Aggregate Demand and Aggregate Supply
CHAPTER ELEVEN
AGGREGATE DEMAND AND AGGREGATE SUPPLY
CHAPTER OVERVIEW
The aggregate expenditures model developed in Chapter10 is a fixed-price-level model. Its focus is on
changes in real GDP, not on changes in the price level. This chapter introduces a variable-price model
in which it is possible to simultaneously analyze changes in real GDP and the price level. This
distinction should be made explicit for those students who have covered Chapter 10. What students learn
in this chapter will help organize their thoughts about equilibrium GDP, the price level, and government
macroeconomic policies. The tools learned will be applied in later chapters.
The present chapter introduces the concepts of aggregate demand and aggregate supply, explaining the
shapes of the aggregate demand and aggregate supply curves and the forces causing them to shift. The
equilibrium levels of prices and real GDP are considered. Finally, the chapter analyzes the effects of
shifts in the aggregate demand and/or aggregate supply curves on the price level and size of real GDP.
WHAT’S NEW
This chapter has undergone significant revision. Those wishing to bypass the Aggregate Expenditures
(AE) model can proceed directly from Chapter 9 to this chapter.
The previous edition’s presentation of the derivation of aggregate demand from the AE model has been
moved to the appendix of the chapter so that instructors can use or ignore this material as warranted.
The discussion of “Determinants of Aggregate Demand” now distinguishes between the “initial change
in spending” (the cause of the shift) and the multiplier effect (the total shift after all multiplier effects
have worked through the system).
The discussion of “Aggregate Supply” now begins by distinguishing between long-run and short-run
aggregate supply.
The short-run aggregate supply (AS) curve is now described as “relatively flat at outputs below the fullemployment output and relatively steep at outputs above it.” The previous edition’s presentation of a
horizontal, intermediate, and vertical range has been eliminated. The explanation for the upward sloping
AS curve has been revised, as has the discussion of the “Determinants of Aggregate Supply.”
Discussion of the recession of 2001 has been incorporated into the discussion of “Full Employment with
Price-Level Stability,” and elsewhere as needed.
A “Consider This” box on the “ratchet effect” has been added. It appeared in the previous edition
website’s “Analogies, Anecdotes, and Insights” section.
End-of-chapter and web questions have been revised to reflect the content changes.
INSTRUCTIONAL OBJECTIVES
After completing this chapter, students should be able to
1. Define aggregate demand and aggregate supply.
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Aggregate Demand and Aggregate Supply
2. Give three reasons why the aggregate demand curve slopes downward.
3. State the determinants of the aggregate demand curve’s location, and explain how the curve will
shift when one of these determinants changes.
4. Distinguish between an initial shift in aggregate demand and the full shift after multiplier effects
have been incorporated.
5. Explain the shape of the long-run aggregate supply curve.
6. Explain the shape of the short-run aggregate supply curve.
7. Indicate the determinants of the aggregate supply curve’s location, and explain how the curve will
shift when one of those determinants changes.
8. Find an economy’s equilibrium price level and real domestic output using AD-AS.
9. Explain how the multiplier effect is weakened when there is demand-pull inflation.
10. Demonstrate and explain how a decrease in aggregate demand can cause a recession without a
drop in the price level.
11. Demonstrate and explain the effects of shifts in aggregates supply on the equilibrium price level
and the real domestic output of an economy.
12. Explain how an economy can maintain full employment and stable prices under conditions of
rising aggregate demand.
13. Explain why unemployment rates in Europe consistently exceed those of the United States.
14. Define and identify terms and concepts at the end of the chapter and in the appendix.
COMMENTS AND TEACHING SUGGESTIONS
1. The aggregate demand-aggregate supply model will be used repeatedly for discussion of
unemployment, inflation, and economic growth in other chapters. It is important for students to
understand the basics in this chapter.
2. While it is helpful to show the similarities between the aggregate model and single-product supply
and demand markets explained in Chapter 3, you need to highlight the differences between the two
models.
3. The concepts of demand-pull and cost-push inflation, which were introduced earlier, can be
analyzed graphically by using the aggregate demand-aggregate supply model (see Figures 11-7 and
11-9).
4. If you have a number of students in your class who are business majors or pursuing careers in
business, you may wish to emphasize the section on productivity. The relationship between
productivity growth and lower per-unit cost of output is important.
5. As you revisit the multiplier and explain how movement up the aggregate supply curve dampens
the effect, you may want to demonstrate how the multiplier determines the size of the shift in
aggregate demand. Emphasize that the full multiplier effect still occurs in terms of the size of the
shift at a given price level, but because the price level can now change, the final effect on output
will be reduced. It is also useful for students to see how the effect gets even weaker as the
aggregate supply curve gets steeper near or beyond the full-employment level of output.
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STUDENT STUMBLING BLOCKS
1. The difference between the aggregate demand-aggregate supply (AD-AS) model and the demandsupply analysis for a single product market is difficult for students to grasp. The similarities are so
great that students often don’t focus on the important differences between the two models.
2. Students will confuse changes in demand and changes in supply. For example, if asked about an
increase in export sales of wheat, some students will inevitably view this as a decrease in supply,
because wheat leaves the country. Repetition of the determinants of demand and supply can help
clarify the distinction.
LECTURE NOTES
I.
Introduction to AD-AS Model
A. AD-AS model is a variable price model. The aggregate expenditures model in Chapter 10
assumed constant price.
B. AD-AS model provides insights on inflation, unemployment, and economic growth.
II.
Aggregate demand is a schedule or curve that shows the various amounts of real domestic
output that domestic and foreign buyers will desire to purchase at each possible price level.
A. The aggregate demand curve is shown in Figure 11-1.
1. It shows an inverse relationship between price level and real domestic output.
2. The explanation of the inverse relationship is not the same as for demand for a single
product, which centered on substitution and income effects.
a. Substitution effect doesn’t apply within the scope of domestically produced goods,
since there is no substitute for “everything.”
b. Income effect also doesn’t apply in the aggregate case, since income now varies with
aggregate output.
3. What is the explanation of the inverse relationship between price level and real output in
aggregate demand?
a. Real balances effect: When price level falls, the purchasing power of existing
financial balances rises, which can increase spending.
b. Interest-rate effect: A decline in price level means lower interest rates that can
increase levels of certain types of spending.
c. Foreign purchases effect: When price level falls, other things being equal, U.S.
prices will fall relative to foreign prices, which will tend to increase spending on
U.S. exports and also decrease import spending in favor of U.S. products that
compete with imports.
B. Determinants of aggregate demand: Determinants are the “other things” (besides price level)
that can cause a shift or change in demand (see Figure 11-2 in text). Effects of the following
determinants are discussed in more detail in the text.
1. Changes in consumer spending, which can be caused by changes in several factors.
a. Consumer wealth
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Aggregate Demand and Aggregate Supply
b. Consumer expectations
c. Household indebtedness
d. Taxes
2. Changes in investment spending, which can be caused by changes in several factors.
a. Interest rates,
b. Expected returns, which are a function of

