1. Aggregate Demand and Aggregate Supply Analysis
Chapter 13
Aggregate Demand and Aggregate Supply Analysis

2. Learning Objectives
Understand what happens during business cycles and their relationship to long-run economic growth.
Discuss the determinants of aggregate demand, and distinguish between a movement along the aggregate demand curve and a shift of the curve.
Discuss the determinants of aggregate supply, and distinguish between a movement along the short-run aggregate supply curve and a shift of the curve.

3. Learning Objectives
Use the aggregate demand and aggregate supply model to illustrate the difference between short-run and long-run macroeconomic equilibrium.
Use the dynamic aggregate demand and aggregate supply model to analyse macroeconomic conditions.

4. Business cycles impacts on Canon
Canon was able to grow rapidly during the economic boom experienced in Australia from the early 1990s to 2007.
The economic downturn in saw a fall in demand by other businesses for Canon’s products.

5. LEARNING OBJECTIVE 1
The Business Cycle
Business cycle: Alternating periods of economic expansion and economic recession.
The expansion phase
Production, employment and income are increasing.
The business cycle peak
The recession phase
Production, employment and income are declining.
The business cycle trough

6. LEARNING OBJECTIVE 1
The Business Cycle
Recession: A significant decline in activity spread across the economy, lasting more than a few months, visible in production, employment, real income and wholesale- retail trade.
Official definition of a recession: Two successive quarters of negative economic growth.

7. Movements in real GDP, Australia, 1980 – 2007: Figure 13.1
Source: Australian Bureau of Statistics (2008), Australian National Accounts, Cat. No
Figure 13.1: Movements in real GDP, Australia,
In 1982 the Australian economy entered a recession, quickly recovered to reach a peak in 1985 only to go into an economic downturn again in The subsequent expansion was short lived with a fall in the rate of growth of real GDP commencing in 1990, with the economy entering a recession. The expansion that began after 1991 continued throughout the late 1990s until 2007.
Source: Australian Bureau of Statistics (2008), Australian National Accounts, Cat. No
Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

8. The Business Cycle What happens during a business cycle?
LEARNING OBJECTIVE 1
The Business Cycle
What happens during a business cycle?
Each business cycle is different, however all share some similarities.
The end of an expansion is typically associated with rising interest rates rising and wages, and profits begin to fall.
A recession often begins with decreased spending by firms on capital goods, and/or decreased spending by households on new houses and consumer durables.

9. The Business Cycle What happens during a business cycle?
LEARNING OBJECTIVE 1
The Business Cycle
What happens during a business cycle?
The effect of the business cycle on car sales.
Consumer durables are affected by the business cycle more than non-durables.
People postpone buying durables, particularly expensive items such as new cars, during a recession.

10. The effect of the business cycle on new car sales, Australia, 1994 – 2007: Figure 13.2
Figure 13.2: The effect of the business cycle on the new car sales, Australia
Source: Australian Bureau of Statistics (2007), Sales of New Motor Vehicles, Australia, Cat. No
Although the sustained economic boom during this time period meant a trend increase in car sales, there were also noticeable cycles associated with changes in real GDP and fluctuations in car sales. One of the most important of these fluctuations was the introduction of the Goods and Services Tax (GST) in 2000, after which the price of new cars fell due to removal of other sales taxes on cars.
Source: Australian Bureau of Statistics (2007), Sales of New Motor Vehicles, Australia, Cat. No
Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

11. The Business Cycle What happens during a business cycle?
LEARNING OBJECTIVE 1
The Business Cycle
What happens during a business cycle?
The impact of a recession on the inflation rate.
During economic expansions the inflation rate usually increases.
Exception: If the expansion is due to rising productivity levels and an expansion of potential GDP.
During recessions the inflation rate usually decreases.
Exception: The recession is caused by a supply shock.

12. The impact of a recession on the inflation rate, Australia: Figure 13
Figure 13.3: The impact of a recession on the inflation rate.
Source: Reserve Bank of Australia (2007), Statistics: Consumer Price Index, All Goods, viewed 29 April 2008 at <
In the late 1980s the inflation rate was over 8%, as it had been for many years. The recession of 1990 caused the inflation rate to fall back to 1% by 1992.
Note: the points on the figure represent the annual inflation rate measured by the change in the CPI for the year ending December.
Source: Reserve Bank of Australia (2007), Statistics: Consumer Price Index, All Goods, viewed 29 April 2008 at <
Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

13. The Business Cycle What happens during a business cycle?
LEARNING OBJECTIVE 1
The Business Cycle
What happens during a business cycle?
The impact of a recession on the unemployment rate.
Recessions cause the unemployment rate to increase.
The rate of unemployment continues to rise after the recession is over, because:
Discouraged workers re-enter the labour force.
Firms continue to operate below capacity after the recession is over and may not re-hire workers for some time.

