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Chapter 23: Aggregate
Demand and Aggregate
Supply
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Learning Objectives
1. Define the aggregate demand curve, explain why it
slopes downward and explain why it shifts
2. Define the aggregate supply curve, explain why it
slopes downward and explain why it shifts
3. Show how the aggregate demand curve and the
aggregate supply curve determine the short-run
equilibrium levels of output and inflation, and show
how the aggregate demand curve, the aggregate
supply curve, and the long-run aggregate supply
curve determine the long-run equilibrium levels of
output and inflation
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Learning Objectives
4. Analyze how the economy adjusts to
expansionary and recessionary gaps and
relate this to the idea of a self-correcting
economy
5. Use the aggregate demand – aggregate
supply model to study the sources of
inflation in the short run and in the long
run
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The Aggregate Demand (AD) and Aggregate
Supply (AS) Model: A Brief Overview
 Shows how output and inflation are determined
simultaneously
 Short
run and long run analysis
 Current situation and future changes
Long-Run Aggregate
Supply (LRAS)
Inflation ()
 Inflation and output on the
axes
 Changes in inflation lead to
changes in spending on AD
 AS shows output gaps
affect inflation
 LRAS shows Y*
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Aggregate
Supply (AS)
Aggregate
Demand (AD)
Y* Output (Y)
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Inflation, Spending, And Output: The
Aggregate Demand Curve
The Keynesian model assumes that
producers meet demand at preset prices.
 Does
not explain inflation
Output gaps can cause inflation to increase
or decrease
The aggregate demand - aggregate supply
model shows both inflation and output
 Effective
for analyzing macroeconomic policies
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Inflation, The Central Bank, And The AD
Curve
 A primary objective of the central bank is to
maintain a low and stable inflation rate
 Inflation
is likely to occur when Y > Y*
 To control inflation, the central bank must keep Y from
exceeding Y*
 When inflation increases, the central bank
increases the nominal interest rate which, in turn,
increases real interest rates

r
C, IP
PAE 
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Y
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Inflation, The Central Bank, And The AD
Curve
 The central bank also responds to a recessionary
gap
 Inflation
is likely to decrease when Y < Y*
 When inflation decreases,
 The
central bank decreases the nominal interest rate
 real interest rates decrease and
 Aggregate spending increases

r
C, IP 
PAE 
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Y
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The Aggregate Demand Curve
 Aggregate demand (AD) curve shows the relationship
between short-run equilibrium output, Y, and the rate
of inflation, 

Holds all other factors constant
 AD has a negative slope
When inflation increases, the
central bank raises interest
rates
 Higher r means lower total
spending
 Along the AD curve, short-run Y
equals planned spending
Inflation ()

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AD
Output (Y)
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A
2
Inflation ()
1
 Initial conditions: 1, r1,Y1
 One point on AD
 Suppose inflation increases to
2
 Economy moves to 2, r2,Y2
 Second point on AD
Planned Spending (PAE)
r1
MPR
Inflation ()
Real interest rate (r)
r2
B
Y = PAE
A
PAE
(r = r1)
PAE
(r = r2)
B
Y2
2
Output (Y)
B
1
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Y1
A
AD
Y2
Y1 Output (Y)
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Shifts in Aggregate Demand Curve
 At a given inflation rate, aggregate demand shifts when

Exogenous changes in spending occur
Central bank's monetary policy reaction function changes
 Exogenous changes in
spending are changes
other than those caused
by changes in output or
the real interest rate



Consumer wealth
Business confidence
Foreign demand for
local goods
Inflation ()

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AD
AD'
Output (Y)
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Exogenous Changes in Spending
 Increases in aggregate demand could occur from
a boom in the stock market
 Consumer
wealth increases
 Consumption increases at each level of output and
real interest rate
Y
PAE curve shifts up
increases for each
possible level of 
 Aggregate demand
curve shift right
Inflation ()

AD
AD'
Output (Y)
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Tightening and Easing Monetary Policy
 The central bank's monetary policy reaction
function ties inflation to real interest rates
 Suppose

the central bank's targets are 1 and r1
MPR is shown in the graph
 Central bank normally follows a stable MPR
bank can tighten
or ease monetary policy

