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CHAPTER 11
AGGREGATE SUPPLY AND
DEMAND
WHAT IS THIS CHAPTER ALL ABOUT?
This chapter looks at macroeconomic problems caused by fluctuations in aggregate supply and
aggregate demand. The examples of the 1929 stock market crash and the ten-year-long Great
Depression provides a vivid introduction to the problems of the business cycle.
There is a review of the major competing theories of the business cycle from Classical economics
to present day economics. The thrust of the chapter is that the distinctions between competing
theories may be most clearly seen in their different emphasis on supply and demand forces.
Critical thinking goals of the chapter are to challenge students to formulate well-founded
answers to the following questions:
1.
What are the major determinants of macro outcomes?
2.
How do the forces of supply and demand fit into the macro picture?
3.
What are the disagreements about causes and cures of macro
ailments?
NEW TO THIS EDITION
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New headline on AS/AD imbalance
New headline on AS/AD shifts after the terrorist attacks
New headline on consumer spending
New Question for Discussion
New Problem
Living Econ on “What do the headlines really mean?”
Chapter 11 – Aggregate Supply and Aggregate Demand – Page 218
LECTURE LAUNCHERS
Where should you start?
1.
Ask students if they think the economy is inherently stable or unstable.
This leads into a discussion of classical and Keynesian economic theory.
2.
Ask students who they think purchase the goods and services produced in a nation.
Help students to list the four areas of aggregate spending in the economy, i.e.
Consumers, businesses, governments, and foreigners. This leads into the
discussion of aggregate demand.
3.
Once you have introduced the concept of AD, ask the students whether they think AD is
currently increasing or decreasing.
This discussion allows you to discuss the current state of the economy. Is the
economy currently in a recession or is it expanding. The changes in the
economy currently taking place can usually be explained by changes in AD.
4.
Another idea is to talk about students’ consumption patterns.
What factors change that stimulates consumption changes? How do they respond
to credit, expectations, inflation, aging, and wealth changes? This leads into a
discussion of the shift factors.
5.
As in the previous chapter, it is possible to draw upon your students' recent experiences.
Ask if any know of recent business openings or closings.
Many will have heard something about changing government policies and business
conditions. They may be aware of major plant openings or closings in the area or
nationwide. They will be interested in offering their opinions and ideas about the
causes of these changes. Cite recent examples of plant openings or closings in your
area. If nothing has happened in your area, cite changes in the auto industry, defense,
or the aerospace industries. Has the volume imports or exports changed recently?
Why have any of these changes occurred? All of these issues affect aggregate demand.
6.
You could also discuss the computer industry.
Why has hiring occurred in this industry? Why is there a high demand for computer
science graduates in recent years? This type of questions all lead into discussions of AD
and its determinants.
7.
Use the aggregate supply/aggregate demand analysis to show unemployment.
Describe how to get to full employment using the aggregate demand. Note: there is no
automatic self-adjustment in a Keynesian model.
Chapter 11 – Aggregate Supply and Aggregate Demand – Page 219
COMMON STUDENT ERRORS
Many students make these common errors. This same list is included in the student study
guide. The first statement in each “common error” below is incorrect. Each incorrect statement
is followed by a corrected version and an explanation.
1.
Full employment is achieved at the equilibrium GDP. WRONG!
Full employment is not necessarily achieved at the equilibrium GDP. RIGHT!
When resources are fully employed, no additional goods and services can be produced.
However, equilibrium GDP refers to the equality between the aggregate demand for
goods and services and the aggregate supply of goods and services, not to any
particular level of resource employment.
2.
Aggregate demand (supply) and market demand (supply) are the same. WRONG!
Aggregate demand (supply) and market demand (supply) involve very different levels of
aggregation. RIGHT!
The market demand (supply) represents the demand (supply) for an individual
product. The aggregate demand (supply) represents the demand (supply) for all goods
in the economy. The market demand and supply curves are used in microeconomic
analysis to help determine equilibrium price and quantity in an individual product
market. The aggregate demand and supply curves are used in macroeconomic
analysis to determine the equilibrium level of prices and output in the economy as a
whole.
3.
The AD and AS curves can be drawn anywhere on the graph. WRONG!
The AD and AS curves are drawn in specific locations on the graph to depict a given
condition in the economy. RIGHT!