14. The impact of a recession on the unemployment rate, Australia: Figure 13.4
Figure 13.4: The impact of a recession on the unemployment rate
Source: Australian Bureau of Statistics (2007), Labour Force: Electronic Delivery, Cat. No
The reluctance of firms to hire new employees during the early stages of a recovery means that the unemployment rate usually continues to rise even after the recession has ended.
Source: Australian Bureau of Statistics (2007), Labour Force: Electronic Delivery, Cat. No
Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

15. The Business Cycle What happens during a business cycle?
LEARNING OBJECTIVE 1
The Business Cycle
What happens during a business cycle?
Recessions are partly due to business cycles and partly due to economic shocks.
1974: Oil price shock – OPEC.
1982/83: High real wages and inflation.
1990: Government induced recession due to high interest rates.
2008/09: World financial crisis – credit shortage.

16. Fluctuations in real GDP, Australia, 1960-2007: Figure 13.5
Figure 13.5: Fluctuations in real GDP, Australia,
Source: Australian Bureau of Statistics (2007), Australian National Accounts, Cat. No
From the 1960s to the early 1990s real GDP had much more severe swings than it has since the early 1990s.
Source: Australian Bureau of Statistics (2007), Australian National Accounts, Cat. No
Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

17. LEARNING OBJECTIVE 2
Aggregate Demand
Aggregate demand and aggregate supply model: A model that explains short-run fluctuations in real GDP and the price level.
Real GDP and the price level are determined in the short run by the intersection of the aggregate demand curve and the short-run aggregate supply curve.

18. LEARNING OBJECTIVE 2
Aggregate Demand
Aggregate demand curve (AD): A curve showing the relationship between the price level and the quantity of real GDP demanded by households, firms and the government.
Short-run aggregate supply curve: (SRAS): A curve showing the relationship in the short-run between the price level and the quantity of real GDP supplied by firms.

19. Aggregate demand and aggregate supply: Figure 13.6
Price level
Short-run aggregate supply, SRAS
100
Figure Aggregate demand and aggregate supply.
In the short run, real GDP and the price level are determined by the intersection of the aggregate demand curve and the short-run aggregate supply curve. In the figure, real GDP is measured on the horizontal axis, and the price level is measured on the vertical axis by the GDP deflator. In this example, equilibrium real GDP is $1000 billion and the equilibrium price level is 100.
Aggregate demand, AD
$1000
Real GDP (billions of dollars)
Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

20. Aggregate Demand Why is the aggregate demand curve downward sloping?
LEARNING OBJECTIVE 2
Aggregate Demand
Why is the aggregate demand curve downward sloping?
The wealth effect
How a change in the price level affects consumption.
The interest rate effect
How a change in the price level affects investment.
The international-trade effect
How a change in the price level affects net exports.

21. LEARNING OBJECTIVE 2
Aggregate Demand
Shifts in the aggregate demand curve versus movements along it.
The AD curve shows the relationship between the price level and the quantity of real GDP demanded, holding everything else constant.
Changes in the price level are depicted as movements up or down a stationary aggregate demand curve.

22. Aggregate Demand The variables that shift the aggregate demand curve:
LEARNING OBJECTIVE 2
Aggregate Demand
The variables that shift the aggregate demand curve:
Changes in government policies.
Examples: taxes; government purchases.
Changes in the expectations of households or firms.
Changes in foreign variables.
Examples: exchange rates; relative income levels between countries.

23. The effect of exchange rates on sales
MAKING THE CONNECTION
13.1
The effect of exchange rates on sales
During some years, the falling value of the Australian dollar against the New Zealand dollar reduced prices of Australian exports to New Zealand.
Elaborately transformed manufactures (ETMs), such as digital devices, account for the majority of manufacturing exports from Australia to New Zealand. From , there was a general downward trend in the value of the Australian dollar relative to the New Zealand dollar with the exception of a temporary rise during This means that, generally, Australian products were relatively cheaper for people in New Zealand during this time period.

24. Determinants of Aggregate Demand
LEARNING OBJECTIVE 2
Determinants of Aggregate Demand
Explain whether each of the following will cause a movement along or a shift of the Aggregate Demand (AD) curve.
In each case, specify which of the four components of AD will be impacted, and explain how.

25. Determinants of Aggregate Demand
LEARNING OBJECTIVE 2
Determinants of Aggregate Demand
a) Rising interest rates cause a drop in consumer optimism as households become concerned about their ability to meet mortgage payments.
b) An increase in the price level decreases the value of superannuation accounts held by Australian households to fund their retirement.
c) The Australian dollar falls in value against the US dollar and other major currencies.

