ECONOMICS 5e
Michael Parkin
CHAPTER
8
Aggregate Supply and
Aggregate Demand
Chapter 25 in Economics
Learning Objectives
• Explain what determines aggregate supply
• Explain what determines aggregate demand
• Explain macroeconomic equilibrium
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 8-2
Learning Objectives (cont.)
• Explain the effects of changes in aggregate
supply and aggregate demand on economic
growth, inflation, and business cycles
• Explain U.S. economic growth, inflation,
and business cycles by using the AS-AD
model
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 8-3
Learning Objectives
• Explain what determines aggregate supply
• Explain what determines aggregate demand
• Explain macroeconomic equilibrium
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 8-4
Aggregate Supply
The model of AGGREGATE SUPPLYAGGREGATE DEMAND improves our
understanding of:
1) Growth of potential GDP
2) Inflation
3) Business cycle fluctuations
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Slide 8-5
Aggregate Supply
Aggregate Supply Fundamentals
The quantity of real GDP supplied (Y) depends
upon:
• The quantity of labor (N)
• The quantity of capital (K)
• The state of technology (T)
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Slide 8-6
Aggregate Supply
Aggregate Supply Fundamentals
The aggregate production function describes
how these factors influence the quantity of GDP
supplied.
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Slide 8-7
Aggregate Supply
The aggregate production function is:
Y = F(N, K, T)
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Slide 8-8
Aggregate Supply
The aggregate production function shows
that the quantity of real GDP supplied is
determined by the quantities of labor and
capital and the state of technology.
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Slide 8-9
Aggregate Supply
Capital and technology are fixed at any
point in time.
However, labor is not fixed.
• Lower wages result in a greater quantity of
labor demanded.
• Higher wages result in a greater quantity of
labor supplied.
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Slide 8-10
Aggregate Supply
Full Employment
Occurs at the wage rate that makes the quantity
of labor demanded equal to the quantity of
labor supplied
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Slide 8-11
Aggregate Supply
Natural Rate of Unemployment
• The unemployment rate that exists at full
employment.
• In 1997 it was about 5.5%.
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Slide 8-12
Aggregate Supply
Potential GDP is the quantity of real GDP
supplied when unemployment is at its
natural rate and there is full employment.
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Slide 8-13
Aggregate Supply
Long-Run Aggregate Supply
The macroeconomic long run is a time frame
that is sufficiently long for forces that move
real GDP toward potential GDP to have done
their work so that full employment prevails.
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Slide 8-14
Aggregate Supply
Long-Run Aggregate Supply
The long-run aggregate supply curve is the
relationship between the quantity of real GDP
supplied and the price level in the long run
when real GDP equals potential GDP.
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Slide 8-15
Price level (GDP deflator, 1992 = 100)
Long-Run Aggregate Supply
LAS
140
130
120
110
100
90
0
Potential
GDP
6.0 6.5 7.0 7.5 8.0 8.5
Real GDP (trillions of 1992 dollars)
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Slide 8-16
Aggregate Supply
Long-Run Aggregate Supply
Potential GDP is independent of the price level
because the price level, wage rate, and other
resource prices all change by the same
percentage.
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Slide 8-17
Aggregate Supply
Short-Run Aggregate Supply (cont.)
The macroeconomic short run is a period
during which real GDP has fallen below or
risen above potential GDP.
The unemployment rate has risen above or
fallen below the natural rate.
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Slide 8-18
Aggregate Supply
Short-Run Aggregate Supply (cont.)
The short-run aggregate supply curve is the
relationship between the quantity of real GDP
supplied and the price level in the short-run
when the money wage rate, other resource
prices, and potential GDP remain constant.
