Chapter 25
Aggregate Demand and Aggregate Supply
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The Aggregate Demand Curve
•
•
•
•
When price level rises, money demand curve shifts rightward
Consequently, interest rate is higher, given money supply is fixed
Then, aggregate expenditure decreases (AE line shifts downward)
As a result, the equilibrium GDP becomes lower
So,
a rise in price level causes a decrease in equilibrium GDP.
The aggregate demand curve shows the negative relationship
between price levels and equilibrium real GDP
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Figure 2: Deriving the Aggregate
Demand Curve
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Understanding the AD Curve
• Each point on the AD curve represents a short-run
equilibrium in economy
• The AD curve is different from a demand curve for
one particular product
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Movements of the AD Curve
• Moving along the AD curve whenever price level
changes
• When anything other than price level cause equilibrium
GDP to change, the AD curve shifts
–
–
–
–
–
–
–
Government purchasing
Taxes
Autonomous consumption spending
Investment spending
Net exports
Money supply
Expectations
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Figure 3: A Spending Shock Shifts
the AD Curve
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Costs and Prices
• To understand how macroeconomic events affect
the price level, we assume
– A firm sets price of its products as a markup over cost
per unit
– So, in the short-run, price level rises when there is an economywide increase in unit costs
• Labor costs
• Costs of natural resources
• How an increase in output level raises the price
level?
– As output increases, demand for inputs rises
– As unit cost increases, price level ( assumed as a markup over unit cost)
rises
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Figure 5: The Aggregate Supply
Curve
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Movements of the AS Curve
• When price level changes due to a change in
real GDP, the change happens along the AS
curve
• When the change of price level is caused by
any factor other than real GDP, the AS curve
shifts
–
–
–
–
Oil prices
Weather
Technological change
Nominal wage
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Figure 6: Shifts of the Aggregate
Supply Curve
Price
Level
AS 2
140
L
100
A
10
AS1
Real GDP
($ Trillions)
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Figure 8: Short-Run Macroeconomic
Equilibrium
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Figure 9: The Effect of a Demand
Shock
Price
Level
AS
130
H
100
J
E
AD2
AD1
10 12 13.5
Real GDP
($ Trillions)
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An Increase in Government
Purchases
– When G , AD curve shifts rightward. As a result, real
GDP , given price level is fixed
– However, when real GDP , unit cost , so price level
– Furthermore, as price level , Md and interest rate ,
which causes aggregate expenditure to decrease
– In the end, real GDP increases by less than horizontal
shift in AD curve
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An Increase in the Money Supply
• Can you demonstrate how an increase in the
money supply affects the real equilibrium GDP?
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Demand Shocks
• A positive demand shock—shifts AD curve
rightward
– Increases both real GDP and price level in
short-run
• A negative demand shock—shifts AD curve
leftward
– Reduces both real GDP and price level in shortrun
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Examples
• The Great Depression 1929 – 1933
– Negative demand shocks
• Oil Crisis 1973 (began on October 17)
– Negative supply shocks
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Demand Shocks: Adjusting to the
Long-Run
• In short-run, wage rate is treated as given
• But in long-run, wage rate can change
– When output is above full employment, wage
rate will rise, shifting AS curve upward
– When output is below full employment, wage
rate will fall, shifting AS curve downward
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Figure 10: The Long-Run Adjustment Process
After A Positive Demand Shock
Price
Level
Long-Run AS Curve
AS2
AS1
P4
K
J
P3
P2
P1
H
E
AD2
AD1
YFEY3Y2
Real GDP
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Figure 11: Long-Run Adjustment
After A Negative Demand Shock
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Figure 13: The Effect of a Supply
Shock
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More examples
• 1990-91 recession
– Oil supplies and price of oil
• 2001 recession
– Money supply
and interest rate
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