1. Aggregate Demand and Aggregate Supply Chapter 15

2. In this chapter we derive the:
The Price Level
Up to this point, we have not said much about prices and the price level (P)
In this chapter we derive the:
Aggregate Demand curve which shows the relation between aggregate expenditure (AE) and the price level (P)
Aggregate Supply curve shows the relation between aggregate production and the price level (P)

3. Derivation of Aggregate Demand (AD) Curve
Start with money demand. An increase in the price level shifts the money demand curve rightward
increasing the equilibrium interest rate (if the Fed does not increase the money supply)
causing the aggregate expenditure line to shift downward
resulting in a lower equilibrium level of GDP.

4. Deriving the Aggregate Demand Curve (a)
Interest
Rate
Money ($ billions)
500 MS
M2d
As the price level, say the CPI, increases from 100 to 140, money demand increases and the interest rate rises. B 9%
M1d A 6%

5. Deriving the Aggregate Demand Curve (b, c)
Real Aggregate
Expenditure
($ Trillions)
Real GDP ($ Trillions)
45°
AEr=6% E 10
AEr=9% F 6
The rise in the interest rate causes real GDP to fall.
Price level
Real GDP ($ Trillions) AD
On the AD curve, a higher price level is associated with a lower real GDP. K
140 6 H
100 10
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6. The Aggregate Demand Curve
a curve indicating equilibrium GDP at each price level, with a constant money supply
its NOT a demand curve at all!
it is actually an “equilibrium-output-at-each-price-level” curve

7. The Aggregate Demand Curve
Movements along the AD curve
a change in the price level causes equilibrium GDP to change
This inverse relationship between P and Y caused by the change in the interest rate is called the interest rate effect

8. The Aggregate Demand (AD) Curve
Another reason for a downward-sloping aggregate demand curve is the Real Wealth Effect
This is the change in consumption brought about by a change in real wealth that results from a change in the price level.

9. Nominal and Real Wealth
Nominal Wealth (W) = Assets – Liabilities
Real Wealth is the purchasing power of wealth =
Two things change real wealth: W or P

10. As P↓ => (W/P)↑ => C↑=> AE↑ => Y↑B
AE0 A
450 Y0 Y1 Y
As P ↑ =>(W/P) ↓ => C ↓ => AE ↓ => Y ↓
P and Y move in opposite directions. The AD curve
Slopes downward to the right.

11. What shifts the AD curve ?
Changes in any of the variables that shift the AE curve:
Government purchases (G)
Planned Investment spending (IP)
Autonomous consumption spending (a)
Taxes (T)
Net exports (NX)
The money supply (M)

12. The Aggregate Demand Curve
AD curve shifts rightward when:
Government purchases (G) increase
Planned Investment spending (IP) increases
Autonomous consumption spending (a) increases
Net exports increase
Net taxes decrease
Money supply increases

13. A Spending Change Shifts the AD Curve
Real Aggregate
Expenditure
($ Trillions)
Real GDP ($ Trillions)
45°
AE2 F
12.5
At any given price level, an increase in government purchases shifts the AE line upward, raising real GDP.
Get the multiplier effect we introduced in chapter 11.
AE1 E 10
Price level
Real GDP ($ Trillions)
AD2
AD1
Since real GDP is higher at the given price level, the AD curve shifts rightward.
H to J is the multiplier effect we introduced in chapter 11 J 10
100 H
12.5

14. Change in Price Level Moves Along the AD Curve (a)
Real GDP
Price level ↑ moves us leftward along the AD curve AD P3 Q3
Price level ↓ moves us rightward along the AD curve P1 Q1 P2 Q2
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15. Effects of Key Changes on the Aggregate Demand Curve (b, c)
Price Level
Real GDP
Price Level
Real GDP
AD2
AD1
AD1
AD2
Entire AD curve shifts rightward if:
• a, Ip, G, or NX increases
• Net taxes decrease
• The money supply increases
Entire AD curve shifts leftward if:
• a, Ip, G, or NX decreases
• Net taxes increase
• The money supply decreases
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16. The Aggregate Supply Curve
Assumptions:
Firms set the price of their products as a markup over unit cost of production
p = unit cost + mark-up
Average percentage markup in the economy is determined by competitive conditions in the economy
so we treat the mark-up as stable (fixed) from year to year
The competitive structure of the economy changes very slowly

17. The Aggregate Supply Curve
In general, changes in GDP affects unit costs of production
As total GDP(output) increases:
greater amounts of inputs are needed to produce the greater output
the prices for non-labor inputs rise
the price of labor, the nominal wage rate, can also increase (but we make an assumption about this in the short-run!)

