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Aggregate Demand and Aggregate
Supply
McGraw-Hill/Irwin
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Aggregate Demand and Aggregate Supply
• Learning objectives – After reading this chapter, students
should be able to:
• 1. Define aggregate demand (AD) and explain the factors that
cause it to change.
• 2. Define aggregate supply (AS) and explain the factors that
cause it to change.
• 3. Discuss how AD and AS determine an economy’s
equilibrium price level and level of real GDP.
• 4. Describe how the AD-AS model explains periods of
demand-pull inflation, cost-push inflation, and recession.
• 5. (Appendix) Identify how the aggregate demand curve
relates to the aggregate expenditures model.
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Aggregate Demand and Aggregate Supply
• AD-AS model is a variable price model. The aggregate
expenditures model in Chapter 28 assumed constant price.
• AD-AS model provides insights on inflation, unemployment
and economic growth.
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Aggregate Demand and Aggregate Supply
• Aggregate Demand
• A schedule or curve that shows the various amounts of real
domestic output that domestic and foreign buyers will desire to
purchase at each possible price level.
• The aggregate demand curve is shown in Figure 32.1.
• It shows an inverse relationship between price level and real
domestic output.
• The explanation of the inverse relationship is not the same as
for demand for a single product, which centered on
substitution and income effects.
– a. Substitution effect doesn’t apply within the scope of domestically
produced goods, since there is no substitute for “everything.”
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Price level
Aggregate Demand
AD
0
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Real domestic output, GDP
Aggregate Demand and Aggregate Supply
– Income effect also doesn’t apply in the aggregate case, since income
now varies with aggregate output.
• What is the explanation of the inverse relationship
between price level and real output in aggregate demand?
• a. Real balances effect: When price level falls, the
purchasing power of existing financial balances (saving
balances e.g., deposits) rises, the public feels richer, which
can increase spending and vice versa.
• b. Interest-rate effect: Given money supply, a decline in price
level decreases the demand for money, which means lower
interest rates that can increase levels of certain types of
spending (C, Ig and Xn). A higher price level increases the
demand for money, which means higher interest rates that can
decrease spending.
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Aggregate Demand and Aggregate Supply
•
c. Foreign purchases effect: When price level falls, other
things being equal, national prices will fall relative to foreign
prices, which will tend to increase spending on national
exports and also decrease import spending in favor of
national. products that compete with imports. (Similar to the
substitution effect.), Xn increases, and vice versa.
• Changes in aggregate demand: Determinants are the “other
things” (besides price level) that can cause a shift or change in
demand (see Figure 32.2 in text). Effects of the following
determinants are discussed in more detail in the text.
• If one of those determinants changes, this directly changes
AD. A multiplier effect produces a greater ultimate change in
AD.
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Price level
Changes in Aggregate Demand
AD2
AD3
AD1
0
Real domestic output, GDP
LO1
Aggregate Demand and Aggregate Supply
• 1. Changes in consumer spending, which can be caused by
changes in several factors.
–
–
–
–
a. Consumer wealth
b. Household borrowing
c. Consumer expectations
d. Personal taxes
• 2. Changes in investment spending, which can be caused
by changes in several factors.
• a. Real interest rates
• b. Expected returns, which are a function of
–
–
–
–
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Expected future business conditions
Technology
Degree of excess capacity
Business taxes
Aggregate Demand and Aggregate Supply
• 3. Changes in government spending.
• 4. Changes in net export spending unrelated to price level,
which may be caused by changes in other factors such as:
– a. National income abroad, and
– b. Exchange rates: For example, depreciation of the Brazilian real
encourages Brazilian exports since Brazilian products become less
expensive when foreign buyers can obtain more reals for their currency.
Conversely, Brazilian real depreciation discourages import buying in
Brazil because the reals can’t be exchanged for as much foreign
currency.
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Aggregate Demand and Aggregate Supply
• Aggregate Supply
• A schedule or curve showing the level of real domestic output
available at each possible price level.
• Aggregate supply in the immediate short-run (Figure 32.3)
• The aggregate supply curve is horizontal at a given price level
due to the rigidity of prices
• Aggregate supply in the short run (Figure 32.4)
• The short run aggregate supply curve is upward sloping.