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Slide 8-19
Short-Run Aggregate Supply
Price Level
Real GDP
(GDP deflator)
(trillions of 1992 dollars)
a
b
c
d
e
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100
105
110
115
120
6.0
6.5
7.0
7.5
8.0
Slide 8-20
Price level (GDP deflator, 1992 = 100)
Short-Run Aggregate Supply
LAS
140
130
SAS
120
d
110
100
90
0
a
b
Real GDP below
potential GDP
e
c
Real GDP above
potential GDP
6.0 6.5 7.0 7.5 8.0 8.5
Real GDP (trillions of 1992 dollars)
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Slide 8-21
Aggregate Supply
Movements Along the LAS and SAS
Curves
When the price level rises, holding the money
wage rate and other resource prices constant,
the quantity of real GDP supplied increases and
there is a movement along the SAS curve.
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Slide 8-22
Price level (GDP deflator, 1992 = 100)
Movements Along The Aggregate
Supply Curves
140
Price level rises and
money wage rate rises
by the same percentage
LAS
130
SAS
120
110
Price level rises and
money wage rate is
unchanged
100
90
6.0
7.0
8.0
Real GDP (trillions of 1992 dollars)
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Slide 8-23
Aggregate Supply
Changes in Aggregate Supply
Occurs when influences on production other
than the price level change
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Slide 8-24
Aggregate Supply
Potential GDP changes as a result of:
1) Changes in the full-employment quantity
of labor
2) Changes in the quantity of capital
3) Advances in technology
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Slide 8-25
Price level (GDP deflator, 1992 = 100)
A Change in Potential GDP
140
130
LAS0
LAS1
Increase in
potential GDP
SAS0
120
SAS1
110
100
90
0
6.0
7.0
8.0
Real GDP (trillions of 1992 dollars)
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Slide 8-26
Aggregate Supply
Changes in the money wage rate changes
short-run aggregate supply but does not
change long-run aggregate supply.
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Slide 8-27
Price level (GDP deflator, 1992 = 100)
A Change in the Money Wage Rate
LAS
140
SAS2
130
SAS0
120
b
110
a
100
90
0
6.0
7.0
8.0
Real GDP (trillions of 1992 dollars)
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 8-28
Learning Objectives
• Explain what determines aggregate supply
• Explain what determines aggregate demand
• Explain macroeconomic equilibrium
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Slide 8-29
Aggregate Demand
The quantity of real GDP demanded is the
sum of the real consumption expenditure
(C), investment (I), government purchases
(G), and exports (X) minus imports (M).
Y=C+I+G+X–M
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Slide 8-30
Aggregate Demand
Aggregate demand is the relationship
between the quantity of real GDP demanded
and the price level.
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Slide 8-31
Aggregate Demand
Price Level
Real GDP
(GDP deflator)
(trillions of 1992 dollars)
a'
b'
c'
d'
e'
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90
100
110
120
130
8.0
7.5
7.0
6.5
6.0
Slide 8-32
Price level (GDP deflator, 1992 = 100)
Aggregate Demand
140
130
120
e'
d'
c'
110
100
90
0
Decrease in
quantity of
real GDP
demanded.
Increase in
quantity of
real GDP
demanded.
b'
a'
AD
6.0 6.5 7.0 7.5 8.0
Real GDP (trillions of 1992 dollars)
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Slide 8-33
Aggregate Demand
The two reasons the demand curve sloped
downward are:
1) Wealth effect
• Changes in the price level, with other things
remaining the same, change real wealth.
• People try to restore wealth by increasing
saving and decreasing consumption.
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Slide 8-34
Aggregate Demand
The two reasons the demand curve sloped
downward are:
2) Substitution effects
• People substitute future consumption for present
consumption as a result of higher interest rates.
• A change in prices cause consumers to spend less
on domestic items and more on imported items.
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Slide 8-35
Aggregate Demand
Changes in the Quantity of Real GDP
Demanded
When the price level changes, other things
remaining the same, the quantity of real GDP
demanded changes and there is movement
along the aggregate demand curve.
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Slide 8-36
Aggregate Demand
Changes in Aggregate Demand
A change in any factor than influences buying
plans other than the price level.