26. Determinants of Aggregate Demand
LEARNING OBJECTIVE 2
Determinants of Aggregate Demand
STEP 1: Review the material. This question is intended to help differentiate between events that will cause a change in aggregate quantity demanded, (a movement along the aggregate demand curve), and a change in aggregate demand (a shift in the AD curve). The material is covered in the sections ‘Why is the aggregate demand curve downward sloping?’, and ‘The variables that shift the aggregate demand curve’.

27. Determinants of Aggregate Demand
LEARNING OBJECTIVE 2
Determinants of Aggregate Demand
STEP 2: Answering (a): Households become pessimistic about the future. In order to ensure they can continue to meet higher mortgage payments caused by rising interest rates, consumers spend less in the present. The AD curve will shift inwards to the left.
STEP 3: Answering (b): This is an example of a change in the value of assets, or the wealth effect. Superannuation accounts are one of the most important assets for many Australians.
An increase in the price level decreases the real value of superannuation funds.

28. Determinants of Aggregate Demand
LEARNING OBJECTIVE 2
Determinants of Aggregate Demand
Aggregate quantity demanded will decrease as households spend less in order to contribute more to their superannuation. This is reflected in an upward movement along the AD curve.
STEP 4: Answering (c): A fall in the value of the Australian dollar means it costs less in terms of other currencies to buy Australian dollars, and hence also goods, services and investments denominated in Australian dollars. Net exports should therefore increase, and this will be reflected in an increase in AD – a shift to the right of the AD curve.
This is an opportunity to briefly explain the nature of superannuation funds in Australia, and the ability Australians have to place more money than is compulsory into these funds – or to diversify into other assets to provide for their retirement.

29. LEARNING OBJECTIVE 3
Aggregate Supply
The long-run aggregate supply curve (LRAS): A curve showing the relationship in the long run between the price level and the quantity of real GDP supplied.
The long-run aggregate supply curve shows that in the long run, increases in the price level do not affect the level of real GDP.
The long-run aggregate supply curve is a vertical line at potential GDP.

30. Aggregate Supply Shifts in the long-run aggregate supply curve.
LEARNING OBJECTIVE 3
Aggregate Supply
Shifts in the long-run aggregate supply curve.
The LRAS curve shifts because potential real GDP increases over time.
Increases in potential GDP (or economic growth) are due to:
An increase in resources.
An increase in machinery and equipment.
New technology.

31. The long-run aggregate supply curve: Figure 13.7
Price level
LRAS2006
LRAS2007
LRAS2008
112
100 95
Figure 13.7: The long-run aggregate supply curve.
Changes in the price level do not affect the level of aggregate supply in the long run. Therefore, the long-run aggregate supply curve (LRAS) is a vertical line at the potential level of real GDP. For instance, the price level was 100 in 2006 and potential real GDP $1100 billion. If the price level had been 95, or if it had been 112, LRAS would still have been a constant $1100 billion. Each year the LRAS curve shifts to the right as the number of workers in the economy increases, more machinery and equipment is accumulated and technological change occurs.
Real GDP (billions of dollars)
$1100
$1140
$1170
Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

32. Aggregate Supply The short-run aggregate supply curve.
LEARNING OBJECTIVE 3
Aggregate Supply
The short-run aggregate supply curve.
The SRAS is upward sloping, showing that in the short-run firms will produce more in response to higher prices.
The prices of inputs tends to rise more slowly than the prices of final products.
Contracts make some wages and prices ‘sticky’.
Firms are often slow to adjust wages.
Menu costs make some prices sticky. Menu costs are costs to firms of changing prices.

33. LEARNING OBJECTIVE 3
Aggregate Supply
Shifts in the short-run aggregate supply curve versus movements along it.
The SRAS curve shows the short-run relationship between the price level and the quantity of goods and services firms are willing to supply, holding everything else constant.
Changes in the price level are depicted as movements up or down a stationary short-run aggregate supply curve.

34. Aggregate Supply Variables that shift the SRAS curve.
LEARNING OBJECTIVE 3
Aggregate Supply
Variables that shift the SRAS curve.
Expected changes in the future price level.
Adjustments of workers and firms to errors in past expectations about the price level.
Unexpected changes in the price of an important natural resource.