• The lag between product prices and resource prices makes it
profitable for firms to increase output when the price level
rises.
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AS: Immediate Short Run
Price level
Immediate-short-run
aggregate supply
P1
0
ASISR
Qf
Real domestic output, GDP
LO2
Aggregate Supply: Short Run
AS
Price level
Aggregate supply
(short run)
0
Qf
Real domestic output, GDP
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Aggregate Demand and Aggregate Supply
• To the left of full-employment output, the curve is relatively flat.
The relative abundance of idle inputs means that firms can
increase output without substantial increases in production
costs.
• To the right of full-employment output the curve is relatively
steep. Shortages of inputs and production bottlenecks will
require substantially higher prices to induce firms to produce.
• Aggregate supply in the long run (Figure 32.5)
• In the long run the aggregate supply curve is vertical at the
economy’s full-employment output.
• The curve is vertical because in the long run resources prices
adjust to changes in the price level, leaving no incentive for
firms to change their output.
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Aggregate Supply: Long Run
Price level
ASLR
Long-run
aggregate
supply
0
Qf
Real domestic output, GDP
LO2
Aggregate Demand and Aggregate Supply
• References to “aggregate supply” in the remainder of the
chapter apply to the short run curve unless otherwise noted.
• Changes in aggregate supply: Determinants are the “other
things” besides price level that cause changes or shifts in
aggregate supply (see Figure 32.6 in text). The following
determinants are discussed in more detail in the text.
• 1. A change in input prices, which can be caused by
changes in several factors.
– a. Domestic resource prices
– b. Prices of imported resources
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Changes in Aggregate Supply
AS3
AS1
Price level
AS2
0
Real domestic output, GDP
LO2
Aggregate Demand and Aggregate Supply
• 2. Changes in productivity (productivity = real output / input)
can cause changes in per-unit production cost (production
cost per unit = total input cost / units of output). If productivity
rises, unit production costs will fall. This can shift aggregate
supply to the right and lower prices. The reverse is true when
productivity falls. Productivity improvement is very important in
business efforts to reduce costs.
• 3. Change in legal-institutional environment, which can be
caused by changes in other factors.
– a. Business taxes and/or subsidies, and
– b. Government regulation.
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Aggregate Demand and Aggregate Supply
• IV. Equilibrium and Changes in Equilibrium
• Equilibrium price and quantity are found where the aggregate
demand and supply curves intersect. (See Key Graph 32.7 for
illustration of why quantity will seek equilibrium where curves
intersect.)
• Increases in aggregate demand cause demand-pull inflation
(Figure 32.8).
• Increases in aggregate demand increase real output and
create upward pressure on prices, especially when the
economy operates at or above its full employment level of
output.
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Price level (index numbers)
Equilibrium
AS
100
a
92
b
AD
0
502
510 514
Real domestic output, GDP
(billions of dollars)
LO3
Real Output
Demanded
(Billions)
Price Level
(Index Number)
Real Output
Supplied
(Billions)
$506
108
$513
508
104
512
510
100
510
512
96
507
514
92
502
Increases in AD: Demand-Pull Inflation
Price level
AS
P2
P1
AD2
AD1
0
Qf
Q1 Q2
Real domestic output, GDP
LO4
Aggregate Demand and Aggregate Supply
• The multiplier effect weakens the further right the aggregate
demand curve moves along the aggregate supply curve. More
of the increase in spending is absorbed into price increases
instead of generating greater real output.
• Decreases in AD: If AD decreases, recession and cyclical
unemployment may result. See Figure 32.9. Prices don’t fall
easily.
1. Fear of price wars keeps prices from being reduced.
2. Menu costs discourage repeated price changes.
3. Wage contracts are not flexible so businesses can’t afford to
reduce prices.
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Decreases in AD: Recession
Price level
AS
P1
P2
b
a
c
AD1
AD2
0
Q1 Q2 Qf
Real domestic output, GDP
LO4
Aggregate Demand and Aggregate Supply
4. Employers are reluctant to cut wages because of impact
on employee effort, etc. Employers seek to pay efficiency
wages – wages that maximize work effort and productivity,
minimizing cost.
5. Minimum wage laws keep wages above that level
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Aggregate Demand and Aggregate Supply
• CONSIDER THIS … Ratchet Effect
• Shifting aggregate supply occurs when a supply determinant
changes.
