1. CHAPTER 8 Aggregate Supply and Aggregate Demand
Michael Parkin
ECONOMICS 5e
CHAPTER 8 Aggregate Supply and Aggregate Demand
Chapter 25 in Economics

2. Learning Objectives Explain what determines aggregate supply
Explain what determines aggregate demand
Explain macroeconomic equilibrium

3. Learning Objectives (cont.)
Explain the effects of changes in aggregate supply and aggregate demand on economic growth, inflation, and business cycles
Explain U.S. economic growth, inflation, and business cycles by using the AS-AD model

4. Learning Objectives Explain what determines aggregate supply
Explain what determines aggregate demand
Explain macroeconomic equilibrium

5. Aggregate Supply
The model of AGGREGATE SUPPLY- AGGREGATE DEMAND improves our understanding of:
1) Growth of potential GDP
2) Inflation
3) Business cycle fluctuations

6. Aggregate Supply Aggregate Supply Fundamentals
The quantity of real GDP supplied (Y) depends upon:
The quantity of labor (N)
The quantity of capital (K)
The state of technology (T)

7. Aggregate Supply Aggregate Supply Fundamentals
The aggregate production function describes how these factors influence the quantity of GDP supplied.

8. Aggregate Supply
The aggregate production function is:
Y = F(N, K, T)

9. Aggregate Supply
The aggregate production function shows that the quantity of real GDP supplied is determined by the quantities of labor and capital and the state of technology.

10. Aggregate Supply
Capital and technology are fixed at any point in time.
However, labor is not fixed.
Lower wages result in a greater quantity of labor demanded.
Higher wages result in a greater quantity of labor supplied.

11. Aggregate Supply Full Employment
Occurs at the wage rate that makes the quantity of labor demanded equal to the quantity of labor supplied

12. Aggregate Supply Natural Rate of Unemployment
The unemployment rate that exists at full employment.
In 1997 it was about 5.5%.

13. Aggregate Supply
Potential GDP is the quantity of real GDP supplied when unemployment is at its natural rate and there is full employment.

14. Aggregate Supply Long-Run Aggregate Supply
The macroeconomic long run is a time frame that is sufficiently long for forces that move real GDP toward potential GDP to have done their work so that full employment prevails.

15. Aggregate Supply Long-Run Aggregate Supply
The long-run aggregate supply curve is the relationship between the quantity of real GDP supplied and the price level in the long run when real GDP equals potential GDP.

16. Long-Run Aggregate Supply
LAS
140
130
120
Price level (GDP deflator, 1992 = 100)
110
100
Potential
GDP
Instructor Notes:
1) The long-run aggregate supply (LAS) curve shows the relationship between potential GDP and the price level.
2) Potential GDP is independent of the price level, so the LAS curve is vertical at potential GDP. 90
6.0
6.5
7.0
7.5
8.0
8.5
Real GDP (trillions of 1992 dollars)

17. Aggregate Supply Long-Run Aggregate Supply
Potential GDP is independent of the price level because the price level, wage rate, and other resource prices all change by the same percentage.

18. Aggregate Supply Short-Run Aggregate Supply (cont.)
The macroeconomic short run is a period during which real GDP has fallen below or risen above potential GDP.
The unemployment rate has risen above or fallen below the natural rate.

19. Aggregate Supply Short-Run Aggregate Supply (cont.)
The short-run aggregate supply curve is the relationship between the quantity of real GDP supplied and the price level in the short-run when the money wage rate, other resource prices, and potential GDP remain constant.

20. Short-Run Aggregate Supply
Price Level Real GDP
(GDP deflator) (trillions of 1992 dollars) a b c d e

21. Short-Run Aggregate Supply
LAS
140
130
SAS a b c d e
120
Price level (GDP deflator, 1992 = 100)
110
100
Instructor Notes:
If the price level is greater than 110, real GDP exceeds potential GDP; if the price level is below 110, real GDP is less than potential GDP.
Real GDP below
potential GDP
Real GDP above
potential GDP 90
6.0
6.5
7.0
7.5
8.0
8.5
Real GDP (trillions of 1992 dollars)

22. Aggregate Supply Movements Along the LAS and SAS Curves
When the price level rises, holding the money wage rate and other resource prices constant, the quantity of real GDP supplied increases and there is a movement along the SAS curve.

