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ECON 2133 Class Outline 7
Chap. 13 – Aggregate Demand and Aggregate Supply
The AD – AS model is an extension of the AE model; however, the AD – AS model
relates output (Y, or GDP) to the economy’s price level .
Model components

AD – ___________________

SRAS – ___________________

LRAS – ___________________
The model helps us

“See” disequilibrium conditions

Understand both ______ and ___________ adjustments

Distinguish short- and long-run ___________
I. The AD curve
Directly relates D for output to the price level (PL)
The PL is the ____________ variable, D for output (GDP) is the _________
variable
The AD curve is derived from the ________ and ____ models
See Fig. 2, pg. 343
Determinants of AD
The PL – Y relationship is what the AD curve models, so that
a Δ in the PL implies a ______________ a given AD curve to a different
Y level (see pg. 344 – 345)
Other determinants of AD (see pg. 345) ________ the AD curve
[G, Tx, Co, I, NX, Ms]
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(See pg. 345 – 348; Fig. 3, pg. 346 and Fig. 4, pg. 347)
II. The SRAS curve
Directly relates supply of output to the PL
S of output (GDP) is the ___________ variable, PL is the _________ variable
WHY?
The SRAS curve is based on production cost theory (pg. 348 – 351). Key
idea:

Increased production implies _________ MC and AC, so that product
prices must ______ with increased Q/S
Determinants of SRAS

A Δ in GDP implies a ______________ a given AS curve
(See
pg. 352 – 353 & Fig. 5)

Other determinants of SRAS (pg. 353 – 356) _______ the SRAS curve
[∆ in input costs for reasons other than a ∆ in Y, weather,
technological change, nominal wage rate]
(See Fig. 6, pg. 354 and Fig. 7, pg. 355)
____________ equilibrium is where the AD and SRAS curves intersect
(Fig. 8, pg. 357)
Short run adjustments to econ. shocks
A “shock” is any event that _________ the AD or AS curve
AD shocks result from any change in autonomous spending
E.g.: Start with the econ. in a full empl. (general) equilib.
Pt. E on Fig. 9 pg. 358 --- Y = 10 tril., P = 100
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1. Suppose G increases to shift AD from AD1 to AD2
Why doesn’t the
increase in Y = the increase in AD (i.e., the distance E – J, or by 2.5 tril.)???
The new equilibrium can’t be at point J because the economy can’t supply
12.5 tril. of Y at a P level of _____!
Why not???
a) Starting at point E, if an AD shock that increases AD from AD1 to AD2
____________ increases Y
b) but the increase in Y will increase production (“unit”) costs – i.e., the
economy’s P level will __________
c) the combination of incr. Y and incr. P means that Md will increase, which
____________ the i rate
d) Higher i rate will __________ Ip and Co (crowding out)
e) So Y only increases from point E (10 tril.) to point N (11.5 tril.), with a
__________________
Study Fig. 9 (p. 358) and the sequence diagram on
p. 359.
2. Suppose Ms increases – the i rate will __________, which _________ Ip and
Co, which _________ AD
But then the sequence of short run adjustments under a) – d), above, will occur,
which leaves the final short run equilib. the same as described in e), above
(Study sequence diagram on p. 360)
The difference between the two e.g.s is that an incr. in G will definitely
____________ the i rate, but an incr. in Ms will first __________ the i rate,
but then __________ it again (likely back to the original i rate)
Bottom line: Both expansionary fiscal (incr. G) and monetary (incr. Ms)
policy increase the __________ (cause inflation). But incr. G generally
increases the ________, while incr. Ms generally does not.
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Long run adjustments to econ. shocks
An AD shock that drives output above the full employment level will

Cause __________ to be unusually high, which means that producers have to
compete for scarce labor

This will increase the D for labor and wage rates __________________ (wage
rates change slowly)

Since the SRAS curve implies a given wage rate, the curve shifts _________
to reflect a higher wage rate

Y returns to its “_______________” level, and ____ increases
See Fig. 10 (pg. 362)
Bottom line: An AD shock that “overheats” the econ. increases Y in the
___________, but increases the P level (i.e., higher rate of inflation) in the
___________.
Starting at Yfe, a negative D shock will

____________ AD

Give a ____________ equilib. with <Y and <P

But in the long run the wage rate will decrease, which shifts the SRAS curve
_________

So that the econ. returns to a long run equilib. with Y returning to Yfe and P
_________
See Fig. 11, pg. 363
All of the above implies that long run equilib. is at Yfe (just as the classical model
says – see Chap. 7)
In the AD – AS model, this means that the LRAS curve may be drawn vertical at the
Yfe level
(Fig. 12, pg. 364)
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What about supply shocks?

A negative S shock ____________ production costs, which shifts the SRAS
curve ______

Yields a short run equilib. with lower Y, but _________ P (commonly called
“stagflation”)

In the long run the wage rate will decrease, which shifts the SRAS curve
back ________

So that the econ. returns to a long run equilib. with Y returning to Yfe and P
__________
See Fig. 13, pg. 366
And a positive AS shock will

Shift the SRAS curve ________

Yields a short run equilib. with ________ Y and ________ P

But if Y > Yfe, then the wage rate will ________, which shifts the SRAS curve
back ____

So that the econ. returns to a long run equilib. at Yfe and P at its __________
level
[ Illustrate ]
Final notes:
“Using the Theory” (pg. 368 – 370) is a good read
Note that

The 1990-91 recession was caused by a negative AS shock (Fig. 14a,
pg. 369), which resulted in a continuing and essentially constant rate
of inflation (Fig. 15b, pg. 370)

The 2001 recession was caused by a negative AD shock (Fig. 14b),
which resulted in a decrease in the inflation rate – and even deflation
in the 3rd quarter of 2001 (Fig. 15d)

See also “Using the Theory” on pp. 331 – 333 for a summary of the
Fed’s actions re. the 2001 recession
XXX Chap. 13