Aggregate Demand and
Aggregate Supply
Slides by: John & Pamela Hall
ECONOMICS: Principles and Applications 3e
HALL & LIEBERMAN
© 2005 Thomson Business and Professional Publishing
Figure 1: The Two-Way Relationship
Between Output and the Price Level
2
The Aggregate Demand Curve
• First step in understanding how price level affects economy is an
important fact
– When price level rises, money demand curve shifts rightward
• Shift in money demand, and its impact on the economy, is illustrated in
Figure 2
• Imagine a rather substantial rise in price level—from 100 to 140
• Compared with our initial position, this new equilibrium has the
following characteristics
–
–
–
–
Money demand curve has shifted rightward
Interest rate is higher
Aggregate expenditure line has shifted downward
Equilibrium GDP is lower
• All of these changes are caused by a rise in price level
• A rise in price level causes a decrease in equilibrium GDP
3
Figure 2: Deriving the Aggregate
Demand Curve
4
Deriving the Aggregate Demand
Curve
• Panel (c) of Figure 2 shows a new
curve
–Shows negative relationship between
price level and equilibrium GDP
• Call aggregate demand curve
–Tells us equilibrium real GDP at any
price level
5
Understanding the AD Curve
• AD curve is unlike any other curve you’ve encountered in
this text
– In all other cases, our curves have represented simple behavioral
relationships
• But AD curve represents more than just a behavioral
relationship between two variables
– Each point on curve represents a short-run equilibrium in economy
• A better name for AD curve would be “equilibrium output at
each price level” curve—not a very catchy name
– AD curve gets its name because it resembles demand curve for an
individual product
– AD curve is not a demand curve at all, in spite of its name
6
Movements Along the AD Curve
• As you will see later in this chapter, a variety of events
can cause price level to change, and move us along AD
curve
– Suppose price level rises, and we move from point E to point H
along this curve
– Following sequence of events occurs
Opposite sequence of events will occur if price level falls, moving us
rightward along AD curve
7
Shifts of the AD Curve
• When we move along AD curve in Figure 2, we assume that price level
changes
– But that other influences on equilibrium GDP are constant
– Keep following rule in mind
• When a change in price level causes equilibrium GDP to change, we move
along AD curve
• Whenever anything other than price level causes equilibrium GDP to change,
AD curve itself shifts
• Equilibrium GDP will change whenever there is a change in any of the
following
–
–
–
–
–
–
Government purchases
Taxes
Autonomous consumption spending
Investment spending
Net exports
Money supply
8
An Increase in Government
Purchases
• Spending shocks initially affect economy by shifting
aggregate expenditure line
• In Figure 3, we assume economy begins at a price level of
100
• Let’s increase government purchases by $2 trillion and ask
what happens if price level remains at 100
– An increase in government purchases shifts entire AD curve
rightward
• AD curve shifts rightward when government purchases,
investment spending, autonomous consumption spending,
or net exports increase, or when taxes decrease
• Analysis also applies in the other direction
– AD curve shifts leftward when government purchases, investment
spending, autonomous consumption spending, or net exports
decrease, or when taxes increase
9
Figure 3: A Spending Shock Shifts
the AD Curve
10
Changes in the Money Supply
• Changes in money supply will also shift
aggregate demand curve
– Imagine that Fed conducts open market
operations to increase money supply
– AD curve shifts rightward
• A decrease in money supply would have the
opposite effect
11
Shifts vs. Movements Along the AD
Curve: A Summary
• Figure 4 summarizes how some events in
economy cause a movement along AD
curve, and other events shift AD curve
• Panels (b) and (c) of Figure 4 tell us how a
variety of events affect AD curve, but not
how they affect real GDP
• Where will price level end up?
– First step in answering that question is to
understand the other side of the relationship
between GDP and price level
12
Figure 4: Effects of Key Changes on
the Aggregate Demand Curve
13
Costs and Prices
• Price level in economy results from pricing
behavior of millions of individual business firms
– In any given year, some of these firms will raise their
prices, and some will lower them
• But often, all firms in the economy are affected by
the same macroeconomic event
– Causing prices to rise or fall throughout the economy
• To understand how macroeconomic events affect
the price level, we begin with a very simple
assumption
– A firm sets price of its products as a markup over cost
per unit
14
Costs and Prices
• Percentage markup in any particular industry will depend
on degree of competition there
• In macroeconomics, we are not concerned with how the
markup differs in different industries
– But rather with average percentage markup in economy
• Determined by competitive conditions
• Competitive structure changes very slowly, so average percentage
markup should be somewhat stable from year-to-year
• But a stable markup does not necessarily mean a stable
price level, because unit costs can change
– In short-run, price level rises when there is an economy-wide
increase in unit costs
• Price level falls when there is an economy-wide decrease in unit costs
15
GDP, Costs, and the Price Level
• Why should a change in output affect unit costs
and price level?