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Slide 8-37
Aggregate Demand
The factors that influence buying plans other
than the price level and bring a change in
aggregate demand are:
1) Expectations
2) Fiscal policy and monetary policy
3) The world economy
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Slide 8-38
Aggregate Demand
Expectations
Expectations about future incomes, inflation,
and profits influence buying plans today.
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Slide 8-39
Aggregate Demand
Fiscal Policy and Monetary Policy
Fiscal policy is the government’s attempt to
influence the economy by setting and changing
taxes, transfer payments, and government
purchases.
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Slide 8-40
Aggregate Demand
Fiscal Policy and Monetary Policy
These influence a household’s disposable
income.
Disposable income equals aggregate income
minus taxes plus transfer payments.
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Slide 8-41
Aggregate Demand
Fiscal Policy and Monetary Policy
Monetary policy consists of changes in
interest rates and in the quantity of money
in the economy.
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Slide 8-42
Aggregate Demand
The World Economy
The exchange rate and foreign income
affect aggregate demand.
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Slide 8-43
Price level (GDP deflator, 1992 = 100)
Changes in Aggregate Demand
140
Increase in
aggregate
demand
130
120
110
100
90
0
Decrease in
aggregate
demand
AD1
AD2
AD0
6.0 6.5 7.0 7.5 8.0
Real GDP (trillions of 1992 dollars)
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Slide 8-44
Changes in Aggregate Demand
Aggregate demand
Decreases if:
Aggregate demand
Increases if:
• Expected future
• Expected future
incomes, inflation, or
profits decrease.
incomes, inflation, or
profits increase.
• Fiscal policy decreases
• Fiscal policy increases
government purchases,
increases taxes, or
decreases transfer
payments.
government purchases,
decreases taxes, or
increases transfer
payments.
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Slide 8-45
Changes in Aggregate Demand
Aggregate demand
Decreases if:
Aggregate demand
Increases if:
• Monetary policy
• Monetary policy
decreases the quantity
of money and increases
interest rates
• The exchange rate
increases or foreign
income decreases
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increases the quantity
of money and decreases
interest rates
• The exchange rate
decreases or foreign
income increases
Slide 8-46
Learning Objectives
• Explain what determines aggregate supply
• Explain what determines aggregate demand
• Explain macroeconomic equilibrium
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 8-47
Macroeconomic Equilibrium
Short-Run Macroeconomic Equilibrium
Occurs when the quantity of real GDP
demanded equals the quantity of real GDP
supplied.
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Slide 8-48
Price level (GDP deflator, 1992 = 100)
Short-Run Equilibrium
140
130
Firms cut
production
and prices
e'
d'
120
c'
110
100
90
0
a
b
c
Firms increase
production
and prices
d
SAS
e
Short-run
macroeconomic
equilibrium
b'
e'
AD
6.0 6.5 7.0 7.5 8.0
Real GDP (trillions of 1992 dollars)
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Slide 8-49
Macroeconomic Equilibrium
Long-Run Macroeconomic Equilibrium
Occurs when real GDP equals potential GDP,
(i.e. the economy is on its long-run aggregate
supply curve).
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Slide 8-50
Price level (GDP deflator, 1992 = 100)
Long-Run Equilibrium
LAS
140
130
SAS
120
110
100
90
0
In the long run,
money wage
adjusts
AD
6.0 6.5 7.0 7.5 8.0
Real GDP (trillions of 1992 dollars)
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 8-51
Learning Objectives (cont.)
Explain the effects of changes in aggregate
supply and aggregate demand on economic
growth, inflation, and business cycles
• Explain U.S. economic growth, inflation,
and business cycles by using the AS-AD
model
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 8-52
Macroeconomic Equilibrium
Economic Growth and Inflation
• Economic growth occurs because the quantity
of labor grows, capital is accumulated, and
technology advances.
