8
AGGREGATE DEMAND AND
AGGREGATE SUPPLY
________________________________________________________________________
CHAPTER OUTLINE
Aggregate Demand
Aggregate Supply
Shifts in Aggregate Demand and Aggregate Supply
Causes of Inflation
How the Government Can Influence (But Probably Not Control) the Economy
Summary
LEARNING OBJECTIVES
LO1: Apply and manipulate the aggregate supply and aggregate demand model of macroeconomics.
LO2: Explain why the aggregate demand curve is downward sloping and why there is controversy over the shape
of the aggregate supply curve.
LO3: List the variables that shift these curves and understand how the shifting translates into price and output
impacts.
LO4: Discriminate between demand-pull and cost-push inflation.
LO5: Summarize what is meant by supply-side economics.
KEY TERMS
Aggregate demand (AD) - the amounts of real domestic output that domestic consumers, businesses,
governments, and foreign buyers collectively will desire to purchase at each possible price level.
Real-balances effect- because higher prices reduce real spending power, prices and output are negatively related.
Foreign purchases effect- when domestic prices are high relative to their imported alternatives, we will export
less to foreign buyers and we will import more foreign producers. Therefore, higher prices lead to less domestic
output.
Interest rate effect- higher prices lead to inflation, which leads to less borrowing and a lowering of RGDP.
Aggregate supply (AS) – the level of real domestic output available at each possible price level.
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Chapter 8
Demand-pull inflation- inflation caused by an increase in aggregate demand.
Cost-push inflation- inflation caused by a decrease in aggregate supply.
Supply-side economics- government policy intended to influence the economy through aggregate supply by
lowering input costs and reducing regulation.
PROBLEMS
1. What impact would the following events have on the aggregate demand (AD) or aggregate supply (AS) curve,
other things being equal?
Put a check in the appropriate box to indicate: a. which of the curves would shift, and
b. whether the curve would decrease and shift to the left or
increase and shift to the right.
Aggregate Demand
Decrease
to the
Left
a. A weaker U.S. dollar
b. Consumers lose confidence as job layoffs increase
c. Government decreases regulation of industries
d. A technological improvement in urban transportation
e. OPEC raises oil prices
f. The Federal Reserve lowers interest rates
g. Government gives consumers a tax rebate
h. A heat wave destroys many crops in the United States
i. Imports into the United States increase
j. Labor productivity increases
Increase
to the
Right
Aggregate Supply
Decrease
to the
Left
Increase
to the
Right
Aggregate Demand and Aggregate Supply
3
2.
Price
Level
(A)
Price
Level
P2
AS
AD1
(B)
AS
AD1
P1
AD2
P1
AD2
________________________
Q1 Q2
Real GDP
____________________________
Q1
Real GDP
AS2
Price
Level
Price
Level
AS
AS1
AD1
P2
(C)
P2
P1
(D)
P1
AD2
Q1
Q2
Real GDP
AD
Q2 Q1
Real GDP
For the above diagrams, circle the appropriate answer, and describe the curve shift that caused this result.
a. Diagram A indicates (demand-pull inflation / cost-push inflation / no inflation), because
__________________________________________________________ .
When AD increases in the Keynesian range, the price level ______ and the output level ________ .
b. Diagram B indicates (demand-pull inflation / cost-push inflation / no inflation), because
__________________________________________________________ .
When AD increases in the Classical range, the price level _______ and the output level _______ .
c. Diagram C indicates (demand-pull inflation / cost-push inflation / no inflation), because
__________________________________________________________ .
When AD increases in the intermediate range, the price level ______ and the output level ______ .
d. Diagram D indicates (demand-pull inflation / cost-push inflation / no inflation), because
__________________________________________________________ .
When AS decreases, the price level _____________ and the output level _____________ .
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Chapter 8
3. In the diagrams below, illustrate what happens to prices (inflation) and to output by shifting the appropriate
aggregate demand and/or supply curve. Be sure to note the new equilibrium price level and output.
Price
Level
Price
Level
AS
P1
AS
P1
AD
_____________________________________
0
Q1
Real GDP
a. A tax cut
AD
___________________________________
0
Q1
Real GDP
b. An increase in the price of oil
4. a. Use the data below to plot an aggregate demand and an aggregate supply curve in the chart on the next
page.
b. Identify:
the equilibrium price level _____________
the equilibrium output _______________
Price Level
Aggregate
Domestic Output
Supplied
(In billions)
Aggregate
Demand
(In billions)
100
$100
100
200
100
300
100
400
$800
125
500
700
150
600
600
175
700
500
200
700
400
225
700
300
Aggregate Demand and Aggregate Supply
5
AGGREGATE DEMAND AND SUPPLY
Price Level (Index)
250
200
150
100
50
0
$0
$200
$400
$600
$800
$1,000
Billions
Real GDP Output
c. Answer the following based on the above table and chart:
i. What income level(s) is (are) associated with the Keynesian range of the aggregate supply curve?
