Chapter 20
Aggregate
Demand and Supply
• Key Concepts
• Summary
• Practice Quiz
• Internet Exercises
©2002 South-Western College Publishing
1
What is the aggregate
demand curve?
The curve shows the level
of real GDP purchased by
households, businesses,
government, and
foreigners at different
price levels during a time
period, ceteris paribus
2
What does the
horizontal axis
measure?
The value of final goods
and services included
in real GDP measured
in base year dollars
3
What does the vertical
axis measure?
It is an index of the overall
price level, such as the
GDP deflator or the CPI
4
Why does the
aggregate demand
curve slope downward
to the right?
• Real balance wealth effect
• Interest rate effect
• Net exports effect
5
What is the
real balance effect?
Consumers spend more on
goods and services
because lower prices make
their dollars more valuable
6
What is the
interest rate effect?
Assuming fixed credit,
an increase in the
price level translates
through higher
interest rates into a
lower real GDP
7
What is the
net exports effect?
A higher domestic price
level makes U.S. goods
more expensive
compared to foreign
goods, exports decrease,
imports increase,
decreasing real GDP
8
$200
$150
$100
Price Level
The Aggregate Demand Curve
A
B
AD
$50
Real GDP
2
4
6
8
10 12
9
What can cause a
shift in the aggregate
demand curve?
Consumption, investments,
government spending and
net exports can change
10
150
100
50
Price Level (CPI)
200
A Shift in the Aggregate
Demand Curve
A
B
AD2
AD1
Real GDP
2
4
6
8
10 12
11
What is the
aggregate supply
curve?
The curve that shows the
level of real GDP
produced at different
price levels during a time
period, ceteris paribus
12
Why did Keynes
assume fixed product
prices and wages?
During a deep recession
or depression, there are
many idle resources in
the economy
13
Why do idle resources
mean fixed prices?
Producers are willing to sell
additional output at
current prices because
there is plenty of
resources to go around for
everyone who wants them
14
Why do idle resources
mean fixed wages?
The supply of unemployed
workers willing to work for
the prevailing wage rate
diminishes the power of
workers to increase their
wages
15
What kind of supply
curve would explain
fixed prices and
wages?
A horizontal supply curve
16
200
150
100
50
Price Level (CPI)
The Keynesian Horizontal
Aggregate Supply Curve
E
E2
1
AD2
AD1
Real GDP
2
4
6
AS
8
10 12
17
Price level remains
constant, while real
GDP and
employment rise
Government
spending (G)
increases
Aggregate demand
increases and the
economy moves
from E1 to E2
18
According to Keynes,
what will a shift in
aggregate demand do?
It will restore a
depressed economy
to full employment
19
150
100
50
Price Level (CPI)
200
The Keynesian Horizontal
Aggregate Supply Curve
full employment
E
E2
AS
1
AD2
AD1
Real GDP
2
4
6
8
10 12
20
What is the Classical
view of the aggregate
supply curve?
It is a vertical line at the
full employment output
21
According to the
Classical economists,
where does the
economy normally
operate?
The economy normally
operates at its full
employment level
22
How do the
Classical
economists view
prices and costs?
The price level of products
and production costs
change by the same
percentage in order to
maintain full employment
23
200
150
100
50
Price Level (CPI)
The Classical Aggregate Supply Curve
Surplus
AS
E1
E
E2
Real GDP
Full employment
AD1
AD2
2 4 6 8 10 12 14 16 17
24
Three Ranges of the Aggregate Supply Curve
Price Level
AS
Classical
Range
Intermediate
Range
Keynesian
Range
Real GDP
YK
Full Employment
YF
25
Increasing Demand
150
Price Level
200
AS
AD6
AD5
100
Full Employment
50
Real GDP
0
2
4
6
AD2
AD1
8
AD4
AD3
10
12
26
What factors can cause
a shift in the
aggregate supply
curve?
A change in
• resource prices
• technology
• taxes
• subsidies
• regulations
27
AS1
150
100
50
Price Level
200
E1
A Rightward Shift in the
Aggregate Supply Curve
AS2
E2
full employment
AD
Real GDP
2 4 6 8 10 12 14 16 17
28
Increase in the aggregate
supply curve
Change in one or more nonpricelevel determinants: resource
prices, technological change,
taxes, subsidies, and regulations
29
What are the two
types of inflation?
• Cost push
• Demand pull
30
What is
cost push inflation?
