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CHAPTER 29: AGGREGATE DEMAND AND AGGREGATE SUPPLY
Introduction
The aggregate demand-aggregate supply (AD-AS) model provides the primary graphic d~piction
of changes in the macroeconomy. Shifts in aggregate supply and aggregate dema~d explam
changes in real output, employment, and price levels in the economy. Chapter 29 mtroduces the
AD-AS model, bringing together the concepts of GDP, inflation, unemployment, and
.
recessionary and inflationary gaps that have been introduced throughout the macroec~nomlcs .
chapters. Material from Chapter 29 is very likely to appear in a large number of multlple-c~OIce
questions and appears as part of a free-response question on nearly every AP macroeconomICS
exam.
Aggregate Demand
Aggregate demand is a curve showing the amount of GOP (output) demanded at each price level.
When the price level rises, fewer products are purchased; when the price level falls, more
products are purchased. Therefore, aggregate demand is a downward-sloping curve, with the
negative slope resulting from three effects: the real balances effect, the interest rate effect, and the
foreign purchases effect.
The real balances effect focuses on the value of consumers' wealth. At a higher price level, the
real value of a consumer's savings (homes, stocks, savings accounts) falls. With less wealth in
real terms. consumers in the economy are Jess likely to buy products. At lower price levels,
consumers buy more because they have more real wealth.
The second reason for the downward slope of the aggregate demand curve is the interest rate
effect. When prices rise, consumers and firms must borrow more money to make the same
purchases. That increased demand for money pushes up the interest rate (the price of borrowing
money), which discourages consumer borrowing to buy products. It also causes firms to reduce
spending for capital, because the higher interest rate can exceed the expected return on the
investment. At lower prices, less borrowing is necessary, so interest rates fall and the quantity of
products demanded in the economy increases.
i
Taking the KEK! Out of Economics
Although the curves look similar, it is important to recognize the differences between the demand
curve for a specific product and the aggregate demand curve for the macroeconomy. Notice the
differences in the axis labels. For individual product demand, the label for the vertical axis is
price; for aggregate demand, the label is price level. This is because, when we're dealing with the
demand for alJ of the products in the economy, there is no one "price" for everything-······and an
"average" price makes little sense if we're talking about the average price of a home and a
toothpick. So instead we talk about a price level, which can show us increases and decreases in
prices, but not precise prices for products. The horizontal axis. which is labeled "quantity" for
the individual product, is labeled "real GOP" or "real output" for macroeconomic analysis,
because we're looking at aU of the spending in the economy together. So while the demand curve
for sp~cific products could help us to identify the specific price of the product and the specific
quantIty sold, the aggregate demand curve shows much more general information about the
economic performance of the entire economy.
......................- - - - - - - - - - - -_ _ _ _ _--1
~~~~~~~~
The third cause of the downward slope in aggregate demand is the foreign purchases effect
When the U.S. price level increases and if exchange rates do not change, Americans buy m~re
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Chapter 29: Aggregate Demand and Aggregate Supply
imports and foreigners buy fewer U.S. exports. As a result, quantity demanded for U.S. goods
falls at higher prices, and at lower prices, the quantity demanded is higher.
Bear in Mind
The aggregate demand-aggregate supply model is part of a free-response question on almost
every AP macroeconomics exam. As part of the question, you are asked to draw a correctly
labeled graph. It is very important that you use the correct labeling to distinguish macroeconomic
graphs from microeconomic graphs. Price is not sufficient; the label must be "price level."
Rather than "quantity," the label should be "real output" or HGDP." "Supply" and "demand"
curve labels are not enough; they must be "aggregate supply" and "aggregate demand." Careful
labeling will help you earn the points you deserve.
Changes in Aggregate Demand
While the real balances, interest rate, and foreign purchases effects can cause movement along the
aggregate demand curve, a number of factors can actually cause the aggregate demand curve to
shift. As was true for the individual product demand curve, increases in aggregate demand shift
the curve to the right, while decreases shift it to the left. Changes in aggregate demand can result
from changes in all four sectors in the macroeconomy.
Consumer sector demand can shift due to changes in wealth, borrowing, expectations, and taxes.
