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McConnell Macroeconomics 13CE
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CH 10 - Aggregate Demand and Aggregate
CHAPTER TEN
AGGREGATE DEMAND AND
AGGREGATE SUPPLY
CHAPTER OVERVIEW
The aggregate expenditures model developed in Chapter 9 is a fixed price level model. Its focus is on
changes in real GDP, not on changes in the price level. This chapter introduces a variable-price model in
which it is possible to simultaneously analyze changes in real GDP and the price level. This distinction
should be made explicit for those students who have covered Chapter 9. What students learn in this
chapter will help organize their thoughts about equilibrium GDP, the price level, and government
macroeconomic policies. The tools learned will be applied in later chapters.
The present chapter introduces the concepts of aggregate demand and the short and long run aggregate
supply, explaining their shapes and the forces causing them to shift. The equilibrium levels of prices and
real GDP are considered. Finally, the chapter analyzes the effects of shifts in the aggregate demand
and/or aggregate supply curves on the price level and size of real GDP in the short run and the long run.
WHAT’S NEW
This chapter has undergone a number of relatively minor revisions.
Throughout the chapter, information about the recession of 2008 – 2009 has been added.
The Quick Reviews have been revised.
The Last Word now includes more current information about oil prices.
All of the relevant tables and data have been updated.
INSTRUCTIONAL OBJECTIVES
After completing this chapter, students should be able to:
1. Define aggregate demand and aggregate supply.
2. Give three reasons why the aggregate demand curve slopes downward.
3. State the determinants of the aggregate demand curve’s location, and explain how the curve will
shift when one of these determinants changes.
4. Distinguish between an initial shift in aggregate demand and the full shift after multiplier effects
have been incorporated.
5. Explain the shape of the long-run aggregate supply curve.
6. Explain the shape of the short-run aggregate supply curve.
7. Indicate the determinants of the aggregate supply curve’s location, and explain how the curve will
shift when one of those determinants changes.
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8. Find an economy’s equilibrium price level and real domestic output using AD-AS.
9. Explain how the multiplier effect is weakened when there is demand-pull inflation.
10. Demonstrate and explain how a decrease in aggregate demand can cause a recession without a drop
in the price level.
11. Demonstrate and explain the effects of shifts in aggregates supply on the equilibrium price level
and real domestic output of an economy.
12. Explain how an economy can maintain full employment and stable prices under conditions of
rising aggregate demand.
13. Explain how the impact of oil price fluctuations has changed for the U.S. economy over the past
couple decades.
14. Define and identify terms and concepts at the end of the chapter and in the appendix.
COMMENTS AND TEACHING SUGGESTIONS
1.
The aggregate demand–aggregate supply model will be used repeatedly for discussion of
unemployment, inflation, and economic growth in other chapters. It is important for students to
understand the basics in this chapter.
2.
While it is helpful to show the similarities between the aggregate model and single-product supply
and demand markets explained in Chapter 3, you need to highlight the differences between the two
models.
3.
The concepts of demand-pull and cost-push inflation that were introduced earlier can be analyzed
graphically by using the aggregate demand–aggregate supply model
4.
If you have a number of students in your class who are business majors or pursuing careers in
business, you may wish to expand on the section on productivity. The relationship between
productivity growth and lower per unit cost of output is especially important for these students to
understand.
STUDENT STUMBLING BLOCKS
1.
The difference between aggregate demand–aggregate supply (AD–AS) model and the demand–
supply analysis for a single product market is difficult for students to grasp. The similarities are so
great that students often don’t focus on the important differences between the two models.
2.
Students continue to confuse changes in demand with changes in supply. For example, if asked
about an increase in export sales of wheat, some students will inevitably view this as a decrease in
supply, because wheat leaves the country. Repetition of the determinants of demand and supply can
help clarify the distinction.
LECTURE NOTES
I.
Introduction to AD-AS Model
A. 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.
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3. Discuss how AD and AS determine an economy’s equilibrium price level and level of
real GDP.
4. (Appendix) Identify how the aggregate demand curve relates to the aggregate expenditure
model
B. AD-AS model is a variable price model. The aggregate expenditures model in Chapter 9
assumed constant price.
C. AD-AS model provides insights on inflation, unemployment and economic growth.
II.
Aggregate Demand
A. 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.
B. The aggregate demand curve is shown in Figure 10-1.
1. It shows an inverse relationship between price level and domestic output.
2. 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 in the aggregate case, since there is no substitute for
“everything.”
b. Income effect also doesn’t apply in the aggregate case, since income now varies with
aggregate output.
3. What is the explanation of 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 rises, which can increase spending.
b. Interest-rate effect: A decline in price level means lower interest rates which can
increase levels of certain types of spending.
c. Foreign trade effect: When price level falls, other things being equal, Canadian
prices will fall relative to foreign prices, which will tend to increase spending on
Canadian exports and also decrease import spending in favour of Canadian products
that compete with imports.
C. Changes in aggregate demand: Determinants are the “other things” (besides price level) that
can cause a shift or change in demand (see Figure 10-2 in text). Effects of the following
determinants are discussed in more detail in the text.
