AS Economics
15
The AS-AD Model
Dr. Sylvain Hours
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PART 1
AGGREGATE DEMAND
Dr. Sylvain Hours
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Aggregate Demand

The Aggregate Demand (AD) indicates the “quantity” of domestically
produced final goods that is demanded in an economy over a given
period of time and for any given price level.

Remark: Since we cannot add cars and tomatoes, we add their market
value instead. However, this market value should really be seen as a
quantity (or volume) of output.

A final good is one that is destined for final consumption by the end user
(unlike intermediate goods).

A domestically produced good or service is one that has been produced
within the borders of an economy.

A price level is a weighted average of the prices of an economy’s final
goods and services.
Dr. Sylvain Hours
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Aggregate Demand

In an economy, the demand for final goods and services can be divided into
4 main categories:

Consumption (C)

Private Investment (I)

Government purchases (G)

Exports (X)
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Consumption

Consumption (C) refers to spending by households on consumer goods.

A consumer good is a good or service purchased by a household for its own
consumption (e.g. wine, bikes, T-shirts, etc.)

Main determinants of C:

Real national disposable income (i.e. the purchasing power of households’
income after direct taxes and welfare benefits have been accounted for)

Real wealth (i.e. the purchasing power of households’ assets)

The interest rate (i.e. consumption-savings trade-off)

Consumer confidence (i.e. expectations)
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Investment

(Private) Investment (I) refers to spending by private businesses on capital
equipment.

Important remark: In economics, investment does NOT refer to the
purchase of financial assets such as stocks, bonds, etc.

In an economy, the level of investment depends on:

The interest rate (i.e. the cost of borrowing the funds required to finance
investment)

The output gap (i.e. the percentage difference between actual and potential
output, a measure of the economy’s level of spare capacity)

Business confidence (i.e. expectations about the future state of the economy)
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Government Purchases

Government spending includes government transfers (GT) and government
purchases of goods and services (G).

Government transfers (GT) are payments that the government makes to
households and firms without expecting a good or service in return (e.g.
welfare benefits, subsidies, etc.). NOT INCLUDED

Government purchases of goods and services (G) is spending by the
government on final goods and services (e.g. infrastructures, national
defense, public education, public health care system, etc.). INCLUDED

The level of government purchases is determined by:

Fiscal policy

The interest rate & the availability of credit

Population demographic characteristics
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Exports

Exports (X) is spending by foreigners on domestically produced final
goods and services.

Exports are mainly determined by:

The economic situation and the existence of protectionist policies in
major trading partners

International competitiveness (e.g. costs of production, export
subsidies, relative price level, product quality, exchange rate, etc.)
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Aggregate Demand

We might be tempted to state that AD is simply the sum of consumption,
government purchases, private investment and exports.

However, this would be incorrect because households, private businesses
and the government purchase both domestic and non-domestic final goods
and services.

That is, C, I and G have a domestic component AND a non-domestic
component.

Since AD only measures the “quantity” demanded of DOMESTICALLY
PRODUCED final goods and services, we must subtract Imports (M) to “take
out” the non-domestic components from C, I and G.
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Imports

Imports (M) is spending by residents on non-domestic goods and services.

Imports are mainly determined by:

National income

International competitiveness (e.g. relative price level, product quality &
diversity, exchange rate, etc.)

Government policy (e.g. import tariffs & quotas)
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Aggregate Demand
+
C
C D + CM
I
ID + IM
+
G
+
X
GD + GM
CM + IM + GM = M
AD = C + I + G + X – M
⇔
AD = CD + ID + GD + X
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Aggregate Demand

The AD curve is downward sloping.

That is, an increase in the price level leads to a decrease the aggregate
quantity demanded and vice versa.

The negative slope of the AD curve is NOT a direct consequence of the
Law of demand (i.e. no substitution effect when the price level changes).

The AD curve slopes downward for 3 reasons:

The wealth effect

The interest rate effect

The international trade effect
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Aggregate Demand Curve
PRICE
LEVEL
AD
REAL
OUTPUT
Dr. Sylvain Hours
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The Wealth Effect

When the price level decreases, C increases due to an increase in
households’ real wealth (i.e. the purchasing power of their assets
increases).

Therefore, a decrease in the price level leads to an increase in the
aggregate quantity demanded (i.e. extension in AD) and this can be
represented by a movement down along the AD curve.

Conversely, when the price level increases, C decreases due to a decrease
in households’ real wealth (i.e. the purchasing power of their assets
decreases).

Therefore, an increase in the price level leads to a decrease in the
aggregate quantity demanded (i.e. contraction in AD) and this can be
represented by a movement up along the AD curve.
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The Interest Rate Effect

Among other reasons, households and firms demand money (i.e. hold
money) in order to purchase goods and services (i.e. transactions motive).

A ceteris paribus increase in the price level reduces the purchasing power
of a given amount of money holdings.

As a result, the demand for money will increase (i.e. households and firms
need to hold more money in order to purchase the same basket of goods
and services as before).

In the money market, an increase in the demand for money will lead to an
increase in the interest rate (i.e. the “price” or opportunity cost of holding
money).
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The Interest Rate Effect

On the one hand, the increase in the interest rate will lead to less I because
it increases the cost of borrowing the funds required to finance investment
projects.

On the other hand, the increase in the interest rate will lead to less C
because households have an incentive to save more of their disposable
income.

Therefore, an increase in the price level leads to a decrease in the
aggregate quantity demanded (i.e. contraction in AD) and this can be
represented by a movement up along the AD curve.
Dr. Sylvain Hours
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The Interest Rate Effect

Conversely, a ceteris paribus decrease in the price level raises the
purchasing power of a given amount of money holdings.