18. The Aggregate Supply Curve
We assume that in the short-run the price of labor, nominal wages, are “fixed”, “sticky”
union contracts
can be costly to firms
reputation for paying stable wages
slow-moving bureaucracies
THIS IS A KEY ASSUMPTION!!!
nominal wage rate is fixed in the short run
changes in output have no effect on the nominal wage rate in the short run

19. The Aggregate Supply Curve
In the short run, a change in output will affect non-labor costs of production
a rise in real GDP raises firms’ unit costs
Input requirements increase: coal, oil lumber, copper,…….
The prices of these non-labor inputs rise
A decrease in real GDP lowers unit costs
Input requirements decrease
Prices of non-labor inputs fall

20. The Aggregate Supply Curve
Aggregate Supply (AS) curve
a curve indicating the price level consistent with firms’ unit costs and markups for any level of output (Y) in the short run
it is actually a “short-run-price-level-at-each-output-level” curve
its upward sloping
Price level on the vertical axis
Total output on the horizontal axis

21. The Aggregate Supply Curve
Price
Level
Real GDP AS
Starting at point A, an increase in output raises unit costs. Firms raise prices, and the overall price level rises. B
130
12.5 A
100 10
Starting at point A, a decrease in output lowers unit costs. Firms cut prices, and the overall price level falls. C 80 6
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22. The Aggregate Supply Curve
Movements along the AS curve
A change in real GDP causes the price level to change
Wages are sticky! Labor costs do not change in the short-run.

23. Another View of the Aggregate Supply Curve
In the short run there must be a lag between changes in output prices and changes in input prices, otherwise the aggregate supply (price/output response) curve would be vertical.
If input and output prices rise by the same percentage amount, no firm would find it advantageous to change its level of output.

24. Slope Matters! Shape of the Short-run Aggregate Supply Curve - Ordinary Conditions
Moderate Levels of :
Unemployment -
Unemployment Rate: 5 -10%
Some excess Capacity -
Ex. Cap Rate: 10-25%
AS exhibits a Positive Slope

25. Aggregate Supply Curve - Ordinary Conditions Implications
With the positive slope:
Change in output (Y) causes a moderate change in the price level (P)

26. Shape of the Short-run Aggregate Supply Curve - Slack Conditions
High Levels of:
Unemployment -
Unemployment Rate > 10%
Lot of excess Capacity - Ex Cap Rate > 25%
• AS is Almost Flat

27. Shape of the Short-run Aggregate Supply Curve - Slack Conditions - Implications
With a flat slope:
The economy can expand a lot with small increase in P because of the excess capacity.

28. Shape of the Short-run Aggregate Supply Curve - Tight Conditions
Low Levels of:
Unemployment -
Unemployment Rate < 3%
Little excess Capacity-
Ex Cap Rate < 10%
• AS is Very Steep

29. Large increase in P for a relatively small increase in GDP (Y).
Shape of the Short-run Aggregate Supply Curve - Tight Conditions - Implication AS
Large increase in P for a relatively small increase in GDP (Y).

30. The Aggregate Supply Curve is not a straight line
Capacity
[--Slack-----]
[--Ordinary--]
[--Tight--]

31. What Causes the Aggregate Supply Curve to Shift?
Increase in AS means the AS curve shifts downward:
Lower world oil prices
Good weather
Technological change
Regulation
Lower nominal wages
Decrease in AS means the AS curve shifts upward:
Higher world oil prices
Bad weather
Technological change(negative?), stupid pills(?)
Higher nominal wages

32. Shift of the Aggregate Supply Curve
Price
Level
Real GDP
AS2
AS1 L
140
When unit costs rise at any given real GDP—e.g., from an increase in world oil prices or bad weather for farm production—the AS curve shifts upward.
100 10 A
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33. Effects of Key Changes on the Aggregate Supply Curve (a)
Price
Level
Real GDP AS
Real GDP ↑ moves us rightward along the AS curve P2 Y2 P1 Y1
Real GDP ↓ moves us leftward along the AS curve P3 Y3
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34. Effects of Key Changes on the Aggregate Supply Curve (b, c)
Price Level
Real GDP
Price Level
Real GDP
AS2
AS1
AS1
AS2
Entire AS curve shifts downward if unit costs ↓ for any reason besides a decrease in real GDP
Entire AS curve shifts upward if unit costs ↑ for any reason besides an increase in real GDP

35. AD and AS: Short-Run Equilibrium
Short-run macroeconomic equilibrium
a combination of price level and GDP consistent with both the AD and AS curves

36. Short-Run Macroeconomic Equilibrium
Price
Level
Real GDP AS AD
Excess Supply B
140 6 14 E
100 10 F 80
Excess Demand
At point E, the price level of 100 is consistent with an output of $10 trillion along the AD curve. The output level of $10 trillion is consistent with a price level of 100 along the AS curve. At any other combination of price level and output, such as point F or point B, at least one condition for equilibrium will not be satisfied.