The AS and AD curves need to be drawn in a position that represents the state of
economy you are trying to describe, i.e., full-employment, recession, inflation, or
stagflation.
4.
The economy can spend no more than its income. WRONG!
The economy can spend more than its income. RIGHT!
The economy can spend more than its income by drawing down inventories of both
public and private goods or by consuming capital (allowing it to depreciate) without
replacing it. If the economy consumes more than its income, it will actually dissave
and experience negative investment.
Chapter 11 – Aggregate Supply and Aggregate Demand – Page 220
HEADLINES
There are five Headline boxes in this chapter. The titles and the concepts illustrated are:
“Too much supply, too little demand.” (Undesirable outcomes)
The article provides evidence that the economy is inside its production possibilities
curve: unwanted passenger jets are in storage; offices are vacant; and prices on
consumer products are falling. Such overcapacity is a standard feature of recession.
“Falling stocks smash nest eggs” (Shifting AD)
The drop in the value of the stock market has made many reconsider purchases and early
retirement that was planned prior to the drop. A decline in the value of stocks may cause
consumers to spend less on goods and services. Such a negative “wealth effect” shifts the
AD curve leftward.
“Attack puts chill on European business” (External Shocks)
Europe’s economic slowdown accelerated after the September 11, 2001 terrorist attacks.
Investments were cut back including, for example, an auto parts maker that canceled
plans for a new factory.
“Difficult passage: After terror attacks, shipping goods takes longer and
costs more” (Shifting AS)
Increased security after the September 11, 2001 terrorist attacks caused added costs and
delays for shipping US goods. For example, one company hired extra security guards and
reparks its vehicles loaded with chemicals. Other companies report additional time for
deliveries because of security checks.
“Consumers are spending big time” (Demand-driven Growth)
Tax cuts the summer of 2003 caused consumer spending to increase at a more than 7
percent annual rate. GDP growth was expected to be quite high. (Later this was
confirmed.)
ANNOTATED CONTENTS IN DETAIL
I.
Macroeconomics
Definition: Macroeconomics - The study of aggregate economic behavior of the
economy as a whole.
II.
Macro View
A.
Macro Outcomes (Figure 11.1)
1.
Output - Total volume of goods and services produced (real GDP).
2.
Jobs - Levels of employment and unemployment.
3.
Prices - Average price of goods and services.
4.
Growth - Year-to-year expansion in production capacity.
5.
International balances - International value of the dollar, trade and
payment balances with other countries
B.
Macro Determinants (Figure 11.1)
Chapter 11 – Aggregate Supply and Aggregate Demand – Page 221
1.
2.
3.
Internal market forces - Population growth, spending behavior,
invention and innovation and the like.
External shocks - Wars, natural disasters, trade disruptions and so on.
Policy levers - Tax policy, government spending changes in the
availability of money and regulation.
III. Stable or Unstable
IV.
A.
Classical Theory – standard economic theory prior to 1930's
1.
Self-Adjustment – According to the Classical view, the economy "selfadjusts" to deviations from its long-term growth.
2.
The cornerstones of Classical optimism are:
a.
Flexible prices
b.
Flexible wages
3.
Say's Law
Definition: Say’s Law - Supply creates its own demand.
a.
Unsold goods will ultimately be sold when buyers and sellers find
an acceptable price.
b.
In the labor market, some people will be unemployed, but can find
new jobs if they are willing to accept lower wages.
4.
According to Classical economists, government intervention in a (selfadjusting) macro economy is unnecessary.
5.
Inflation and unemployment (Figure 11.2).
B.
The Keynesian Revolution
1.
John Maynard Keynes provided an alternative to the classical model.
2.
No Self-Adjustment
a.
Keynes thought the private economy was inherently unstable.
b.
Argued that the Great Depression not a unique event and would
recur if reliance on the market to "self-adjust" continued.
3.
In Keynes’ view, the inherent instability of the marketplace required
government intervention.
4.
"Policy levers" necessary and effective.
The Aggregate Supply-Demand Model
A.
Aggregate Demand
Definition: Aggregate Demand - The total quantity of output demanded at
alternative price levels in a given time period, ceteris paribus.
1.
Real GDP
Definition: Real GDP - The inflation-adjusted value of GDP; the value
of output measured in constant prices.
