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Chapter 20
Aggregate Demand
and Supply
• Key Concepts
• Summary
• Practice Quiz
• Internet Exercises
1
In this chapter, you will
learn to solve these
economic puzzles:
Why
does
the
Was
John
Maynard
Would the greenhouse
aggregate
supply
Keynes’s
prescription
effect
cause
inflation,
for the
Great
curve
have
three
unemployment,
or both?
Depression
right?
different segments?
2
What is the Aggregate
Demand Curve?
The curve shows the level
of real GDP purchased by
households, businesses,
government, and
foreigners at different
price levels during a time
period, ceteris paribus
3
What does the Horizontal
Axis measure?
The value of final goods
and services included in
real GDP measured in
base year dollars
4
What does the Vertical
Axis measure?
It is an index of the overall
price level, such as the
GDP deflator or the CPI
5
Why does the Aggregate
Demand Curve slope
downward to the right?
• Real balance wealth effect
• Interest rate effect
• Net exports effect
6
What is the
Real Balance Effect?
Consumers spend more on
goods and services
because lower prices make
their dollars more valuable
7
What is the
Interest Rate Effect?
Assuming fixed credit, an
increase in the price
level translates through
higher interest rates into
a lower real GDP
8
What is the
Net Exports Effect?
A higher domestic price
level makes U.S. goods
more expensive compared
to foreign goods, exports
decrease, imports increase,
decreasing real GDP
9
$200
$150
Price Level
The Aggregate Demand Curve
A
B
$100
AD
$50
Real GDP
2
4
6
8
10 12
10
What can cause a shift
in the Aggregate
Demand Curve?
Consumption, investments,
government spending and
net exports can change
11
150
100
50
Price Level (CPI)
200
A Shift in the Aggregate
Demand Curve
A
B
AD2
AD1
Real GDP
2
4
6
8
10 12
12
What is the
Aggregate Supply Curve?
The curve that shows the
level of real GDP
produced at different
price levels during a time
period, ceteris paribus
13
Why did Keynes
assume fixed product
prices and wages?
During a deep recession or
depression, there are
many idle resources in
the economy
14
Why do idle Resources
mean Fixed Prices?
Producers are willing to
sell additional output at
current prices because
there is plenty of
resources to go around for
everyone who wants them
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Why do idle Resources
mean Fixed Wages?
The supply of unemployed
workers willing to work
for the prevailing wage
rate diminishes the power
of workers to increase
their wages
16
What kind of Supply
Curve would explain
Fixed Prices and Wages?
A horizontal supply curve
17
200
150
100
50
Price Level (CPI)
The Keynesian Horizontal
Aggregate Supply Curve
E1
E2
AS
AD2
AD1
Real GDP
2
4
6
8
10 12
18
Price level remains
constant, while real
GDP and
employment rise
Government
spending (G)
increases
Aggregate demand
increases and the
economy moves
from E1 to E2
19
According to Keynes,
what will a shift in
Aggregate Demand do?
It will restore a
depressed economy to
full employment
20
200
150
100
50
Price Level (CPI)
The Keynesian Horizontal
Aggregate Supply Curve
Full employment
E1
E2
AS
AD2
AD1
Real GDP
2
4
6
8
10 12
21
What is the Classical
view of the Aggregate
Supply Curve?
It is a vertical line at the
full employment output
22
According to the
Classical Economists,
where does the economy
normally operate?
The economy normally
operates at its full
employment level
23
How do the Classical
Economists view
Prices and Costs?
The price level of products
and production costs
change by the same
percentage in order to
maintain full employment
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The Classical Aggregate Supply Curve
AS
200
150
100
50
Price Level (CPI)
Surplus
Full employment
E1
E

E2
AD1
Real GDP
AD2
2 4 6 8 10 12 14 16 17
25
Three Ranges of the Aggregate Supply Curve
Price Level
AS
Classical Range
Intermediate Range
Full Employment
Keynesian Range
Real GDP
YK
YF
26
Increasing Demand
200
150
Price Level
AS
AD6
AD5
100
Full Employment
50
Real GDP
0
2
4
6
AD2
AD1
8
AD4
AD3
10
12
27
What factors can cause a
shift in the
Aggregate Supply Curve?
A change in ~
• resource prices
• technology
• taxes
• subsidies
• regulations
28
AS1
200
100
50
Price Level
150
E1
A Rightward Shift in the
Aggregate Supply Curve
AS2
E2
Full employment
AD
Real GDP
2 4 6 8 10 12 14 16 17
29
Increase in the aggregate
supply curve
Change in one or more nonpricelevel determinants: resource
prices, technological change,
taxes, subsidies, and regulations
30
What are the two
types of Inflation?
• Cost push
• Demand pull
31
What is
Cost Push Inflation?