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. 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
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
b. Exchange rates: Depreciation of the dollar encourages Canadian exports since
Canadian products become less expensive when foreign buyers can obtain more
dollars for their currency. Conversely, dollar depreciation discourages import buying
in Canada because our dollars can’t be exchanged for as much foreign currency.
III.
Aggregate Supply
A. A schedule or curve showing the level of real domestic output available at each possible price
level.
B. Aggregate supply in the long run (Figure 10-5)
1. In the long run the aggregate supply curve is vertical at the economy’s full-employment
output.
2. The curve is vertical because in the long run resource prices adjust to changes in the price
level, leaving no incentive for firms to change their output.
C. Aggregate supply in the short run (Figure 10-4)
1. The short-run aggregate supply curve is upward sloping.
2. The lag between product prices and resource prices makes it profitable for firms to
increase output when the price level rises.
3. 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.
4. 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.
D. Aggregate supply in the long run (Figure 10.5)
1. In the long run the aggregate supply curve is vertical at the economy’s full-employment
output.
2. 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.
E. References to “aggregate supply” in the remainder of the chapter apply to the short run
curve unless otherwise noted
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F. Changes in aggregate supply: Determinants are the “other things” besides price level that
cause changes or shifts in aggregate supply (see Figure 10-6 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
c. Market power in certain industries
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
b. Government regulation
IV.
Equilibrium: Real Output and the Price Level
A. Equilibrium price and quantity are found where the aggregate demand and supply curves
intersect. (See Key Graph 10-7 for illustration of why quantity will seek equilibrium where
curves intersect.)
B. Try the Quick Quiz in Figure 10-7.
C. Increases in aggregate demand cause demand-pull inflation (Figure 10-7).
1. 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.
2. 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 rather than generating greater real output.
D. Decreases in AD: If AD decreases, recession and cyclical unemployment may result. See
Figure 10.9. Prices don’t fall easily.
1. Wage contracts are not flexible so businesses can’t afford to reduce prices.
2. 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.
3. Minimum wage laws keep wages above that level.
4. Menu costs are difficult to implement.
5. Fear of price wars keeps prices from being reduced.
6. CONSIDER THIS … Ratchet Effect
E. Shifting aggregate supply occurs when a supply determinant changes.
1. Leftward shift in curve illustrates cost-push inflation (see Figure 10-10).
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2. Rightward shift in curve will cause a decline in price level (see Figure 10-11). See text
for discussion of this desirable outcome.
V.
LAST WORD: Has the Impact of Oil Prices Diminished?
A. In the mid- and late 1970s, oil price shocks caused cost-push inflation, rising
unemployment, and a negative GDP gap (stagflation).
B. 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 US$34 per
barrel in March 2000). This price shock did not cause the cost-push inflation and
recessionary conditions as with previous shocks.
C. 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).
Canadian inflation rose in 2005, but not core inflation (inflation rate minus price changes
in food and energy).
D. 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.
E. A number of reasons explain why oil price shocks have had less of an impact:
1. Lower production costs from productivity increases have offset inflationary pressures
from oil price increases.
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. Bank of Canada monetary policy helped keep oil price increases from becoming
generalized.
APPENDIX TO CHAPTER 10
I.
The Relationship of the Aggregate Demand Curve to the Aggregate Expenditures Model
A. Deriving AD-curve from aggregate expenditures model. (See Appendix Figure 1)
1. Both models measure real GDP on horizontal axis.
2. Suppose initial price level is P1 and aggregate expenditures AE1 as shown in Appendix
Figure 1a. Equilibrium real domestic output is Q1. There will be a corresponding point
on the aggregate demand curve (Point 1 on Appendix Figure 1b).
3. 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. (See Appendix Figure 1a.) Then
new equilibrium is at Q2. That generates a point (Point 2) up and to the left of Point 1 on
Appendix Figure 1b.
4. If price rises to P3, real asset balance value falls, interest rates rise again, net exports fall
and new equilibrium is at Q3. Again see Appendix Figures 1a and 1b.
5. Technically, the aggregate demand curve is found by drawing a line (or curve) through
Points 1, 2, and 3 on Appendix Figure 1b.
B. Aggregate demand shifts and the aggregate expenditures model (Appendix Figure 2):
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1. When there is a change in one of the determinants of aggregate demand, there will be a
change in the aggregate expenditures as well. Look at Appendix Figure 2a.
2. The change in aggregate expenditures is multiplied and aggregate demand shifts by more
than the initial change in spending (see Appendix Figure 2b). The text illustrates the
multiplier effect of a change in investment spending.
3. Shift of AD curve = initial change in spending x multiplier
4. The effect of the shift on real domestic output and the price level will depend on the
starting point relative to full-employment output, as well as the relative steepness of the
aggregate supply curve.