2.
Price Level – The aggregate demand curve illustrates how the volume of
purchases varies with average prices. (Figure 11.3)
3.
The AD is downward sloping for three reasons.
a.
Real balances effect - Real value of money balances measured
by how many goods and services each dollar will buy. As prices
fall money balances can purchase more goods.
b.
Foreign trade effect - If domestic prices decline consumers
demand more domestic output and fewer imports.
c.
Interest-rate effect - Changes in price level affect amount of
money that must be borrowed.
Chapter 11 – Aggregate Supply and Aggregate Demand – Page 222
V.
B.
Aggregate Supply
Definition: Aggregate Supply - The total quantity of output producers are
willing and able to supply at alternative price levels in a given
time-period, ceteris paribus.
1.
Profit Margins – If prices rise, producers, who have relatively constant
short-run costs like rent, interest payments, negotiated wages, and inputs
already contracted for, will increase the rate of output when price levels
rise.
2.
Costs – To increase output, producers must acquire more resources and
use existing plant and equipment more intensively. Cost pressures tend
to intensify as capacity is approached.
3.
The aggregate supply curve is relatively flat when capacity is underutilized
but begins to slope upward as producers approach capacity. (Figure 11.4)
C.
Macro Equilibrium
1.
Aggregate supply and demand curves summarize the market activity of
the whole economy.
2.
Equilibrium (Macro) (Figure 11.5)
Definition: Equilibrium (macro) - The combination of price level
and real output that is compatible with both aggregate
demand and aggregate supply.
Note: Equilibrium is the only price-output combination mutually
compatible with aggregate supply and demand.
3.
Disequilibrium (Figure 11.5) – Any combination of average prices and
output that is not an equilibrium combination.
4.
Market Adjustments – Changes in output and prices that lead toward
equilibrium. Equilibrium is unique; it is the only price-output
combination that is mutually compatible with aggregate supply and
demand.
Macro Failure
A.
Potential Problems With Macro Equilibrium.
1.
Undesirability - the price-output relationship at equilibrium may not
satisfy our macroeconomic goals.
2.
Instability - even if designated macro equilibrium is optimal, it may be
displaced by macro disturbances.
B.
Undesirable outcomes (Figure 11.6)
1.
Unemployment
Definition: Unemployment - The inability of labor-force
participants to find jobs.
2.
Inflation
Definition: Inflation - An increase in the average level of prices of
goods and services
3.
Headline: “Too much supply, too little demand.” (Undesirable
outcomes)
The article provides evidence that the economy is inside its production
possibilities curve: unwanted passenger jets are in storage; offices are
Chapter 11 – Aggregate Supply and Aggregate Demand – Page 223
vacant; and prices on consumer products are falling. Such overcapacity is
a standard feature of recession.
C.
Unstable Outcomes (Figure 11.7)
1.
Macro Disturbances
a.
Shifts in aggregate demand.
b.
Shifts in aggregate supply.
c.
Headline: “Falling stocks smash nest eggs” (Shifting AD)
The drop in the value of the stock market has made many
reconsider purchases and early retirement that was planned prior
to the drop. A decline in the value of stocks may cause consumers
to spend less on goods and services. Such a negative “wealth
effect” shifts the AD curve leftward.
2.
Recurrent Shifts
Definition: Business Cycle - Alternating periods of economic growth
and contraction.
Note: Business cycles are a result of recurrent shifts of the aggregate
supply and demand curves.
D.
Shift Factors
1.
Demand shifts - a variety of factors can shift AD such as:
a.
Consumer tax changes
b.
Interest rate changes
d.
Changes in export sales
2.
Supply shifts - a variety of factors can shift AS such as:
a.
Price or availability of raw materials
b.
Business tax changes
c.
Environmental and work place regulations
3.
Headline: “Attack puts chill on European business” (External
Shocks)
Europe’s economic slowdown accelerated after the September 11, 2001
terrorist attacks. Investments were cut back including, for example, an
auto parts maker that canceled plans for a new factory.
Headline: “Difficult passage: After terror attacks, shipping
goods takes longer and costs more” (Shifting AS)
Increased security after the September 11, 2001 terrorist attacks caused
added costs and delays for shipping US goods. For example, one company
hired extra security guards and reparks its vehicles loaded with chemicals.
