Aggregate Demand
and Aggregate Supply
© 2003 South-Western/Thomson Learning
The Aggregate Demand
Curve
The Aggregate Demand Curve combines the
elements of the simple Keynsian model with the
monetary sector so as to display the relationship
between the aggregate price level and spending
balance real GDP
Spending balance real GDP is what we had called
‘equilibrium GDP’ in the simple Keynesian
model -- that level of real GDP where the AE
curve intersects the 45° line.
The Aggregate Demand Curve
The derivation of the AD curve proceeds in two steps:
(1) In the money market it is noted that higher prices shift
out the demand for money, thereby increasing the
equilibrium interest rate;
(2) In the spending balance diagram, higher interest rates
lead to a lowering of the AE curve resulting in lower
spending balance. This exercise shows that higher price
levels are associated with lower spending balance. The
AD curve is simply a locus of all such price level -spending balance combinations, and must have a
declining slope.
P
AD curve is a relationship between
the aggregate price level and Real GDP
AD
Real GDP
Deriving The Aggregate
Demand Curve
A rise in price level causes the
• money demand curve to shift
rightward
• interest rate to rise
• aggregate expenditure line to shift
downward
• equilibrium GDP to decrease
The Aggregate Demand Curve
(a)
Interest
Rate
9%
6%
M
(b)
Aggregate
Expenditure
($ Trillions)
s
AEr = 6%
AEr = 9%
E
H
E
H
d
M2
d
M1
500
6
Money
($ Billions)
10
(c)
Real GDP
($ Trillions)
Price
Level
H
140
E
100
AD
6
10
Real GDP
($ Trillions)
The Aggregate Demand Curve
(a )
Interest
Rate
9%
6%
M
(b)
s
Aggregate
Expend iture
($ Trillions)
AE r =
E
H
6%
AEr =
9%
E
d
H
M2
d
M1
500
Money
($ Billions)
A rise in price level causes the
•money demand curve to shift rightward
•interest rate to rise
•aggregate expenditure line to shift downward
•equilibrium GDP to decrease
6
10
(c )
Rea l GD P
($ Trillions)
Price
Level
H
140
E
100
AD
6
10
Rea l GD P
($ Trillions)
The Aggregate
Demand Curve
A rise in the price level causes a
decrease in equilibrium GDP.
Deriving the Aggregate
Demand Curve
Aggregate Demand (AD) Curve
A curve indicating equilibrium GDP
at each price level.
Understanding the Aggregate
Demand Curve
Each point on the AD curve
represents a short-run equilibrium
in the economy.
Understanding the Aggregate
Demand Curve
P768 fig 1
Price
goes up
Increase in
money
demand
r goes up
a and I P
go down
Equilibrium
GDP goes down
Understanding the Aggregate
Demand Curve
P768 fig 1
Price
goes
down
Decrease
in money
demand
r goes
down
a and I P
go up
Equilibrium
GDP goes up
Shifts of the Aggregate
Demand Curve
• When a change in the price level causes
equilibrium GDP to change, we move
along the AD curve.
• Whenever anything other than the price
level causes equilibrium GDP to change,
the AD curve itself shifts.
Shifts of the Aggregate Demand Curve
(a)
Real
Aggregate
Expenditure
($ Trillions)
AE 2
AE 1
H
E
10
13.5
Real GDP
($ Trillions)
(b)
Price
Level
100
H
E
AD1 AD2
10
13.5
Real GDP
($ Trillions)
Shifts of the Aggregate Demand Curve
(a)
Real
Aggregate
Expenditure
($ Trillions)
AE 2
AE 1
H
E
Here we show
the impact of
a positive spending
shock. AE shifts up
resulting in a higher
equilibrium GDP for
the prevailing price
level.
10
13.5
Real GDP
($ Trillions)
(b)
Price
Level
100
H
E
AD1 AD2
10
13.5
Real GDP
($ Trillions)
Spending Shocks
The AD curve shifts rightward when
• government purchases
• investment spending
• autonomous consumption spending
• or net exports increase
• or when taxes decrease.
Spending Shocks
The AD curve shifts leftward when
• government purchases
• investment spending
• autonomous consumption spending
• or net exports decrease
• or when taxes increase.
Changes in the Money Supply
• An increase in the money supply shifts
the AD curve rightward.
• A decrease in the money supply shifts
the AD curve leftward.
How the Fed Changes the
Interest Rate
At point E, the money
market is in equilibrium at
an interest rate of 6 percent.
Interest
Rate
6%
s
M1
s
M2
To lower the interest rate, the
Fed could increase the money
supply to $800 billion.
The excess supply of money
(and excess demand for bonds)
would cause bond prices to rise,
and the interest rate to fall, until
a new equilibrium is established
at point F with an interest rate
of 3 percent.