QUIZ
1. A rightward shift of the AD curve in the very steep upper part of the upsloping AS curve will:
A. increase real output by more than the price level.
B. increase the price level by more than real output.
C. reduce real output by more than the price level.
D. reduce the price level by more than real output.
Answer: B
2. The fear of unwanted price wars may explain why many firms are reluctant to:
A. reduce wages when a decline in aggregate demand occurs.
B. reduce prices when a decline in aggregate demand occurs.
C. expand production capacity when an increase in aggregate demand occurs.
D. provide wage increases when labor productivity rises.
Answer: B
3. The foreign purchases effect suggests that an increase in the Canadian price level relative to other
countries will:
A. increase the amount of Canadian real output purchased.
B. increase Canadian imports and decrease Canadian exports
C. increase both Canadian imports and Canadian exports.
D. decrease both Canadian imports and Canadian exports.
Answer: B
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4. Which set of events would most likely decrease aggregate demand?
A. A reduction in the excess capital of the existing capital stock
B. A reduction in business and personal tax rates
C. An increase in investment spending
D. An increase in personal income tax rates
Answer: D
5. The slope of the immediate-short-run aggregate supply curve is based on the assumption that:
A. Both input and output prices are fixed
B. Neither input nor output prices are fixed
C. Input prices are flexible but output prices are fixed
D. Input prices are fixed but output prices are flexible
Answer: A
6. A fall in the price of capital goods will shift the aggregate:
A. Demand curve leftward
B. Demand curve rightward
C. Supply curve rightward
D. Supply curve leftward
Answer: C
7. A decline in the quantity of real output demanded along the aggregate demand curve is a result of
a(n):
A. Decrease in the level of income
B. Increase in the price level
C. Increase in the level of income
D. Decrease in the price level
Answer: B
8. Efficiency wages are associated with:
A. A price level that is inflexible upward
B. A price level that is inflexible downward
C. A domestic output that cannot be increased
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D. A domestic output that cannot be decreased
Answer: B
9. The economy experiences an increase in the price level and a decrease in real domestic output.
Which is a likely explanation?
A. Productivity has increased
B. Input prices have increased
C. Excess capacity has decreased
D. Government regulations have been reduced
Answer: B
10. If at a particular price level, real domestic output from producers is greater than real domestic
output desired by purchasers, there will be a:
A. Surplus and the price level will rise
B. Surplus and the price level will fall
C. Shortage and the price level will rise
D. Shortage and the price level will fall
Answer: B
ANSWERS TO END-OF-CHAPTER QUESTIONS AND PROBLEMS
QUESTIONS
1. Why is the aggregate demand curve downsloping? Specify how your explanation differs from the
downsloping demand curve for a single product. LO 10-1
Answer: The aggregate demand (AD) curve shows that as the price level drops, purchases of real
domestic output increase. The AD curve slopes downward for three reasons. The first is the interest-rate
effect. We assume the supply of money to be fixed. When the price level increases, more money is
needed to make purchases and pay for inputs. With the money supply fixed, the increased demand for it
will drive up its price, the rate of interest. These higher rates will decrease the buying of goods with
borrowed money, thus decreasing the amount of real output demanded.
The second reason is the real balances effect. As the price level rises, the real value—the purchasing
power—of money and other accumulated financial assets (bonds, for instance) will decrease. People will
therefore become poorer in real terms and decrease the quantity demanded of real output.
The third reason is the foreign trade effect. As Canada’s price level rises relative to other countries,
Canadians will buy more abroad in preference to their own output. At the same time foreigners, finding
Canadian goods and services relatively more expensive, will decrease their buying of Canadian exports.
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Thus, with increased imports and decreased exports, Canadian net exports decrease and so, therefore,
does the quantity demanded of Canadian real output.
These reasons for the downsloping AD curve have nothing to do with the reasons for the downsloping
single-product demand curve. In the case of the dropping price of a single product, the consumer with a
constant money income substitutes more of the now relatively cheaper product for those whose prices
have not changed. Also, the consumer has become richer in real terms, because of the lower price of the
one product, and can buy more of it and all other products. But with the AD curve, moving down the
curve means all prices are dropping—the price level is dropping. Therefore, the single-product
substitution effect does not apply. Also, whereas when dealing with the demand for a single product the
consumer’s income is assumed to be fixed, the AD curve specifically excludes this assumption.
Movement down the AD curve indicates lower prices but, with regard to the circular flow of economic
activity, it also indicates lower incomes. If prices are dropping, so must the receipts or revenues or
incomes of the sellers. Thus, a decline in the price level does not necessarily imply an increase in the
nominal income of the economy as a whole.
2. Distinguish between “real-balances effect” and “wealth effect,” as the terms are used in this chapter.
How does each relate to the aggregate demand curve? LO 10-1
Answer: The “real balances effect” refers to the impact of price level on the purchasing power of asset
balances. If prices decline, the purchasing power of assets will rise, so spending at each income level
should rise because people’s assets are more valuable. The reverse outcome would occur at higher price
levels. The “real balances effect” is one explanation of the inverse relationship between price level and
quantity of expenditures.
The “wealth effect” assumes the price level is constant, but a change in consumer wealth causes a shift in
consumer spending; the aggregate expenditures curve will shift right. For example, the value of stock
market shares may rise and cause people to feel wealthier and spend more. A stock decline can cause a
decline in consumer spending.