Other companies report additional time for deliveries because of security
checks.
VI.
Competing Theories of Short-Run Instability
A.
Macro controversies focus on the shape of aggregate supply and demand curves
and the potential to shift them.
B.
Demand-Side Theories
1.
Keynesian Theory
a.
Keynes argues that if people demand a product, producers will
supply it.
Chapter 11 – Aggregate Supply and Aggregate Demand – Page 224
b.
c.
d.
e.
2.
3.
If aggregate spending isn’t sufficient, some goods will remain
unsold and some production capacity will be idled.
During World War II, the sudden surge in government spending
shifted the AD curve to the right.
In the 1990s, the rise in the stock market provided the impetus for
a surge in consumer spending.
Headline: “Consumers are spending big time” (Demanddriven Growth)
Tax cuts the summer of 2003 caused consumer spending to
increase at a more than 7 percent annual rate. GDP growth was
expected to be quite high. (Later this was confirmed.)
Keynesian theory urges increased government spending or tax cuts as
mechanisms for increasing aggregate demand (Figure 11.8a).
Monetary theories
a.
Monetary theories focus on the control of money and interest rates
as mechanisms for shifting the aggregate demand curve.
b.
Money and credit affect the ability and willingness of people to buy
goods and services.
c.
If the right amount of money is not available, aggregate demand
may be too small.
d.
An increase in interest rates decreases aggregate demand.
B.
Supply-side theories:
1.
Shifting the AS curve will counter business cycle. (Figure 11.8b)
2.
Macro controversies focus on the shape of aggregate supply and demand
curves and the potential to shift them.
C.
Eclectic explanations - Shifts in both supply and demand curves may occur.
(Figure 11.8c)
VII. Policy Options
A.
Government Has Three Choices
1.
Shift the aggregate demand curve.
2.
Shift the aggregate supply curve.
3.
Do nothing.
B.
Fiscal Policy (AD)
Definition: Fiscal Policy - The use of government taxes and spending to alter
macroeconomic outcomes.
Note: Congressional debates over budgets occur annually.
C.
Monetary policy (AD)
Definition: Monetary policy - The use of money and credit controls to
influence macroeconomic activity.
Note: The Federal Reserve is a regulatory body that controls supply of money.
D.
Supply - side policy (AS)
Chapter 11 – Aggregate Supply and Aggregate Demand – Page 225
1.
2.
3.
4.
Definition: Supply-side policy - The use of tax rates, (de) regulation,
and other mechanisms to increase the ability and
willingness to produce goods and services.
The most famous supply side lever are the tax cuts implemented by the
Reagan administration in 1981.
Education is another method of shifting AS by making the work force
more productive. Hence, government subsides to higher education and
job-training programs are intended to increase AS.
Deregulation of the business environment should also decrease
production costs thus shifting AS.
VIII. Policy Perspectives: The Changing Choice of Policy Levers
A.
Do nothing approach - The Great Depression.
B.
The 1960s - Emphasis on fiscal policy.
C.
The 1970s - Monetary policy was the focus.
D.
The 1980s - Supply-side policies prevalent with Ronald Reagan’s tax cuts.
E.
The 1990s - Reversal of supply-side policy in 1990's with Bill Clinton and a
movement toward monetary policy.
F.
Current Policy – The fiscal restraint of the late 1990’s helped the federal
budget move from deficits to surpluses. During the Presidential campaign, one of
the biggest points of debate was whether to use the surplus to cut taxes, increase
government spending, or pay down the debt. Several rounds of tax cuts shifted
the AD to the right.
IN-CLASS DEBATE, EXTENDING THE DEBATE, AND DEBATE
PROJECTS
In-class Debate
Aggregate demand or aggregate supply?
Think of a recent US fiscal policy change or monetary policy change. Describe it in one sentence:
Will this policy change have an impact primarily on aggregate demand or aggregate supply—or
will it have a nearly equal effect on both? Explain.
Chapter 11 – Aggregate Supply and Aggregate Demand – Page 226
Use the aggregate demand/aggregate supply curve analysis to describe the impact on output and
prices of your policy change. (Make certain that your curves shift correctly to the right or to the
left.)
As instructed, compare your results with the analysis by another student.