23. Movements Along The Aggregate Supply Curves
Price level rises and
money wage rate rises
by the same percentage
140
LAS
130
SAS
120
Price level (GDP deflator, 1992 = 100)
Price level rises and
money wage rate is
unchanged
110
100
Instructor Notes:
1) A rise in the price level with no change in the money wage rate and other resource prices brings an increase in the quantity of real GDP supplied and a movement along the short-run aggregate supply curve.
2) A rise in the price level with equal percentage rises in the money wage rate and other resource prices keeps the quantity of real GDP supplied constant and brings a movement along the long-run aggregate supply curve. 90
6.0
7.0
8.0
Real GDP (trillions of 1992 dollars)

24. Aggregate Supply Changes in Aggregate Supply
Occurs when influences on production other than the price level change

25. Aggregate Supply Potential GDP changes as a result of:
1) Changes in the full-employment quantity of labor
2) Changes in the quantity of capital
3) Advances in technology

26. A Change in Potential GDP
LAS0
LAS1
140
Increase in
potential GDP
130
SAS0
120
SAS1
Price level (GDP deflator, 1992 = 100)
110
100
Instructor Notes:
An increase in potential GDP increases both long-run aggregate supply and short-run aggregate supply and shifts both aggregate supply curves rightward, from LAS0 to LAS1 and from SAS0 to SAS1 . 90
6.0
7.0
8.0
Real GDP (trillions of 1992 dollars)

27. Aggregate Supply
Changes in the money wage rate changes short-run aggregate supply but does not change long-run aggregate supply.

28. A Change in the Money Wage Rate
LAS
140
SAS2
130
SAS0
120
Price level (GDP deflator, 1992 = 100) b
110 a
100
Instructor Notes:
1) A rise in the money wage rate decreases short-run aggregate supply and shifts the short-run aggregate supply curve leftward from SAS0 to SAS2.
2) A rise in the money wage rate does not change potential GDP, so the long-run aggregate supply curve does not shift. 90
6.0
7.0
8.0
Real GDP (trillions of 1992 dollars)

29. Learning Objectives Explain what determines aggregate supply
Explain what determines aggregate demand
Explain macroeconomic equilibrium

30. Aggregate Demand Y = C + I + G + X – M
The quantity of real GDP demanded is the sum of the real consumption expenditure (C), investment (I), government purchases (G), and exports (X) minus imports (M).
Y = C + I + G + X – M

31. Aggregate Demand
Aggregate demand is the relationship between the quantity of real GDP demanded and the price level.

32. Aggregate Demand a' 90 8.0 b' 100 7.5 c' 110 7.0 d' 120 6.5 e' 130 6.0
Price Level Real GDP
(GDP deflator) (trillions of 1992 dollars) a' b' c' d' e'

33. Aggregate Demand 140 e' d' c' b' a' 130 AD 120 110 100 90 6.0 6.5 7.0
Decrease in
quantity of
real GDP
demanded.
140 e' d' c' b' a'
130 AD
120
Price level (GDP deflator, 1992 = 100)
110
Increase in
quantity of
real GDP
demanded.
100
Instructor Notes:
1) The aggregate demand curve (AD) shows the relationship between the quantity of real GDP demanded and the price level.
2) The aggregate demand curve is based on the schedule in the table.
3) Each point a’ through e’ on the curve corresponds to the row in the table identified by the same letter.
4) Thus when the price level is 110, the quantity of real GDP demanded is $7.0 trillion, shown by point c’ in the figure. 90
6.0
6.5
7.0
7.5
8.0
Real GDP (trillions of 1992 dollars)

34. Aggregate Demand The two reasons the demand curve sloped downward are:
1) Wealth effect
Changes in the price level, with other things remaining the same, change real wealth.
People try to restore wealth by increasing saving and decreasing consumption.

35. Aggregate Demand The two reasons the demand curve sloped downward are:
2) Substitution effects
People substitute future consumption for present consumption as a result of higher interest rates.
A change in prices cause consumers to spend less on domestic items and more on imported items.

36. Aggregate Demand Changes in the Quantity of Real GDP Demanded
When the price level changes, other things remaining the same, the quantity of real GDP demanded changes and there is movement along the aggregate demand curve.

37. Aggregate Demand Changes in Aggregate Demand
A change in any factor than influences buying plans other than the price level.