As a result, the demand for money will decrease (i.e. households and firms
need to hold less money in order to purchase the same basket of goods and
services as before).

In the money market, a decrease in the demand for money will lead to a
decrease in the interest rate (i.e. the “price” or opportunity cost of holding
money).
Dr. Sylvain Hours
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The Interest Rate Effect

On the one hand, the decrease in the interest rate will lead to more I
because it decreases the cost of borrowing the funds required to finance
investment projects.

On the other hand, the decrease in the interest rate will lead to more C
because households have an incentive to save less of their disposable
income.

Therefore, a decrease in the price level leads to an increase in the
aggregate quantity demanded (i.e. extension in AD) and it can be
represented by a movement down along the AD curve.
Dr. Sylvain Hours
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The International Trade Effect

A ceteris paribus increase in the domestic price level makes a country’s
domestic products less internationally competitive (i.e. relatively more
expensive) and it makes foreign products more internationally competitive
(i.e. relatively cheaper).

In that case, X can be expected to decrease while M can be expected to
increase, leading to a decrease in net exports.

Therefore, an increase in the domestic price level will lead to a decrease in
the aggregate quantity demanded (i.e. contraction in AD) and it can be
represented by a movement up along the AD curve.
Dr. Sylvain Hours
postmaster@econdoctor.com
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The International Trade Effect

A ceteris paribus decrease in the domestic price level makes a country’s
domestic products more internationally competitive (i.e. relatively
cheaper) and it makes foreign products less internationally competitive
(i.e. relatively more expensive).

In that case, X can be expected to increase while M can be expected to
decrease, leading to an increase in net exports.

Therefore, a decrease in the domestic price level will lead to an increase in
the aggregate quantity demanded (i.e. extension in AD) and it can be
represented by a movement down along the AD curve.
Dr. Sylvain Hours
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Why Does AD Slope Downward?
WEALTH
EFFECT
DECREASE
IN PRICE
LEVEL
INTEREST
RATE
EFFECT
INT.
TRADE
EFFECT
INCREASE
IN REAL
WEALTH
DECREASE
IN DEMAND
FOR MONEY
DECREASE
IN INTEREST
RATE
GREATER
INTERNATIONAL
COMPETITIVENESS
INCREASE
IN C
INCREASE
IN C AND I
INCREASE IN
AGGREGATE
QUANTITY
DEMANDED
INCREASE
IN NET
EXPORTS
Dr. Sylvain Hours
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Why Does AD Slope Downward?
WEALTH
EFFECT
INCREASE
IN PRICE
LEVEL
INTEREST
RATE
EFFECT
INT.
TRADE
EFFECT
DECREASE
IN REAL
WEALTH
INCREASE IN
DEMAND
FOR MONEY
INCREASE IN
INTEREST
RATE
LOWER
INTERNATIONAL
COMPETITIVENESS
DECREASE
IN C
DECREASE
IN C AND I
DECREASE IN
AGGREGATE
QUANTITY
DEMANDED
DECREASE
IN NET
EXPORTS
Dr. Sylvain Hours
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Changes in the Price Level

Changes in the price level lead to changes in the AGGREGATE QUANTITY
DEMANDED and they are associated with MOVEMENTS ALONG the AD curve.

Changes in the price level do NOT lead to changes in AD and they are NOT
associated with SHIFTS of the AD curve.

On the one hand, a decrease in the price level leads to an increase in the
AGGREGATE QUANTITY DEMANDED, a situation known as an extension of
AD, and is associated with a MOVEMENT DOWN ALONG the AD curve.

On the other hand, an increase in the price level leads to a decrease in the
AGGREGATE QUANTITY DEMANDED, a situation known as a contraction of
AD, and is associated with a MOVEMENT UP ALONG the AD curve.
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Changes in the Price Level
PRICE
LEVEL
𝑃1
AD
𝑌1
REAL
OUTPUT
Dr. Sylvain Hours
postmaster@econdoctor.com
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Changes in the Price Level
PRICE
LEVEL
A DECREASE IN THE
PRICE LEVEL LEADS TO
A MOVEMENT DOWN
ALONG THE AD CURVE
(I.E. EXTENSION IN AD)
𝑃1
𝑃2
AD
𝑌1
𝑌2
REAL
OUTPUT
Dr. Sylvain Hours
postmaster@econdoctor.com
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Changes in the Price Level
PRICE
LEVEL
REAL
OUTPUT
Dr. Sylvain Hours
postmaster@econdoctor.com
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Changes in the Price Level
PRICE
LEVEL
AD
REAL
OUTPUT
Dr. Sylvain Hours
postmaster@econdoctor.com
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www.econdoctor.com
Changes in the Price Level
PRICE
LEVEL
𝑃1
AD
𝑌1
REAL
OUTPUT
Dr. Sylvain Hours
postmaster@econdoctor.com
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Changes in the Price Level
PRICE
LEVEL
𝑃2
𝑃1
AD
𝑌2
𝑌1
REAL
OUTPUT
Dr. Sylvain Hours
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Changes in the Price Level
PRICE
LEVEL
A INCREASE IN THE
PRICE LEVEL LEADS TO A
MOVEMENT UP ALONG
THE AD CURVE (I.E.
CONTRACTION IN AD)
𝑃2
𝑃1
AD
𝑌2
𝑌1
REAL
OUTPUT
Dr. Sylvain Hours
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The Determinants of AD

The determinants of AD are factors whose changes lead to changes in AD
and are associated with SHIFTS of the AD curve.