Teaching note
Ask student pairs to work together after completing the steps above. Students might pair to
check answers. Or, students might be asked to find someone who chose to analyze a different
fiscal or monetary policy. These pairs of students could then compare policies and choose one as
the best for the current economy.
Extending the Debate
Was the 2002 tax cut a good idea?
The Job Creation and Worker Assistance Act of 2002 was the second of the three tax cutting
bills cutting proposed by the administration of George W. Bush. It became law on March 9,
2002. The biggest tax cut in the bill was an accelerated depreciation provision. This provision
allowed businesses to write off equipment they purchased more rapidly, if they bought it
between September 2001 and September 2004. This meant that businesses could reduce the
corporate income tax they owed during those years by buying new machinery, software, or
factories. The goal of this tax cut was to increase investment spending and thus raise aggregate
demand.
Did the accelerated depreciation provision do what the president and Congress hoped? To
answer that question, go to a web page of the Federal Reserve Bank of St. Louis that provides
economic data.
http://research.stlouisfed.org/fred2/
-Click on “Gross Domestic Product (GDP) and Components,”
-and then on “Real Nonresidential Investment: Equipment & Software.”
-You should see a chart of investment by businesses, corrected for inflation, over the last
5 years. The data are quarterly. That is, the first number for a year represents JanuaryMarch, the second represents April-June, etc.
Chapter 11 – Aggregate Supply and Aggregate Demand – Page 227
Based on what you see, do you think the 2002 tax cut succeeded in raising investment? Please
explain your reasoning.
Debate project
For related debate material see “Economic Growth” in Chapter 1, and “Should we abolish the
estate tax?” in Chapter 12.
ANSWERS TO QUESTIONS FOR DISCUSSION, WEB
ACTIVITIES AND PROBLEMS
QUESTIONS FOR DISCUSSION
1.
If the price level were below PE in Figure 11.5, what macro problems would we observe?
Why is PE considered an equilibrium?
If the price level were below PE, there would exist a macroeconomic shortage of
goods and services in the economy. In general, consumers want to purchase
more goods and services than producers are willing to supply. As a result, there
will be a tendency for the general price level to rise accompanied by an increase
in real output. When the price level reaches PE, aggregate quantity supplied
equals aggregate quantity demanded and macroeconomic equilibrium will be
achieved.
2.
What factors might cause a rightward shift of the aggregate demand curve? What might
induce a rightward shift of aggregate supply?
Changes in the shift parameters will cause either AS or AD to shift position.
Factors which would cause an increase in AD, a rightward shift, would include
decreases in the interest rate, an increase in the population, increased consumer
confidence, increases in government spending, lower consumer taxes, and
increases in exports. Factors which would cause an increase in AS, a rightward
shift, are improvements in productivity, resulting from increased investment in
plant and equipment, increases in the size of the labor force which reduce
wages, improved business confidence and changes in tax policies and
government regulation which favorably impact businesses.
3.
What kind of external shock would benefit an economy?
Any external shock that resulted in a macro equilibrium at, or at least closer to,
the desired price level and rate of unemployment would be beneficial. For
example, if both the price level and unemployment were too high, the discovery
of a readily accessible supply of oil would increase Aggregate Supply, thereby
lowering the price level and the unemployment rate.
4.
If all wages and prices fell by 20 percent, would you be better or worse off? Could you
buy more goods?
Chapter 11 – Aggregate Supply and Aggregate Demand – Page 228
The point of this question is to have students think about real income effects and
to ask themselves about the relative price impact. In an overall sense there
would be no change. However, a 20 percent drop in some prices might seem to
the individual as relatively unimportant, while the same percentage drop in
other prices might seem significant. Thus, choices about what to consume might
be affected. If all prices and wages fell equally, you wouldn't be able to buy any
more or less goods.
5.
What would a horizontal aggregate supply curve imply about producer behavior? How
about a vertical AS curve?
A horizontal curve would imply the economy has the ability to increase output
while incurring no limitations on input availability, cost or quality. In other
words, output could increase with no inflationary pressure. This might occur in
an economy that is producing well below capacity, i.e., one that is below the
production-possibility frontier. A vertical curve would indicate the economy
was at the limits of its production-possibility frontier and could not change its
output at all. Any attempt to increase output of one commodity without
reducing the output of some other commodity would cause inflation.
