The Aggregate Supply–Aggregate Demand Model

In this chapter, you will learn about:

1. Macroeconomic Perspectives on Demand and Supply
2. Building a Model of Aggregate Supply and Aggregate Demand
3. Shifts in Aggregate Supply
4. Shifts in Aggregate Demand
5. How the AS–AD Model Incorporates Growth, Unemployment,
and Inflation
6. Keynes’ Law and Say’s Law in the AS–AD Model
1.MACROECONOMIC PERSPECTIVES ON
DEMAND AND SUPPLY

By the end of this section, you will be able to:

1. Explain Say’s Law and understand why it primarily applies in the long run
2. Explain Keynes’ Law and understand why it primarily applies in the short run

Say’s law
“supply creates its own demand”

Keynes’ law
“demand creates its own supply”
SAY’S LAW

The intuition behind Say’s law: Each time a good or

service is produced and sold, it generates income that is
earned for someone: a worker, a manager, an owner, or
those who are workers, managers, and owners at firms
that supply inputs along the chain of production.
Say’s law argues, a given value of supply must create an
equivalent value of demand somewhere else in the
economy.
Modern economists who generally subscribe to the Say’s
law view on the importance of supply for determining the
size of the macroeconomy are called neoclassical
economists.
RECESSION???

If supply always creates exactly enough demand at the macroeconomic

level, then (as Say recognized), it is hard to understand why periods of
recession and high unemployment should ever occur?
A recession is a situation in which the economy as a whole is shrinking in
size, business failures outnumber the remaining success stories, and
many firms end up suffering losses and laying off workers.
Over shorter time horizons of a few months or even years, recessions or
even depressions occur in which firms, as a group, seem to face a lack of
demand for their products.
Say’s law that supply creates its own demand does seem a good
approximation for the long run. Because over periods of some years or
decades, as the productive power of an economy to supply goods and
services increases, total demand in the economy grows at roughly the
same pace.
FIGURE 24.1

At the peak of the housing bubble, many people across the country were able to secure
the loans necessary to build new houses. (Credit: modification of work by Tim
Pierce/Flickr Creative Commons)
FIGURE 24.2

From the early 1990s up through 2005, the number of new single family houses sold
rose steadily. In 2006, the number dropped dramatically and this dramatic decline
continued through 2011. By 2014, the number of new houses sold had begun to climb
back up, but the levels are still lower than those of 1990. (Source: U.S. Census Bureau)
1. MACROECONOMIC PERSPECTIVES ON
DEMAND AND SUPPLY

The economic history of the United States is cyclical in nature

with recessions and expansions.
Some of these fluctuations are severe, such as the economic
downturn that occurred during the Great Depression in the 1930s
which lasted several years.
Why does the economy grow at different rates in different years?
What are the causes of the cyclical behavior of the economy?
This chapter will introduce an important model, the aggregate
demand–aggregate supply model, to begin our understanding of why
economies expand and contract over time.
2. BUILDING A MODEL OF AGGREGATE DEMAND AND
AGGREGATE SUPPLY

To build a useful macroeconomic model, we need a

model that shows what determines total supply or
total demand for the economy, and how total demand
and total supply interact at the macroeconomic level.

We call this the aggregate demand/aggregate supply

model. This module will explain aggregate supply,
aggregate demand, and the equilibrium between
them.
IMPORTANCE OF THE AGGREGATE
DEMAND/AGGREGATE SUPPLY MODEL

Macroeconomics takes an overall view of the economy, which means

that it needs to juggle many different concepts. For example, start with
the three macroeconomic goals of growth, low inflation, and low
unemployment.
Aggregate demand has four elements: consumption, investment,
government spending, and exports less imports.
Aggregate supply reveals how businesses throughout the economy
will react to a higher price level for outputs. Finally, a wide array of
economic events and policy decisions can affect aggregate demand
and aggregate supply, including government tax and spending
decisions; consumer and business confidence; changes in prices of
key inputs like oil; and technology that brings higher levels of
productivity.
The aggregate demand/aggregate supply model is one of the
fundamental diagrams in this because it provides an overall
framework for bringing these factors together in one diagram.
THE AGGREGATE DEMAND