If consumer wealth significantly rises, such as by receiving an inheritance or from increasing
stock values, consumers gain confidence and increase their demand for products at all prices. If
consumers borrow money, their demand for products increases. If consumers expect their real
future incomes to increase, or if they fear inflation in the near future, they increase demand for
products ahead of the price increase. And if personal taxes decline, consumers have more
disposable income to spend, so aggregate demand increases. If consumer wealth falls, consumers
borrow less, they are concerned about a decrease in real income, or their personal taxes increase,
aggregate demand falls.
The investment sector's investment spending for capital goods depends on the interest rate and
expected return on investment. If interest rates fall, aggregate demand increases because costs are
now lower than expected return on the investment. Firms also increase investment if the expected
returns increase due to optimism about future business conditions, improvements in technology,
production at capacity, or a reduction in business taxes. Higher interest rates or lower expected
returns on investment reduce aggregate demand through investment. Because interest rates and
expectations can change so quickly and often, the investment sector is the most volatile of the
four sectors.
The third sector, government spending, is straightforward. If government spending increases
(and taxes and interest rates do not change), aggregate demand increases. Decreases in
government spending reduce aggregate demand.
Finally, changes in net exports can also change aggregate demand. If exports increase due to
higher foreign incomes, U.S. aggregate demand increases and the curve shifts to the right. If the
value of the U.S. dollar depreciates in foreign exchange markets, foreign currency gets stronger,
and so it appears that U.S. products are cheaper. In this case, demand for U.S. exports increases.
At the same time, because the U.S. dollar is weaker, imports look more expensive, and so imports
decrease. Because exports increase while imports decrease, net exports increase, increasing
Chapter 29: Aggregate Demand and Aggregate Supply
20t
.
th U S dollar appreciates in currency markets
'
aggregate demand. If foreign incomes declIne or e . '
U.S. aggregate demand falls.
Taking the EEK! Out of Economics
. .
Causes of the downward slope of aggregate demand may seem ~ery Similar to the causes of shifts
ect
in the aggregate demand curve. The real balances effect looks hke the wealth et:r , and the
interest rate and foreign purchases effects look very similar to causes of change m aggregate
the three factors
demand. A way to keep them straight is to look at the cause of each effect.
in
that explain the downward slope, a higher price level is the root cause of each effe~t. The
price level causes a decline in the value of wealth, a higher interest rate for borrowmg, and a shift
toward buying relatively lower-priced imports. At higher prices, people buy fewer products. But
for the causes of change in aggregate demand, shifts in the curve result from causes other than a
change in the prices of products in the economy. Changes in expectations for economic
performance, tax rates, incomes, and currency values are among the reasons the entire curve
. would shift.
Aggregate Supply
Aggregate supply is the quantity of goods produced in an economy at all price levels. The shape
of the aggregate s~pply curve varies depending on the time period discussed. The costs of inputs
sticky or unchangeable in the short run
(resources) and pnces of outputs to consumers tend to
but more flexible in the long run.
In the immediate short run (or immediate period), both
costs resources and the prices
~harge~ to cus~omers are fixed. As a result, the aggregate supply curve is horizontal in the
Immediate penod. If aggregate demand increases in this time period, output increases but the
pnce level does not change.
'
AS
o~--------------------~
Qr
Real domestic output. GOP
The aggregate supply curve (short run)
In the short run, output prices are flexible but res
stickiness is primarily due to wages beca~se source costs are either fixed or very sticky The
.'
0 many workers ar
'd'
.
e pal Via a contract whose
terms carmot be changed qUickly. As a result th h
P
d
'
'
e
sort-run
aggr
t
.
sIopmg. ro ucers proVide more products as the . I
. ega e supply curve is upwardlevel falls. When current output is significantly I pnce evel nses and fewer products as the price
.
.
.
OWer than the
firm' s capaCity,
. firms can increase
in productIOn cost. B t
.
ou t put WI·th l'IttIe mcrease
u as ProduCtlOn ap proac hes or even passes full-
202
Chapter 29' A
. ggregate Demand and Aggregate Supply
employment output, the per-unit cost of production
short-run aggregate supply curve slopes upward, becoming
much more quickly. As a result,
as output increases.
ASLR
/
Lon,.run
ag,regate
supply
o
Qr
Real domestic output, GDP
Aggregate supply in the long run
Bear in Mind
The aggregate supply curve can also be presented as representing Keynesian, intermediate, and
classical ranges.