E
F
3%
M
500
800
d
Money
($ Billions)
Monetary Policy
and the Economy
P=100
(b)
(a )
Interest
M 1s
M 2s
Rea l
Rate
AE r = 4.5%
Ag gregate
Expenditures
H
($ Trillions)
AE r = 6%
E
6%
E
H
4.5%
d
M Y = $10 trillion
3%
F
d
MY = $8 trillion
500
800
Money
($ Billions)
45º
8
10
Rea l GD P
($ Trillions)
P
P=125
P=100
AD’
AD
8
10
Real GDP
(a)
Price
Level
Effects of Key
Changes on the
AD Curve
Price level
moves us leftward
along the AD curve
P3
Price level
moves us rightward
along the AD curve
P1
P2
AD
Q3
(b)
Price
Level
Entire AD curve
shifts rightward if:
• A , Ip , G , or NX increases
• Taxes decrease
• The money supply
increases
AD 2
Q1
Price
Level
Q2
Real GDP
(c)
Entire AD curve
shifts leftward if:
• A , I p, G , or NX decreases
• Taxes increase
• The money supply
decreases
AD 1
AD 2
AD 1
Real GDP
Real GDP
The Aggregate Supply Curve
Costs and Prices
A firm sets the price of its products
as a markup over cost per unit.
Costs and Prices
The average percentage markup in the
economy is determined by competitive
conditions in the economy.
Markup= price/unit cost - 1
In the short-run we assume this mark-up to
be fixed
Costs and Prices
In the short run
• the price level rises when there is an
economy-wide increase in unit costs,
and
• the price level falls when there is an
economy-wide decrease in unit costs.
Outputs, Costs, and the Price
Level
As total output increases
• Greater amounts of inputs may be
needed to produce a unit of output.
• The prices of non-labor inputs rise.
• The nominal wage rate rises.
Output, Costs, and the Price
Level
For a year or so after a change in
output, changes in the average
nominal wage are less important than
other forces that change unit costs.
Output, Costs, and the Price
Level
Assume that changes in output have no
effect on the nominal wage rate in the
short run. In the short run
• a rise in real GDP will also cause a rise in
the price level.
• a fall in real GDP will also cause a
decrease in the price level.
Deriving the Aggregate Supply
Curve
Aggregate Supply (AS) Curve
A curve indicating the price level
consistent with firms’ unit costs and
markups for any level of output over the
short run.
Deriving the Aggregate Supply Curve
Price
Level
AS
130
B
100
80
A
C
6
10
13.5
Real GDP
($ Trillions)
Movements Upward Along the
Aggregate Supply Curve
Prices of non-labor inputs go up
Real
GDP
goes up
Unit
costs
go up
Input requirements per unit of
output go up
Price
level goes
up
Movements Downward Along the
Aggregate Supply Curve
P768 fig 1Input requirements per unit of
output go down
Real GDP
goes
down
Unit
costs go
down
Prices of non-labor inputs go down
Price
level goes
down
Shifts of the Aggregate Supply
Curve
• When a change in real GDP causes
the price level to change, we move
along the AS curve.
• When anything other than a change in
real GDP causes the price level to
change, the AS curve itself shifts.
Shifts of the Aggregate
Supply Curve
Examples of changes that shift AS
• Changes in world oil prices
• Changes in the weather
• Technological change
• Adjustment to the long run
Shifts of the Aggregate Supply
Curve
Price
Level
AS2
AS1
140
L
100
A
10
Real GDP
($ Trillions)
Shifts of the Aggregate Supply
Curve
Price
Level
AS2
AS1
140
L
100
A
10
Real GDP
($ Trillions)
(a)
Price
Level
Effects of Key
Changes on
the Aggregate
Supply Curve
AS
Real GDP
moves us rightward
along the AS curve
P2
Real GDP
moves us leftward
along the AS curve
P1
P3
Q3
Q1
(b)
Price
Level
Real GDP
(c)
AS2
Entire AS curve
shifts upward if
unit costs for any
reason besides an
increase in real GDP
Q2
AS1
Real GDP
Price
Level
AS1
Entire AS curve
shifts downward if
unit costs for any
reason besides a
decrease in real GDP
AS2
Real GDP
AD and AS Together:
Short-Run Equilibrium
Short-Run Macroeconomic Equilibrium
A combination of price level and GDP
consistent with both the AD and AS
curves
The Aggregate Demand Curve
Aggregate Demand Curve
Price
Level
Real
GDP
Aggregate Supply Curve
AD and AS Together:
Short-Run Equilibrium
Price
Level
AS
B
140
E
100
F
AD
6
10
14
Real GDP
($ Trillions)