflation, and Cycles
From1963 to 2003:
Real GDP and
potential GDP grew
from $2.8 trillion to
$10.3 trillion.
The price level rose
from 22 to 105.
Business cycle
expansions
alternated with
recessions.
10:27 PM 53
U.S. Economic Growth,
Inflation, and Cycles
Economic Growth
Real GDP growth was rapid during the 1960s and
1990s and slower during the 1970s and 1980s.
Inflation
Inflation was the most rapid during the 1970s.
Business Cycles
Recessions occurred during the mid-1970s, 1982,
1991–1992, and 2001.
10:27 PM 54