When the AD curve shifts to the right, we say that there is an increase in
AD.

In that case, there is an increase in the aggregate quantity demanded at
any given price level.

When the AD curve shifts to the left, we say that there is a fall in AD.

In that case, there is a decrease in the aggregate quantity demanded at
any given price level.
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The Determinants of AD


Main determinants of C: (for a given level of real national income)

Wealth (for a given price level)

The interest rate (for a given price level)

Expectations (i.e. consumer confidence)

Fiscal policy (i.e. taxes and subsidies)
Main determinants of I:

The Interest rate

Business confidence

The output gap
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The Determinants of AD

Main determinant of G:


Fiscal policy
Main determinants of X – M:

The exchange rate

Government policy (e.g. tariffs, quotas, etc.)

The state of foreign economies

The relative inflation rate (i.e. for a given domestic price level)
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Shifts of the AD Curve

Shifts of the AD curve are changes in the quantity of goods and services
demanded at any given price level.

An increase in AD implies that the quantity of aggregate output demanded
increases at any given aggregate price level and it is represented by a rightward
shift of the AD curve.

A decrease in AD implies that the quantity of aggregate output demanded
decreases at any given aggregate price level and it is represented by a leftward
shift of the AD curve.
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Shifts of the AD Curve
AGGREGATE
PRICE LEVEL
INCREASE IN
AGGREGATE
DEMAND
𝑝1
AD1
𝑌11
𝑌21
AD2
AGGREGATE OUTPUT
Dr. Sylvain Hours
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Shifts of the AD Curve
AGGREGATE
PRICE LEVEL
DECREASE IN
AGGREGATE
DEMAND
𝑝1
AD2
𝑌21
𝑌11
AD1
AGGREGATE OUTPUT
Dr. Sylvain Hours
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Changes in Expectations

Both consumer spending and planned investment spending depend in part
on people’s expectations about the future.

Consumers base their spending not only on their current disposable income but
also on the disposable income they expect to earn in the future (i.e. permanent
income hypothesis).

Firms base their planned investment spending not only on the current conditions
but also on the sales they expect to make in the future.
Dr. Sylvain Hours
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Changes in Wealth & Spare Capacity


Consumer spending depends in part on the value of household assets.

When the real value of these assets rises, the purchasing power they embody
also rises, leading to an increase in AD.

When the real value of these assets falls, the purchasing power they embody also
falls, leading to a decrease in AD.
The current level of planned investment spending is influenced by the
firm’s level of spare capacity.

A decrease in the overall level of spare capacity is likely to trigger an increase in
planned investment spending, leading to an increase in AD.

An increase in the overall level of spare capacity is likely to trigger a fall in
planned investment spending, leading to a decrease in AD.
Dr. Sylvain Hours
postmaster@econdoctor.com
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PART 2
AGGREGATE SUPPLY
Dr. Sylvain Hours
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Aggregate Supply

An Aggregate Supply (AS) curve shows the total “quantity” of final goods
and services supplied by domestic firms over a given period of time and
for any given price level.

Important remark: The price level measures the overall price level of final
goods and services in the economy so it does NOT include input prices.
Dr. Sylvain Hours
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Monetarist vs Keynesian AS

The Monetarist school and the Keynesian school have different views on AS.

First, we will introduce the Monetarist view the AS/AD model.

Second, we will consider the Keynesian view of AS/AD model.
Dr. Sylvain Hours
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The Short-Run Aggregate Supply Curve

In the SR, input prices are assumed to be fixed.

In particular, (nominal) wages are inflexible in the SR because they are set
by contracts that were signed some time ago.

It follows that (nominal) wages are slow to fall even in the face of high
unemployment and slow to rise even in the face of labour shortages.

This phenomenon is known as sticky wages.

The Short-Run Aggregate Supply (SRAS) curve shows the total “quantity”
of final goods and services supplied by domestic firms, for any given price
level and when input prices can be taken as fixed.
M
Dr. Sylvain Hours
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www.econdoctor.com
The Short-Run Aggregate Supply Curve

There is a positive relationship between the price level and the quantity of
aggregate output supplied in the SR

That is, an increase in price level leads to an increase in quantity of
aggregate output supplied in the SR and vice versa.

This all means that the SRAS curve is upward sloping.

Intuition: Since input prices are fixed in the SR, an increase in the price
level leads to a higher profit so firms have an incentive to produce more.
M
Dr. Sylvain Hours
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Short-Run Aggregate Supply Curve
PRICE
LEVEL
M
SRAS
AGGREGATE
OUTPUT
Dr. Sylvain Hours
postmaster@econdoctor.com
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Movements Along the SRAS Curve
PRICE
LEVEL
M
SRAS
𝑝1
A DECREASE IN PRICE
LEVEL LEADS TO A
MOVEMENT DOWN
ALONG THE SRAS CURVE
𝑝2
𝑌2
𝑌1
AGGREGATE
OUTPUT
Dr. Sylvain Hours
postmaster@econdoctor.com
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Movements Along the SRAS Curve
PRICE
LEVEL
M
SRAS
𝑝2
AN INCREASE IN PRICE
LEVEL LEADS TO A
MOVEMENT UP ALONG
THE SRAS CURVE
𝑝1
𝑌1
𝑌2
AGGREGATE
OUTPUT
Dr. Sylvain Hours
postmaster@econdoctor.com
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Shifts of the SRAS Curve

An increase in SRAS is represented by a rightward shift of the SRAS curve.

In that case, there is an increase in the quantity of aggregate output
supplied at any given price level.