Aggregate Supply
AS
P
Classical Range
r
i
c
e
L
e
v
e
Intermediate Range
I
RealGDP
Remember, classical economists were convinced that the economy naturally produced at fullemployment output. While prices and wages were flexible, output was not. This theory is
represented in the vertical range of the aggregate supply curve. Keynesian theory held the
opposite assumptions, with flexible output and employment but fixed
and wages. These
assumptions are found in the horizontal section of the aggregate supply curve. The intermediate
supply curve
range of the aggregate supply curve corresponds with the short-run
discussed in the text. AP macroeconomics exam questions about short-run aggregate supply
generally
to this upward-sloping aggregate supply curve unless they specifically note
are
a vertical or horizontal aggregate supply curve. lfyou see a question referring to
the intermediate range of the aggregate supply curv~,itis_referring to tl1~llP\lVard-sloping section.
"'U<1plJer
29: Aggregate Demand and Aggregate Supply
203
In the long run, the costs of inputs, including labor, as weU as the prices charged to customers, are
flexible. Long-run aggregate supply is a vertical curve, located at full-employment output
Although increases in aggregate demand may cause short-run increases in production beyond
fun-employment GDP, the additional costs of paying workers overtime and paying a premium for
resources will cause finns to reduce production back to full-employment GDP in the long run.
Changes in Aggregate SuppJy
Changes in aggregate supply are directly connected to changes in the per-unit costs of production
faced by firms. If costs of production fall, aggregate supply increases, shifting the curve to the
right so that more output is produced at every price leveL Increases in the cost of production
reduce aggregate supply, shifting the curve leftward.
Changes in the costs of land, labor, and capital resources are a major determinant of changes in
aggregate supply. As costs increase, firms reduce supply, lowering output and employment and
raising prices. Productivity is another important determinant of aggregate supply. If productivity
increases as a result of better worker education or technology, aggregate supply increases, so
firms increase output and employment while lowering prices. Changes in government policy can
also affect aggregate supply. Ifbusiness taxes are increased or the government institutes
regulations, the increased costs of production reduce aggregate supply. If business taxes are
reduced, the government grants firms a subsidy, or if regulation is reduced, the lower per-unit
costs of production lead firms to increase production, and aggregate supply increases.
Equilibrium GDP
AS
AD
i
~
o
!
, ..,....",.",-
502
510 514
Real domestic output. GOP
(billion. of doll .... )
Equilibrium price level and equilibrium real GDP
Equilibrium GDP occurs at the point where aggregate demand equals aggregate supply. This
equilibrium establishes price level and real GOP for the economy. In this figure, equilibrium
occurs at a real GOP of $5 10 billion in output and a price level of 100. At price level 92, firms
would only produce $502 billion of output while aggregate demand at that price level is $514
billion in output. Given the shortage of goods at that price, consumers would bid up the price.
The higher price leads firms to increase production and consumers to reduce quantity demanded
until equilibrium is again reached.
204
Chapter 29: Aggregate Demand and Aggregate Supply
AS
o
Qr QI Qz
Re.1 domestic output, GDP
An increase in aggregate demand that causes demand-pull inflation
lfthe economy is in equilibrium at full-employment output, an increase in
demand
causes demand-pull inflation-an inflationary gap. Prices increase as well as real GDP. It is
important to note that because the price increased, the full multiplier
did not occur. The
full multiplier requires a horizontal aggregate supply curve so that the full multiplier effect goes
to output, rather than being partially absorbed by a
AS
o
QI Ql Qf
Real domestic output. GDP
A decrease in aggregate demalld that causes a recessioll
A decrease in aggregate demand causes a decrease in production-a recessionary
Employment falls and cyclical unemployment rises as a result, because firms do not
as many
With the
workers to produce fewer products. The effect on prices can be harder to
lower demand, disinflation (a reduction in the rate of inflation) tends to occur. But do prices
actually
Wages and prices are sticky downward, so in many recessions,
lHJOr~'al'l'lp demand fully impacts output but does not cause a change in price level. As illustrated
of the multiplier occurs in the
in this
when the price does not change, the full
changing real GDP. If prices do actually fall, part of the multiplier effect is absorbed by the
and teal GDP does not fall by
full amount of the change in aggregate demand.