Aggregate demand (AD) refers to the amount of total spending on

domestic goods and services in an economy. (Strictly speaking, AD is
what economists call total planned expenditure. For now, just think
of aggregate demand as total spending)
It includes all four components of demand: consumption, investment,
government spending, and net exports (exports minus imports):
C + I + G + (X – M)
This demand is determined by a number of factors, but one of them is
the price level—recall though, that the price level is an index number
such as the GDP deflator that measures the average price of the
things we buy. (CPI and PPI ?)
The aggregate demand (AD) curve shows the total spending on
domestic goods and services at each price level.
THE AGGREGATE DEMAND

Aggregate demand (AD) slopes down, showing that, as the price level rises, the
amount of total spending on domestic goods and services declines.
THE AGGREGATE SUPPLY AND POTENTIAL GDP

Firms make decisions about what quantity to supply based on the

profits they expect to earn.
They determine profits, in turn, by the price of the outputs they sell
and by the prices of the inputs, like labor or raw materials, that they
need to buy.
Aggregate supply (AS) refers to the total quantity of output (i.e. real
GDP) firms will produce and sell.
The aggregate supply (AS) curve shows the total quantity of
output (i.e. real GDP) that firms will produce and sell at each
price level.
THE AGGREGATE SUPPLY

Aggregate supply (AS) slopes up, because as the price level for outputs rises, with the
price of inputs remaining fixed, firms have an incentive to produce more and to earn
higher profits.
The potential GDP line shows the maximum that the economy can produce with full
employment of workers and physical capital.
WHY DOES AS CROSS POTENTIAL GDP?

How can an economy produce at an output level which is higher than

its “potential” or “full employment” GDP?
in short term
EQUILIBRIUM

The diagram's horizontal axis shows real GDP—that is, the level of GDP adjusted for inflation. The
vertical axis shows the price level, which measures the average price of all goods and services
produced in the economy.
In other words, the price level in the AD-AS model is what we called the GDP Deflator.
Remember that the price level is different from the inflation rate.
Visualize the price level as an index number, like the Consumer Price Index, while the inflation
rate is the percentage change in the price level over time.
EQUILIBRIUM

The equilibrium, where aggregate supply (AS) equals aggregate demand (AD), occurs
at a price level of 90 and an output level of 8,800.
DEFINING SRAS AND LRAS

We differentiated between short run changes in aggregate supply

which the AS curve shows and long run changes in aggregate supply
which the vertical line at potential GDP defines.
In the short run, if demand is too low (or too high), it is possible for
producers to supply less GDP (or more GDP) than potential.
In the long run, however, producers are limited to producing at
potential GDP.
For this reason, we may also refer to what we have been calling
the AS curve as the short run aggregate supply (SRAS) curve.
We may also refer to the vertical line at potential GDP as the long
run aggregate supply (LRAS) curve.
3. SHIFT IN AS (24.7)

(a) The rise in productivity causes the AS curve to shift to the right. The original equilibrium E0 is at the
intersection of AD and AS0. When AS shifts right, then the new equilibrium E1 is at the intersection
of AD and AS1, and then yet another equilibrium, E2, is at the intersection of AD and AS2. Shifts in
AS to the right, lead to a greater level of output and to downward pressure on the price level.
(b) A higher price for inputs means that at any given price level for outputs, a lower quantity will be
produced so aggregate supply will shift to the left from AS0 to AS1. The new equilibrium, E1, has a
reduced quantity of output and a higher price level than the original equilibrium (E0).
4. SHIFT IN AD (FIGURE 24.8)

