Aggregate demand and aggregate supply model
A model that explains short-run fluctuations in real
GDP and the price level.
Aggregate Demand (Y) has four components: consumption (C),
investment (I), government purchases (G), and net exports (NX).
Y = C + I + G + NX
When Price (P) Rises Aggregate Demand Decreases, ceteris paribus
•The International-Trade Effect (substitution of foreign stuff for our
stuff): When our Price level (P) rises, foreigners buy less of our
exports and we import more things from abroad: NX falls.
•Wealth Effect: When our price level rises, the real value of our monetary
wealth (M/P) declines. We feel poorer and spend less: C falls .
In addition, when our price level rises and real money balances (M/P)
become scarcer, our interest rate rises.
•The Interest-Rate Effect: A higher interest rate discourages
spending, investment spending in particular: I falls (C may also fall)
•Exchange-Rate Effect: A higher interest rate increases capital inflows to
the US, the dollar appreciates. Our goods become more expensive for
foreigners and their goods become cheaper for us: NX falls yet more.
What Shifts the Aggregate Demand Curve?
Changes in Government Policies intended to achieve
macroeconomic objectives: high employment, price stability, steady
economic growth.
•Monetary policy Actions the Federal Reserve takes to manage the
money supply and interest rates.
•Fiscal policy Changes in federal taxes and purchases.
Changes in Expectations of Households and Firms
•If households become more optimistic about their future incomes,
they are likely to increase their current consumption.
Changes in Foreign Variables
•If foreign economies expand, foreign firms and households will
buy more U.S. goods.
•If the dollar depreciates, foreign firms and households will buy
more U.S. goods and U.S. firms and households will buy fewer
foreign goods.
Net exports will rise and the aggregate demand curve
will shift to the right.
Movements along the Aggregate Demand Curve
versus Shifts of the Aggregate Demand Curve
When price rises, less domestic
output is demanded owing to the
international-trade effect, the wealth
effect, the interest rate effect and
the exchange rate effect.
When taxes increase or government
spending decreases, when the
money supply is reduced or when
people lose confidence, aggregate
demand shifts to the left
Variables That Shift the Aggregate Demand Curve
Variables That Shift the Aggregate Demand Curve
The Long-Run Aggregate Supply Curve
LRAS reflects the economy’s output capacity at full employment of
available resources using the best available technology.
LRAS shifts outward as capital accumulates, the labor force grows
and as technology improves.
The Short-Run Aggregate Supply Curve
Why does the short-run aggregate supply curve slope upward?
1 Contracts make some wages and prices “sticky.”
2 Firms are often slow to adjust wages...efficiency wage idea
3 Menu costs make some prices sticky.
Variables That Shift the Short-Run Aggregate Supply Curve
Also:
•Adjustments of Workers
and Firms to Errors in
Past Expectations about
the Price Level
•Unexpected Changes in
the Price of an Important
Natural Resource

Supply Shock
•Expected Changes in the Future Price Level
Variables That Shift the Short-Run Aggregate Supply Curve
Variables That Shift the Short-Run Aggregate Supply Curve
Unexpected Changes in the Price of an Important
Natural Resource
Macroeconomic Equilibrium
in the Long Run and the Short Run
Macroeconomic Equilibrium: Begin at Potential Real GDP
of $10 trillion and steady price level of 100
Now: The Short-Run and
Long-Run Effects of a
Decrease in Aggregate
Demand
Recession and Automatic
Recovery
Macroeconomic Equilibrium: Begin at Potential Real
GDP of $10 trillion and steady price level of 100
Now: The Short-Run
and Long- run Effects
of an Increase in
Aggregate Demand
Expansion and Automatic
Return to Potential GDP
Learning Objective 12.3
Macroeconomic Equilibrium
in the Long Run and the Short Run
Recessions, Expansions, and Supply Shocks
Supply Shock
Stagflation A combination
of inflation and recession,
usually resulting from a
supply shock.
Macroeconomic Equilibrium: Begin at Potential Real
GDP of $10 trillion and steady price level of 100
Now: The Short-Run and LongRun Effects of a Supply Shock
Supply Shock
 Stagflation
A Dynamic Aggregate Demand
and Aggregate Supply Model
We can create a dynamic aggregate demand and
aggregate supply model by making three changes to
the basic model.
• Potential real GDP increases continually,
shifting the long-run aggregate supply curve to
the right.
• During most years, the aggregate demand
curve will be shifting to the right.
• Except during periods when workers and firms
expect high rates of inflation, the short-run
aggregate supply curve will be shifting to the
right as productivity increases.
A Dynamic Aggregate Demand
and Aggregate Supply Model
A Dynamic Aggregate Demand
and Aggregate Supply Model
A Dynamic Aggregate Demand
and Aggregate Supply Model
The Usual Cause of Inflation: AD increases by more than AS
A Dynamic Aggregate Demand
and Aggregate Supply Model
The Slow Recovery from the Recession of 2001
The recession of 2001 was caused by a decline in
aggregate demand. Several factors contributed to
this decline:
• The end of the stock market “bubble.”
• Excessive investment in information technology.
• The terrorist attacks of September 11, 2001.
• The corporate accounting scandals.
The Slow Recovery from the Recession of 2001
Aggregate demand increased
slowly following the dot.com
bust and 9/11
Key Terms
Aggregate demand and aggregate supply model
Aggregate demand curve
Fiscal policy
Long-run aggregate supply curve
Menu costs
Monetary policy
Short-run aggregate supply curve
Stagflation
Supply shock
Macroeconomic Schools of Thought
Keynesian revolution The name given to the widespread
acceptance during the 1930s and 1940s of John Maynard Keynes’s
macroeconomic model and activist policy prescriptions.
These alternative schools of thought use models that differ
significantly from the standard aggregate demand and aggregate
supply model. We can briefly consider each of the three major
alternative models:
1 The monetarist model
2 The new classical model
3 The real business cycle model
Macroeconomic Schools of Thought
The Monetarist Model
The monetarist model—also known as the neo-Quantity Theory of
Money model—was developed beginning in the 1940s by Milton
Friedman, an economist at the University of Chicago who was
awarded the Nobel Prize in Economics in 1976.
Monetary growth rule A plan for increasing the
quantity of money at a fixed rate that does not respond
to changes in economic conditions.
Monetarism The macroeconomic theories of Milton
Friedman and his followers; particularly the idea that
the quantity of money should be increased at a
constant rate.
Macroeconomic Schools of Thought
The New Classical Model
The new classical model was developed in the mid-1970s by a
group of economists including Nobel laureate Robert Lucas of the
University of Chicago, Thomas Sargent of New York University,
and Robert Barro of Harvard University.
New classical macroeconomics The macroeconomic
theories of Robert Lucas and others, particularly the
idea that workers and firms have rational expectations.
Macroeconomic Schools of Thought
The Real Business Cycle Model
Beginning in the 1980s, some economists, including Nobel
laureates Finn Kydland of Carnegie Mellon University and Edward
Prescott of Arizona State University, argued that Lucas was correct
in assuming that workers and firms formed their expectations
rationally and that wages and prices adjust quickly to supply and
demand but wrong about the source of fluctuations in real GDP.
Real business cycle model A macroeconomic model
that focuses on real, rather than monetary, causes of
the business cycle.
Making
Karl Marx: Capitalism’s Severest Critic
Connection … or most perceptive analyst?
the
Karl Marx predicted that a final
economic crisis would lead to
the collapse of the market system.