Expected future business conditions

Technology

Degree of excess capacity

Business taxes
3. Changes in government spending.
4. Changes in net export spending unrelated to price level, which may be caused by changes
in other factors such as
a. National income abroad
b. Exchange rates: Depreciation of the dollar encourages U.S. exports since U.S.
products become less expensive when foreign buyers can obtain more dollars for
their currency. Conversely, dollar depreciation discourages import buying in the
U.S. because our dollars can’t be exchanged for as much foreign currency.
III.
Aggregate supply is a schedule or curve showing the level of real domestic output available
at each possible price level.
A. Aggregate supply in the long run (Figure 11-3)
1. In the long run the aggregate supply curve is vertical at the economy’s full-employment
output.
2. The curve is vertical because in the long run resource prices adjust to changes in the
price level, leaving no incentive for firms to change their output.
B. Aggregate supply in the short run (Figure 11-4)
1. The short-run aggregate supply curve is upward sloping.
2. The lag between product prices and resource prices makes it profitable for firms to
increase output when the price level rises.
3. To the left of full-employment output, the curve is relatively flat. The relative
abundance of idle inputs means that firms can increase output without substantial
increases in production costs.
4. To the right of full-employment output the curve is relatively steep. Shortages of inputs
and production bottlenecks will require substantially higher prices to induce firms to
produce.
5. References to “aggregate supply” in the remainder of the chapter apply to the short-run
curve unless otherwise noted. (The long run will be revisited in Part 5.)
C. Determinants of aggregate supply: Determinants are the “other things” besides price level
that cause changes or shifts in aggregate supply (see Figure 11-5 in text). The following
determinants are discussed in more detail in the text.
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1. A change in input prices, which can be caused by changes in several factors.
a. Domestic resource prices
b. Prices of imported resources
c. Market power in certain industries
2. Changes in productivity (productivity = real output / input) can cause changes in per-unit
production cost (production cost per unit = total input cost / units of output). If
productivity rises, unit production costs will fall. This can shift aggregate supply to the
right and lower prices. The reverse is true when productivity falls. Productivity
improvement is very important in business efforts to reduce costs.
3. Change in legal-institutional environment, which can be caused by changes in other
factors.
a. Business taxes and/or subsidies
b. Government regulation
IV.
Equilibrium: Real Output and the Price Level
A. Equilibrium price and quantity are found where the aggregate demand and supply curves
intersect. (See Key Graph 11-6 for illustration of why quantity will seek equilibrium where
curves intersect.) (Key Questions 4 and 7)
B. Try Quick Quiz 11-6.
C. Increases in aggregate demand cause demand-pull inflation (Figure 11-7).
1. Increases in aggregate demand increase real output and create upward pressure on prices,
especially when the economy operates at or above its full employment level of output.
2. The multiplier effect weakens the further right the aggregate demand curve moves along
the aggregate supply curve. More of the increase in spending is absorbed into price
increases rather than generating greater real output.
D. Decreases in AD: If AD decreases, recession and cyclical unemployment may result. See
Figure 11-8. Prices don’t fall easily.
1. Wage contracts are not flexible so businesses can’t afford to reduce prices.
2. Employers are reluctant to cut wages because of impact on employee effort, etc.
Employers seek to pay efficiency wages – wages that maximize work effort and
productivity, minimizing cost.
3. Minimum wage laws keep wages above that level.
4. Menu costs are difficult to implement.
5. Fear of price wars keeps prices from being reduced.
6. CONSIDER THIS … Ratchet Effect
E. Shifting aggregate supply occurs when a supply determinant changes. (See Key Questions 5,
6, 7).
1. Leftward shift in curve illustrates cost-push inflation (see Figure 11-9).
2. Rightward shift in curve will cause a decline in price level (see Figure 11-10). See text
for discussion of this desirable outcome.
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Aggregate Demand and Aggregate Supply
3. In the late 1990s, despite strong increases in aggregate demand, prices remained
relatively stable (low inflation) as aggregate supply shifted right (productivity gains).
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