(a) An increase in consumer confidence or business confidence can shift AD to the right, from AD0 to AD1. When AD
shifts to the right, the new equilibrium (E1) will have a higher quantity of output and also a higher price level
compared with the original equilibrium (E0). In this example, the new equilibrium (E1) is also closer to potential GDP.
An increase in government spending or a cut in taxes that leads to a rise in consumer spending can also shift AD to
the right.
(b) A decrease in consumer confidence or business confidence can shift AD to the left, from AD0 to AD1. When AD shifts
to the left, the new equilibrium (E1) will have a lower quantity of output and aslso a lower price level compared with
the original equilibrium (E0). In this example, the new equilibrium (E1) is also farther below potential GDP. A decrease
in government spending or higher taxes that leads to a fall in consumer spending can also shift AD to the left.
5. HOW THE AD/AS MODEL INCORPORATES GROWTH,
UNEMPLOYMENT, AND INFLATION phải indicate 3 đều này
nếu explain AD/AS model
By the end of this section, you will be able to:
1. Use the aggregate demand/aggregate supply model to show periods
of economic growth and recession
2. Explain how unemployment and inflation impact the aggregate
demand/aggregate supply model
3. Evaluate the importance of the aggregate demand/aggregate supply
model
The AD/AS model can convey a number of interlocking relationships
between the three macroeconomic goals of growth, unemployment,
and low inflation.
Moreover, the AD/AS framework is flexible enough to accommodate both
the Keynes’ law approach that focuses on aggregate demand and the
short run, while also including the Say’s law approach that focuses on
aggregate supply and the long run.
These advantages are considerable. Every model is a simplified version
of the deeper reality and, in the context of the AD/AS model, the three
macroeconomic goals arise in ways that are sometimes indirect or
incomplete.
GROWTH AND RECESSION IN THE AD/AS DIAGRAM

In the AD/AS diagram, long-run economic growth due to productivity increases

over time will be represented by a gradual shift to the right of aggregate supply.
The vertical line representing potential GDP (or the “full employment level of
GDP”) will gradually shift to the right over time as well. Earlier Figure 24.7 (a)
showed a pattern of economic growth over three years, with the AS curve shifting
slightly out to the right each year.
However, the factors that determine the speed of this long-term economic growth
rate—like investment in physical and human capital, technology, and whether an
economy can take advantage of catch-up growth—do not appear directly in the
AD/AS diagram.
In the short run, GDP falls and rises in every economy, as the economy dips into
recession or expands out of recession. The AD/AS diagram illustrates recessions
when the equilibrium level of real GDP is substantially below potential GDP, as we
see at the equilibrium point E0 in Figure 24.9. From another standpoint, in years of
resurgent economic growth the equilibrium will typically be close to potential GDP,
as equilibrium point E1 in that earlier figure shows.
RECESSION (24.9)

Whether the economy is in a recession is illustrated in the AS–AD model by how

close the equilibrium is to the potential GDP line.
In this example, the level of output Y0 at the equilibrium E0 is relatively far from the
potential GDP line, so it can represent an economy in recession, well below the full
employment level of GDP.
In contrast, the level of output Y1 at the equilibrium E1 is relatively close to potential GDP,
and so it would represent an economy with a lower unemployment rate.
UNEMPLOYMENT IN THE AD/AS DIAGRAM

We described two types of unemployment in the Unemployment (NEXT LECTURE)

Short run variations in unemployment (cyclical unemployment) are caused by the business
cycle as the economy expands and contracts.
Over the long run, in the United States, the unemployment rate typically hovers around 5%
(give or take one percentage point or so), when the economy is healthy. In many of the
national economies across Europe, the unemployment rate in recent decades has only
dropped to about 10% or a bit lower, even in good economic years. We call this baseline
level of unemployment that occurs year-in and year-out the natural rate of unemployment and
we determine it by how well the structures of market and government institutions in the
economy lead to a matching of workers and employers in the labor market. Potential GDP
can imply different unemployment rates in different economies, depending on the natural rate
of unemployment for that economy.
The AD/AS diagram shows cyclical unemployment by how close the economy is to the
potential or full GDP employment level. Returning to Figure 24.9, relatively low cyclical
unemployment for an economy occurs when the level of output is close to potential GDP, as
in the equilibrium point E1. Conversely, high cyclical unemployment arises when the output is
substantially to the left of potential GDP on the AD/AS diagram, as at the equilibrium point E0.
Although we do not show the factors that determine the natural rate of unemployment
separately in the AD/AS model, they are implicitly part of what determines potential GDP or
full employment GDP in a given economy.
INFLATIONARY PRESSURES IN THE AD/AS DIAGRAM
Inflation fluctuates in the short run. Higher inflation rates have typically occurred
either during or just after economic booms: for example, the biggest spurts of inflation
in the U.S. economy during the twentieth century followed the wartime booms of World
War I and World War II. Conversely, rates of inflation generally decline during
recessions. As an extreme example, inflation actually became negative—a situation
called “deflation”—during the Great Depression.
Even during the relatively short 1991-1992 recession, the inflation rate declined from
5.4% in 1990 to 3.0% in 1992. During the relatively short 2001 recession, the rate of
inflation declined from 3.4% in 2000 to 1.6% in 2002. During the deep recession of
2007–2009, the inflation rate declined from 3.8% in 2008 to –0.4% in 2009. Some
countries have experienced bouts of high inflation that lasted for years. In the U.S.
economy since the mid–1980s, inflation does not seem to have had any long-term
trend to be substantially higher. Instead, it has stayed in the 1–5% range annually.
The AD/AS framework implies two ways that inflationary pressures may arise.
One possible trigger is 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 AS curve's steep portion.
In Figure 24.10 (a), there is a shift of aggregate demand to the right. The new
equilibrium E1 is clearly at a higher price level than the original equilibrium E0. In this
situation, the aggregate demand in the economy has soared so high that firms in the
economy are not capable of producing additional goods, because labor and physical
capital are fully employed, and so additional increases in aggregate demand can only
result in a rise in the price level.
INFLATIONARY PRESSURES IN THE AD/AS DIAGRAM
(FIGURE 24.10)