6.
If equilibrium is compatible with both buyers' and sellers' intentions how can it be
undesirable?
Equilibrium simply means there is no tendency for the economy to move away
from its current income and price level. In the Keynesian view, there is no
necessary connection between equilibrium and full employment or a
satisfactory distribution of income or goods and services. Equilibrium depends
only on well-functioning markets. If economic agents are pessimistic or overly
optimistic about the economy, the economy can reach an equilibrium state that
is undesirable, i.e., unemployment, prices, or both are too high, but stable.
7.
From 1996 to 2000, the U.S. stock market more than doubled in value. How might this
have affected aggregate demand? What happens to aggregate demand when the stock
market plunges?
If stockholders actually sold some of their stock and cashed in on the stock
market rise, then they realized real increases in wealth causing AD to shift to
the right. Even if they did not sell any of their stock assets, the increased
confidence resulting from the increase in wealth on paper would cause many
people to spend more, and save less, of their disposable income, again shifting
the AD curve to the right. The reverse will happen if the stock market plunges.
8.
President George Bush maintained a "hands-off" policy during the 1990-1991 recession.
How did he expect the economy to recover?
He expected the forces of the market to generate recovery. A depletion of
business inventories and the wearing out of consumer durables such as
automobiles would eventually force businesses to increase hiring and
consumers to spend more.
Chapter 11 – Aggregate Supply and Aggregate Demand – Page 229
WEB ACTIVITIES
1.
Log on to www.whitehouse.gov/fsbr/output.html. Find data on the current level of
nonresidential fixed investment. What does the trend suggest is happening to Aggregate
Demand?
The answer to this question will depend upon the time period in which the question is
answered. If nonresidential fixed investment in increasing, this generally suggests that
AD is increasing (shifting to the right).
2.
Log on to www.bea.doc.gov/briefrm/tables/ebr6.htm. Find data on the personal savings
rate percentage. At the bottom of the page, click on "Chart Saving Rate." All other things
remaining constant, what does the trend suggest is happening to current consumption
spending?
The answer to this question will depend upon the time period in which the question is
answered. Since disposable income equals consumption plus savings, there is an
inverse relationship between savings and consumption. If the savings rate is
increasing, consumption must be falling. If the savings rate is declining, then
consumption must be increasing.
3.
Log on to www.bea.doc.gov/briefrm/tables/ebr6.htm. Find data on current disposable
income. All other things remaining constant, what does the trend suggest is happening
to consumption and savings?
See the answer to question 2.
4.
Log on to www.bea.doc.gov/briefrm/price.htm and observe the average price level
changes. Using AS and AD analysis, explain what some possible explanations are for the
trends in this data.
The answer to this question will depend upon the time period in which the question is
answered. General answers to this question could be any of the following. Ceteris
paribus, if prices are rising along with GDP, then AD must be increasing. If prices are
falling while GDP is increasing, then AS must be increasing. If prices are rising while
GDP is falling, then AS must be decreasing. If prices are falling while GDP is falling,
then AD must be decreasing. Your answer should also include a discussion of the shape
of the AS curve and where the economy is located relative to full-employment.
PROBLEMS
1.
Illustrate these events with AS and AD shifts:
a.
Government increases defense spending.
b.
The first Headline story on page 264.
c.
Imported raw materials get cheaper.
d.
Congress cuts corporate income tax.
Chapter 11 – Aggregate Supply and Aggregate Demand – Page 230
ASA
ASB
Price Level
ADA
ADB
Real Output
a.
b.
c.
d.
2.
An increase in government spending would shift AD from ADA to ADB.
The External Shock Headline (the first Headline on pg. 264) would result in a
shift from ADB to ADA A decline in wealth results in shifting AD from ADB to
ADA.
Imported raw materials are a factor of production and thus affect AS. A
decrease in the price of imported raw materials will result in shifting AS from
ASA to ASB.
A cut in corporate income taxes is a supply side cut and would result in shifting
AS from ASA to ASB.
Based on the second Headline on page 264:
a.
Illustrate the AS and AD shifts that occur.
b.
Identify the old (Eo) and the new (E1) macro equilibrium.
c.
What macro ailments result?
d.
How can the economy stay healthy in this case?