A decrease in SRAS is represented by a leftward shift of the SRAS curve.

In that case, there is a decrease in the quantity of aggregate output
supplied at any given price level.
M
Dr. Sylvain Hours
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M
Shifts of the SRAS Curve
SRAS1
SRAS2
PRICE
LEVEL
INCREASE
IN SRAS
𝑝1
𝑌11
𝑌21
AGGREGATE
OUTPUT
Dr. Sylvain Hours
postmaster@econdoctor.com
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M
Shifts of the SRAS Curve
SRAS2
SRAS1
PRICE
LEVEL
DECREASE
IN SRAS
𝑝1
𝑌21
𝑌11
AGGREGATE
OUTPUT
Dr. Sylvain Hours
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Shifts of the SRAS Curve

Broadly speaking, the SRAS curve shifts whenever there is a change in the
economy’s costs of production.

This includes (but not limited to):

A change in the price of a key resource (e.g. oil, labour, electricity)

A change in taxes on and/or subsidies for businesses.

A change in factor productivity (also a shifter of the LRAS curve)
M
Dr. Sylvain Hours
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Shifts of the SRAS Curve

An increase in the price of a key resource (e.g. oil, labour, electricity, etc.)
leads to a decrease in SRAS and vice versa.

An increase in the taxes on businesses leads to a decrease in SRAS and vice
versa.

An increase in the subsidies for businesses leads to an increase in SRAS and
vice versa.

An increase in factor productivity leads to an increase in SRAS and vice
versa.
M
Dr. Sylvain Hours
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The Long-Run Aggregate Supply

Reminder: In the SR, when input prices are sticky, a decrease in price level
leads to a decrease in the quantity of aggregate output supplied and vice
versa.

In the LR, however, contracts will be renegotiated to take into account
changed economic circumstances so input prices are flexible.

The Long-Run Aggregate Supply (LRAS) curve shows the total “quantity” of
final goods and services supplied by domestic firms, for any given price
level and when input prices are flexible.

Question: Assume all prices - including input prices – are multiplied by 2.
Will the quantity of quantity of aggregate output supplied increase,
decrease or remain the same?
M
Dr. Sylvain Hours
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The Long-Run Aggregate Supply

In the LR, changes in price level have no effect on the quantity of
aggregate output supplied because they are accompanied by equal
proportional changes in all input prices.

It follows that the LRAS curve is perfectly inelastic with respect to the
price level (i.e. it is represented by a vertical line).

The horizontal intercept of the LRAS curve is equal to the economy’s
Potential (or Full Employment) output, the maximum level of output an
economy can produce using all factors of production at sustainable levels.
M
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M
Movements Along the LRAS
PRICE
LEVEL
LRAS
A FALL IN PRICE LEVEL
HAS NO INFLUENCE ON
THE QUANTITY OF
AGGREGATE OUTPUT
SUPPLIED IN THE LR.
𝑝1
𝑝2
𝑌𝑃
AGGREGATE
OUTPUT
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M
Movements Along the LRAS
PRICE
LEVEL
LRAS
A RISE IN PRICE LEVEL
HAS NO INFLUENCE ON
THE QUANTITY OF
AGGREGATE OUTPUT
SUPPLIED IN THE LR.
𝑝2
𝑝1
𝑌𝑃
AGGREGATE
OUTPUT
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Shifts of the LRAS Curve

Basically, the factors that lead to a shift of the LRAS curve are the same
as those that lead to a shift of the PPC.

An increase in the economy’s productive potential (i.e. potential
economic growth) is associated with an increase in LRAS (i.e. rightward
shift of the LRAS curve).

It can be caused by an increase in the quantity and/or productivity of
resources. (see PPT on the PPC)

A decrease in the economy’s productive potential (i.e. economic
decline) is associated with a decrease in LRAS (i.e. leftward shift of the
LRAS curve).

It can be caused by a decrease in the quantity and/or productivity of
resources. (see PPT on the PPC)
M
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M
Potential Economic Growth
PRICE
LEVEL
LRAS2017
LRAS2018
INCREASE
IN LRAS
𝑌𝑃2017
𝑌𝑃2018
AGGREGATE
OUTPUT
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M
Economic Decline
PRICE
LEVEL
LRAS2018
LRAS2017
DECREASE
IN LRAS
𝑌𝑃2018
𝑌𝑃2017
AGGREGATE
OUTPUT
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PART 3
SHORT-RUN
MACROECONOMIC EQUILIBRIUM
M
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SR Macroeconomic Equilibrium

The economy is in a SR macroeconomic equilibrium when the quantity of
aggregate output supplied is equal to the quantity demanded by domestic
households, firms, the government and the rest of the world.

Graphically speaking, the SR macroeconomic equilibrium lies where the AD
curve and SRAS curve interest.

The SR equilibrium price level is the price level at the SR macroeconomic
equilibrium.

The SR equilibrium aggregate output is the aggregate output at the SR
macroeconomic equilibrium.
M
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SR Macroeconomic Equilibrium

Reminder: When studying microeconomics, we saw that the existence of a
shortage leads an increase in price while the existence of a surplus leads to
a decrease in price.

The same logic applies to the SR macroeconomic equilibrium.

If the price level is above the equilibrium price level, the quantity of
aggregate output supplied exceeds the quantity of aggregate output
demanded, leading to a fall in the price level so the economy moves towards
its equilibrium position.