(a) A shift in aggregate demand, from AD0 to AD1, when it happens in the area of the AS
curve that is near potential GDP, will lead to a higher price level and to pressure for a
higher price level and inflation. The new equilibrium (E1) is at a higher price level (P1)
than the original equilibrium.
(b) A shift in aggregate supply, from AS0 to AS1, will lead to a lower real GDP and to
pressure for a higher price level and inflation. The new equilibrium (E1) is at a higher
price level (P1), while the original equilibrium (E0) is at the lower price level (P0).
INFLATIONARY PRESSURES IN THE AD/AS DIAGRAM

An alternative source of inflationary pressures can occur due to a rise in input prices
that affects many or most firms across the economy—perhaps an important input to
production like oil or labor—and causes the aggregate supply curve to shift back to the
left. In Figure 24.10 (b), the SRAS curve's shift to the left also increases the price level
from P0 at the original equilibrium (E0) to a higher price level of P1 at the new
equilibrium (E1). In effect, the rise in input prices ends up, after the final output is
produced and sold, passing along in the form of a higher price level for outputs.
The AD/AS diagram shows only a one-time shift in the price level. It does not address
the question of what would cause inflation either to vanish after a year, or to sustain
itself for several years.
There are two explanations for why inflation may persist over time. These two reasons
are interrelated, because if a government fosters a macroeconomic environment with
inflationary pressures, then people will grow to expect inflation. However, the AD/AS
diagram does not show these patterns of ongoing or expected inflation in a direct way.
One way that continual inflationary price increases can occur is if the government
continually attempts to stimulate aggregate demand in a way that keeps pushing the
AD curve when it is already in the SRAS curve's steep portion.
A second possibility is that, if inflation has been occurring for several years, people
might begin to expect a certain level of inflation. If they do, then these expectations will
cause prices, wages and interest rates to increase annually by the amount of the
inflation expected.
6. KEYNES’ LAW AND SAY’S LAW IN THE AD/AS
MODEL

By the end of this section, you will be able to:

1. Identify the neoclassical zone, the intermediate zone, and the
Keynesian zone in the aggregate demand/aggregate supply model

2. Use an aggregate demand/aggregate supply model as a diagnostic

test to understand the current state of the economy
We can use the AD/AS model to illustrate both Say’s law that supply
creates its own demand and Keynes’ law that demand creates its
own supply. Consider the SRAS curve's three zones which Figure
24.11 identifies: the Keynesian zone, the neoclassical zone, and the
intermediate zone.
6. KEYNES’ LAW AND SAY’S LAW IN THE AD/AS
MODEL