Use the graph for Problem #1. Both the AS and AD curves shift to the left. The macro
ailment that results is recession. In order to stay healthy there should be some
government intervention to promote investment and aggregate demand.
3.
Graph the following aggregate supply and demand curves (be sure to draw to scale)
a.
b.
c.
d.
What explains the shape of the AS curve?
What is the equilibrium price level?
What is the equilibrium output?
If the quantity of output demanded at every price level increases by $1 trillion,
what happens to equilibrium output and prices? Graph your answer.
a.
An upward sloping AS curve indicates that as the average price level increases
output supplied in the economy increases.
The equilibrium price level is slightly above P= 110 where aggregate quantity
supplied equals aggregate quantity demanded.
b.
Chapter 11 – Aggregate Supply and Aggregate Demand – Page 231
c.
d.
The equilibrium output level is between 10 and 11 where AS=AD at a common
price.
If the quantity of output demanded at every price level increase by $1 trillion,
the equilibrium output and prices will increase.
Aggregate Supply and Demand
250
Real Prices
200
150
AD1
AS
AD2
100
50
0
0
5
10
15
20
Real Output
4.
Draw a conventional aggregate demand curve on a graph. Then add three
different aggregate supply curves, labeled
S1: Horizontal curve
S2: Upward-sloping curve
S3: Vertical curve
all intersecting the AD curve at the same point.
If AD were to increase (shift to the right), which AS curve would lead to
(a)
The biggest increase in output?
(b.)
The largest jump in prices?
(c)
The least inflation?
ASv
ASu
Real
Prices
ASh
AD2
AD1
Chapter 11 – Aggregate Supply and Aggregate Demand – Page 232
Real GDP
5.
(a)
The biggest increase in output occurs on the horizontal AS curve, ASh
(b)
The largest jump in prices occurs on the vertical AS curve, ASv
(c)
The least inflation would occur on the horizontal AS curve, ASh
The following schedule provides information with which to draw both an aggregate
demand curve and an aggregate supply curve. Both curves are assumed to be straight
lines.
Average Price
Quantity Demanded Quantity Supplied
(dollars per unit) (units per year)
(units per year)
$1,000
0
1,000
100
900
100
a.
b.
c.
d.
e.
At what price level does equilibrium occur?
What curve would have shifted if a new equilibrium were to occur at an output
level of 700 and a price level of $700?
What curve would have shifted if a new equilibrium were to occur at an output
level of 700 and a price level of $500?
What curve would have shifted if a new equilibrium were to occur at an output
level of 700 and a price level of $300?
Compared to the initial equilibrium (a), how have the outcomes in (b), (c), and
(d) changed price levels or output?
$1,200
AS
$1,000
Price
Level
$800
$600
$400
$200
AD
$0
0
200
400
600
800
Real
Output
Chapter 11 – Aggregate Supply and Aggregate Demand – Page 233
1000
1200
6.
(a)
$500
(b)
AD shifts to the right, raising both prices and output
(c)
Both AD and AS must shift to the right for this to occur. Prices stay the same
and output increases.
(d)
AS shifts to the right, raising output and lowering prices
(e)
The answers to part (e) are contained in answers (b) - (d) above.
Graph the “wealth effect” described in the Headline on p. 263.
Price
Levels
AS
AD2
AD1
Real Output
Aggregate Demand would increase from some AD1 to some AD2 due to the
wealth effect. However, it also works in reverse, and when the value of stocks
declines people are less wealthy and Aggregate Demand would decrease (shift
to the left). Without more information, it is not possible to say whether it shifts
back to AD1, somewhere to the left of AD1 or somewhere between AD1 and AD2.
Chapter 11 – Aggregate Supply and Aggregate Demand – Page 234
MEDIA EXERCISE
Chapter 11
Aggregate Supply and Demand
Name: ___________________
Section: __________________
Grade: ___________________
Find an article that describes an event that would cause such a shift in Aggregate Demand. Use
the article to fulfill the following instructions and questions:
1. Mount a copy (do not cut up newspapers or magazines) of the article on a letter-sized page or
print an article from an Internet news agency such as www.cnn.com, www.msnbc.com,
www.abc.com, www.nytimes.com, etc.
2. Below the article write "shifts upward" if the event you have chosen causes an upward shift
in the aggregate expenditure curve. Write "shifts downward" if the event causes a downward
shift of the aggregate expenditure curve.