38. Aggregate Demand
The factors that influence buying plans other than the price level and bring a change in aggregate demand are:
1) Expectations
2) Fiscal policy and monetary policy
3) The world economy

39. Aggregate Demand Expectations
Expectations about future incomes, inflation, and profits influence buying plans today.

40. Aggregate Demand Fiscal Policy and Monetary Policy
Fiscal policy is the government’s attempt to influence the economy by setting and changing taxes, transfer payments, and government purchases.

41. Aggregate Demand Fiscal Policy and Monetary Policy
These influence a household’s disposable income.
Disposable income equals aggregate income minus taxes plus transfer payments.

42. Aggregate Demand Fiscal Policy and Monetary Policy
Monetary policy consists of changes in interest rates and in the quantity of money in the economy.

43. Aggregate Demand The World Economy
The exchange rate and foreign income affect aggregate demand.

44. Changes in Aggregate Demand
140
AD1
Increase in
aggregate
demand
130
120
Price level (GDP deflator, 1992 = 100)
AD2
110
Decrease in
aggregate
demand
100 90
AD0
6.0
6.5
7.0
7.5
8.0
Real GDP (trillions of 1992 dollars)

45. Changes in Aggregate Demand
Decreases if:
Aggregate demand
Increases if:
Expected future incomes, inflation, or profits decrease.
Fiscal policy decreases government purchases, increases taxes, or decreases transfer payments.
Expected future incomes, inflation, or profits increase.
Fiscal policy increases government purchases, decreases taxes, or increases transfer payments.

46. Changes in Aggregate Demand
Decreases if:
Aggregate demand
Increases if:
Monetary policy decreases the quantity of money and increases interest rates
The exchange rate increases or foreign income decreases
Monetary policy increases the quantity of money and decreases interest rates
The exchange rate decreases or foreign income increases

47. Learning Objectives Explain what determines aggregate supply
Explain what determines aggregate demand
Explain macroeconomic equilibrium

48. Macroeconomic Equilibrium
Short-Run Macroeconomic Equilibrium
Occurs when the quantity of real GDP demanded equals the quantity of real GDP supplied.

49. Short-Run Equilibrium
140
Firms cut
production
and prices e'
130
SAS d'
120
Price level (GDP deflator, 1992 = 100) e c' c' d
110
Short-run
macroeconomic
equilibrium c b' b
100
Firms increase
production
and prices a
1) If the price level is 100 and real GDP is $6 trillion (point a), people will not be able to buy all the goods and services they demand.
2) Firms will increase production and raise their prices. e' 90 AD
6.0
6.5
7.0
7.5
8.0
Real GDP (trillions of 1992 dollars)

50. Macroeconomic Equilibrium
Long-Run Macroeconomic Equilibrium
Occurs when real GDP equals potential GDP, (i.e. the economy is on its long-run aggregate supply curve).

51. Long-Run Equilibrium LAS 140 130 AD SAS 120 110 100 90 6.0 6.5 7.0 7.5
Price level (GDP deflator, 1992 = 100)
110
100
In the long run,
money wage
adjusts
Instructor Notes:
1) In long-run macroeconomic equilibrium, real GDP equals potential GDP.
2) So long-run equilibrium occurs where the aggregate demand curve intersects the long-run aggregate demand curve.
3) In the long run, aggregate demand determines the price level and has no effect on real GDP.
4) The money wage rate adjusts in the long run so that the SAS curve intersects the LAS curve at the long-run equilibrium price level. 90
6.0
6.5
7.0
7.5
8.0
Real GDP (trillions of 1992 dollars)

52. Learning Objectives (cont.)
Explain the effects of changes in aggregate supply and aggregate demand on economic growth, inflation, and business cycles
Explain U.S. economic growth, inflation, and business cycles by using the AS-AD model

53. Macroeconomic Equilibrium
Economic Growth and Inflation
Economic growth occurs because the quantity of labor grows, capital is accumulated, and technology advances.
Inflation occurs when aggregate demand increases by more than long-run aggregate supply.