– As total output increases
• Greater amounts of inputs may be needed to produce a unit of
output
• Price of non-labor inputs rise
• Nominal wage rate rises
• A decrease in output affects unit costs through the
same three forces, but with opposite result
16
The Short Run
• All three of our reasons are important in explaining why a
change in output affects price level
– However, they operate within different time frames
• But our third explanation—changes in nominal wage
rate—is a different story
• For a year or more after a change in output, changes in
average nominal wage are less important than other
forces that change unit costs
• Some of the more important reasons why wages in many
industries respond so slowly to changes in output
– Many firms have union contracts that specify wages for up to three
years
– Wages in many large corporations are set by slow-moving
bureaucracies
– Wage changes in either direction can be costly to firms
– Firms may benefit from developing reputations for paying stable
wages
17
The Short Run
• Nominal wage rate is fixed in short-run
– We assume that changes in output have no
effect on nominal wage rate in short-run
• Since we assume a constant nominal wage
in short-run, a change in output will affect
unit costs through the other two factors
– In short-run, a rise (fall) in real GDP, by causing
unit costs to increase (decrease), will also
cause a rise (decrease) in price level
18
Deriving the Aggregate Supply Curve
• Figure 5 summarizes discussion about effect of
output on price level in short-run
• Each time we change level of output, there will be
a new price level in short-run
– Giving us another point on the figure
– If we connect all of these points, we obtain economy’s
aggregate supply curve
• Tells us price level consistent with firms’ unit costs and their
percentage markup at any level of output over short-run
• A more accurate name for AS curve would be
“short-run-price-level-at-each-output-level” curve
19
Figure 5: The Aggregate Supply
Curve
20
Movements Along the AS Curve
• When a change in output causes price level to
change, we move along economy’s AS curve
– What happens in economy as we make such a
move?
– As we move upward along AS curve, we can
represent what happens as follows
21
Shifts of the AS Curve
• Figure 5 assumed that a number of important variables
remained unchanged
– But in real world, unit costs sometimes change for reasons other
than a change in output
• In general, we distinguish between a movement along AS
curve, and a shift of curve itself, as follows
– When a change in real GDP causes the price level to change, we
move along AS curve
• When anything other than a change in real GDP causes price level to
change, AS curve itself shifts
• What can cause unit costs to change at any given level of
output?
–
–
–
–
Changes in world oil prices
Changes in the weather
Technological change
Nominal wage, etc.
22
Figure 6: Shifts of the Aggregate
Supply Curve
Price
Level
AS 2
140
L
100
A
10
AS1
Real GDP
($ Trillions)
23
Figure 7: Effects of Key Changes on
the Aggregate Supply Curve
24
AD and AS Together: Short-Run
Equilibrium
• Where will the economy settle in short-run?
– Where is our short-run macroeconomic
equilibrium?
• We know that in equilibrium, economy must be at
some point on AD curve
• Short-run equilibrium requires economy be operating
on its AS curve
• Only when economy is at point E—on both
curves—will we have reached a sustainable
level of real GDP and the price level
25
Figure 8: Short-Run Macroeconomic
Equilibrium
26
What Happens When Things
Change?