3. What assumptions cause the immediate-short-run aggregate supply curve to be horizontal? Why is the
long-run aggregate supply curve vertical? Explain the shape of the short-run aggregate supply curve. Why
is the short-run curve relatively flat to the left of the full-employment output and relatively steep to its
right? LO 10-2
Answer: The immediate short-run supply curve is horizontal because of contractual agreements. These
‘contracts’ for both input and output prices imply that prices do not change along the immediate short-run
aggregate supply curve.
The long-run aggregate supply curve is vertical (at the full-employment or potential output) because the
economy’s potential output is determined by the availability and productivity of real resources, not by the
price level. The availability and productivity of real resources is reflected in the prices of inputs, and in
the long run these input prices (including wages) adjust to match changes in the price level. Firms have
no incentive to increase production to take advantage of higher prices if they simultaneously face equally
higher resource prices.
The shape of the short-run supply curve is upsloping. Wages and other input prices adjust more slowly
than the price level, leaving room for firms to take advantage of these higher prices (temporarily) by
increasing output. Firms face increasing per unit production costs as they increase output, making higher
prices necessary to induce them to produce more.
To the left of full-employment output the curve is relatively flat because of the large amounts of unused
capacity and idle human resources. Under such conditions, per-unit production costs rise slowly because
of the relative abundance of available inputs. Additional resources are easily brought into production, as
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the suppliers of these resources (especially labor) are anxious to employ them and are happy to accept
current prices.
To the right of full-employment output the curve is relatively steep because most resources are already
employed. Those resources that are not yet in production require higher prices to induce them, or
generate higher per-unit production costs because they are less productive than currently employed inputs.
Firms trying to increase production bid up input prices as they attempt to attract resources away from
other firms. Even if the firm succeeds in pulling resources from another firm, the aggregate increase in
output is minimal at best, as resources are merely shifted from one productive process to another.
4. What effects would each of the following have on aggregate demand or short-run aggregate supply,
other things equal? In each case use a diagram to show the expected effects on the equilibrium price level
and level of real output, assuming that the price level is flexible both upward and downward. LO 10-3
a. A widespread fear 0f recession among consumers.
b. A new national tax on producers based on the value-added between the costs of the inputs and the
revenue received from their output.
c. A reduction in interest rates at each price level.
d. A major increase in federal spending for health care.
e. The expectation of rapid inflation.
f. The complete disintegration of OPEC, causing oil prices to fall by one-half.
g. A 10 percent reduction in personal income tax rates.
h. A sizable increase in labour productivity (with no change in nominal wages).
i. A 12 percent increase in nominal wages (with no change in productivity).
j. An increase in exports that exceeds an increase in imports (not due to tariffs).
Answer:
(a)
AD curve left, output down and price level down (assuming no ratchet effect).
(b)
AS curve left, output down and price level up.
(c)
AD curve right, output and price level up.
(d)
AD curve right, output and price level up (any real improvements in health care resulting
from the spending would eventually increase productivity and shift AS right).
(e)
AD curve right, output and price level up.
(f)
AS curve right, output up and price level down.
(g)
AD curve right, output and price level up.
(h)
AS curve right, output up and price level down.
(i)
AS curve left, output down and price level up.
(j)
AD curve right (increased net exports); AS curve left (higher input prices)
5. Assume that (a) the price level is flexible upward but not downward and (b) the economy is currently
operating at its full-employment output. Other things equal, how will each of the following affect the
equilibrium price level and equilibrium level of real output in the short run? LO 10-3
a. An increase in aggregate demand.
b. A decrease in aggregate supply, with no change in aggregate demand.
c. Equal increases in aggregate demand and aggregate supply.
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d. A decrease in aggregate demand.
e. An increase in aggregate demand that exceeds an increase in aggregate supply.
Answer:
(a)
Price level rises rapidly and little change in real output.
(b)
Price level rises and real output decreases.
(c)
Price level does not change, but real output increases.
(d)
Price level does not change, but real output declines.
(e)
Price level increases somewhat, as does real output.
6. Explain how an upsloping aggregate supply curve weakens the impact of a rightward shift of the
aggregate demand curve. LO 10-3
Answer: An upsloping aggregate supply curve weakens the effect of the multiplier because any increase
in aggregate demand will have both a price and an output effect. For example, if aggregate demand
grows by $110 million as a result of increased in investment spending, this could represent an increase of
$100 million in real output and $10 million in higher prices if the inflation rate averages 10 percent. The
multiplier is weakened because some of the increase in aggregate demand is absorbed by the higher prices
and real output does not change by the full extent of the change in aggregate demand.
7. Why does a reduction in aggregate demand in the actual economy reduce real output, rather than the
price level? Why might a full-strength multiplier apply to a decrease in aggregate demand? LO 10-3
Answer: A reduction in aggregate demand causes a decline in real output rather than the price level
because prices are inflexible downward (“sticky”). If we assume prices are completely inflexible
downward, then a reduction in demand is essentially moving leftward and the aggregate supply curve is
flat (horizontal), which means reduced output at a constant price. To say prices are completely inflexible
downward may be an exaggeration, but prices don’t fall easily for several reasons: wage contracts,
minimum wage laws, employee morale, fear of price wars and the “menu cost” notion.