37. Short-Run Macroeconomic Equilibrium
At point B, AS > AD. Excess Supply.
P will fall from 140 to 100 and Y will fall from 14 to 10.
As P and Y fall, the interest rate falls which means C and Ip increases causing AD to increase.
Movements along the curves!
Price
Level
Real GDP AS AD
Excess Supply B
140 6 14 E
100 10 F 80
Excess Demand
The is a lot more complicated than the basic AE model presented in chapters 10 and 11 where only Y fell as inventories increased.
Here, Y, P , money demand, the interest rate(r) and AE all adjust.

38. Short-Run Macroeconomic Equilibrium
At point F, AD > AS.
Excess Demand.
P will increase from 80 to 100 and Y will increase from 6 to 10.
As P and Y increase, the interest rate rises which means C and Ip fall causing AD to decrease
Movements along the curves!
Price
Level
Real GDP AS AD
Excess Supply B
140 6 14 E
100 10 F 80
Excess Demand
The is a lot more complicated than the basic AE model presented in chapters 10 and 11 where only Y fell as inventories decreased. Here, Y, P , money demand, the interest rate(r) and AE all adjust.

39. What Happens When Things Change?
Demand shock
this is any event that causes the AD curve to shift
for example, a change in government purchases or a change in the money supply
Supply shock
an event that causes the AS curve to shift
e.g., increase or decrease in world oil price, regulation, nominal wages.

40. The Effect of a Demand Shock: Increase G
Starting at point E, an increase in government purchases would shift the AD curve rightward to AD2
Relate back to the Keynesian 450 graph. Multiplier= (1/(1-MPC).
Price
Level
Real GDP
$ Trillions AS
AD1
AD2 N
110 E J
11.5
100
10.0
12.5
Point J illustrates where the economy would move if the price level remained constant; multiplier = (1/(1-MPC).
But, as output increases, the price level rises. Thus, the economy moves along the AS curve from point E to point N.

41. What Happens When Things Change?
Increase in government purchases
Crowding-out of interest-sensitive spending. Multiplier is less than (1/(1-MPC). Inflation and rising interest rates reduce the size of the multiplier.

42. The Effect of a Demand Shock
As P increases, money demand increases. If the money supply is constant, the interest rate rises and crowds-out interest sensitive investment and consumer spending. Move up along the AD curve from point J to N.
Crowding-out of interest-sensitive spending means the size of the multiplier is reduced.
Inflation and the increase in the interest rate reduce the size of the multiplier.

43. What Happens When Things Change?
Decrease in government purchases
Crowding-in of interest-sensitive spending. Multiplier is larger than (1/(1-MPC). Falling prices and falling interest rates increase the size of the multiplier.

44. What Happens When Things Change?
Increase in money supply
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45. To sum up the short-run -
A positive demand shock
shifts the AD curve rightward
increases both real GDP and the price level in the short run
A negative demand shock
shifts the AD curve leftward
decreases both real GDP and the price level in the short run

46. Demand Shocks: Adjusting to Long Run
In the short run we treat the wage rate and labor costs as given
In the long run
the wage rate will change
when output is above full employment
Wage rate will rise, shifting the AS curve upward
when output is below full employment
Wage rate will fall, shifting the AS curve downward

47. Demand Shocks: Adjusting to Long Run
Self-correcting mechanism
the adjustment process where price and wage changes return the economy to full-employment output in the long run
If a demand shock pulls the economy away from full employment
changes in the wages and the price level will eventually cause the economy to correct itself and return to full-employment output

48. Demand Shocks: Adjusting to Long Run
Positive demand shock
NOTE: Y >YFE => U <Un

49. Long-Run Adjustment after a Positive Demand Shock
St point E, a positive demand shock would shift the aggregate demand curve to AD2, raising both output and the price level.
In the short-run the economy moves to point N, output is above the full-employment level, YFE.
Firms compete to hire scarce workers, driving up the wage rate. In the long-run the higher wage rate will shift the AS curve to AS2.
The economy returns to full-employment output at point L in the long-run.
Price
Level
Real GDP
AS2
AD2
AS1 L P4
AD1 P2 N Y2 P1 E
YFE