Shifts MPR
 Tightening
monetary
policy lowers the long-run
inflation target
Real interest rate (r)
 Central
MPR
r1
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1
Inflation ()
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Tightening Monetary Policy
 Tighter monetary policy
results in each interest rate,
r, being associated with a
lower rate of inflation
leftward shift of the MPR
 The economy begins at the
original target inflation rate,
1
 MPR
shifts to MPR2
 Central bank increases
interest rate from r1 to r2
Real interest rate (r)
A
MPR2
MPR1
r2
r1
2
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1
Inflation ()
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Easing Monetary Policy
 Easing monetary policy
results in each interest
rate, r, being associated
with a higher rate of
inflation
rightward shift of the
MPR
 The economy begins at the
original target inflation
rate, 1
 MPR
shifts to MPR3
 Central bank decreases
interest rate from r1 to r3
Real interest rate (r)
A
MPR1
r1
MPR3
r3
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1
3
Inflation ()
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Shift in Aggregate Demand
 MPR shifts up; interest rate increases from r1*
to r2*
r decreases PAE and shifts AD to AD'
MPR'
r2*
r1*
B
A
MPR
Inflation ()
Real interest rate (r)
 Higher
AD
AD'
1
1*
Inflation ()
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A
B
Y2
Y1
Output (Y)
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Inflation and Aggregate Supply
 Aggregate supply curve (AS) shows the
relationship between the rate of inflation and
the short-run equilibrium level of output
 Holds
all other factors constant
 Aggregate supply curve has a positive slope
 When
output is below potential, actual inflation is
above expected inflation
 When output is above potential, actual inflation is
below expected inflation
 Movement along the AS curve is related to
inflation inertia and output gaps
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Inflation Inertia, Output Gaps, And The AS
Curve
 Inflation will remain have inertia if the economy is
operating at Y*

No external shocks to the price level
 Three factors that can increase the inflation rate


Output gap
Inflation shock
■ Shock
to potential output
 In industrial economies, inflation tends to change
slowly from year to year for two reasons


Inflation expectations
Long-term wage and price contracts
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Inflation Expectations
 Today's expectations affect tomorrow's inflation
 Inflation
expectations are built into the pricing in
multi-period contracts
 The higher the expected
rate of inflation, the more
nominal wages and the
cost of other inputs will
increase
Slow Increase
in Wages and
Production
Costs
rising input costs,
firms increase their
prices to cover costs
Low
Inflation
 With
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Low
Expected
Inflation
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Expected Inflation
 Expectations are influenced by recent experience
 If
inflation is low and stable, people expect that to
continue
 Volatile inflation leads
Slow Increase
to volatile expectations
 Low and stable inflation
creates a virtuous circle
that keeps inflation low
 High and stable inflation
creates a vicious circle
that keeps inflation high
in Wages and
Production
Costs
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Low
Inflation
Low
Expected
Inflation
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Long-term Wage and Price Contracts
 Long-term contracts reduce the cost of
negotiations between buyers and sellers
 Cost
- Benefit Principle
 Labor contracts may be multi-year agreements
 Supply agreements, particularly for high cost
inputs, extend over several years
 Long-term contracts build in wage and price
increases that build in current expectations
about inflation
 In the absence of external shocks, inflation
tends to be stable over time
 Especially
true in industrialized economies
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Output Gaps and Inflation
Relationship of Output
to Potential Output
Behavior of Inflation
Expansionary gap
Y > Y*
Inflation increases
No output gap
Y = Y*
Inflation is stable
Recessionary gap
Y < Y*
Inflation decreases
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Deriving the AS Curve: Graphical Analysis
Current inflation () = expected inflation (e) +
inflation from an output gap
Inflation ()
 If the economy is operating at potential output,
then
 = e = 1 at A
Aggregate
Supply (AS)
 If the economy has an
B
inflationary gap, Y > Y*

and 2 > e at B
A

 If the economy has an
3 C
expansionary gap, Y < Y*
and 3 < e at C
Y2 Y* Y1 Output (Y)
 The AS curve slope up
2
1
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Shifts in the AS Curve
 Two changes can shift the
AS curve
 Inflation
expectations
 Inflation shocks
AS curve shifts to
the left
 At each level of output,
inflation is higher

AS2
Inflation ()
 If actual inflation exceeds
expectations, expected
inflation increases
AS1
2
1
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Y*
Output (Y)
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Inflation Shock
 An inflation shock is a sudden change in the normal
behavior of inflation

A shock is not related to an output gap
 A sudden rise in the price of oil increases prices of



Gasoline, diesel fuel, jet fuel, heating oil
Goods made with oil (synthetic rubber, plastics, etc.)
Transportation of most goods
 OPEC reduced supplies in 1973; price of oil
quadrupled


Food shortages occurred at the same time
Sharp increase in inflation in 1974
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Inflation Shocks
An adverse inflation shock shifts the
aggregate supply curve to the left
 Increases
inflation at each output level
 Oil price increases in 1973
A favorable inflation shock shifts the
aggregate supply curve to the right
 Lower
inflation at each output level
 Oil price decrease in 1986
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Aggregate Demand – Aggregate Supply
Analysis
 In the long run,
 Actual
output equals
potential output
 Actual inflation equals
expected inflation
 Aggregate
demand
 Aggregate supply and
 Long-run aggregate
supply
Inflation ()
 Long-run equilibrium
occurs at the intersection
of
Long-Run Aggregate
Supply (LRAS)
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Aggregate
Supply (AS)
Aggregate
Demand (AD)
Y* Output (Y)
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Aggregate Demand – Aggregate Supply
Analysis
Short-run equilibrium
occurs when there is
either an expansionary
gap or a recessionary gap
 Intersection
Short-run equilibrium is
temporary
LRAS
Inflation ()
of AD and
AS curves at a level of
output different from Y*
 Point A in the graph
AS1
1
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A
AD
Y* Y1
Output (Y)
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An Expansionary Gap
 Initial short-run equilibrium
at A
 AD
 Inflation increases and
expected inflation increases
 Shifts
AS curve to AS2
 Output is at potential, Y*
 New expected inflation
is 2
LRAS
Inflation ()
is stable as long as there
is no change in the central
bank's monetary policy rule
and no exogenous changes in
spending
AS2
2
1
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AS1
A
AD
Y* Y1
Output (Y)
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Adjustment from an Expansionary Gap
 When output is above potential output, firms increase
prices faster than the expected rate of inflation