Chapter 29:
AP'I>TNyMf'
n~.~~.",1 and Aggregate Supply
205
AD
o
Q, Qr
Ft.al domestic output. GDP
A decrease in aggregate supply that causes cost-push inflation
A reduction in aggregate supply causes cost-push inflation. As the cost of production increases,
firms reduce output and raise prices. A sustained decrease in aggregate supply is known as
stagflation-a stagnant economy, high inflation (thus the name stagflation), and high
unemployment all at the same time. High oil prices in the 1970s sent the U.S. economy into its
most significant period of stagflation in history. An increase in aggregate supply resulting from
increased productivity and technology shifts the aggregate supply curve to the right. Real GDP
and employment increase and prices can fall as a result of the lower per-unit costs of production.
o
Q, Ql QJ
Real domestic output. GDP
Growth,full employment, and relative price stability
It is possible for both aggregate demand and aggregate supply to shift at the same time, as
multiple factors affect the economy. In the late 1990s, full employment, higher incomes, and
high consumer confidence led to higher aggregate demand. At the same time, increases in
technology and productivity via computers increased aggregate supply. Increases in both curves
significantly increased real GDP, while the price level only moderately increased because the
curve shifts had contradictory effects on prices.
Changes in aggregate supply and aggregate demand cause recessionary and inflationary gaps and
affect real GDP, employment, and prices. In subsequent chapters, we will examine the tools
policymakers have available to mitigate-and potentially reverse-the effects of such curve
shifts.
206
Chapter 29: Aggregate Demand and Aggregate Supply
Multiple-Choice QUestions
l.
The ::10'("""'7"
demand curve slopes downward because as the price level rises,
(A)
the real value of consumers' wealth increases
(B)
(C)
(D)
(E)
interest rates "'-'_1"<'''".
consumers
mOre imports.
the unemployment rate decreases.
real output increases.
2.
Consumer spending as a component of
demand increases when
1.
consumer wealth increases.
consumer borrowing decreases.
consumer expectations about the economy are optimistic.
IV.
personal taxes increase.
(A)
I only
II and IV only
(B)
(C)
I and III only
II, III, and IV only
I, II, III, and IV
3.
of the following would result in an increase in
an increase in
(A)
interest rates.
(B)
exports.
(C)
govemment spending.
(D)
finns' expected return on investment.
exports.
(E)
incomes in countries buying
4.
O'O'rpO'''TP
demand EXCEPT
supply increases as the result of an increase in
cost of production.
worker productivity.
taxes.
government regulation of business.
the price of oil.
=P'O'''lt"
(A)
(B)
(C)
(D)
(E)
5.
Stagflation is caused by
(A)
an increase in aggregate demand.
(B)
a decrease in aggregate demand.
(C)
an increase in aggregate supply.
(D)
a decrease in aggregate supply.
(E)
a simultaneous increase in aggregate supply and ""'"""<.1,p demand.
6.
The equilibrium point of aggregate supply and aggregate demand detennines
(A)
wages and spending.
(B)
saving and investment.
(C)
taxes and government "1.1,",U\.1I'UF.'
(D)
profit and saving.
(E)
real GDP and price level.
Cnaptler 29: Aggregate Demand and Aglgre!~iUo;; Supply
207
7.
Which of the following situations would most likely result in a decrease in the price level
and a decrease in real GOP?
(A)
a decrease in consumer confidence
(B)
an increase in wages
(C)
a decrease in interest rates
(D)
an increase in productivity
(E)
an
in exports
8.
An increa:;;e in aggregate supply causes which of the following output and price level
effects?
(A)
(B)
(C)
(D)
(E)
Output
Increase
Decrease
No
Increase
Decrease
Price Level
Increase
No
Decrease
Decrease
Increase
9.
If the aggregate supply curve is horizontal and government spending increases, how will
price level, output, and employment be affected?
Price Level
Output
Employment
(A)
Increase
Increase
Increase
(B)
Decrease
Decrease
Decrease
(C)
No change
Increase
Increase
(D)
Decrease
No change
No change
(E)
Increase
Decrease
10.
If equilibrium
is in the intennediate range of aggregate supply and interest rates
how will price
output. and unemployment be affected?
Level
Output
Cnemploymen{
(A)
Increase
Increase
Increase
(B)
Decrease
Decrease
Decrease
(C)
Increase
Decrease
Increase
(D)
Decrease
Decrease
(E)
Increase
Increase
Free-Response Questions
1.