35. Real GDP (billions of dollars)
How expectations of the future price level affect the short-run aggregate supply: Figure 13.8
Price level
1. If firms and workers expect the price level to be 3% higher in 2010 than in 2009 …
SRAS2010
SRAS2009
103
2. … the SRAS curve will shift to the left to reflect worker and firm expectations of rising costs.
Figure How expectations of the future price level affect the short-run aggregate supply.
The SRAS curve shifts to reflect worker and firm expectations of future prices.
If workers and firms expect the price level to rise by 3% from 100 to 103, they will adjust their wages and prices by that amount.
Holding constant all other variables that affect aggregate supply, the SRAS curve will shift to the left. If workers and firms expect the price level to be lower in the future, the SRAS curve will shift to the right.
100
$1000
Real GDP (billions of dollars)
Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

36. LEARNING OBJECTIVE 3
Aggregate Supply
Variables that shift the short-run and the long-run aggregate supply curves.
Increases in the labour force and/or in the capital stock, and/or in resources.
Technological change.

37. Macroeconomic equilibrium in the long run and the short run
LEARNING OBJECTIVE 4
Macroeconomic equilibrium in the long run and the short run
In long-run equilibrium, the aggregate demand and short-run aggregate supply curves intersect at a point along the long-run aggregate supply curve.

38. Long-run macroeconomic equilibrium: Figure 13.9
Price level
LRAS
SRAS
100
Figure 13.9: Long-run macroeconomic equilibrium.
In long-run macroeconomic equilibrium, the AD and SRAS curves intersect at a point on the LRAS curve. In this case, equilibrium occurs at real GDP of $1000 billion and a price level of 100. AD
$1000
Real GDP (billions of dollars)
Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

39. Macroeconomic equilibrium in the long run and the short run
LEARNING OBJECTIVE 4
Macroeconomic equilibrium in the long run and the short run
Recessions, expansions and supply shocks.
The following analysis of the aggregate demand and aggregate supply model begins with a simplified case, using two assumptions:
The price level is currently at 100, and workers and firms expect it to remain at 100 in the future.
Potential GDP is at $1000 billion and will remain at that level in the future.

40. Macroeconomic equilibrium in the long run and the short run
LEARNING OBJECTIVE 4
Macroeconomic equilibrium in the long run and the short run
Recession
The short-run effect of a decline in aggregate demand.
AD curve shifts left, and real GDP declines.
Adjustment back to potential GDP in the long run.
Automatic adjustment mechanism: SRAS curve shifts right, (which may take several years).

41. Real GDP (billions of dollars)
The short-run and long-run effects of a decrease in aggregate demand: Figure 13.10
Price level
LRAS
SRAS1
1. A decline in investment shifts AD to the left causing a recession.
SRAS2
2. As firms and workers adjust to the price level being lower than expected, costs will fall, and cause SRAS to shift to the right.
100 A 98 B
Figure 13.10: The short-run and long-run effects of a decrease in aggregate demand.
In the short run, a decrease in aggregate demand causes a recession. In the long run, it causes only a decrease in the price level.
The decline in investment shifts aggregate demand from AD1 to AD2. Short-run equilibrium moves from potential GDP at point A to recession at point B.
The price level of 98 at point B is lower than the price level of 100 that workers and firms had expected. As workers and firms adjust to the lower price level, prices and wages fall, and the SRAS curve shifts from SRAS1 to SRAS2.
Equilibrium moves from point B back to potential GDP at point C, with a lower price level of 96. 96 C
AD1
AD2
$980
1000
3. Equilibrium moves from point B back to potential GDP at point C, with a lower price level.
Real GDP (billions of dollars)
Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

42. Macroeconomic equilibrium in the long run and the short run
LEARNING OBJECTIVE 4
Macroeconomic equilibrium in the long run and the short run
Expansion
The short-run effect of an increase in aggregate demand.
AD curve shifts right, real GDP and the price level rise.
Adjustment back to potential GDP in the long run.
Automatic adjustment mechanism: SRAS curve shifts left, (which may take a year or more).

43. Real GDP (billions of dollars)
The short-run and long-run effects of an increase in aggregate demand: Figure 13.11
Price level
LRAS
SRAS2
1. An increase in investment shifts AD to the right, causing an inflationary expansion.
SRAS1
2. As firms and workers adjust to the price level being higher than expected, costs will rise, and cause SRAS to shift to the left. C
106 B
103
Figure 13.11: The short-run and long-run effects of an increase in aggregate demand.
In the short run, an increase in aggregate demand causes an increase in real GDP. In the long run, it causes only an increase in the price level.
The increase in investment shifts aggregate demand from AD1 to AD2. Short-run equilibrium moves from potential GDP at point A to beyond potential GDP at point B.
The price level of 103 at point B is higher than the price level of 100 that workers and firms had expected. As workers and firms adjust to the higher price level, prices and wages rise, and the SRAS curve shifts from SRAS1 to SRAS2.
Equilibrium moves from point B back to potential GDP at point C, with a higher price level of 106.
100 A
AD2
AD1
$1000
1030
3. Equilibrium moves from point B back to potential GDP at point C, with a higher price level.
Real GDP (billions of dollars)
Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

44. Macroeconomic equilibrium in the long run and the short run
LEARNING OBJECTIVE 4
Macroeconomic equilibrium in the long run and the short run
Supply shock: An unexpected event that causes the short-run aggregate supply curve to shift.
Stagflation: A combination of inflation and recession, usually resulting from a supply shock.