Causes inflation to increase above expected level
As inflation rises, the central bank increases interest rates
Consumption and planned investment spending decrease
Planned aggregate expenditures decrease
Output decreases
 This process continues until the economy reaches
equilibrium at the potential level of output

Actual inflation is higher than initial level of inflation
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A Recessionary Gap
 Initial equilibrium is at B, a recessionary gap
 AD
curve remains stable unless MPR changes or
exogenous spending changes
 Aggregate
to AS2
supply shifts
 The new long-run
equilibrium is at potential
output and an inflation
level of 2
LRAS
Inflation ()
 With inflation above its
expected value, the central
bank lowers interest rates
1
2
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B
AS1
AS2
AD
Y1 Y*
Output (Y)
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Self-Correcting Economy
 In the long-run the economy tends to be selfcorrecting


Missing from Keynesian model
Concentrates on the short-run; no price adjustments
 Given time, output gaps disappear without any
changes in monetary or fiscal policy
 Whether stabilization policies are needed depends
on the speed of the self-correction process


If the economy returns to potential output quickly,
stabilization policies may be destabilizing
The greater the gap, the longer the adjustment period
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Self-Correcting Economy
 A slow self-correcting mechanism
 Fiscal
and monetary policy can help stabilize the
economy
 A fast self-correcting mechanism
 Fiscal
and monetary policy are not effective and
may destabilize the economy
 The speed of correction will depend on


The use of long-term contracts
The efficiency and flexibility of labor markets
 Fiscal
and monetary policy are most useful when
attempting to eliminate large output gaps
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Sources of Inflation: Excessive Aggregate
Spending
 Wars can trigger an inflationary gap
 Economy starts in long-run equilibrium, 1 and Y*
 Wartime government spending shifts AD to AD2

 If
Expansionary gap opens
Short-run equilibrium at
2 and Y2
AD stays at AD2 and
the central bank does not
change monetary policy,
inflation is higher than
expected
 AS shifts to AS2
LRAS
Inflation ()

3
2
AS2
AS1
1
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AD2
Y* Y2
AD1
Output (Y)
33
Wartime Spending
The increased output created by the shift in
aggregate demand is temporary
 Economy
returns to its potential output at Y*
but at a higher inflation rate
 Since Y has decreased, some component of
aggregate spending has also decreased


As inflation rose, the central bank increased the
real interest rate
Investment spending declined, crowded out by
government spending
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The War and the Central Bank
The central bank can prevent the increased
inflation from the rise in military spending
 The
central bank aggressively tightens money
during the military buildup
 Real interest rates increase
 Consumption and planned investment decrease
to offset the increase in spending for the war

Lowers current and future standards of living
 Planned
spending is stable
 No expansionary gap occurs
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The Effects of an Adverse Inflation Shock
Persistent inflation may be caused by an
adverse oil shock
 Aggregate
supply decreases, creating a
recessionary gap, resulting in stagflation, that
is higher inflation and a recessionary gap
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The Effects of an Adverse Inflation Shock
 Adverse oil shocks and stagflation are policy
challenges
 Government




can keeps policies constant
Inflation will eventually decrease
Aggregate supply curve shifts right
Recessionary gap closes
However, economy has a prolonged recession while
adjustment occurs
 If
the government attacks the recessionary gap
with added government spending and loosening
monetary policy, inflation increases

Higher and higher inflation rates resulted
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The Effects of an Adverse Inflation Shock
 Initial equilibrium is at 1 and Y*, potential output
 Oil shock reduces aggregate supply to AS2
Short-term equilibrium is a recessionary gap at 2 and
Y2
 Government can increase
AD to AD2 to address
recessionary gap

Raises inflation to 3
 Government can keep
policies constant and let
the economy adjust back
to AS1 with 1 and Y*
LRAS
Inflation ()

3
2
AS2
AS1
1
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AD2
Y2 Y*
AD1
Output (Y)
38
Shocks to Potential Output
 Oil shocks may lead to lower potential output
the inflationary effects of the shock
 Suppose long-run equilibrium
is at Y1 and 1
 Potential
output falls to Y2
and LRAS shifts to LRAS2
 Expansionary gap at Y1,
1 leads to lower output and
higher inflation
LRAS2
Inflation ()
 Compounds
LRAS1
2
1
AD
Y2 Y
Output (Y)
 Aggregate supply shock is
either an inflation shock or a shock to potential
output
1
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39