50. Demand Shocks: Adjusting to Long Run
Negative demand shock
NOTE: Y <YFE => U >Un

51. Long-Run Adjustment after a Negative Demand Shock
Price
Level
Real GDP
AS1
AD1
AD2
AS2 E P1
YFE P2 N Y2 P3 M
Starting from point E, a negative demand shock shifts the AD curve to AD2, lowering GDP and the price level. In the short-run, output is below the full-employment level at point N. With unemployed labor available, wages and unit costs will fall, causing firms to lower their prices. The AS curve shifts downward until full employment is regained at point M, with a lower price level in the long-run.

52. Demand shock : The self-correcting mechanism in the long-run
When output exceeds its full-employment level
Wages will eventually rise
Causing a rise in the price level and a drop in GDP until full employment is restored
When output is less than its full-employment level
Wages will eventually fall
Causing a drop in the price level and a rise in GDP until full employment is restored

53. Long-run Aggregate Supply Curve
A vertical line
Indicating all possible output and price-level combinations at which the economy could end up in the long run
The self-correcting mechanism
Shows us that, in the long run, the economy will eventually behave as the classical model predicts

54. This figure illustrates a positive demand shock, but focuses on the long-run effects. The initial equilibrium is at point E, with output at full employment (YFE) and price level P1. After the positive demand shock and all the long-run adjustments to it, the economy ends up at point L with a higher price level (P4), but the same full-employment output level (YFE). The long-run AS curve—a vertical line—shows all possible combinations of price level and output for the economy, skipping over the short-run changes. The vertical, long-run AS curve shows that in the long run, demand shocks can affect the price level but not output.
The Long-Run AS Curve
Price
Level
Real GDP
Long-Run AS Curve
AS2
AD2
AS1 L P4
AD1 P2 N Y2 P1 E
YFE

55. Supply Shocks Negative supply shock. In the short run
the AS curve shifts upward
Decreasing output and increasing the price level
causes stagflation (falling output and rising prices)
Positive supply shock. In the short run
the AS curve shifts downward
Increasing output and decreasing the price level

56. The Effect of a Negative Supply Shock
Price
Level
Real GDP
YFE
Long-Run AS Curve
A negative supply shock would shift the AS curve upward from AS1 to AS2.
In the short-run, equilibrium is at point R, the price level is higher and output (Y2) is below YFE.
Eventually, wages will fall, causing unit costs to fall, and the AS curve will shift back down to its original position.
AS1
AS2 AD R P2 Y2 E P1

57. The Effect of a Positive Supply Shock
Price
Level
Real GDP
YFE
Long-Run AS Curve
A positive supply shock would shift the AS curve down from AS1 to AS2. In the short-run equilibrium at point R, the price level is lower and output is above YFE.
Eventually, wages will rise, causing unit costs to rise, and the AS curve will shift back up to its original position.
AS1 AD
AS2 E P1 R P2 Y2

58. Supply Shocks In the long run
The economy self-corrects after a long-lasting supply shock
When output differs from its full-employment level
The wage rate changes
AS curve shifts until full employment is restored

59. The Story of Two Recessions
The recession of
a supply-shock recession
caused by a reduction in oil supply
Price of oil doubled
The recession of
a powerful, negative demand shock
Home prices – falling
Stock prices – plunged

60. An AD and AS Analysis of Two Recessions: 1990-91Recession
Price
Level
Real GDP
1. In 1990, a supply shock
from higher oil prices shifted the AS curve leftward …
AS1991
AD1990 P2
AS1990 R Y2 E
3. and the price level to rise P1
YFE
2. causing output to fall…

61. An AD and AS Analysis of Two Recessions: 2008-09 Recession
Price
Level
Real GDP
4. In , a demand shock from several factors caused the AD curve to shift leftward …
AS2007
AD2007
AD2009 E P1
YFE
6. and the price level to fall P2
5. causing output to fall… R Y2

62. GDP and the Price Level in Two Recessions
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63. More Real World Examples

64. The Aggregate Supply Curve is not a straight line
Expansionary policy is inflationary and has small impact on aggregate output (Y) P4
AD4 P3
AD3
Expansionary policy is not inflationary and has relatively large impact on aggregate output (Y) P2 P1
AD2
Capacity
AD1
[--Slack-----]
[--Ordinary--]
[--Tight--]