________________________________________________________
What accounts for the shape? __________________________________________________________
________________________________________________________
ii. What income level(s) is (are) associated with the Intermediate range of the aggregate supply curve?
_________________________________________________________
What accounts for the shape? ___________________________________________________________
_________________________________________________________
iii. What income level(s) is (are) associated with the Classical range of the aggregate supply curve?
_________________________________________________________
What accounts for the shape?
_________________________________________________________
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Chapter 8
5. What is the shape of the aggregate supply curve under each of the following conditions?
a. Each person who wants a job can have one, if he or she is willing to work at the market wage rate.
b. Some industries are at full employment, while others are not.
c. There are always more people willing to work than there are jobs.
SELF TEST --- MULTIPLE-CHOICE QUESTIONS
1. When economists say that the economy is at full-employment, they mean that
a. there is no frictional unemployment.
b. there is no seasonal unemployment.
c. there is no structural unemployment.
d. there is no cyclical unemployment.
2. The Classical economists believe that
a. there is no cyclical unemployment.
b. there is always a high level of unemployment.
c. the aggregate supply curve is perfectly Keynesian.
d. there is involuntary unemployment.
3. The Keynesian economists believe that
a. there is no cyclical unemployment.
b. there is never a high level of unemployment.
c. the aggregate supply curve is perfectly Classical.
d. there is involuntary unemployment.
4. The Keynesian portion of the aggregate supply curve is
a. downward sloping.
b. upward sloping.
c. horizontal.
d. vertical.
5. The Classical portion of the aggregate supply curve is
a. downward sloping.
b. upward sloping.
c. horizontal.
d. vertical.
6. The Intermediate portion of the aggregate supply curve is
a. downward sloping.
b. upward sloping.
c. horizontal.
d. vertical.
Aggregate Demand and Aggregate Supply
7. When aggregate demand increases in the Keynesian range of the aggregate supply curve,
a. the price level increases and the output increases.
b. the price level stays the same and the output increases.
c. the price level increases and the output stays the same.
d. the price level increases and the output decreases.
8. When aggregate demand increases in the Intermediate range of the aggregate supply curve,
a. the price level increases and the output increases.
b. the price level stays the same and the output increases.
c. the price level increases and the output stays the same.
d. the price level increases and the output decreases.
9. When aggregate demand increases in the Classical range of the aggregate supply curve,
a. the price level increases and the output increases.
b. the price level stays the same and the output increases.
c. the price level increases and the output stays the same.
d. the price level increases and the output decreases.
10. When aggregate supply decreases,
a. the price level increases and the output increases.
b. the price level stays the same and the output increases.
c. the price level increases and the output stays the same.
d. the price level increases and the output decreases.
11. All of the following will result in a leftward shift of the aggregate supply curve, except
a. an increase in oil prices.
b. an increase in government regulation.
c. an improvement in technology.
d. a decrease in productivity.
12. All of the following will result in a leftward shift of the aggregate demand curve, except
a. an increase in taxes paid by individuals.
b. an decrease in government spending.
c. monetary policy that purposefully decreases interest rates.
d. a decline in consumer confidence.
13. Other things equal, a increase in regulation will shift
a. AD to the right (cause it to increase).
b. AD to the left (cause it to decrease).
c. AS to the right (cause it to increase).
d. AS to the left (cause it to decrease).
14. Other things equal, an improvement in productivity will shift
a. AD to the right (cause it to increase).
b. AD to the left (cause it to decrease).
c. AS to the right (cause it to increase).
d. AS to the left (cause it to decrease).
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8
Chapter 8
15. Other things equal, a strong dollar will shift
a. AD to the right (cause it to increase).
b. AD to the left (cause it to decrease).
c. AS to the right (cause it to increase).
d. AS to the left (cause it to decrease).
16. Other things equal, a decline in interest rates will shift
a. AD to the right (cause it to increase).
b. AD to the left (cause it to decrease).
c. AD to the left (cause it to decrease) and AS to the right (cause it to increase).
d. AS to the left (cause it to decrease).
17. Cost-push inflation is caused by which of the following, other things equal?
a. An increase in input costs.
b. A decrease in government regulation.
c. A decrease in government spending.
d. Monetary policy that purposefully decreases interest rates.
18. Demand-pull inflation is caused by which of the following, other things equal?
a. An increase in input costs.
b. A decrease in government regulation.
c. A decrease in government spending.
d. Monetary policy that purposefully decreases interest rates.
19. Inflation would not result, if aggregate demand shifts to the right in the
a. classical range of the aggregate supply curve.
b. intermediate range of the aggregate supply curve.
c. Keynesian range of the aggregate supply curve.
d. none of the above.
