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AD & AS in the Short Run
19-Sep-2006
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Learning Objectives
1. Explain why an exogenous change in the price level
shifts the AE curve and changes the equilibrium level of
real GDP.
2. Derive the AD curve and explain why it shifts.
3. Explain the meaning of the AS curve and why it shifts when
technology or factor prices change.
4. Define macroeconomic equilibrium.
5. Explain the effects of aggregate demand and aggregate
supply shocks on real GDP and the price level.
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1 The Demand Side of the Economy
Shifts in the AE Curve
Consider an exogenous change in the price level, P. What
happens to equilibrium GDP?
An increase in P reduces the real value of money held by the
private sector. A fall in P raises the real value of money
holdings.
Changes in P also affect the wealth of bondholders and bond
issuers, but because the changes offset each other, there is
no change in the aggregate wealth.
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In summary, an increase in P reduces private-sector wealth
and leads to a fall in desired consumption — this implies a
downward shift in the AE curve.
Conversely, a fall in P increases private-sector wealth and
leads to an increase in desired consumption — this implies an
upward shift in the AE curve.
There is also an effect on net exports:
• A rise in P (with unchanged foreign prices) shifts the NX
function downward — this causes a further downward
shift in the AE curve. The reverse will occur after a fall in
P.
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Changes in Equilibrium GDP
AE
AE =Y
E0
•
AE0
AE1
•E
1
Y1
Y0
Y
An increase in P reduces
private-sector wealth and
therefore reduces desired
aggregate expenditure.
This causes the AE curve to
shift down, reducing the
equilibrium level of real
GDP.
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The Aggregate Demand Curve
The aggregate demand (AD) curve relates equilibrium real
GDP to the price level.
For any given price level, the AD curve shows the level of real
GDP for which desired aggregate expenditure equals actual
GDP.
Changes in the price level that cause shifts in the AE curve
cause movements along the AD curve.
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AE =Y
E0
• AE0
AE1
AE
E1
AE2
•
E2
•
Y2
Y1
Y0
Y
Consider a rise in the price
level, from P0 to P2:
A rise in P causes the AE
curve to shift down. This is
a movement upward along
the AD curve.
P
P2
•
P1
P0
(Conversely, a fall in P
causes the AE curve to
shift up. This is a
movement downward along
the AD curve.)
•
• AD
Y2
Y1
Y0
Y
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AD & AS in the Short Run
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AE
E1
AE =Y
AE1
Shifts in the AD Curve
•
AE0
E0
•
Y0
Y1
Y
P
P0
E0
•
E1
•
AD1
AD0
Y0
Y1
Any shock that increases
equilibrium GDP at a given
price level shifts the AD
curve to the right.
Any shock that reduces
equilibrium Y at a given
price level shifts the AD
curve to the left.
The simple multiplier
measures the horizontal shift
of the AD curve.
Y
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2 The Supply Side of the Economy
The Aggregate Supply Curve
The aggregate supply (AS) curve relates the price level to the
quantity of output that firms would like to produce and sell.
The AS curve is drawn on the assumption that technology
and factor prices remain constant.
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Shifts in the Aggregate Supply Curve
Price Level
Because unit costs rise with output, both price-taking and
price-setting firms will produce more output only if prices
increase. The AS curve is therefore upward sloping.
A change in either factor
prices or productivity will
change costs and shift
the AS curve.
AS1
P1
P0
•
•
•
Y1
Y0
AS0
Real GDP
An increase in factor
prices or a decrease in
productivity shifts the
AS curve up and to
the left.
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The Increasing Slope of the AS Curve
The slope of the AS curve is increasing because when output
is low, firms typically have excess capacity. This means that
output can be expanded without causing a large increase in
unit costs. Therefore, only a small increase in price may be
needed to induce them to expand production.
Once output gets closer to capacity, however, increases in
output cause larger increases in unit costs. Therefore, larger
price increases are needed to induce firms to expand output.
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3 Macroeconomic Equilibrium
Demand behaviour is
only consistent with
supply behaviour at the
interSec of the AS and
AD curves.
At P1 there is more
output demanded (Y2)
than what firms want
to produce (Y1).
Price Level
AD
P0
P1
AS
E0
•
•
Y1
•
Y0
Y2
Real GDP
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Changes in the Macroeconomic Equilibrium
A demand shock can either be expansionary or
contractionary. An expansionary demand shock shifts the AD
curve to the right, increasing both P and Y.
A supply shock can also be either expansionary or
contractionary. An expansionary supply shock shifts the AS
curve to the right, increasing Y but decreasing P.
Notice that we use the word “expansionary” or
“contractionary” to refer to the effect of the shock on the
equilibrium level of output.
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Aggregate Demand Shocks
AD1
Price Level
Demand shocks cause
P and Y to change in
the same direction;
both rise with an
increase in demand,
and both fall with a
decrease in demand.
AS
AD0
P1
P0
• E1
E0
•
Y0
Y1 Real GDP
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AE
AE =Y
E´1 AE´
1
•
AE1
AE0
E1
•
∆A
•E0
Y0
Y1
Y´1
Y
The Mechanics of an AD
Shift
An increase in autonomous
expenditure causes the AE
curve to shift upward, but
the rise in the price level
causes it to shift part of the
way down again.
P
AS
E1
P1
P0
•
E´1
•
E0
Y0
AD0
Y1
• AD
1
Y´1
Hence, when the AS
curve is upward sloping,
the multiplier is smaller
than the simple multiplier.
Y
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AD4
AD3
The steeper the AS
curve, the greater the
price effect and the
smaller the output
effect.
AS
AD2
P4
Price Level
The effect of any given
shift of the AD curve will
depend on the slope of
the AS curve.
P3
AD1
•
AD0
•
P2
P1
P0
•
•
•
Y0
Y1
Y2 Y3Y4
Real GDP
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In the 45 degree model, it was shown that shifts in the AE
curve always change real GDP. But now we see an
extreme case — a vertical AS curve — in which there is
no change in real GDP.
How can these seemingly contradictory statements be true?
The answer is that each AE curve is drawn for a given price
level. As the price level changes, the AE curve shifts.
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Aggregate Supply Shocks
E0
AE
Aggregate supply shocks
cause P and Y to change in
opposite directions.
•
AE =Y
AE0
AE1
•E
1
Consider the effects of a
negative supply shock.
An example of a negative
supply shock is an increase in P
the price of oil, as happened in
the early and late 1970s.
P1
P0
Y1
Y
Y0
AS1
AS0
E1
•
• E0
AD
Y1
Y0
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A Word of Warning
Many economic events (especially changes in the world
prices of raw materials) cause both aggregate demand and
aggregate supply shocks.
The overall effect on the economy depends on the relative
importance of the two separate effects.
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