Without price changes to mitigate the effects of an aggregate demand change, the multiplier is at full
strength. If price were flexible downward, the decrease in spending would lower prices, encouraging
some individuals within the macro-economy to spend more, dampening the multiplier effects.
8. Explain: “Unemployment can be caused by a decrease of aggregate demand or a decrease of aggregate
supply.” In each case, specify the price-level outcomes. LO 10-3
Answer: The statement is true, although the magnitude of the effect on unemployment can vary
considerably, particularly with decreases in aggregate demand. A decrease in aggregate supply will
unambiguously increase the price level and reduce real output. With the decrease in output we would
expect unemployment to rise. If the economy is operating above its full-employment output, a decrease
in aggregate demand will have more modest effects on unemployment, having its strongest impact on the
price level (reducing it). If aggregate demand falls while the economy is operating to the left of fullemployment output, the increases in unemployment will be more substantial, and the effects on the price
level weaker.
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9. Use shifts of the AD and AS curves to explain (a) the Canadian experience of strong economic growth,
full employment, and price stability between 2006 and early 2008 and (b) how a strong negative wealth
effect (from, say, a precipitous drop in the stock market)could cause a recession even though productivity
is surging. LO 10-3
Answer:
(a)
While AD is increasing and shifting to right, AS is shifting rightward as well, because of
productivity increasing and growing behaviour force. Thus, both output and employment can rise
while price level remains constant. The equilibrium shifts rightward, not upward because AS
and AD shift by similar magnitudes. (see Figure 10.11)
(b)
In this situation AD shifts left from AD1 to AD2 because of the precipitous drop in stock prices
while AS shifts right from AS1 to AS2 because productivity is surging. This causes prices to fall
from P to P2 and output to fall from Q to Q2 , resulting in a recession.
Price Level
AS1
AS2
P1
P2
AD1
AD2
Q2
Q1
Real Domestic Output GDP
10. In late 2008 consumption and investment spending sharply declined in Canada because of the spread
of the global financial crisis. Use AD-AS analysis to show the two impacts on real GDP. LO 10-3
Answer: Both events would be represented by a leftward shift in aggregate demand, and the initial
declines in spending would be multiplied. (See Figure 10-2, shift from AD1 to AD3.) This would cause
real GDP to drop and, assuming flexible prices, a drop in the price level. To the extent the drop in
investment spending affected productivity, it could have either shifted AS left (if productivity dropped) or
slowed the rightward movement of AS.
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The LAST WORD Go to the OPEC website, www.opec.org, and find the current “OPEC basket price”
of oil. By clicking on that amount, you will find the annual prices of oil for the past five years. By what
percentage is the current price higher or lower than five years ago? Next, go to the Statistics Canada
website http://www.statcan.gc.ca/tables-tableaux/sum-som/l01/cst01/econ05-eng.htm
(http://www40.statcan.ca/l01/cst01/econ05-eng.htm) and find Canada’s real GDP for the past five years.
By what percentage is real GDP higher or lower than it was five years ago? What if, anything, can you
conclude about the relationship between the price of oil and the level of real GDP in Canada?
Answer: Answers will vary depending on when this question is assigned.
PROBLEMS
1. Suppose that consumer spending initially rises by $5 billion for every 1 percent rise in household
wealth and that investment spending initially rises by $20 billion for every one percentage point fall in
the real interest rate. Also assume that the economy’s multiplier is 4. If household wealth falls by 5
percent because of declining house values, and the real interest rate falls by two percentage points, in
what direction and by how much will the aggregate demand curve initially shift at each price level? In
what direction and by how much will it eventually shift? LO 10-1
Answers: rightward by $15 billion; rightward by $60 billion.
Feedback: Consider the following example. Suppose that consumer spending initially rises by $5 billion
for every 1 percent rise in household wealth and that investment spending initially rises by $20 billion for
every 1 percentage point fall in the real interest rate. Also assume that the economy’s multiplier is 4. If
household wealth falls by 5 percent because of declining house values, and the real interest rate falls by
two percentage points, in what direction and by how much will the aggregate demand curve initially shift
at each price level? In what direction and by how much will it eventually shift?
Suppose that consumer spending initially rises by $5 billion for every 1 percent rise in household wealth.
If household wealth falls by 5 percent because of declining house values the initial shift in aggregate
demand will be to the left (decline in real GDP) by $25 billion ( = 5 (percent decline in wealth) x $5
(consumer spending for every 1% change)). Note the positive relationship between wealth and consumer
spending.
Also, suppose that investment spending initially rises by $20 billion for every 1 percentage point fall in
the real interest rate. If the real interest rate falls by two percentage points the initial shift in aggregate
demand will be to the right (increase in real GDP) by $40 billion ( = 2 (percentage point decline in
interest rate) x $20 (investment spending for every 1 percentage point change)). Note the inverse
relationship between the interest rate and investment.