If the price level is below the equilibrium price level, the quantity of
aggregate output demanded exceeds the quantity of aggregate output
supplied , leading to a rise in the price level so the economy moves towards
its equilibrium position.
M
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FURTHER
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M
SR Macroeconomic Equilibrium
SRAS
PRICE
LEVEL
𝑝∗
AD
𝑌∗
AGGREGATE
OUTPUT
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Important Remark

Quite surprisingly, changes in the price level in the AS/AD diagram are
often interpreted as changes in the rate of inflation.

That is, an increase in the price level in the AS/AD diagram is often
interpreted as an increase in the rate of inflation (i.e. accelerating
inflation instead of inflation).

Similarly, a decrease in the price level in the AS/AD diagram is often
interpreted as a decrease in the rate of inflation (i.e. decelerating inflation
or disinflation instead of deflation).
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Demand Shocks


M
An event that shifts the AD curve is known as a demand shock.

An event that shifts the AD curve to the right (i.e. increase in AD) is known as
a positive demand shock.

An event that shifts the AD curve to the left (i.e. decrease in AD) is known as
a negative demand shock.
In the SR, demand shocks cause aggregate output and the price level to
move in the same direction.

In the SR, a positive demand shock leads to an increase in both aggregate
output and the price level.

In the SR, a negative demand shock leads to a decrease in both aggregate
output and the price level.
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M
Positive Demand Shock
SRAS
PRICE
LEVEL
𝑝2∗
INCREASE IN
PRICE LEVEL
POSITIVE
DEMAND
SHOCK
𝑝1∗
AD1
𝑌1∗
𝑌2∗
INCREASE IN
AGGREGATE OUTPUT
AD2
AGGREGATE
OUTPUT
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M
Negative Demand Shock
SRAS
PRICE
LEVEL
DECREASE IN
PRICE LEVEL
𝑝1∗
NEGATIVE
DEMAND
SHOCK
𝑝2∗
AD2
𝑌2∗
𝑌1∗
DECREASE IN
AGGREGATE OUTPUT
AD1
AGGREGATE
OUTPUT
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Supply Shocks



M
An event that shifts the AS curve is known as a supply shock.

An event that shifts the AS curve to the right (i.e. increase in AS) is known as
a positive supply shock.

An event that shifts the AS curve to the left (i.e. decrease in AS) is known as a
negative supply shock.
In the SR, supply shocks cause aggregate output and the price level to
move in opposite directions.

In the SR, a positive supply shock leads to an increase in aggregate output
and a decrease in the price level.

In the SR, a negative supply shock leads to a decrease in aggregate output
and an increase the price level.
Remark: The combination of a higher price level (or higher inflation) and
a lower aggregate output that follows a negative supply shock is known
as stagflation (i.e. stagnation + inflation).
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M
Positive Supply Shock
SRAS1
PRICE
LEVEL
DECREASE IN
PRICE LEVEL
SRAS2
𝑝1∗
POSITIVE
SUPPLY
SHOCK
𝑝2∗
AD
𝑌1∗
𝑌2∗
INCREASE IN
AGGREGATE OUTPUT
AGGREGATE
OUTPUT
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M
Negative Supply Shock
SRAS2
PRICE
LEVEL
INCREASE IN
PRICE LEVEL
SRAS1
𝑝2∗
NEGATIVE
SUPPLY
SHOCK
𝑝1∗
AD
𝑌2∗
𝑌1∗
DECREASE IN
AGGREGATE OUTPUT
AGGREGATE
OUTPUT
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PART 4
LONG-RUN
MACROECONOMIC EQUILIBRIUM
M
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LR Macroeconomic Equilibrium

The economy is in a LR macroeconomic equilibrium when the quantity of
aggregate output supplied in the LR is equal to the quantity demanded by
domestic households, firms, the government and the rest of the world.

Graphically speaking, the SR macroeconomic equilibrium lies where the AD
curve and LRAS curve interest.

The LR equilibrium price level is the price level at the LR macroeconomic
equilibrium.

The LR equilibrium aggregate output is the aggregate output at the LR
macroeconomic equilibrium.
M
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M
LR Macroeconomic Equilibrium
LRAS
PRICE
LEVEL
𝑝∗
AD
𝑌𝑃
AGGREGATE
OUTPUT
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Demand & Supply Shocks


M
In the LR, demand shocks lead to changes in the price level but they
leave aggregate output unchanged.

In the LR, a positive demand shock leads to an increase in the price level but
it leaves aggregate output unchanged.

In the LR, a negative demand shock leads to a decrease in the price level but
it leaves aggregate output unchanged.
In the LR, supply shocks cause aggregate output and the price level to
move in opposite directions.

In the LR, a positive supply shock leads to an increase in aggregate output
and a decrease in the price level.

In the LR, a negative supply shock leads to a decrease in aggregate output
and an increase the price level.
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M
Negative Demand Shock
LRAS
PRICE
LEVEL
𝑝1∗
NEGATIVE
DEMAND
SHOCK
DECREASE IN
PRICE LEVEL
𝑝2∗
AD2
𝑌𝑃
AD1
AGGREGATE
OUTPUT
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M
Positive Demand Shock
LRAS
PRICE
LEVEL
𝑝2∗
POSITIVE
DEMAND
SHOCK
INCREASE IN
PRICE LEVEL
𝑝1∗
AD1
𝑌𝑃
AD2
AGGREGATE
OUTPUT
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M
Negative Supply Shock
LRAS2
LRAS1
PRICE
LEVEL
INCREASE IN
PRICE LEVEL
NEGATIVE
SUPPLY
SHOCK
𝑝2∗
𝑝1∗
AD
𝑌𝑃2
𝑌𝑃1
DECREASE IN
AGGREGATE OUTPUT
AGGREGATE
OUTPUT
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M
Positive Supply Shock
LRAS1
LRAS2
PRICE
LEVEL
DECREASE IN
PRICE LEVEL
POSITIVE
SUPPLY
SHOCK
𝑝1∗
𝑝2∗
AD
𝑌𝑃1
𝑌𝑃2
INCREASE IN
AGGREGATE OUTPUT
AGGREGATE
OUTPUT
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LR Macroeconomic Equilibrium

Simply put, the economy is in LR macroeconomic equilibrium when the
point of the SR macroeconomic equilibrium lies on the LRAS curve.