• Inflation occurs when aggregate demand
increases by more than long-run aggregate
supply.
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Slide 8-53
Price level (GDP deflator, 1992 = 100)
Economic Growth and Inflation
140
Increase in LAS
brings economic
growth
LAS0
LAS1
130
120
Inflation
110
AD1
100
90
0
Economic
growth
6.0
AD0
7.0
Bigger increase
in AD than in LAS
brings inflation
8.0
Real GDP (trillions of 1992 dollars)
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Slide 8-54
Macroeconomic Equilibrium
In the long-run, the main influence on
aggregate demand is the growth rate of the
quantity of money.
Real GDP fluctuates around potential GDP
in a business cycle.
Inflation fluctuates at the same time.
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Slide 8-55
Macroeconomic Equilibrium
Business Cycles
Occur because aggregate demand and short-run
aggregate supply fluctuate but the money wage
rate does not adjust quickly enough to keep real
GDP at potential GDP.
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Slide 8-56
Macroeconomic Equilibrium
Below Full-employment Equilibrium
A macroeconomic equilibrium in which
potential GDP exceeds real GDP
The difference is called a recessionary gap.
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Slide 8-57
Macroeconomic Equilibrium
Long-Run Equilibrium
Occurs when real GDP equals potential GDP.
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Slide 8-58
Macroeconomic Equilibrium
Above Full-employment Equilibrium
A macroeconomic equilibrium in which real
GDP exceeds potential GDP
The difference is called an inflationary gap.
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Slide 8-59
Price level (GDP deflator, 1992 = 100)
The Business Cycle
LAS
130
Recessionary
gap
SAS0
120
110
Below full-employment
equilibrium
a
100
AD0
0
6.8
7.0
7.2
Real GDP (trillions of 1992 dollars)
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Slide 8-60
Real GDP (trillions of 1992 dollars)
The Business Cycle
7.2
Fluctuations in
real GDP
Recesssionary
gap
Potential
GDP
7.0
Actual
GDP
6.8
0
a
1
2
3
4
Year
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Slide 8-61
Price level (GDP deflator, 1992 = 100)
The Business Cycle
LAS
Full
employment
130
SAS1
120
110
Long-run
equilibrium
b
100
AD1
0
6.8
7.0
7.2
Real GDP (trillions of 1992 dollars)
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Slide 8-62
Real GDP (trillions of 1992 dollars)
The Business Cycle
7.2
Recessionary
gap
Full
employment
Potential
GDP
7.0
6.8
Fluctuations in
real GDP
b
Actual
GDP
0
a
1
2
3
4
Year
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Slide 8-63
Price level (GDP deflator, 1992 = 100)
The Business Cycle
LAS
130
120
Above full-employment
equilibrium
Inflationary
gap
SAS2
110
c
100
0
AD2
7.0
7.2
Real GDP (trillions of 1992 dollars)
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Slide 8-64
Real GDP (trillions of 1992 dollars)
The Business Cycle
7.2
Recessionary
gap
Fluctuations in
real GDP
Potential
GDP
7.0
6.8
Full
employment
c
b
Inflationary
gap
Actual
GDP
0
a
1
2
3
4
Year
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Slide 8-65
Macroeconomic Equilibrium
Fluctuations in Aggregate Demand
Real GDP sometimes fluctuates as a result
of changes in aggregate demand.
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Slide 8-66
Price level (GDP deflator, 1992 = 100)
An Increase in Aggregate Demand
LAS
140
130
SAS0
Short-run
effect
115
110
100
AD1
90
0
AD0
6.0
7.0 7.5
Real GDP (trillions of 1992 dollars)
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Slide 8-67
Price level (GDP deflator, 1992 = 100)
An Increase in Aggregate Demand
LAS
140
SAS1
130
125
SAS0
Long-run
effect
115
100
AD1
90
0
6.0
7.0 7.5
Real GDP (trillions of 1992 dollars)
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Slide 8-68
Macroeconomic Equilibrium
An economy cannot produce in excess of
potential forever.