A rise in the general
price level resulting
from an increase in the
cost of production
32
200
150
Price Level
Cost Push Inflation
AS2
100
AS1
E2
Full employment
E1
50
AD
Real GDP
2 4 6 8 10 12 14 16 17
33
What is
Demand Pull Inflation?
A rise in the general price
level resulting from an
excess of total spending
34
200
150
Price Level
Demand Pull Inflation
100
AS
E2
E1
50
Real GDP
Full employment
AD2
AD1
2 4 6 8 10 12 14 16 17
35
What determines the
Business Cycle?
Shifts in the aggregate
demand and aggregate
supply curves
36
Key Concepts
37
Key Concepts
• What is the Aggregate Demand Curve?
• Why does the Aggregate Demand Curve
slope downward to the right?
• What can cause a shift in the Aggregate
Demand Curve?
• What is the Aggregate Supply Curve?
• Why did Keynes assume fixed product
prices and wages?
• What kind of Supply Curve would
explain Fixed Prices and Wages?
38
Key Concepts cont.
• According to Keynes, what will a shift in
Aggregate Demand do?
• What is the Classical view of the Aggregate
Supply Curve?
• According to the Classical Economists,
where does the economy normally operate?
• What factors can cause a shift in the
Aggregate Supply Curve?
• What are the two types of Inflation?
39
Summary
40
The aggregate demand curve
shows the level of real GDP purchased
in the economy at different price levels
during a period of time.
41
Reasons why the aggregate
demand curve is downward-sloping
include the following three effects:
42
(1) The real balances or wealth
effect is the impact on real GDP
caused by the inverse relationship
between the purchasing power of
fixed value financial assets and
inflation, which causes a shift in the
consumption schedule.
43
(2) The interest-rate effect
assumes a fixed money supply, and,
therefore, inflation increases the
demand for money. As the demand
for money increases, the interest rate
rises, causing consumption and
investment spending to fall.
44
(3) The net exports effect is the
impact on real GDP caused by the
inverse relationship between net
exports and inflation. An increase in
the U.S. price level tends to reduce
U.S. exports and increase imports,
and vice versa.
45
150
100
50
Price Level (CPI)
200
A Shift in the Aggregate
Demand Curve
A
B
AD2
AD1
Real GDP
2
4
6
8
10 12
46
The aggregate supply curve
shows the level of real GDP that the
economy will produce at different
possible price levels. The shape of
the aggregate supply curve depends
on the flexibility of prices and
wages as real GDP expands and
contracts. The aggregate supply
curve has three ranges:
47
(1) The Keynesian range of the
curve is horizontal because neither
the price level nor production costs
will increase when there is
substantial unemployment in the
economy.
48
(2) In the intermediate range,
both prices and costs rise as real
GDP rises toward full employment.
Prices and production costs rise
because of bottlenecks, the stronger
bargaining power of labor, and the
utilization of less productive
workers and capital
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(3) The classical range is the
vertical segment of the aggregate
supply curve. It coincides with the
full-employment output. Because
output is at its maximum, increases
in aggregate demand will only cause
a rise in the price level.
50
Three Ranges of the Aggregate Supply Curve
Price Level
AS
Classical Range
Intermediate Range
Full Employment
Keynesian Range
Real GDP
YK
YF
51
Aggregate demand and aggregate
supply analysis determines the
equilibrium price level and the
equilibrium real GDP by the
intersection of the aggregate demand
and the aggregate supply curves. In
macroeconomic equilibrium,
businesses neither overestimate nor
underestimate the real GDP demanded
at the prevailing price level.
52
Stagflation exists when an
economy experiences inflation and
unemployment simultaneously.
Holding aggregate demand constant,
a decrease in aggregate supply
results in the unhealthy condition of
a rise in the price level and a fall in
real GDP and employment.
53
Cost-push inflation is inflation
that results from a decrease in the
aggregate supply curve while the
aggregate demand curve remains
fixed. Cost-push inflation is
undesirable because it is
accompanied by declines in both
real GDP and employment.
54
200
150
Price Level
Cost Push Inflation
AS2
100
AS1
E2
Full employment
E1
50
AD
Real GDP
2 4 6 8 10 12 14 16 17
55
Demand-pull inflation is
inflation that results from an
increase in the aggregate demand
curve in both the classical and the
intermediate ranges of the aggregate
supply curve while the aggregate
supply curve is fixed.
56
200
150
Price Level
Demand Pull Inflation
100
AS
E2
E1
50
Real GDP
Full employment
AD2
AD1
2 4 6 8 10 12 14 16 17
57
Chapter 20 Quiz
©2000 South-Western College Publishing
58
1. The aggregate demand curve is defined as
a. the net national product.
b. the sum of wages, rent, interest, and profits.
c. the real GDP purchased at different possible
price levels.
d. the total dollar value of household
expectations.
C. Answers a, b, and c are not real GDP
purchases at different possible price levels
during a time period.