• Now that we know how short-run equilibrium is
determined, and armed with our knowledge of AD and AS
curves, we are ready to put model through its paces
• Our short-run equilibrium will change when either AD
curve, AS curve, or both, shift
– An event that causes AD curve to shift is called a demand shock
– An event that causes AS curve to shift is called a supply shock
• In earlier chapters, we’ve used phrase spending shock
– A change in spending by one or more sectors that ultimately affects
entire economy
– Demand shocks and supply shocks are just two different
categories of spending shocks
27
An Increase in Government
Purchases
• Shifts AD curve rightward
– Can see how it affects economy in short-run
• Process we’ve just described is not entirely
realistic
– Assumes that when government purchases rise,
first output increases, and then price level rises
– In reality, output and price level tend to rise
together
28
Figure 9: The Effect of a Demand
Shock
Price
Level
AS
130
H
100
J
E
AD2
AD1
10 12 13.5
Real GDP
($ Trillions)
29
An Increase in Government
Purchases
• Can summarize impact of price-level changes
– When government purchases increase, horizontal shift
of AD curve measures how much real GDP would
increase if price level remained constant
• But because price level rises, real GDP rises by less than
horizontal shift in AD curve
30
An Decrease in Government
Purchases
31
An Increase in the Money Supply
• Although monetary policy stimulates economy
through a different channel than fiscal policy
– Once we arrive at AD and AS diagram, two look very
much alike
– Can represent situation as follows
32
Other Demand Shocks
• A positive demand shock—shifts AD curve
rightward
– Increases both real GDP and price level in
short-run
• A negative demand shock—shifts AD curve
leftward
– Decreases both real GDP and price level in
short-run
33
An Example: The Great Depression
• U.S. economy collapsed far more seriously during
1929 through 1933—the onset of the Great
Depression—than it did at any other time
• What do we know about demand shocks that
caused Great Depression?
– Fall of 1929, bubble of optimism burst
– Stock market crashed, and investment and
consumption spending plummeted
– Demand for products exported by United States fell
– Fed reacted by cutting money supply sharply
• Each of these events contributed to a leftward shift of AD curve
– Causing both output and price level to fall
34
Demand Shocks: Adjusting to the
Long-Run
• In Figure 9, point H shows new equilibrium after a
positive demand shock in short-run—a year or so
after the shock
– But point H is not necessarily where economy will end
up in long-run
• In short-run, we treat wage rate as given
– But in long-run, wage rate can change
– When output is above full employment, wage rate will
rise, shifting AS curve upward
– When output is below full employment, wage rate will
fall, shifting AS curve downward
35
Demand Shocks: Adjusting to the
Long Run
• Increase in government purchases has no effect
on equilibrium GDP in long-run
– Economy returns to full employment, which is just
where it started
– This is why long-run adjustment process is often called
economy’s self-correcting mechanism
• If a demand shock pulls economy away from full
employment
– Change in wage rate and price level will eventually
cause economy to correct itself and return to fullemployment output
36
Figure 10: The Long-Run
Adjustment Process
Price
Level
Long-Run AS Curve
AS2
AS1
P4
K
J
P3
P2
P1
H
E
AD2
AD1
YFEY3Y2
Real GDP
37
Demand Shocks: Adjusting to the
Long Run
• For a positive demand shock that shifts AD
curve rightward, self-correcting mechanism
works like this
38
Figure 11: Long-Run Adjustment
After A Negative Demand Shock
39
Demand Shocks: Adjusting to the
Long Run
• Complete sequence of events after a negative
demand shock looks like this
40
Demand Shocks: Adjusting to the
Long Run
• Can summarize economy’s self-correcting
mechanism as follows
– Whenever a demand shock pulls economy away from
full employment
• Self-correcting mechanism will eventually bring it back
– When output exceeds its full-employment level, wages
will eventually rise
• Causing a rise in price level and a drop in GDP until full
employment is restored
– When output is less than its full employment level
wages will eventually fall
• Causing a drop in price level and a rise in GDP until full
employment is restored
41
The Long-Run Aggregate Supply
Curve
• Self-correcting mechanism provides an important link
between economy’s long-run and short-run behaviors
• Long-run aggregate supply curve also illustrates another
classical conclusion
– An increase in government purchases causes complete crowding
out
• Rise in government purchases is precisely matched by a drop in
consumption and investment spending
– Leaving total output and total spending unchanged
• Self-correcting mechanism shows that, in long-run,
economy will eventually behave as classical model
predicts
• But notice the word eventually in the previous statement
– This is why governments around the world are reluctant to rely on
self-correcting mechanism alone to keep economy on track
42
Figure 12: The Long-Run
Adjustment Process
43
Short-Run Effects of Supply Shocks
• Figure 13 shows an example of a supply shock
– An increase in world oil prices that shifts aggregate supply curve
upward, from AS1 and AS2
– Called negative supply shock, because of negative effect on output
• In short-run a negative supply shock shifts AS curve upward,
decreasing output and increasing price level
• Notice sharp contrast between effects of negative supply
shocks and negative demand shocks in short-run
– Economists and journalists have coined term “stagflation” to
describe a stagnating economy experiencing inflation
• A negative supply shock causes stagflation in short-run
• Examples of positive supply shocks include unusually
good weather, a drop in oil prices, and a technological
change that lowers unit costs
– In addition, a positive supply shock can sometimes be caused by
government policy
44
Figure 13: The Effect of a Supply
Shock
45
Long-Run Effects of Supply Shocks
• What about effects of supply shocks in long-run?