45. Macroeconomic equilibrium in the long run and the short run
LEARNING OBJECTIVE 4
Macroeconomic equilibrium in the long run and the short run
Supply shock
The short-run effect of a supply shock.
SRAS curve shifts left, real GDP falls and the price level rises.
Adjustment back to potential GDP in the long run.
SRAS curve shifts right, (which may take several years).

46. The short-run and long-run effects of a supply shock: Figure 13.12
2. …moving short-run equilibrium to point B, with lower real GDP and a higher price level.
Price
level
Price
level
LRAS
SRAS2
SRAS2
LRAS
SRAS1
SRAS1 B B
104
104
2. Equilibrium moves from point B potential GDP at the original price level.
100
1. An increase in oil prices shifts SRAS to the left … A
100 A
Figure 13.12: The short-run and long-run effects of a supply shock.
Panel (a) shows that a supply shock, such as a large increase in oil prices, will cause a recession and a higher price level in the short run. The recession caused by the supply shock increases unemployment and reduces output. AD AD
$970
1000
Real GDP (billions of dollars)
$970
1000
Real GDP (billions of dollars)
(a) A recession with a rising price level – the short-run effect of a supply shock.
(b) Adjustment back to potential GDP – the long-run effect of a supply shock.
Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia 46

47. The short-run and long-run effects of a supply shock: Figure 13.12
1. The recession caused by the supply shock eventually leads to falling wages and prices, shifting SRAS back to its original position.
2. …moving short-run equilibrium to point B, with lower real GDP and a higher price level.
Price
level
Price
level
LRAS
SRAS2
SRAS2
LRAS
SRAS1
SRAS1 B B
104
104
2. Equilibrium moves from point B to potential GDP at the original price level.
100
1. An increase in oil prices shifts SRAS to the left … A
100 A
Figure 13.12: The short-run and long-run effects of a supply shock.
In panel (b), rising unemployment and falling output result in workers being willing to accept lower wages and firms being willing to accept lower prices. The SRAS curve shifts from SRAS2 to SRAS1. Equilibrium moves from point B back to potential GDP and the original price level at point A. AD AD
$970
1000
Real GDP (billions of dollars)
$970
1000
Real GDP (billions of dollars)
(a) A recession with a rising price level – the short-run effect of a supply shock.
(b) Adjustment back to potential GDP – the long-run effect of a supply shock.
Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia 47

48. Using the Aggregate Demand Aggregate Supply model.
LEARNING OBJECTIVE 4
Using the Aggregate Demand Aggregate Supply model.
Assume the economy is initially in equilibrium with long-run aggregate supply (LRAS) constant. Now suppose growing GDP in China and India leads to an increase in demand and higher prices for Australian resources. Explain both the initial change in equilibrium and the longer term effect.

49. Using the Aggregate Demand Aggregate Supply model.
LEARNING OBJECTIVE 4
Using the Aggregate Demand Aggregate Supply model.
STEP 1: Review the chapter material. The basic equilibrium model is explained in the section on ‘Macroeconomic equilibrium in the long run and in the short run’.
STEP 2: An increase in demand for Australian exports will cause an increase in AD represented by a rightward shift of the AD curve. Short-run equilibrium will move beyond potential GDP, causing an increase in the price level.

50. Using the Aggregate Demand Aggregate Supply model.
LEARNING OBJECTIVE 4
Using the Aggregate Demand Aggregate Supply model.
The price level is now higher than workers and firms had expected. As workers and firms adjust to the higher price level, prices and wages rise, and the short-run aggregate supply curve shifts inwards to the left.
Equilibrium moves back to potential GDP, but at a higher price level.
It may be useful to note, either here or after discussing the dynamic model, that an increase in demand for Australian exports increases the profitability of firms, and also affects the future expectations of owners and managers. As a result, an increase in investment is likely to occur, and as resources are such an important part of the Australian economy, this can flow on to greater investment in infrastructure, such as road and port facilities.
In other words, in the dynamic model, we are likely to see a shift out in the LRAS curve, and an increase in potential GDP.