59
2. When the supply of credit is fixed, an
increase in the price level stimulates the
demand for credit, which, in turn, reduces
consumption and investment spending. This
effect is called the
a. real balance effect.
b. interest-rate effect.
c. net exports effect.
d. substitution effect.
B. At a high price level, the demand for
borrowed money increases and results in
higher cost of borrowing (interest rates).
Higher interest rates result in lower
consumption and investment spending.
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3. The real balance effect occurs because a
higher price level reduces the real value of
people’s
a. financial assets.
b. wages.
c. unpaid debt.
d. physical investments.
A. As price increase the dollars people receive in
their paychecks and wealth are worth less. As
a result, real GDP demand decreases.
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4. The net exports effect is the inverse
relationship between net exports and the
_______of an economy.
a. Real GDP.
b. GDP deflator.
c. Price level.
d. Consumption spending.
C. A higher domestic price level makes
U.S. goods more expensive relative to
foreign goods and vice versa.
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5. Which of the following will shift the
aggregate demand curve to the left?
a. An increase in exports.
b. An increase in investment.
c. An increase in government spending.
d. A decrease in government spending.
D. Answers a, b, c shift the aggregate
demand curve to the right.
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6. Which of the following will not shift the
aggregate demand curve to the left?
a. Consumers become more optimistic about
the future.
b. Government spending decreases.
c. Business optimism decreases.
d. Consumers become pessimistic about the
future.
A. Answers b, c and d shift the aggregate
demand curve leftward.
64
7. The popular theory prior to the Great
Depression that the economy will automatically
adjust to achieve full employment is
a. supply-side economics.
b. Keynesian economics.
c. classical economics.
d. mercantilism.
C. Supply-side economic concerns shifts in
aggregate supply. Keynesians do not believe
the economy automatically adjusts to full
employment. Mercantilism is the idea that gold
or silver is the source of a nation’s wealth.
65
8. Classical economists believed that the
a. price system was stable.
b. goal of full employment was impossible.
c. price system automatically adjusts the
economy to full employment in the long run.
d. government should not attempt to restore
full employment.
C. This is a key assumption for the vertical
shape of the classical aggregate supply curve.
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9. Which of the following is not a range on the
eclectic or general view of the aggregate supply
curve?
a. Classical range.
b. Keynesian range.
c. Intermediate range.
d. Monetary range.
D. Answers a, b, and c are the three district
ranges of the aggregate supply at a level of
real GDP below full employment.
67
Three Ranges of the Aggregate Supply Curve
Price Level
AS
Classical Range
Intermediate Range
Full Employment
Keynesian Range
Real GDP
YK
YF
68
10. Macroeconomic equilibrium occurs when
a. aggregate supply exceeds aggregate demand.
b. the economy is at full employment.
c. aggregate demand equals aggregate supply.
d. aggregate demand equals the average price
level.
C. Note that aggregate demand can equal
aggregate supply at a level of real GDP
below full employment.
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11. Along the classical or vertical range of
the aggregate supply curve, a decrease in
the aggregate demand curve will decrease
a. both the price level and real GDP.
b. only real GDP.
c. only the price level.
d. neither real GDP or the price level.
C. Along the vertical range of the aggregate
supply curve, the economy is at full
employment and only the price level changes.
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12. Other factors held constant, a decrease in
resource prices will shift the aggregate
a. demand curve leftward.
b. demand curve rightward.
c. supply curve leftward.
d. supply curve rightward.
D. Changes in production costs do not
affect the aggregate demand curve.
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13. Assuming a fixed aggregate demand curve, a
leftward shift in the aggregate supply curve
causes a (an)
a. increase in the price level and a decrease in
real GDP.
b. increase in the price level and an increase in
real GDP.
c. decrease in the price level and a decrease in
real GDP.
d. decrease in the price level and an increase in
real GDP.
A.
72
200
150
Price Level
Cost Push Inflation
AS2
AS1
E2
Full employment
E1
100
AD
50
Real GDP
2 4 6 8 10 12 14 16 17
73
14. An increase in the price level caused by a
rightward shift of the aggregate demand curve
is called
a. cost-push inflation.
b. supply shock inflation.
c. demand shock inflation.
d. demand-pull inflation.
D.
74
200
150
Price Level
Demand Pull Inflation
AS
E2
E1
100
50
Real GDP
Full employment
AD2
AD1
2 4 6 8 10 12 14 16 17
75
15. Suppose workers become pessimistic about
their future employment, which causes them to
save more and spend less. If the economy is on
the intermediate range of the aggregate supply
curve, then
a. both real GDP and the price level will fall.
b. real GDP will fall and the price level will
rise.
c. real GDP will rise and the price level will
fall.
d. both real GDP and the price level will rise.
A. A leftward movement of the aggregate
demand curve along a downward sloping
aggregate supply curve will result in lower
prices and less employment.
76
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END
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