– In some cases, we need not concern ourselves with this
question, because some supply shocks are temporary
• In other cases, however, a supply shock can last
for an extended period
• In long-run, economy self-corrects after a supply
shock, just as it does after a demand shock
– When output differs from its full-employment level
• Wage rate changes
• AS curve shifts until full employment is restored
46
Some Important Provisos About the
AS Curve
• Upward-sloping aggregate supply curve we’ve presented
in this chapter gives a realistic picture of how economy
behaves after a demand shock
• However, the story we have told about what happens as
we move along AS curve is somewhat incomplete
– Made assumption that prices are completely flexible—that they can
change freely over short periods of time
• In fact, however, some prices take time to adjust, just as wages take
time to adjust
– Assumed that wages are completely inflexible in short-run
• But in some industries, wages respond quickly
– More to process of recovering from a shock than adjustment of
prices and wages
47
Using the Theory: The Recession of
1990-91
• Story of 1990-91 recession begins in mid1990, when Iraq invaded Kuwait
– During this conflict, Kuwait’s oil was taken off
world market, as was Iraq’s
– Reduction in oil supplies resulted in a rapid and
substantial increase in price of oil
48
Using the Theory: The Recession of
2001
• Story of 2001 recession was quite different
– This time, there was no spike in oil prices and no other significant
supply shock to plague economy
– Rather, there was a demand shock, and a Federal reserve policy
during the year before the recession that might have made it a bit
worse
• During late 1990s, Fed had become concerned that
investment boom and consumer optimism were shifting AD
curve rightward too rapidly
– Creating a danger that we would overshoot potential GDP and set
off higher inflation
– Fed responded by tightening money supply and raising interest
rate
– Effects of this policy may have continued into early 2001,
exacerbating decrease in investment that was occurring for other
reasons
• In this way, rate hikes themselves may have contributed to a further
leftward shift of AD curve
49
Figure 14: An AD and AS analysis of
Two Recessions
50
Figure 15: GDP and the Price Level
in Two Recessions
51
Using the Theory: Jobless
Expansions
• After a recession, economy enters expansion phase of business cycle
– Employment usually grows rapidly during this period as well
• But in our two most recent recessions, economy experienced
abnormal, prolonged periods during which employment did not grow at
all
• Figure 16 illustrates behavior of employment during our two most
recent recession
– Called trough of recession
• Vertical axis shows an employment index—employment divided by
employment at the trough
• Blue line shows that employment falls during the contraction phase of
average cycle
– Rises rapidly during the first year of the expansion phase
• But red and pink lines show what happened in first year of our most
recent expansions—during 1992 and 2002
– In both cases, employment drifted slightly downward, telling us that total
number of jobs decreased during year
52
Figure 16: The Average Expansion
Versus Two Recent Jobless Expansions
53
Explaining Jobless Expansions
• Since story is similar for both of these expansions,
let’s focus on period from late 2001 to late 2002—
the first year of expansion after our most recent
recession
– Using equation for economic growth
• Real GDP = productivity x average hours x (emp / pop) x
population
• But equation can be used in different ways
– Now we’re using equation to account for deviations in
employment away from full employment in short-run
• For this purpose, we’ll need to make some
adjustments to equation
– Real GDP = productivity x average hours x employment
54
Explaining Jobless Expansions
• Let’s convert equation to percentage
changes
– %Δ real GDP = %Δ productivity + %Δ
employment
• Finally, rearranging
– %Δ employment (-0.3%) = %Δ real GDP (2.9%)
- %Δ productivity (3.2%)
• Numbers in parentheses show actual
percentage changes for each of these
variables during 2002
55
Explaining Jobless Expansions
• Why didn’t real GDP growth keep up with productivity?
– Because growth in real GDP was unusually low
– Productivity grew at about the same rate as average expansion, in
spite of the low growth in output
– Throughout period, firms were reluctant to hire full-time, permanent
workers
• Created uncertainty about strength and duration of expansion
• Instead, business expanded output by hiring part-time and temporary
workers
• Why would this boost productivity?
– Enabled firms to adjust their workforce more easily to fluctuations
in production
• Phrase “jobless expansion” refers to just part of expansion
phase
– Eventually, employment catches up—even to higher levels of
output made possible by productivity growth
56