Macroeconomics

Module 8: The Aggregate Demand-Aggregate Supply Model

The Aggregate Demand/Aggregate Supply Model

• Aggregate Demand/Aggregate
Supply Model: a model that shows
what determines real GDP and the
aggregate price level through the
interaction between total spending
on domestic goods and services (i.e
aggregate demand) and total
production by businesses (i.e.
aggregate supply)
Building a Model of Aggregate Supply and
Aggregate Demand Vocabulary
• Aggregate Demand (AD): the amount of total spending on domestic goods
and services in an economy
• Aggregate Supply (AS): the total quantity of output (ie real GDP) firms will
produce and sell
• Aggregate Demand (AD) curve: the total spending on domestic goods and
services at each aggregate price level
• Aggregate Supply (AS) curve: the total quantity of output (ie real GDP) that
firms will produce and sell at each aggregate price level
• Foreign Price Effect: if prices rise in the United States while remaining fixed in
other countries, then goods in the United States will be relatively more
expensive compared to goods in the rest of the world
• Interest Rate Effect: as the aggregate price level rises, the same purchases
will take more money or credit to accomplish, driving up interest rates
Building a Model of Aggregate Supply and Aggregate
Demand Vocabulary (cont.)
• Long Run: period of time during which all wages and prices are fully flexible
• Long Run Aggregate Supply (LRAS) curve: vertical line at potential GDP showing
no relationship between the aggregate price level and real GDP in the long run
• Potential GDP: the maximum quantity that an economy can produce given full
employment of its existing levels of labor, physical capital, technology, and
institutions; also known as full employment GDP
• Short Run: period of time during which wages (and some prices) are sticky in
response to a change in demand
• Short Run Aggregate Supply (SRAS) curve: positive short run relationship between
the aggregate price level and real GDP, holding the prices of inputs fixed
• Wealth Effect: as price level increases, the buying power of savings that people
have stored up in bank accounts and other assets will diminish
Aggregate Supply
• The horizontal axis of the diagram
shows real GDP—that is, the level
of GDP adjusted for inflation
• The vertical axis shows the
aggregate price level
• The slope of an AS curve changes
from nearly flat at its far left to
nearly vertical at its far right
• As the quantity produced
increases, however, certain firms
and industries will start running into
limits
Aggregate Supply (cont.)
• In the long run all wages and prices
are fully flexible. As a consequence,
all resources will be fully employed
and real GDP will equal potential,
regardless of the price level.
• In the long run, real GDP will be
independent of the price level, and
the long run aggregate supply
(LRAS) curve will be a vertical line at
potential (or the full employment
level of) GDP. This can be seen on a
graph as potential GDP (as in the
figure) or as LRAS.
The Aggregate Demand Curve

• Just like the aggregate supply

curve, the horizontal axis shows
real GDP and the vertical axis
shows the price level
• The AD curve is
downward sloping from left to
right, which means that
a decrease in the
aggregate price level leads to
an increase in the amount of
total spending on domestic
goods and services
• Even though the AD
curve looks like a
microeconomic demand curve,
it doesn’t operate the same
way
Why is the AD Curve downward-sloping?

• Wealth effect: as the price level increases, the buying power of savings
that people have saved up will diminish, eaten away to some extent by
inflation. Because a rise in the price level reduces people’s wealth,
consumption spending will fall as the price level rises.
• Interest rate effect: as prices for outputs rise, the same purchases will
take more money or credit to accomplish. This additional demand for
money and credit will push interest rates higher, which will reduce
borrowing by businesses for investment purposes and reduce borrowing
by households for homes and cars—thus reducing consumption and
investment spending.
• Foreign price effect: if prices rise in the United States while remaining
fixed in other countries, then goods in the United States will be relatively
more expensive compared to goods in the rest of the world. A higher
domestic price level, relative to price levels in other countries, will
reduce net export expenditures.
Interpreting the AD-AS Model

• Step 1: Draw your x- and y-axis.