20. Which of the following is not considered an aspect of supply-side economics?
a. Policies to reduce input costs.
b. Large cuts in the personal income taxes of individuals.
c. Investment tax credits to business.
d. Reduced regulation to the transportation industry.
21. Which of the following is an argument of those who oppose supply-side economic policies?
a. The policies increase the incentive to take risks.
b. The policies increase the incentives to innovate.
c. The policies increase incentives increase government spending on things such as national
defense.
d. The policies remove impediments created by government regulation.
22. What happened to the value of the U.S. dollar relative to the Euro from August to November of 2008?
a. It depreciated slightly
b. It depreciated by 25%
c. It appreciated by 25%
d. It appreciated slightly
Aggregate Demand and Aggregate Supply
9
23. What caused the short spike in inflations during 2007 through early 2008?
a. A decrease in interest rates
b. Anincrease of world price of crude oil
c. Government spending
d. Tax cuts
SELF TEST --- TRUE / FALSE QUESTIONS
T
F
1. According to the real balances effect, higher prices cause the real value of wealth and savings to
decrease, and this in turn, causes the level of spending to decrease.
T
F
2. According to the interest rate effect, higher prices and inflation cause the interest rates to fall,
and this in turn, causes the level of spending to increase.
T
F
3. According to the foreign purchases effect, higher prices in the United States cause Americans to
reduce their imports from abroad and foreigners to increase their purchases of U.S. exports.
This will increase the buying of American products.
T
F
4. Keynesian economists believe that we are always at full employment.
T
F
5. The vertical portion of the aggregate supply curve is called the Classical range.
T
F
6. Inflation caused by an increase in oil prices is called demand-pull inflation.
T
F
7. An improvement in technology will shift the aggregate demand curve to the right.
T
F
8. An increase in personal income taxes or a decrease in government spending will shift aggregate
demand to the left.
T
F
9. Movements of the aggregate supply curve to the right have only good consequences: inflation
is reduced and real GDP is increased.
T
F
10. An income tax rebate to consumers will shift the aggregate supply curve to the right.
T
F
11. Advocates of supply-side economics argue for more government regulations to control
pollution.
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Chapter 8
ANSWERS TO STUDY QUESTIONS
PROBLEMS
1.
Aggregate Demand
Decrease
to the
Left
Increase
to the
Right
Decrease
to the
Left
Increase
to the
Right
X
a. A weaker U.S. dollar
b. Consumers lose confidence as job layoffs increase
Aggregate Supply
X
c. Government decreases regulation of industries
X
d. A technological improvement in urban transportation
X
X
e. OPEC raises oil prices
f. The Federal Reserve lowers interest rates
X
g. Government gives consumers a tax rebate
X
X
h. A heat wave destroys many crops in the United States
i. United States imports rise
X
j. Labor productivity increases
X
2. a. Diagram A indicates no inflation because aggregate demand increases.
When AD increases in the Keynesian range, the price level remains unchanged and the output level
increases.
b. Diagram B indicates demand-pull inflation because aggregate demand increases.
When AD increases in the Classical range, the price level rises and the output level remains the same.
c. Diagram C indicates demand-pull inflation because aggregate demand increases.
When AD increases in the Intermediate range, the price level rises and the output level rises.
d. Diagram D indicates cost-push inflation because aggregate supply decreases.
When AS decreases, the price level rises and the output level falls.
Aggregate Demand and Aggregate Supply
11
3.
a. A Tax Cut
b. An Increase in the Price of Oil
AS2
Price
Level
Price
Level
AS
AS1
AD1
P2
P2
P1
P1
AD2
Q1
Q2
AD
Real GDP
Q2 Q1
Prices Rise and Total Output Increases
Prices Rise and Total Output Falls
4. a.
AGGREGATE DEMAND AND SUPPLY
Price Level (Index)
250
AS
200
150
100
AD
50
0
$0
$200
$400
$600
$800
$1,000
Billions
Real GDP Output
b. The equilibrium price level = 150
The equilibrium output = $600 billion
c. Keynesian Range:
Intermediate Range:
Classical Range:
Real GDP
$100 billion, $200 billion, $300 billion, $400 billion
The price level remains the same as the total output rises.
$500 billion, $600 billion
Total output increases as the price level rises.
$700 billion
The total output remains the same as the price level rises.
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Chapter 8
5.
a. The aggregate supply curve is vertical
b. The aggregate supply curve is upward sloping
c. The aggregate supply curve is horizontal
MULTIPLE-CHOICE QUESTIONS
1.
2.
3.
4.
5.
D
A
D
C
D
6.
7.
8.
9.
10.
B
B
A
C
D
11.
12.
13.
14.
15.
C
C
D
C
B
16.
17.
18.
19.
20.
TRUE / FALSE QUESTIONS
1.
2.
3.
4.
5.
T
F
F
F
T
6.
7.
8.
9.
10.
F
F
T
T
F
11. F
A
A
D
C
B
21. C
22. C
23. B