54. Economic Growth and Inflation
Increase in LAS
brings economic
growth
LAS0
LAS1
140
130
AD1
120
Price level (GDP deflator, 1992 = 100)
Inflation
110
100
Bigger increase
in AD than in LAS
brings inflation
Instructor Notes:
1) Economic growth is the persistent increase in potential GDP.
2) Economic growth is shown as an ongoing rightward movement in the LAS curve.
3) Inflation is the persistent rise in the price level.
4) Inflation occurs when aggregate demand increases by more than the increase in long-run aggregate supply 90
Economic
growth
AD0
6.0
7.0
8.0
Real GDP (trillions of 1992 dollars)

55. Macroeconomic Equilibrium
In the long-run, the main influence on aggregate demand is the growth rate of the quantity of money.
Real GDP fluctuates around potential GDP in a business cycle.
Inflation fluctuates at the same time.

56. Macroeconomic Equilibrium
Business Cycles
Occur because aggregate demand and short-run aggregate supply fluctuate but the money wage rate does not adjust quickly enough to keep real GDP at potential GDP.

57. Macroeconomic Equilibrium
Below Full-employment Equilibrium
A macroeconomic equilibrium in which potential GDP exceeds real GDP
The difference is called a recessionary gap.

58. Macroeconomic Equilibrium
Long-Run Equilibrium
Occurs when real GDP equals potential GDP.

59. Macroeconomic Equilibrium
Above Full-employment Equilibrium
A macroeconomic equilibrium in which real GDP exceeds potential GDP
The difference is called an inflationary gap.

60. The Business Cycle LAS 120 100 110 130 SAS0 a AD0 6.8 7.0 7.2
Recessionary
gap
SAS0
Below full-employment
equilibrium
Price level (GDP deflator, 1992 = 100) a
Instructor Notes:
1)The graph shows a below full-employment equilibrium in year 1.
2) There is a recessionary gap and the economy is at point a.
AD0
6.8
7.0
7.2
Real GDP (trillions of 1992 dollars)

61. The Business Cycle
7.2
Fluctuations in
real GDP
Recesssionary
gap
Real GDP (trillions of 1992 dollars)
Potential
GDP
7.0
Actual
GDP
Instructor Notes:
The graph shows how real GDP fluctuates around potential GDP in a business cycle.
6.8 a 1 2 3 4
Year

62. The Business Cycle LAS 120 100 110 130 SAS1 b AD1 6.8 7.0 7.2 Long-run
Full
employment
120
100
110
130
Long-run
equilibrium
SAS1
Price level (GDP deflator, 1992 = 100) b
Instructor Notes:
1) The graph shows a long-run equilibrium in year 2.
2) There is a long-run equilibrium and the economy is at point b.
AD1
6.8
7.0
7.2
Real GDP (trillions of 1992 dollars)

63. The Business Cycle 7.2 7.0 b 6.8 a 1 2 3 4 Fluctuations in real GDP
Recessionary
gap
Full
employment
Potential
GDP
Real GDP (trillions of 1992 dollars)
7.0 b
Instructor Notes:
The graph shows how real GDP fluctuates around potential GDP in a business cycle.
Actual
GDP
6.8 a 1 2 3 4
Year

64. The Business Cycle LAS 120 100 110 130 SAS2 c AD2 7.0 7.2
Above full-employment
equilibrium
Inflationary
gap
SAS2
Price level (GDP deflator, 1992 = 100) c
Instructor Notes:
1) The graph shows an above full-employment equilibrium in year 3.
2) There is an inflationary gap and the economy is at point c.
AD2
7.0
7.2
Real GDP (trillions of 1992 dollars)

65. The Business Cycle c 7.2 7.0 b 6.8 a 1 2 3 4 Fluctuations in real GDP
Recessionary
gap
Full
employment
Potential
GDP
Real GDP (trillions of 1992 dollars)
Inflationary
gap
7.0 b
Instructor Notes:
The graph shows how real GDP fluctuates around potential GDP in a business cycle.
Actual
GDP
6.8 a 1 2 3 4
Year

66. Macroeconomic Equilibrium
Fluctuations in Aggregate Demand
Real GDP sometimes fluctuates as a result of changes in aggregate demand.