The combined initial effect is a shift to the right of the aggregate demand curve by $15 billion. There is a
decrease of $25 billion from consumer expenditure and an increase of $40 billion from investment
expenditure, thus, the net effect is a positive $15 billion.
Given that the multiplier is 4, the aggregate demand curve will shift to the right by $60 billion after the
multiplier process works its way through the economy ( = 4 (multiplier) x $15 billion (initial net impact
on aggregate demand).
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2. Answer the following questions on the basis of the three sets of data for the country of North
Vaudeville: LO 10-2
a. Which set of data illustrates aggregate supply in the immediate short-run in North Vaudeville? The
short run? The long run?
b. Assuming no change in hours of work, if real output per hour of work increases by 10 percent, what
will be the new levels of real GDP in the right column of A? Does the new data reflect an increase in
aggregate supply or does it indicate a decrease in aggregate supply?
Answers: (a) B, A, C; (b) 302.5, 275, 247.5, 220; an increase.
Feedback: Consider the following data as an example.
Part a:
Which set of data illustrates aggregate supply in the immediate short-run in North Vaudeville?
The data in B. The price level does not have time to adjust in the immediate short-run. Only output can
change.
Which set of data illustrates aggregate supply in the short-run in North Vaudeville?
The data in A. The price level only has time to partially adjust in the short-run. Both the price level and
output can change
Which set of data illustrates aggregate supply in the long-run in North Vaudeville?
The data in C. The price level has time to completely adjust in the long-run. Only price will change.
Part b:
Assuming no change in hours of work, if real output per hour of work increases by 10 percent, what will
be the new levels of real GDP in the right column of A?
To find the new level of output at each price level multiply the original values by 1.1.
Price level 110: New output equals 302.5 (=1.1 x 275)
Price level 100: New output equals 275 (=1.1 x 250)
Price level 95: New output equals 247.5 (=1.1 x 225)
Price level 90: New output equals 220 (=1.1 x 200)
Does the new data reflect an increase in aggregate supply or does it indicate a decrease in aggregate
supply?
This is an increase in aggregate supply because output has increased at every price level.
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3. Suppose that the aggregate demand and aggregate supply schedules for a hypothetical economy are as
shown below: LO 10-3
a. Use these sets of data to graph the aggregate demand and aggregate supply curves. What is the
equilibrium price level and the equilibrium level of real output in this hypothetical economy? Is the
equilibrium real output also necessarily the full-employment real output?
b. If the price level in this economy is 150, will quantity demanded equal, exceed, or fall short of quantity
supplied? By what amount? If the price level is 250, will quantity demanded equal, exceed, or fall short
of quantity supplied? By what amount?
c. Suppose that buyers desire to purchase $200 billion of extra real output at each price level. Sketch in
the new aggregate demand curve as AD1. What is the new equilibrium price level and level of real
output?
Answer: (a) See the graph. Equilibrium price level = 200; equilibrium real output = $300 billion. No.
(b) Exceed by $200 billion; fall short by $200 billion.
(c) On the original graph, AD curve shifts rightward. The new equilibrium price level = 250. The new
equilibrium GDP = $400 billion.
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Feedback:
(a) See the graph. Equilibrium price level = 200, which occurs where aggregate supply equals
aggregate demand, Thus the equilibrium real output = $300 billion. No, the full-capacity
level of GDP cannot be determined without more information.
(b) At a price level of 150, real GDP supplied is a maximum of $200 billion, less than the real
GDP demanded of $400 billion. Thus, quantity demanded exceeds the quantity supplied by
$200 billion. At a price level of 250, real GDP supplied is $400 billion, which is more than
the real GDP demanded of $200 billion. Thus, quantity demanded falls short of the quantity
supplied by $200 billion.
(c) See the graph from part a. Increases in consumer, investment, government, or net export
spending might shift the AD curve rightward. The new values for the aggregate demand
schedule are:
Amount of Real GDP
Demanded, Billions
Price Level
(Price Index)
Amount of Real GDP
Supplied, Billions
$300 (=$100 + $200)
300
$450
$400 (=$200 + $200)
250
400
$500 (=$300 + $200)
200
300
$600 (=$400 + $200)
150
200
$700 (=$500 + $200)
100
100
The new equilibrium price level = 250 where aggregate supply equals aggregate demand. The
new equilibrium GDP = $400 billion.
4. Suppose that the table below shows an economy’s relationship between real output and the inputs
needed to produce that output: LO 10-3
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a. What is productivity in this economy?
b. What is the per-unit cost of production if the price of each input unit is $2?
c. Assume that the input price increases from $2 to $3 with no accompanying change in productivity.
What is the new per-unit cost of production? In what direction would the $1 increase in input price push
the aggregate supply curve? What effect would this shift of the short-run aggregate supply have on the
price level and the level of real output?
d. Suppose that the increase in input price does not occur but, instead, that productivity increases by 100
percent. What would be the new per-unit cost of production? What effect would this change in per-unit
production cost have on the short-run aggregate supply curve? What effect would this shift of the shortrun aggregate supply have on the price level and the level of real output?