In that case, the SR equilibrium aggregate output is equal to the economy’s
potential output.

There is a recessionary gap when the SR equilibrium aggregate output is
below the economy’s potential output.

There is an inflationary gap when the SR equilibrium aggregate output is
above the economy’s potential output.

The output gap is percentage difference between the SR equilibrium
aggregate output and the economy’s potential output.
Output Gap = (YSR - YP) / YP x 100
M
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LR Macroeconomic Equilibrium

In the LR, the output gap is always equal to zero (i.e. the SR equilibrium
aggregate output is always equal to the economy’s potential output).

When there is a recessionary gap (i.e. negative output gap), nominal wages
will eventually fall (i.e. positive supply shock), moving the economy back to
potential output (i.e. zero output gap).

When there is an inflationary gap (i.e. positive output gap), nominal wages
will eventually rise (i.e. negative supply shock), moving the economy back
to potential output (i.e. zero output gap).

In the LR, the economy is self-correcting (i.e. shocks to AD affect aggregate
output in the SR but not in the LR).
M
ONE STEP
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M
LR Macroeconomic Equilibrium
PRICE
LEVEL
LRAS
ONE STEP
FURTHER
SRAS
𝑝∗
AD
𝑌𝑃
AGGREGATE
OUTPUT
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M
Negative Demand Shock
PRICE
LEVEL
LRAS
ONE STEP
FURTHER
SRAS1 SRAS2
NEGATIVE
DEMAND
SHOCK
𝑝1∗
𝑝2∗
𝑝3∗
RG
𝑌1∗ 𝑌𝑃
AD2
AD1
AGGREGATE
OUTPUT
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M
Practice Time!
ONE STEP
FURTHER
PRICE
LEVEL
AGGREGATE
OUTPUT
THE REAL VALUE OF HOUSEHOLD ASSETS HAS DECREASED
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M
Positive Demand Shock
PRICE
LEVEL
ONE STEP
FURTHER
SRAS2 SRAS1
LRAS
POSITIVE
DEMAND
SHOCK
𝑝3∗
𝑝2∗
𝑝1∗
AD1
IG
𝑌𝑃
𝑌1∗
AD2
AGGREGATE
OUTPUT
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M
Practice Time!
ONE STEP
FURTHER
PRICE
LEVEL
AGGREGATE
OUTPUT
PERSONAL INCOME TAXES HAVE BEEN DECREASED
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PART 5
KEYNESIAN
MACROECONOMIC EQUILIBRIUM
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Keynesian Aggregate Supply
K
ONE STEP
FURTHER
“In the long-run, we are all dead.”
John M. Keynes

According to the Keynesian school, factor prices - and especially wages –
are sticky downwards, even in the LR.

Wages may indeed be considered sticky downwards for 2 main reasons:

Trade unions fighting to maintain wage levels.

The existence of a national minimum wage.
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Keynesian Aggregate Supply

Therefore, Keynesians believe that economy can settle to a LR equilibrium
that is below the economy’s potential output because the economy cannot
self-heal (i.e. wages fail to adjust downward).

In the presence of a recessionary gap, the economy can suffer from an
extended period of depressed aggregate output and high unemployment.

For this reason, Keynesians argue that the government needs to implement
expansionary demand-side policies (i.e. macroeconomic policies whose aim
is to increase AD) in order to help the economy reach full-employment.

Monetarists disagree with the Keynesians and argue that government
intervention is not necessary because the economy will eventually self-heal
and return to its .
K
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Keynesian Long-Run Aggregate Supply

The shape of the Keynesian LRAS is determined by the level of spare
capacity in the economy.

When the economy has a large spare capacity the LRAS is perfectly priceelastic (i.e. represented by a horizontal line).

In that case, indeed, the existence of high unemployment implies that firms do
not have to increase wages to attract more workers.

Therefore, firms can increase their output without exerting any upward
pressure on factor prices (i.e. their unit cost of production is constant).

It follows that firms are willing to supply more output even if the price level
remains unchanged (i.e. firms maintain their profit margin even though they
cannot sell their output at a higher price).
K
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FURTHER
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Keynesian Long-Run Aggregate Supply

K
ONE STEP
FURTHER
When the economy has a low spare capacity the LRAS is upward sloping.

In that case, indeed, the existence of low unemployment implies that firms have
to increase wages to attract more workers.

Therefore, as firms increase their output, they exert an upward pressure on
factor prices (i.e. their unit cost of production rises).

It follows that firms are willing to supply more output only if the price level in
the economy increases (i.e. firms maintain their profit margin as long as the rise
in factor prices is matched by an increase in the price level).
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Keynesian Long-Run Aggregate Supply

K
ONE STEP
FURTHER
When the economy has a no spare capacity the LRAS is perfectly priceinelastic (i.e. represented by a vertical line).

In that case, indeed, the economy is operating at its potential level of aggregate
output.

It is not possible to sustain a higher level of production in the LR.