51. A dynamic aggregate demand and aggregate supply model
LEARNING OBJECTIVE 5
A dynamic aggregate demand and aggregate supply model
A dynamic aggregate demand and aggregate supply model can be created by making three changes to the basic model:
Potential real GDP increases continually, shifting the long-run aggregate supply curve to the right.
During most years the aggregate demand curve will be shifting to the right.
Except during periods when workers and firms expect high rates of inflation, the short-run aggregate supply curve will be shifting to the right.

52. A dynamic aggregate demand and aggregate supply model: Figure 13.13
Price level
2. During the course of a year, increases in the labour force and capital stock as well as technological change cause a shift from LRAS1 to LRAS2.
LRAS1
LRAS2
SRAS1
1. The economy begins in equilibrium at point A with SRAS1 and AD1 intersecting at a point on LRAS1.
SRAS2
3. The same factors that cause the LRAS curve to shift during the year also cause the SRAS curve to shift. A B
100
4. During the course of the year, rising income and population, increasing investment, and increasing government purchases cause the AD curve to shift, and the economy ends in a new equilibrium at point B.
5. The dynamic AD-AS model allows us to give a more accurate account of changes in real GDP and the price level.
Figure 13.13: A dynamic aggregate demand and aggregate supply model.
We start with the basic aggregate demand and aggregate supply model. In the dynamic model, increases in the labour force and capital stock as well as technological change cause long-run aggregate supply to shift over the course of a year, from LRAS1 to LRAS2. Typically these same factors cause short-run aggregate supply to shift from SRAS1 to SRAS2. Aggregate demand will shift from AD1 to AD2 if, as is usually the case, spending by consumers, firms, and the government increases during the year.
AD2
AD1
$1000
1030
Real GDP (billions of dollars)
Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

53. Real GDP (billions of dollars)
Using dynamic aggregate demand and aggregate supply to understand inflation: Figure 13.14
Price level
LRAS1
LRAS2
SRAS1
SRAS2
1. If AD shifts to the right more than LRAS …
104 B A
100
2. …the price level rises.
Figure 13.14: Using dynamic aggregate demand and aggregate supply to understand inflation.
The most common cause of inflation is total spending increasing faster than total production.
The economy begins at point A, with real GDP of $1000 billion and a price level of An increase in full-employment real GDP from $1000 billion to $1050 billion causes LRAS to shift from LRAS1 to LRAS2. Aggregate demand shifts from AD1 to AD2.
Because AD shifts to the right by more than the LRAS curve, the price level in the new equilibrium rises from 100 to 104.
AD2
AD1
$1000
1050
Real GDP (billions of dollars)
Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

54. Does rising productivity growth reduce employment?
MAKING THE CONNECTION
13.2
Does rising productivity growth reduce employment?
New technology and equipment increases labour productivity.
While increasing productivity per labour hour may be associated with a decrease in the number of workers required to produce a given quantity of output, it is reduces the cost of that output, and hence the price a firm needs to charge. The quantity demanded of a firm’s output may therefore increase, which may in turn mean that the firm’s demand for labour remains relatively constant. Rising productivity across an entire economy is typically associated with lower prices, hence greater demand for a range of goods and services, and hence more workers are required and employment grows.

55. An Inside Look
JB Hi-Fi reports sales up 36% and net profit after tax up 56%.

56. An Inside Look
Figure 1: Australian economic expansion between 2002 and 2007
Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

57. Key Terms Aggregate demand and aggregate supply model
Aggregate demand curve (AD)
Business cycle
Long-run aggregate supply curve (LRAS)
Menu costs
Short-run aggregate supply curve (SRAS)
Stagflation
Supply shock

58. Get Thinking!
At various times, the Australian dollar increases in value against the US dollar and other major currencies. At the same time, higher education continues as an important component of Australia’s export revenue. The cost of education in Australia therefore increases when the Australian dollar rises relative to other currencies.
Discuss with your fellow students from other countries the role the changing value of the Australian dollar played in their decision to study in Australia.
Explain the impact that such changes have on the net export component of aggregate demand, and hence aggregate demand, ceteris paribus.

59. Check Your Knowledge
Q1. From a trough to a peak, the economy goes through:
a. The recession phase of the business cycle.
b. The expansion phase of the business cycle.
c. A contraction.
d. A depression.

60. Check Your Knowledge
Q1. From a trough to a peak, the economy goes through:
a. The recession phase of the business cycle.
b. The expansion phase of the business cycle.
c. A contraction.
d. A depression.

61. Check Your Knowledge Q2. During the early stages of a recovery:
a. Firms usually rush to hire new employees before other firms employ them.
b. Firms are usually reluctant to hire new employees.
c. The rate of unemployment surges dramatically.
d. The rate of unemployment decreases dramatically.