3. Below the article write, "more of a leakage," "less of a leakage," "more of an injection," "less
of an injection," or "change in consumption"--whichever best captures the nature of the
change that you have found.
4. Find information that is consistent with the shift that you have chosen. Underline the word,
phrase, or sentence (not more than one sentence) in the article about a change in a leakage
(savings, taxes, or imports), an injection (investment, government expenditure, or exports),
or consumption that would cause your choice in number 2.
5. Circle the statement that shows that real income of the economy or the economic growth has
responded in a way that is consistent with the shift that you have chosen.
6. In the remaining space below your article, indicate the source (name of newspaper or
magazine), title (newspaper headline or magazine article title), date, and page for the article
you have chosen. Use this format:
Source: _____________________ Date: _______________ Page: ____________
Headline: ________________________________________________________
If this information also appears in the article itself, circle each item.
7.
Neatness counts.
Chapter 11 – Aggregate Supply and Aggregate Demand – Page 235
Professor's Note
Learning Objective for Media Exercise
To give students practice in shifting aggregate expenditure curves, to review the concepts of
injections and leakages, and to recognize the concept of shifting aggregate spending in the
media.
Suggestions for Correcting Media Exercise
1. Check for consistency between the shift written below the article and the change in leakage
or injection claimed below the article.
2. See if the change in injection or leakage written below the article matches (or is consistent)
with the underlined part of the article.
3. This exercise can be used to provide grades to the students orally in class. After you have
collected papers, ask students to describe the change that they found, the change in the type
of leakage or injection that is involved, and how the aggregate spending curve shifts. Grades
can reflect:
a. Ability to recall the article (some students may not have done their own article).
b. Critical thinking skills.
c. Ability to communicate with a succinct, well-thought-out response.
Small classes (thirty or fewer students) are ideal for this approach. For a class of thirty, no more
than two minutes should be spent per student--an important limit if all students are to be
graded orally. Having done the exercise orally and hearing other student examples, students
generally find injections and leakages much easier to identify in the media.
Likely Student Mistakes and Lecture Opportunities
1. Students invariably come up with micro examples to illustrate aggregate expenditure
changes.
2. Several of the students will not visualize that more of a leakage means a shift downward in
aggregate expenditures. Occasionally a student will think of the aggregate expenditure curve
as if it were an aggregate supply curve, thinking that an upward shift means that there is less
output at every price. Making examples from such mistakes may be helpful to the class.
3. Students are inclined to underline too much and to include more than one event causing
shifts in aggregate expenditure. This is an opportunity to emphasize that ceteris paribus
applies to aggregate expenditure curves, not just demand and supply; it's just that something
different is being held constant (namely, prices).
4. Quite likely there will be some examples of secondary, multiplying effects. Although
multiplying effects have not been covered in this chapter, the next chapter will cover them.
You can tell who is ahead in the reading by seeing if anyone can identify these secondary
effects with the "multiplier."
Chapter 11 – Aggregate Supply and Aggregate Demand – Page 236
Supplementary Sources
Patinkin, Don: "Keynes, John Maynard" in Eatwell, et al. (eds.), The New Palgrave,
Macmillan Press, London, 1987, pp. 19-39. A tour-de-force , simultaneously a
readable (though tough for students) and a comprehensive survey with an
extensive bibliography.
"Symposium: Keynesian Economics Today," The Journal of Economic Perspectives,
Winter 1993, pp. 3-82. Provides a readable up-to-date overview of Keynesian
theory.
Bernstein, Peter: "Savings and Investment and Other Myths," Public Interest, Spring 92,
pp. 87-94. Easily readable by students and provides an excellent application of
the paradox of thrift, recommending incentives to investment, not saving.
Galbraith, John: The Great Crash: 1929, Houghton Mifflin Co., Boston, 1988. Provides
a description of the Great Crash.
Skidelsky, Robert: John Maynard Keynes : The Economist As Savior 1920-1937 : A
Biography.
"Symposium: The Great Depression," The Journal of Economic Perspectives, Spring
1993, pp. 19-102. Surveys the history of the depression in four essays that can be
read by the students.
Chapter 11 – Aggregate Supply and Aggregate Demand – Page 237