Near the equilibrium Ek, in the Keynesian zone at the far left of the AS curve, small shifts in AD, either to the
right or the left, will affect the output level Yk, but will not much affect the price level. In the Keynesian zone,
AD largely determines the quantity of output.
Near the equilibrium En, in the neoclassical zone at the far right of the AS curve, small shifts in AD, either to
the right or the left, will have relatively little effect on the output level Yn, but instead will have a greater effect
on the price level.
In the neoclassical zone, the near-vertical AS curve close to the level of potential GDP largely determines
the quantity of output. In the intermediate zone around equilibrium Ei, movement in AD to the right will
increase both the output level and the price level, while a movement in AD to the left would decrease both
the output level and the price level.
6. KEYNES’ LAW AND SAY’S LAW IN THE AD/AS MODEL

This approach of dividing the SRAS curve into different zones works
as a diagnostic test that we can apply to an economy, like a doctor
checking a patient for symptoms.
First, figure out in what zone the economy is. This will clarify the
economic issues, tradeoffs, and policy choices. Some economists
believe that the economy is strongly predisposed to be in one zone or
another.
Thus, hard-line Keynesian economists believe that the economies
are in the Keynesian zone most of the time, and so they view the
neoclassical zone as a theoretical abstraction.
Conversely, hard-line neoclassical economists argue that economies
are in the neoclassical zone most of the time and that the Keynesian
zone is a distraction. The Keynesian Perspective and The
Neoclassical Perspective should help to clarify the underpinnings and
consequences of these contrasting views of the macroeconomy.
6. KEYNES’ LAW AND SAY’S LAW IN THE AD/AS MODEL
Focus first on the Keynesian zone, that portion of the SRAS curve on the far left which
is relatively flat. If the AD curve crosses this portion of the SRAS curve at an equilibrium
point like Ek, then certain statements about the economic situation will follow. In the
Keynesian zone, the equilibrium level of real GDP is far below potential GDP, the
economy is in recession, and cyclical unemployment is high. If aggregate demand
shifted to the right or left in the Keynesian zone, it will determine the resulting level of
output (and thus unemployment). However, inflationary price pressure is not much of a
worry in the Keynesian zone, since the price level does not vary much in this zone.
Now, focus your attention on the neoclassical zone of the SRAS curve, which is the
near-vertical portion on the right-hand side. If the AD curve crosses this portion of the
SRAS curve at an equilibrium point like En where output is at or near potential GDP,
then the size of potential GDP pretty much determines the level of output in the
economy. Since the equilibrium is near potential GDP, cyclical unemployment is low in
this economy, although structural unemployment may remain an issue. In the
neoclassical zone, shifts of aggregate demand to the right or the left have little effect on
the level of output or employment. The only way to increase the size of the real GDP in
the neoclassical zone is for AS to shift to the right. However, shifts in AD in the
neoclassical zone will create pressures to change the price level.
Finally, consider the SRAS curve's intermediate zone. If the AD curve crosses this
portion of the SRAS curve at an equilibrium point like Ei, then we might expect
unemployment and inflation to move in opposing directions. For instance, a shift of AD
to the right will move output closer to potential GDP and thus reduce unemployment,
but will also lead to a higher price level and upward pressure on inflation. Conversely, a
shift of AD to the left will move output further from potential GDP and raise
unemployment, but will also lead to a lower price level and downward pressure on
inflation.
TAKE-AWAY

The Pandemic-Induced Recession: Supply or Demand?

A pandemic could cause a shock in the short- or long-run aggregate supply curve
by temporarily reducing labor supply and slowing or stopping production of goods
and services. Pandemics can also affect aggregate demand. When people are
hesitant to spend or travel, or if they are not allowed to spend or travel because of
social restrictions, this will affect spending in the economy. Consumers spend less
at restaurants, hotels, and travel, among other areas, while firms stop investing
because of the lack of demand and an uncertain future. Both actions lead to a
leftward shift in the aggregate demand curve.
While there is some debate over whether the pandemic-induced recession
that the U.S. economy experienced in 2020 was primarily a supply- or
demand-driven one, most likely, it is a combination of both.
In March and April 2020, workers left the labor market en masse, and later in the
year, they were hesitant to return due to health and safety concerns. Many people
were also forced to cancel travel plans or voluntarily did so out of concern for their
safety, further reducing aggregate demand. These changes caused deep cuts in
the global economy that continued to be felt two years after the initial pandemic-
induced shocks.