Indeed, in the event of a SR inflationary gap, wages will adjust upward in the LR
and the economy will move back to potential level of aggregate output.
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Keynesian Aggregate Supply
PRICE
LEVEL
K
LRAS
𝑌𝑃
AGGREGATE
OUTPUT
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K
Keynesian Aggregate Supply
LRAS
PRICE
LEVEL
SECTION 1:
THE ECONOMY HAS
LARGE SPARE CAPACITY.
AN INCREASE IN AGGREGATE OUTPUT
DOES NOT CREATE ANY UPWARD
PRESSURE ON FACTOR PRICES.
SECTION 1
𝑌𝑃
AGGREGATE
OUTPUT
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K
Keynesian Aggregate Supply
PRICE
LEVEL
LRAS
SECTION 2:
THE ECONOMY HAS
SMALL SPARE CAPACITY.
AN INCREASE IN AGGREGATE
OUTPUT CREATES AN UPWARD
PRESSURE ON FACTOR PRICES.
𝑌𝑃
AGGREGATE
OUTPUT
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K
Keynesian Aggregate Supply
PRICE
LEVEL
LRAS
SECTION 3:
SECTION 3
THE ECONOMY HAS
NO SPARE CAPACITY.
AGGREGATE OUTPUT
CANNOT BE INCREASED.
𝑌𝑃
AGGREGATE
OUTPUT
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Keynesian Macroeconomic Equilibrium
K
LRAS
PRICE
LEVEL
THE ECONOMY SETTLES TO
A LR EQUILIBRIUM WITH A
LARGE RECESSIONARY
GAP (I.E. HIGH LEVEL OF
SPARE CAPACITY).
𝑝∗
AD
𝑌∗
𝑌𝑃
RECESSIONARY GAP
AGGREGATE
OUTPUT
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Keynesian Macroeconomic Equilibrium
K
LRAS
PRICE
LEVEL
THE ECONOMY SETTLES TO
A LR EQUILIBRIUM WITH A
SMALL RECESSIONARY
GAP (I.E. LOW LEVEL OF
SPARE CAPACITY).
𝑝∗
AD
𝑌∗
𝑌𝑃
RECESSIONARY GAP
AGGREGATE
OUTPUT
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Keynesian Macroeconomic Equilibrium
K
LRAS
PRICE
LEVEL
THE ECONOMY OPERATES AT
ITS POTENTIAL LEVEL OF
AGGREGATE OUTPUT
(I.E. NO SPARE CAPACITY).
𝑝∗
AD
𝑌 ∗ = 𝑌𝑃
AGGREGATE
OUTPUT
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Positive Demand Shock

The effect of a small positive demand shock on the price level and
aggregate output depends on the initial level of the economy’s spare
capacity.

If the initial level of the economy’s spare capacity is high (i.e. horizontal
section of the LRAS curve), then a small positive demand shock leads to an
increase in aggregate output and it has no effect on the price level.

If the initial level of the economy’s spare capacity is low (i.e. increasing
section of the LRAS curve), then a small positive demand shock leads to an
increase in both aggregate output and the price level.

If the initial level of the economy’s spare capacity is zero (i.e. vertical
section of the LRAS curve), then a small positive demand shock leads to an
increase in the price level and it has no effect on aggregate output.
K
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K
Positive Demand Shock
PRICE
LEVEL
LRAS
AD1
AD2
THE INITIAL LEVEL
OF SPARE
CAPACITY IS HIGH
NO CHANGE
IN PRICE LEVEL
𝑝1 = 𝑝2
𝑌1
𝑌2
INCREASE
IN AGGREGATE OUTPUT
𝑌𝑃
AGGREGATE
OUTPUT
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K
Positive Demand Shock
PRICE
LEVEL
LRAS
AD1
AD2
THE INITIAL
LEVEL OF SPARE
CAPACITY IS LOW
INCREASE IN
PRICE LEVEL
𝑝2
𝑝1
𝑌1
𝑌2 𝑌𝑃
INCREASE
IN AGGREGATE OUTPUT
AGGREGATE
OUTPUT
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K
Positive Demand Shock
PRICE
LEVEL
LRAS
𝑝2
INCREASE IN
PRICE LEVEL
THE INITIAL
LEVEL OF SPARE
CAPACITY IS ZERO
𝑝1
AD1 AD2
𝑌1 = 𝑌2 = 𝑌𝑃
NO CHANGE
IN AGGREGATE OUTPUT
AGGREGATE
OUTPUT
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Negative Demand Shock

The effect of a small negative demand shock on the price level and
aggregate output depends on the initial level of the economy’s spare
capacity.

If the initial level of the economy’s spare capacity is high (i.e. horizontal
section of the LRAS curve), then a small negative demand shock leads to a
decrease in aggregate output and it has no effect on the price level.

If the initial level of the economy’s spare capacity is low (i.e. increasing
section of the LRAS curve), then a small negative demand shock leads to a
decrease in both aggregate output and the price level.