A rise in the general
price level resulting
from an increase in
the cost of production
31
200
150
100
Price Level
Cost Push Inflation
50
AS2
AS1
E2
E1
full
employment
AD
Real GDP
2 4 6 8 10 12 14 16 17
32
What is
demand pull inflation?
A rise in the general price
level resulting from an
excess of total spending
33
150
Price Level
200
Demand Pull Inflation
100
AS
E2
E1
50
Real GDP
full
employment
AD2
AD1
2 4 6 8 10 12 14 16 17
34
What determines the
business cycle?
Shifts in the
aggregate demand
and aggregate
supply curves
35
Key Concepts
36
Key Concepts
• What is the aggregate demand curve?
• Why does the aggregate demand curve
slope downward to the right?
• What can cause a shift in the aggregate
demand curve?
• What is the aggregate supply curve?
• Why did Keynes assume fixed product
prices and wages?
• What kind of supply curve would explain
fixed prices and wages?
37
Key Concepts cont.
• According to Keynes, what will a shift in
aggregate demand do?
• What is the Classical view of the aggregate
supply curve?
• According to the Classical economists,
where does the economy normally operate?
• What factors can cause a shift in the
aggregate supply curve?
• What are the two types of inflation?
38
Summary
39
The aggregate demand curve
shows the level of real GDP
purchased in the economy at
different price levels during a
period of time.
40
Reasons why the aggregate
demand curve is downwardsloping include the following
three effects:
41
(1) The real balances or wealth
effect is the impact on real GDP
caused by the inverse
relationship between the
purchasing power of fixed value
financial assets and inflation,
which causes a shift in the
consumption schedule.
42
(2) The interest-rate effect
assumes a fixed money supply,
and, therefore, inflation
increases the demand for
money. As the demand for
money increases, the interest
rate rises, causing consumption
and investment spending to fall.
43
(3) The net exports effect is the
impact on real GDP caused by
the inverse relationship between
net exports and inflation. An
increase in the U.S. price level
tends to reduce U.S. exports and
increase imports, and vice versa.
44
150
100
50
Price Level (CPI)
200
A Shift in the Aggregate
Demand Curve
A
B
AD2
AD1
Real GDP
2
4
6
8
10 12
45
The aggregate supply curve
shows the level of real GDP that
the economy will produce at
different possible price levels.
46
The shape of the aggregate
supply curve depends on the
flexibility of prices and wages as
real GDP expands and contracts.
The aggregate supply curve has
three ranges:
47
(1) The Keynesian range of the
curve is horizontal because
neither the price level nor
production costs will increase
when there is substantial
unemployment in the economy.
48
(2) In the intermediate range,
both prices and costs rise as real
GDP rises toward full
employment. Prices and
production costs rise because of
bottlenecks, the stronger
bargaining power of labor, and
the utilization of less productive
workers and capital
49
(3) The classical range is the
vertical segment of the aggregate
supply curve. It coincides with the
full-employment output. Because
output is at its maximum, increases
in aggregate demand will only
cause a rise in the price level.
50
Three Ranges of the Aggregate Supply Curve
Price Level
AS
Classical
Range
Intermediate
Range
Keynesian
Range
Real GDP
YK
Full
Employment
YF
51
Aggregate demand and
aggregate supply analysis
determines the equilibrium price
level and the equilibrium real
GDP by the intersection of the
aggregate demand and the
aggregate supply curves.
52
Stagflation exists when an
economy experiences inflation
and unemployment
simultaneously. Holding
aggregate demand constant, a
decrease in aggregate supply
results in the unhealthy condition
of a rise in the price level and a
fall in real GDP and employment.
53
Cost-push inflation is inflation
that results from a decrease in
the aggregate supply curve
while the aggregate demand
curve remains fixed.
54
Cost-push inflation is
undesirable because it is
accompanied by declines in
both real GDP and employment.
55
150
Price Level
200
Cost Push Inflation
100
AS2
E2
AS1
full
employment
E1
50
AD
Real GDP
2 4 6 8 10 12 14 16 17
56
Demand-pull inflation is inflation
that results from an increase in
the aggregate demand curve in
both the classical and the
intermediate ranges of the
aggregate supply curve while the
aggregate supply curve is fixed.
57
150
Price Level
200
Demand Pull Inflation
100
AS
E2
E1
50
Real GDP
full
employment
AD2
AD1
2 4 6 8 10 12 14 16 17
58
END
59