Label the x-axis “Real GDP” and
the y-axis “Price Level”
• Step 2: Plot AD on your graph
• Step 3: Plot AS on your graph
• Step 4: Determine where AD and
AS intersect
• Step 5: Look at the graph to
determine where equilibrium is
located
• Step 6: Determine what the steep
portion of the AS curve indicates
Examining the AS-AD Model

• Step 8: Draw conclusions from the given

information.
• If equilibrium occurs in the flat range of AS,
then economy is not close to potential GDP
and will experiencing unemployment, but
stable price level
• If equilibrium occurs in the steep range of AS,
then the economy is close or at potential
GDP and will be experiencing rising price
levels or inflationary pressures, but will have a
low unemployment rate
Examining the AS-AD Model

Considering the schedule below, what is the equilibrium price level and real GDP?
a. 115; 9.0
b. 100; 13.0
c. 90; 1.2

Current Price level Real GDP-quantity Real GDP-quantity

demanded per supplied per trillion
trillion
115 17.0 8.0
110 15.0 10.0
100 13.0 13.0
90 10.0 11.2
Shifts in Aggregate Demand

• Demand Shocks: events that shift the aggregate demand curve

• Positive Demand Shock: a rightward shift in AD
• Negative Demand Shock: a leftward shift in AD
• Business Confidence: If businesses feel more confident, ceteris paribus, then
firms tend to spend more on investment, believing that the future payoff from
that investment will be substantial; if business confidence drops, then
investment spending declines
• Consumer Confidence: when consumers feel more confident about the
future of the economy, ceteris paribus, they tend to increase spending; when
they feel less confident they tend to decrease spending
Shifts in Aggregate Supply

• Negative Supply Shock: a leftward shift in the SRAS and LRAS curves
• Positive Supply Shock: a rightward shift in the SRAS and LRAS curves
• Stagflation: an economy experiences stagnant growth and high inflation at
the same time
• Supply Shock: an event that shifts both short run and long run aggregate
supply curves
Shifts in AD OR AS?

When an economy’s output increases and the price level increases, the
________ curve has shifted to the ________.
a. AS; left
b. AD; left
c. AD; right
How Productivity Growth Shifts the AS Curve

• The most important factor shifting the AS curve is productivity growth

• Productivity means how much output can be produced with a given
quantity of inputs
• Productivity grows so that the same quantity of labor can produce more
output
• The real growth in GDP per capita in an advanced economy like the United
States has averaged about 2% to 3% per year
• Productivity growth has been faster during certain extended periods like the
1960s and the late 1990s through the early 2000s, or slower during periods like
the 1970s
Business Cycles and Growth in the AD-AS Model

• Business cycles represent the

slowing down, declining and
speeding up of the
economy, or more formally,
recessions and expansions
• The AD-AS model gives us
one way to understand
business cycles
• Recessions occur as a result
of negative demand or
supply shocks, which
cause the equilibrium level
of real GDP to
fall substantially below
potential GDP
Unemployment in the AD-AS Diagram

• In the AD–AS diagram,

cyclical unemployment is
shown by how close the
economy is to the potential
or full employment level of
GDP
• Cyclical unemployment
increases when the output
falls substantially below
potential GDP on the AD–AS
diagram, as at the
equilibrium point E0
Inflationary Pressures in the AD-As Diagram

• The AD–AS framework implies

two ways that inflationary
pressures may arise
• If aggregate demand
continues to shift to the right
when the economy is already
at or near potential GDP and
full employment, thus pushing
the macroeconomic
equilibrium into the steep
portion of the AS curve
Quick Review
• Describe the aggregate supply-aggregate demand model
• Define and explain the aggregate supply curve and the economic behavior
behind it
• Compare and contrast the short run and long run aggregate supply curves
• Define and explain the aggregate demand curve and the economic
behavior behind it
• What is the difference between the two concepts of aggregate demand
and aggregate supply?
• Identify the equilibrium level of real GDP and equilibrium price level using the
AD-AS model
• What conclusions can be made about the macro economy using the AD-AS
supply model?
More Quick Review

• What are the causes and implications of shifts in aggregate demand?

• How does productivity growth and changes in input prices change the
aggregate supply curve?
• Use the aggregate demand-aggregate supply model to explain recessions,
expansions and economic growth
• Explain how unemployment and inflation can be explained using the
aggregate demand-aggregate supply model
• What is the importance of the AS-AD model?