Answer: (a) 2.6667; (b) $0.75; (c) $1.125; shift left; output will decrease and prices will rise in the shortrun; (d) $0.375; shift to right; prices will fall and output will increase in the short run.
Feedback: Consider the following example.
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Part a:
What is productivity in this economy?
Productivity is defined by how much output each unit of the input produces.
Productivity = Real GDP / Input Quantity
You can use any of the three combinations above.
Productivity = $400 / 150 = 2.6667
Part b:
What is the per-unit cost of production if the price of each input unit is $2?
The per unit cost is defined by how much each unit of output costs to produce. The total cost of
production equals $300 (you can use any combination above) when real GDP is $400.
Per unit cost = (price of input unit x input quantity) / real GDP
For the values above,
per unit cost = ($2 x 150) / $400 =$300 / $400 = $0.75
Part c:
Assume that the input price increases from $2 to $3 with no accompanying change in
productivity. What is the new per-unit cost of production? In what direction would the $1
increase in input price push the economy’s aggregate supply curve? What effect would this shift
of the short-run aggregate supply have on the price level and the level of real output?
The new per unit cost = ($3 x 150) / $400 =$450 / $400 = $1.125.
This would cause firms to raise prices at every level of output (higher input cost), thus the
aggregate supply schedule would shift left.
This would cause output to decrease and prices to rise in short-run.
Part d:
Suppose that the increase in input price does not occur but, instead, that productivity increases by
100 percent. What would be the new per-unit cost of production? What effect would this change
in per-unit production cost have on the short-run aggregate supply curve? What effect would this
shift of aggregate supply have on the price level and the level of real output?
If productivity increases by 100%, this implies output will double at every input quantity. Real
GDP will now be $800 at the input quantity of 150.
New productivity = 2 x 2.6667 (original productivity) = 5.3334
From this we can find the required level of real GDP.
Productivity = Real GDP / Input Quantity or 5.3334 = Real GDP / 150
Thus, real GDP = $800 = 150 x 5.3334 (rounding).
Once we have the new level of real GDP we can find the per unit cost.
Per unit cost = (price of input unit x input quantity) / real GDP
Per unit cost = ($2 x 150) / $800 = $0.375
This reduction in per unit cost will increase the supply of goods at every price level, thus the
aggregate supply schedule will shift to the right.
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This will cause prices to fall and output to increase in the short run.
5. Refer to the data in the table that accompanies Problem 2. Suppose that the present equilibrium price
level and level of real GDP are 100 and $225, and that data set B represents the relevant aggregate supply
schedule for the economy. LO 10-3
a. What must be the current amount of real output demanded at the 100 price level?
b. If the amount of output demanded declined by $25 at the 100 price levels in B, what would be the new
equilibrium real GDP? In business cycle terminology, what would economists call this change in real
GDP?
Answers: $225; $200; a recession.
Feedback: Consider the following example. Suppose that the present equilibrium price level and level of
real GDP are 100 and $225, and that data set B represents the relevant aggregate supply schedule for the
economy.
Part a:
What must be the current amount of real output demanded at the 100 price level?
Given that the economy is equilibrium aggregate supply equals aggregate demand. Thus, the real output
demanded must also equal $225 (quantity supplied given above).
Part b:
If the amount of output demanded declined by $25 at the 100 price shown levels in B, what would be the
new equilibrium real GDP? In business cycle terminology, what would economists call this change in real
GDP?
If output demanded fell by $25, the new level of demand is $200. Since the price level does not change
the quantity supplied would also fall by $25.
The new equilibrium level of real GDP is $200. This decline in output is likely a recession.
Chapter 10 Aggregate Demand and Aggregate Supply (Appendix)
QUESTIONS
1. Explain carefully: “A change in the price level shifts the aggregate expenditures curve but not the
aggregate demand curve.” LO A10-1
Answer: A change in the price level does not shift the aggregate demand curve. It simply represents a
movement along the curve, because there is an inverse relationship between the price level and aggregate
quantity demanded. However, a change in the price level will shift the aggregate expenditures curve,
which responds to the wealth, interest-rate, and foreign trade effects occurring with a change in price
level. When the price level declines, aggregate expenditures will rise, and when the price level rises,
aggregate expenditures will fall. The aggregate expenditures model assumes a constant price level, so it
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is expressed in “real” terms. Appendix Figures 1 and 2 graphically illustrates the relationship between the
two models.
2. Suppose that the price level is constant and that investment decreases sharply. How would you show
this decrease in the aggregate expenditures model? What would be the outcome for real GDP? How
would you show this fall in investment in the aggregate demand–aggregate supply model, assuming the
economy is operating in what, in effect, is a horizontal section of the aggregate supply curve? LO A10-1
Answer: A decrease in investment spending represents a decrease in aggregate expenditures and a
downward shift in the aggregate expenditures curve. The outcome would be a new, lower equilibrium
output level. This fall in output would be equal to a multiple of the initial change in investment spending
based on the multiplier effect. The multiplier is 1/MPS in this model.