Assume the United States economy is currently operating at equilibrium.
(a)
Draw a correctly labeled aggregate supply and
demand graph, and show
of the following.
(i)
output
(ii)
price level
(b)
Now assume the price of oil, an important resource for U.S. production, increases
significantly. Illustrate the effect of the oil price increase on the AD-AS graph.
(c)
Identify and explain the effect of the increase in oil price on each of the following.
(i)
real output
(ii)
price level
(iii)
employment
208
Chapter 2Q: Aggregate Demand and Aggregate Supply
2.
(a)
(b)
(c)
Assume the ~nited
economy is currently operating at equilibrium.
Now assume mterest rates for investment loans increase.
(i)
~se a correctly labeled aggregate supply and aggregate demand graph to
Illustrate
effect of the
rate.
(ii)
Explain the mechanism that causes this change in the curve.
Explain
effect of the change in investment spending on each ofthe following.
0)
real output
Oi)
price level
(iii)
employment
Identify one fiscal policy government could implement to reverse the change in
investment spending.
Multiple-Choice Explanations
I.
(C)
When domestic prices rise, consumers buy relatively lower-priced imports,
the value of
reducing the quantity demanded of domestic goods. Higher prices
wealth and result in higher interest rates, which both reduce quantities demanded. With
the lower quantity demanded, real output is lower, leading to reduced employment.
2.
(C)
Increases in wealth and optimism about economic performance lead consumers
their demand for products at all prices. An increase in consumer borrowing
a reduction in personal taxes would also leave consumers with more available
income to increase aggregate demand.
3.
(A)
An increase in interest rates makes it more expensive for consumers and firms to
borrow, so their demand
products would de(:reclse.
4.
(B)
Increases in productivity lower per-unit costs of production, causing an increase
in aggregate supply. The other options increase costs.
5.
(D)
A decrease in aggregate supply
and unemployment at the same
time, which is characteristic of stagflation.
6.
(E)
Real GDP and price level are the axes of the aggregate expenditures model
graph, and each is determined by the level of aggregate supply and aggregate demand in
the economy.
7.
(A)
If consumers
confidence in future economic performance, they
a potential loss of a job.
aggregate demand out of concern
8.
(D)
An increase in aggregate supply shifts the curve to the right.
9.
(C)
An increase in government spending
output, so employment
to make
those products. Because price is inflexible, it
not change.
10.
(D)
Higher interest rates reduce aggregate demand, so price
and output fall.
Fewer workers are needed to produce output, so unemployment
Free-Response Explanations
I.
10 points (3 + 1 + 6)
(a)
3 points:
.. 1 point is earned for a correctly labeled AD-AS
.. 1 point is earned for
real output from the equilibrium point.
.. I point is earned for identifying price level from the equilibrium point.
(b)
1 point:
• 1 point is earned for shifting the aggregate supply curve to the left.
(c)
6 points:
• I point is
stating that real output will decrease.
• I point is earned for explaining that with a higher cost of production, firms produce
Chapter 29: Aggregate Demand and Aggregate Supply
209
•
•
•
•
2.
(a)
•
•
•
(b)
•
•
•
(c)
•
210
I point is earned for stating that the price level will increase.
1 point is earned for explaining that with a higher cost of production and lower output,
firms increase prices.
1 point is earned for stating that employment will fall.
I point is earned for explaining that because firms are producing less, they need fewer
workers to create the output.
7 points (3 + 3 + I)
3 points:
I point is earned for a correctly labeled AD-AS graph.
I point is earned for shifting aggregate demand to the left.
I point is earned for explaining that because the higher interest rate increases the cost of
investment, firms reduce investment spending.
3 points:
I point is earned for explaining that real output decreases because of reduced investment
spending.
I point is earned for explaining that the price level decreases because of reduced
aggregate demand or that prices remain the same if the answer specifically explains that
prices and wages are sticky downward.
I point is earned for explaining that employment decreases because fewer workers are
needed to produce the reduced output.
I point:
I point is earned for identifying either an increase in government spending or a decrease
in taxes as an appropriate fiscal policy to increase aggregate demand.
Chapter 29: Aggregate Demand and Aggregate Supply