67. An Increase in Aggregate Demand
LAS
140
AD1
Short-run
effect
130
SAS0
115
Price level (GDP deflator, 1992 = 100)
110
100
Instructor Notes:
1) An increase in aggregate demand shifts the aggregate demand curve from AD0 to AD1.
2) In the short-run equilibrium, real GDP is $7.5 trillion and the price level rises to 115.
3) In this situation, there is an inflationary gap. 90
AD0
6.0
7.0
7.5
Real GDP (trillions of 1992 dollars)

68. An Increase in Aggregate Demand
LAS
140
SAS1
Long-run
effect
130
125
SAS0
115
Price level (GDP deflator, 1992 = 100)
100
Instructor Notes:
1) The money wage rate rises, and the short-run aggregate supply curve shifts leftward from SAS0 to SAS1.
2) As it shifts, it intersects the aggregate demand curve AD1at higher price levels and lower real GDP levels.
3) Eventually, the price level rises to 125 and real GDP decreases to $7.0 trillion--potential GDP.
AD1 90
6.0
7.0
7.5
Real GDP (trillions of 1992 dollars)

69. Macroeconomic Equilibrium
An economy cannot produce in excess of potential forever.
Workers begin to demand higher wages
Eventually, wage rates rise by the same percentage as the price level.

70. Macroeconomic Equilibrium
Fluctuations in Aggregate Supply
Fluctuations in short-run aggregate supply can bring fluctuations in real GDP around potential GDP.
A decrease in aggregate supply can lead to a recession and inflation — stagflation.

71. A Decrease in Aggregate Supply
LAS
140
SAS1
130
SAS0
120
Price level (GDP deflator, 1992 = 100)
110
An oil price rise
decreases short-run
aggregate supply
100
Instructor Notes:
1) An increase in the price of oil decreases short-run aggregate supply and shifts the short-run aggregate supply curve from SAS0 to SAS1 .
2) Real GDP decreases from $7.0 trillion to $6.5 trillion, and the price level rises from 110 to 120.
3) The economy experiences both recession and inflation--stagflation. 90
AD0
6.0
6.5
7.0
7.5
8.0
8.5
Real GDP (trillions of 1992 dollars)

72. Learning Objectives (cont.)
Explain the effects of changes in aggregate supply and aggregate demand on economic growth, inflation, and business cycles
Explain U.S. economic growth, inflation, and business cycles by using the AS-AD model

73. Aggregate Supply and Aggregate Demand: 1960–1998

74. U.S. Economic Growth, Inflation, and Cycles
The forces that bring economic growth were stronger during the 1960s and mid-1980s that at other times.
During the 1970s, growth was slow.

75. U.S. Economic Growth, Inflation, and Cycles
The main force generating the persistent increase in the price level is a tendency for aggregate demand to increase at a faster pace than the increase in long-run aggregate supply

76. U.S. Economic Growth, Inflation, and Cycles
Cycles arise because both the expansion of short-run aggregate supply and the growth of aggregate demand do not proceed at a fixed, steady pace.

77. U.S. Economic Growth, Inflation, and Cycles
The Evolving Economy: 1960–1996
During the 1960s, real GDP growth was rapid and inflation was low.
Rapid increases in aggregate supply and moderate increases in aggregate demand

78. U.S. Economic Growth, Inflation, and Cycles
The Evolving Economy: 1960–1996
During the mid-1970s there was rapid inflation and recession — stagflation.
Oil price increases shifted short-run aggregate supply leftward.

79. U.S. Economic Growth, Inflation, and Cycles
The Evolving Economy: 1960–1996
A rapid increase in the quantity of money shifted the aggregate demand curve rightward.
Recession occurred because the short-run aggregate supply curve shifted leftward at a faster pace than the aggregate demand curve shifted rightward.

80. U.S. Economic Growth, Inflation, and Cycles
The Evolving Economy: 1960–1996
The rest of the 1970s saw high inflation and moderate growth in real GDP.
By 1980, inflation was a major problem.
The Fed took strong action to reduce it.
Interest rates increased to levels not seen before.

81. U.S. Economic Growth, Inflation, and Cycles
The Evolving Economy: 1960–1996
Aggregate demand decreased as a result.
The economy went into a deep recession.

82. U.S. Economic Growth, Inflation, and Cycles
The Evolving Economy: 1960–1996
During the years 1982 to 1990, capital accumulation and steady technological advance resulted in a sustained rightward shift of the long-run aggregate supply curve.
Aggregate demand growth kept pace with the growth of aggregate supply.

83. U.S. Economic Growth, Inflation, and Cycles
The Evolving Economy: 1960–1996
A decrease in aggregate demand led to the 1991 recession.
The economy has continually expanded through 1996.

84. The End