It would be a leftward shift of aggregate demand, and the new equilibrium output would fall to the left of
the original equilibrium by the full extent of the shift in aggregate demand. The price level (assumed by
using the AE model) will not change. See figure below.
AS
Price
Level
AD1
AD2
Q2
Q1
Real GDP
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PROBLEMS
1. Refer to Figure 1a and 1b in the Appendix. Assume that Q1 is 300, Q2 is 200, Q3 is 100, P3 is 120, P2
is 100, and P1 is 80. If the price level increases from P1 to P3 in part (b), in what direction and by how
much will real GDP change? If the slopes of the AE lines in Figure 1a are .8 and equal to the MPC, in
what direction will the aggregate expenditures schedule in Figure 1a need to shift to produce the
previously determined change in real GDP? What is the size of the multiplier in this example? LO A10-1
Answers: A decrease of $200; a decrease of $40; 5.
Feedback: Consider the following example. Refer to Figure 1a and 1b in the Appendix. Assume that Q1
is 300, Q2 is 200, Q3 is 100, P3 is 120, P2 is 100, and P1 is 80. If the price level increases from P1 to P3
in graph (b), in what direction and by how much will real GDP change? If the slopes of the AE lines in
graph (a) are .8 and equal to the MPC, in what direction will the aggregate expenditures schedule in graph
(a) need to shift to produce the previously determined change in real GDP? What is the size of the
multiplier in this example?
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If the price level increases from P1 to P3 in graph (b), in what direction and by how much will
real GDP change?
Real GDP will fall (movement along the AD schedule and a shift downward of the AE schedule).
The decrease in real GDP will be 200 (Q1 - Q3 = 300 - 100 = 200).
If the slopes of the AE lines in graph (a) are .8 and equal to the MPC, in what direction will the
aggregate expenditures schedule in graph (a) need to shift to produce the previously determined
change in real GDP? What is the size of the multiplier in this example?
The first step is to determine the multiplier for this problem. Given the MPC is 0.8 the multiplier
is 5 (= 1/(1-MPC) = 1/(1-0.8) = 1/0.2 = 5).
Since the multiplier is 5, we can find by how much the aggregate expenditure curve must change.
Real GDP decreases, which implies the AE schedule must fall (to AE3 at P3)
The AE curve must fall by $40 since the total decrease in output is $200.
To see this, note that a decrease in AE by $40 with a multiplier of 5 is $200 (= 5 x $40).
Change in real GDP = multiplier x change in AE
Rearranging this equation,
Change in AE = change in real GDP/multiplier
Using the values above, the change in AE equals -$200/5 = -$40, or we can express the negative
as a decrease of $40 as above.
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2. Refer to Figure A10-2 in the Appendix and assume that Q1 is $400 and Q2 is $500, the price level is
stuck at P1, and the slopes of the AE lines in Figure A10-2a are .75 and equal to the MPC. In what
direction and by how much does the aggregate expenditures schedule in Figure A10-2a need to shift in
order to shift he aggregate demand curve in Figure A10-2b from AD1 to AD2? What is the multiplier in
this example? Given the multiplier, what must be the distance between AD1 and the broken line to its
right at P1? LO A10-1
Answers: increase by $25; 4, $25.
Feedback: Consider the following example. Refer to Figure 2 in the Appendix and assume that Q1 is
$400 and Q2 is $500, the price level is stuck at P1, and the slopes of the AE lines in graph (a) are .75 and
equal to the MPC. In what direction and by how much does the aggregate expenditures schedule in graph
(a) need to shift in order to shift the aggregate demand curve in graph (b) from AD1 to AD2? What is the
multiplier in this example? Given the multiplier, what must be the distance between AD1 and the broken
line to its right at P1?
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Refer to Figure 2 in the Appendix and assume that Q1 is $400 and Q2 is $500, the price level is
stuck at P1, and the slopes of the AE lines in graph (a) are .75 and equal to the MPC. In what
direction and by how much does the aggregate expenditures schedule in graph (a) need to shift in
order to shift the aggregate demand curve in graph (b) from AD1 to AD2? What is the multiplier
in this example?
First, we note that the change in output is an increase of $100 (Q2 - Q1 = $500 - $400).
Second, given the MPC is 0.75 the multiplier is 4 (= 1 / (1-MPC) = 1 / (1-0.75) = 1 / 0.25 = 4).
Thus, the AE curve must increase by $25 since the total decrease in output is $100.
To see this, note that an increase in AE by $25 with a multiplier of 4 is $100 (= 4 x $25).
Change in real GDP = multiplier x change in AE
Rearranging this equation,
Change in AE = change in real GDP/multiplier
Using the values above, the change in AE equals $100/4 = $25.
Given the multiplier, what must be the distance between AD1 and the broken line to its right at
P1?
This distance is the initial shift following the increase in expenditure by $25 (the shift in the AE
curve). Thus, the answer is $25 (this is before the multiplier process works its way through the
economy).
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