If the initial level of the economy’s spare capacity is zero (i.e. vertical
section of the LRAS curve), then a small negative demand shock leads to a
decrease in the price level and it has no effect on aggregate output.
K
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K
Negative Demand Shock
PRICE
LEVEL
LRAS
𝑝1
DECREASE IN
PRICE LEVEL
THE INITIAL LEVEL
OF SPARE
CAPACITY IS ZERO
𝑝2
AD2 AD1
𝑌1 = 𝑌2 = 𝑌𝑃
NO CHANGE
IN AGGREGATE OUTPUT
AGGREGATE
OUTPUT
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K
Negative Demand Shock
PRICE
LEVEL
LRAS
AD2
AD1
THE INITIAL LEVEL
OF SPARE
CAPACITY IS LOW
DECREASE IN
PRICE LEVEL
𝑝1
𝑝2
𝑌2
𝑌1 𝑌𝑃
DECREASE
IN AGGREGATE OUTPUT
AGGREGATE
OUTPUT
Dr. Sylvain Hours
postmaster@econdoctor.com
WeChat: sylvainhoursCN
www.econdoctor.com
K
Negative Demand Shock
PRICE
LEVEL
LRAS
AD2
AD1
THE INITIAL LEVEL
OF SPARE
CAPACITY IS HIGH
NO CHANGE
IN PRICE LEVEL
𝑝1 = 𝑝2
𝑌2
𝑌1
DECREASE
IN AGGREGATE OUTPUT
𝑌𝑃
AGGREGATE
OUTPUT
Dr. Sylvain Hours
postmaster@econdoctor.com
WeChat: sylvainhoursCN
www.econdoctor.com
Positive Supply Shock

The effect of a small positive supply shock on the price level and aggregate
output depends on the initial level of the economy’s spare capacity.

If the initial level of the economy’s spare capacity is high (i.e. horizontal
section of the LRAS curve), then a small positive supply shock has no effect
on both aggregate output and the price level.

If the initial level of the economy’s spare capacity is low or zero (i.e.
increasing or vertical section of the LRAS curve), then a small positive
supply shock leads to an increase in aggregate output and to a decrease in
the price level.
K
Dr. Sylvain Hours
postmaster@econdoctor.com
WeChat: sylvainhoursCN
www.econdoctor.com
K
Positive Supply Shock
PRICE
LEVEL
LRAS1
LRAS2
AD
THE INITIAL LEVEL
OF SPARE
CAPACITY IS HIGH
NO CHANGE
IN PRICE LEVEL
𝑝1 = 𝑝2
𝑌1 = 𝑌2
NO CHANGE
IN AGGREGATE OUTPUT
𝑌𝑃1
𝑌𝑃2
AGGREGATE
OUTPUT
Dr. Sylvain Hours
postmaster@econdoctor.com
WeChat: sylvainhoursCN
www.econdoctor.com
K
Positive Supply Shock
AGGREGATE
PRICE LEVEL
LRAS1
LRAS2
THE INITIAL LEVEL
OF SPARE
CAPACITY IS LOW
AD
DECREASE IN
PRICE LEVEL
𝑝1
𝑝2
𝑌1 𝑌𝑃1 𝑌2
𝑌𝑃2
INCREASE
IN AGGREGATE OUTPUT
AGGREGATE
OUTPUT
Dr. Sylvain Hours
postmaster@econdoctor.com
WeChat: sylvainhoursCN
www.econdoctor.com
K
Positive Supply Shock
PRICE
LEVEL
AD
LRAS1
LRAS2
𝑝1
THE INITIAL LEVEL
OF SPARE
CAPACITY IS ZERO
DECREASE IN
PRICE LEVEL
𝑝2
𝑌1 = 𝑌𝑃1 𝑌2 𝑌𝑃2
INCREASE
IN AGGREGATE OUTPUT
AGGREGATE
OUTPUT
Dr. Sylvain Hours
postmaster@econdoctor.com
WeChat: sylvainhoursCN
www.econdoctor.com
Negative Supply Shock

The effect of a small negative supply shock on the price level and aggregate
output depends on the initial level of the economy’s spare capacity.

If the initial level of the economy’s spare capacity is high (i.e. horizontal
section of the LRAS curve), then a small negative supply shock has no
effect on both aggregate output and the price level.

If the initial level of the economy’s spare capacity is low or zero (i.e.
increasing or vertical section of the LRAS curve), then a small negative
supply shock leads to a decrease in aggregate output and to an increase in
the price level.
K
Dr. Sylvain Hours
postmaster@econdoctor.com
WeChat: sylvainhoursCN
www.econdoctor.com
K
Negative Supply Shock
LRAS2
PRICE
LEVEL
LRAS1
AD
THE INITIAL LEVEL
OF SPARE
CAPACITY IS HIGH
NO CHANGE
IN PRICE LEVEL
𝑝1 = 𝑝2
𝑌1 = 𝑌2
NO CHANGE
IN AGGREGATE OUTPUT
𝑌𝑃2
𝑌𝑃1
AGGREGATE
OUTPUT
Dr. Sylvain Hours
postmaster@econdoctor.com
WeChat: sylvainhoursCN
www.econdoctor.com
K
Negative Supply Shock
LRAS2
PRICE
LEVEL
LRAS1
THE INITIAL LEVEL
OF SPARE
CAPACITY IS LOW
AD
INCREASE IN
PRICE LEVEL
𝑝2
𝑝1
𝑌2 𝑌𝑃2 𝑌1
𝑌𝑃1
DECREASE
IN AGGREGATE OUTPUT
AGGREGATE
OUTPUT
Dr. Sylvain Hours
postmaster@econdoctor.com
WeChat: sylvainhoursCN
www.econdoctor.com
K
Negative Supply Shock
PRICE
LEVEL
AD
LRAS2
LRAS1
𝑝2
INCREASE IN
PRICE LEVEL
THE INITIAL LEVEL
OF SPARE
CAPACITY IS ZERO
𝑝1
𝑌2 = 𝑌𝑃2
𝑌1 = 𝑌𝑃1
DECREASE
IN AGGREGATE OUTPUT
AGGREGATE
OUTPUT
Dr. Sylvain Hours
postmaster@econdoctor.com
WeChat: sylvainhoursCN
www.econdoctor.com