62. Check Your Knowledge Q2. During the early stages of a recovery:
a. Firms usually rush to hire new employees before other firms employ them.
b. Firms are usually reluctant to hire new employees.
c. The rate of unemployment surges dramatically.
d. The rate of unemployment decreases dramatically.

63. Check Your Knowledge
Q3. The aggregate demand curve shows the relationship between the price level and the quantity of real GDP demanded by:
a. Households.
b. Firms.
c. The government.
d. All of the above.

64. Check Your Knowledge
Q3. The aggregate demand curve shows the relationship between the price level and the quantity of real GDP demanded by:
a. Households.
b. Firms.
c. The government.
d. All of the above.

65. Check Your Knowledge
Q4. Which of the following factors do not cause the aggregate demand curve to shift?
a. A change in the price level.
b. A change in government policies.
c. A change in the expectations of households and firms.
d. A change in foreign factors.

66. Check Your Knowledge
Q4. Which of the following factors do not cause the aggregate demand curve to shift?
a. A change in the price level.
b. A change in government policies.
c. A change in the expectations of households and firms.
d. A change in foreign factors.

67. Check Your Knowledge
Q5. How can government policies shift the aggregate demand curve to the right?
a. By increasing personal income taxes.
b. By increasing business taxes.
c. By increasing government purchases.
d. All of the above.

68. Check Your Knowledge
Q5. How can government policies shift the aggregate demand curve to the right?
a. By increasing personal income taxes.
b. By increasing business taxes.
c. By increasing government purchases.
d. All of the above.

69. Check Your Knowledge Q6. Which of the following statements is true?
a. In the long run, increases in the price level result in an increase in real GDP.
b. In the long run, increases in the price level result in a decrease in real GDP.
c. In the long run, increases in the price level result in no change in real GDP.
d. In the long run, increases in the price level may increase or decrease real GDP.

70. Check Your Knowledge Q6. Which of the following statements is true?
a. In the long run, increases in the price level result in an increase in real GDP.
b. In the long run, increases in the price level result in a decrease in real GDP.
c. In the long run, increases in the price level result in no change in real GDP.
d. In the long run, increases in the price level may increase or decrease real GDP.

71. Check Your Knowledge
Q7. Which of the following would shift both the short-run and the long-run aggregate supply curves?
a. A higher expected future price level.
b. An increase in the current price level.
c. A technological advance.
d. All of the above.

72. Check Your Knowledge
Q7. Which of the following would shift both the short-run and the long-run aggregate supply curves?
a. A higher expected future price level.
b. An increase in the current price level.
c. A technological advance.
d. All of the above.

73. Check Your Knowledge
Q8. Which of the following is usually the cause of stagflation?
a. Reductions in government spending.
b. Increases in investment.
c. Printing money to finance government expenditures.
d. An adverse supply shock.

74. Check Your Knowledge
Q8. Which of the following is usually the cause of stagflation?
a. Reductions in government spending.
b. Increases in investment.
c. Printing money to finance government expenditures.
d. An adverse supply shock.

75. The aggregate expenditure model
APPENDIX
The aggregate expenditure model
Aggregate Expenditure Model: A macroeconomic model that focuses on the relationship between total spending and real GDP, assuming the price level is constant.
The model is composed of a graph called the 45° line diagram to illustrate macroeconomic equilibrium.
Sometimes the model is also known as the Keynesian cross diagram.

76. An example of a 45° line diagram: Figure 13A.1
Figure 13A.1: An example of a 45 degree line diagram.
The 45 degree line shows all the points that are equal distances from both axes. Points such as A and B, at which the quantity produced equals the quantity sold, are on the 45 degree line. Points such as C, at which the quantity sold is greater than the quantity produced, lie above the line. Points such as D, at which the quantity sold is less than the quantity produced, lie below the line.
Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

77. The aggregate expenditure model
APPENDIX
The aggregate expenditure model
Aggregate Expenditure (AE): The total amount of spending in the economy: the sum of consumption (C), planned investment (I), government purchases (G), and net exports (NX).
AE = C + I + G + NX

78. Graphing macroeconomic equilibrium
APPENDIX
Graphing macroeconomic equilibrium
Using the 45° line diagram to illustrate macroeconomic equilibrium.
The 45° line measures real national income against planned real aggregate expenditure.
All points of macroeconomic equilibrium must lie along the 45° line.
At points above the 45° line, aggregate expenditures are greater than GDP.
At points below the 45° degree line, aggregate expenditures are less than GDP.