• Workers begin to demand higher wages
• Eventually, wage rates rise by the same
percentage as the price level.
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Slide 8-69
Macroeconomic Equilibrium
Fluctuations in Aggregate Supply
Fluctuations in short-run aggregate supply can
bring fluctuations in real GDP around potential
GDP.
A decrease in aggregate supply can lead to a
recession and inflation — stagflation.
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Slide 8-70
Price level (GDP deflator, 1992 = 100)
A Decrease in Aggregate Supply
LAS
140
SAS1
130
120
110
100
90
0
SAS0
An oil price rise
decreases short-run
aggregate supply
AD0
6.0 6.5 7.0 7.5 8.0 8.5
Real GDP (trillions of 1992 dollars)
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 8-71
Learning Objectives (cont.)
• Explain the effects of changes in aggregate
supply and aggregate demand on economic
growth, inflation, and business cycles
• Explain U.S. economic growth, inflation,
and business cycles by using the AS-AD
model
Copyright © 2000 Addison Wesley Longman, Inc.
Slide 8-72
Aggregate Supply and
Aggregate Demand: 1960–1998
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Slide 8-73
U.S. Economic Growth,
Inflation, and Cycles
Economic Growth
• The forces that bring economic growth were
stronger during the 1960s and mid-1980s that at
other times.
• During the 1970s, growth was slow.
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Slide 8-74
U.S. Economic Growth,
Inflation, and Cycles
Inflation
The main force generating the persistent
increase in the price level is a tendency for
aggregate demand to increase at a faster pace
than the increase in long-run aggregate supply
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Slide 8-75
U.S. Economic Growth,
Inflation, and Cycles
Cycles
Cycles arise because both the expansion of
short-run aggregate supply and the growth of
aggregate demand do not proceed at a fixed,
steady pace.
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Slide 8-76
U.S. Economic Growth,
Inflation, and Cycles
The Evolving Economy: 1960–1996
• During the 1960s, real GDP growth was rapid
and inflation was low.
• Rapid increases in aggregate supply and
moderate increases in aggregate demand
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Slide 8-77
U.S. Economic Growth,
Inflation, and Cycles
The Evolving Economy: 1960–1996
• During the mid-1970s there was rapid inflation
and recession — stagflation.
• Oil price increases shifted short-run aggregate
supply leftward.
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Slide 8-78
U.S. Economic Growth,
Inflation, and Cycles
The Evolving Economy: 1960–1996
• A rapid increase in the quantity of money
shifted the aggregate demand curve rightward.
• Recession occurred because the short-run
aggregate supply curve shifted leftward at a
faster pace than the aggregate demand curve
shifted rightward.
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Slide 8-79
U.S. Economic Growth,
Inflation, and Cycles
The Evolving Economy: 1960–1996
• The rest of the 1970s saw high inflation and
moderate growth in real GDP.
• By 1980, inflation was a major problem.
• The Fed took strong action to reduce it.
• Interest rates increased to levels not seen
before.
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Slide 8-80
U.S. Economic Growth,
Inflation, and Cycles
The Evolving Economy: 1960–1996
• Aggregate demand decreased as a result.
• The economy went into a deep recession.
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Slide 8-81
U.S. Economic Growth,
Inflation, and Cycles
The Evolving Economy: 1960–1996
• During the years 1982 to 1990, capital
accumulation and steady technological advance
resulted in a sustained rightward shift of the
long-run aggregate supply curve.
• Aggregate demand growth kept pace with the
growth of aggregate supply.
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Slide 8-82
U.S. Economic Growth,
Inflation, and Cycles
The Evolving Economy: 1960–1996
• A decrease in aggregate demand led to the 1991
recession.
• The economy has continually expanded through
1996.
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Slide 8-83
The End
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Slide 8-84