• 1. Leftward shift in curve illustrates cost-push inflation (see
Figure 32.10).
• 2. Rightward shift in curve will cause a decline in price level
(see Figure 32.11). See text for discussion of this desirable
outcome.
• 3. In the late 1990s, despite strong increases in aggregate
demand, prices remained relatively stable (low inflation) as
aggregate supply shifted right (productivity gains).
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Decreases in AS: Cost-Push Inflation
Price level
AS2
AS1
b
P2
P1
a
AD
0
Q1 Qf
Real domestic output, GDP
LO4
Increases in AS: Full-Employment
Price level
AS1
P3
P2
P1
AS2
b
c
a
AD2
AD1
0
Q1
Q2 Q3
Real domestic output, GDP
LO4
Aggregate Demand and Aggregate Supply
• LAST WORD: Has the Impact of Oil Prices Diminished?
• In the mid- and late 1970s, oil price shocks caused cost-push
inflation, rising unemployment, and a negative GDP gap
(stagflation).
• In the late 1980s and through most of the 1990s, oil prices fell,
prompting OPEC (along with Mexico, Norway, and Russia) to
restrict output and raise prices (up to $34 per barrel in March
2000). This price shock did not cause the cost-push inflation
and recessionary conditions as with previous shocks.
• In 2005, conflict in the Middle East, combined with rapidly
rising demand for oil in India and China, pushed oil prices
above $60 per barrel (and over $70 per barrel in July 2006).
U.S. inflation rose in 2005, but not core inflation (inflation rate
minus price changes in food and energy).
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Aggregate Demand and Aggregate Supply
• In 2007 oil prices again increased to $50 per barrel and in July
of 2008 prices increased to $140 per barrel, but inflation didn’t
occur.
• A number of reasons explain why oil price shocks have had
less of an impact:
• 1. Oil prices are less significant in the U.S. economy today
than in the 1970s.
• 2. The amount of gas and oil used to produce each dollar of
output has declined by about 50 percent since 1970. (from
14,000 BTUs to 7,000 BTUs per dollar of GDP).
• 3. A reallocation of production from larger, heavier energy
intensive items to make toward smaller, lighter goods.
• 4. Federal reserve monetary policy helped keep oil price
increases from becoming generalized.
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Derivation of Aggregate Demand
• In Figure 1 we are deriving the aggregate demand curve from
the aggregate expenditures model. Both models measure real
GDP on the horizontal axis.
• Suppose the initial price level is P1 and aggregate
expenditures is AE1. Equilibrium real domestic output is Q1.
There will be a corresponding point on the aggregate demand
curve (Point 1).
• If price rises to P2, aggregate expenditures will fall to AE2
because purchasing power of wealth falls, interest rates may
rise, and net exports fall. Then new equilibrium is at Q2. That
generates a point (Point 2) up and to the left of Point 1.
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Derivation of Aggregate Demand
• If price rises to P3, real asset balance value falls, interest rates
rise again, net exports fall and new equilibrium is at Q3. This
generates a point (Point 3).
• Technically, the aggregate demand curve is found by drawing
a line (or curve) through Points 1, 2, and 3.
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Derivation of Aggregate Demand
AE1 (at P1 )
AE2 (at P2 )
AE3 (at P3 )
Aggregate Expenditures
(billions of dollars)
1
2
3
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LO1
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Price Level
45°
3
P3
2
P2
1
AD
P1
Q3
Q2
Q1
Real Domestic Product, GDP
LO5
Aggregate Demand Shifts
•
LO1
Figure 2 shows shifts of the aggregate expenditures schedule
and of the aggregate demand curve. When there is a change
in one of the determinants of consumption, investment, or net
exports, there will be a change in the aggregate expenditures
as well. The change in aggregate expenditures is multiplied
and aggregate demand shifts by more than the initial change
in spending. The text illustrates the multiplier effect of a
change in investment spending. Shift of AD curve = initial
change in spending x multiplier.
Aggregate Demand Shifts
AE2 (at P1 )
Aggregate Expenditures
AE1 (at P1 )
Price Level
45°
P1
AD2
AD1
Q1
Q2
Real Domestic Product, GDP
LO5
Aggregate Demand and Aggregate Supply
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