79. The relationship between planned aggregate expenditure and GDP on a 45° line diagram: Figure 13A.2
Figure 13A.2: The relationship between planned aggregate expenditure and GDP on a 45 degree line diagram.
Every point of macroeconomic equilibrium is on the 45 degree line, where planned expenditure equals GDP. At points above the line, planned aggregate expenditure is greater than GDP. At points below the line, planned aggregate expenditure is less than GDP.
Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

80. The aggregate expenditure model
APPENDIX
The aggregate expenditure model
Consumption function: The relationship between consumption spending and disposable income.
The consumption function intersects the vertical axis on the 45° diagram at a point above zero due to autonomous consumption.
Autonomous consumption: Consumption that is independent of income.
Induced consumption: Consumption that is determined by the level of income.

81. Macroeconomic equilibrium on the 45° line diagram: Figure 13A.3
Figure 13A.3: Macroeconomic equilibrium on the 45 degree line diagram.
Macroeconomic equilibrium occurs where the aggregate expenditure line (AE) crosses the 45° line. The lowest upward-sloping line, C, represents the consumption function. The quantities of planned investment, government purchases and net exports are constant because we assumed that the variables they depend on are constant. So, the total of planned aggregate expenditure at any level of GDP is just the amount of consumption at that level of GDP plus the sum of the constant amounts of planned investment, government purchases and net exports. We successively add each component of spending to the consumption function line to arrive at the line representing aggregate expenditure.
Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

82. The aggregate expenditure model
APPENDIX
The aggregate expenditure model
The AE line intersects the 45° line at equilibrium real GDP.
At points above the 45° line, planned aggregate expenditures are greater than GDP, inventories will fall, leading to an increase in production.
At points below the 45° degree line, planned aggregate expenditures are less than GDP, firms will experience an unplanned increase in inventories, leading to a decrease in production.

83. Macroeconomic equilibrium : Figure 13A.4
Figure 13A.4: Macroeconomic equilibrium.
Macroeconomic equilibrium occurs where the AE line crosses the 45° line. In this case, that occurs at a GDP of $1000 billion. If GDP is less than $1000 billion, the corresponding point on the AE line is above the 45° line, planned aggregate expenditure is greater than total production, firms will experience an unplanned decrease in inventories and GDP will increase. If GDP is greater than $1000 billion, the corresponding point on the AE line is below the 45° line, planned aggregate expenditure is less than total production, firms will experience an unplanned increase in inventories and GDP will decrease.
Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

84. The aggregate expenditure model
APPENDIX
The aggregate expenditure model
Showing a recession on the 45° line diagram
Macroeconomic equilibrium can occur at any point on the 45° line.
Ideal to have equilibrium occur at potential real GDP.
If there is insufficient aggregate spending, equilibrium will occur below potential real GDP: the economy will be in a recession.

85. Showing a recession on the 45° line: Figure 13A.5
Figure 13A.5: Showing a recession on the 45° line.
When the aggregate expenditure line intersects the 45° line at a level of GDP below potential real GDP, the economy is in recession. The figure shows potential real GDP is $1000 billion, but because planned aggregate expenditure is too low, the equilibrium level of GDP is only $980 billion, where the AE line intersects the 45° line. As a result, some firms will be operating below their normal capacity and unemployment will be above the natural rate of unemployment. We can measure the shortfall in planned aggregate expenditure as the vertical distance between the AE line and the 45° line at the level of potential real GDP.
Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

86. Check Your Knowledge
QA1. The idea of the aggregate expenditure model is that, in any particular year, the level of gross domestic product (GDP) is determined mainly by:
a. The economy’s endowment of economic resources and technology.
b. The level of interest rate for the economy as a whole.
c. The level of aggregate expenditures.
d. The level of government expenditures.

87. Check Your Knowledge
QA1. The idea of the aggregate expenditure model is that, in any particular year, the level of gross domestic product (GDP) is determined mainly by:
a. The economy’s endowment of economic resources and technology.
b. The level of interest rate for the economy as a whole.
c. The level of aggregate expenditures.
d. The level of government expenditures.

88. Check Your Knowledge
QA2. Which of the following statements is correct?
Actual investment and planned investment are always the same.
b. Actual investment will equal planned investment only when inventories rise.
c. Actual investment will equal planned investment only when there is no unplanned change in inventories.
d. Actual investment and planned investment only when inventories decline.

89. Check Your Knowledge
QA2. Which of the following statements is correct?
Actual investment and planned investment are always the same.
b. Actual investment will equal planned investment only when inventories rise.
c. Actual investment will equal planned investment only when there is no unplanned change in inventories.
d. Actual investment and planned investment only when inventories decline.