Ch 10. Aggregate Demand and
Aggregate Supply



Aggregate Demand-Aggregate Supply
model (AD-AS model).
Enables us to analyze changes in real GDP
and the price level simultaneously.
Provides insights on inflation, recession,
unemployment, and economic growth.
A.
Aggregate Demand – schedule or
graph that shows the amounts of real
output that buyers collectively desire
to purchase at each possible price
level.
-- Aggregate Demand = all demand together.
AS
D
0
Real domestic output, GDP
The aggregate demand curve: downsloping
indicates an inverse (negative) relationship
between the price level and the amount of real
output purchased.
Also downsloping due to real wealth balance
effect (how we feel about market), foreign trade
effect (P =  sales), and interest rate effect.
Change in Aggregate Demand



A change in the
determinants of
AD will SHIFT the
AD curve.
Right shift from
AD1 to AD2
shows an
increase in AD.
Left shift from
AD1 to AD3
shows a
decrease.
AD3
Changes in Aggregate Demand
Changes in Aggregate Demand Curve
Price Level
Increase in
Aggregate
Demand
Decrease in
Aggregate
Demand
AD2
AD1
AD3
Real Domestic Output, GDP
B.
Aggregate Supply – schedule or
graph showing the level of real
output that firms will produce at
each possible price level.
-- AS = supply of everything in our economy (U.S. GDP).
-- Sticky Wages = labor contracts stuck at a certain level.
Aggregate Supply
2003
1.
Aggregate Supply in the LongRun (ASLR) – vertical at fullemployment level of real GDP
(Qf).
-- Long run – In Microeconomics, a period of time long enough to enable producers of
a product to change the quantities of all the resources they employ.
 Price =  real output.
 Price =  real output.
Aggregate
Supply
(short-run)
Price Level
PL
Qf
Real domestic output, GDP
2.
Q
Upsloping AS curve
indicates a direct
(or positive) relationship
between the price
level and the amount
of real output that
Firms will offer for sale.
AS in the short-run (ASSR)
-- Short-run – In Microeconomics, a period in time in which producers are able to
change the quantities of some, but not all of the resources they employ.
-- If price-level rises, output increases, and profits increase because wages are fixed.
-- Wages are fixed and sticky because of contracts, unawareness.
Changes in Aggregate Supply
Understanding Productivity
Productivity
Total Output
Total Inputs
=
=
Total Output
Total Inputs
10
5
= 2
3.
Determinants of AS
Which is a decrease and
which is an increase?
-- Aka aggregate supply shifters.
-- Change in Aggregate Supply
Changes in Aggregate Supply
Changes in Aggregate Supply Curve
AS3
AS1
Decrease in
Aggregate
Supply
Price Level
AS2
Increase in
Aggregate
Supply
Real Domestic Output, GDP


(a) shows decreases & increases in price level.
(b) shows decreases & increases in aggregate
supply.
C.
Equilibrium – intersection of the AS
& AD curves.
-- Equilibrium price level and equilibrium real output = intersection.
-- AS & AD jointly establish the price level and level of real GDP.
AD/AS Model
PL
AS (Factors of
Production)
shifting
Pe
AD (C + I + G + Xn)
shifts
0



Qe
Q
AS: Factors of Productions (land, labor, capital, & entrepreneurial); can
also include business tax & business regulation.
AD: Consumer expenditures, bus. investment, gov’t expend. & net exports.
The “I” in AD is business investment on demand side because the market
demands payment.
Equilibrium and Changes in
Equilibrium
Tabular View…
Real Output
Demanded
(Billions)
Price Level
(Index Number)
Real Output
Supplied
(Billions)
$506
108
$513
508
104
512
510
100
510
512
96
507
514
92
502
Equilibrium Price Level and
Equilibrium Price Level
Equilibrium and Changes in
Equilibrium
Price Level
AS
Equilibrium
100
92
a
b
AD
502
510 514
Real Domestic Output, GDP
(Billions of Dollars)
In the short-run
Prices 
Real GDP 
Qf
D.
Q1
Increases in AD: Demand-Pull
Inflation – price level is being pulled
up by increase in AD.
Equilibrium and Changes in
Equilibrium
Increase in Aggregate Demand
Price Level
AS
Demand-Pull
Inflation
P2
P1
AD1
AD
Qf
Q1 Q2
Real Domestic Output, GDP
P1
E.
Decrease in
AD: recession
& cyclical
unemployment.
a
b
Q1
Qf
-- AS = Factors of Productions (land, labor, capital, & entrepreneurial);
can also include business tax & business regulation.
-- AD = C + I + G + Xn.
-- A decrease in aggregate demand that causes a recession.
-- A negative GDP gap of Q1 minus Qf results.
Equilibrium and Changes in
Equilibrium
Decrease in Aggregate Demand
Price Level
AS
b
P1
a
c
P2
Creates a
Recession
AD1
AD2
Q1 Q 2 Qf
Real Domestic Output, GDP
“Cut in gov’t spending”
P2
Q2
-- AD = C + I + G + Xn
-- AS = Factors of Production
Q
Q
“During a Recession”
PL
LRAS
AS
Pe 
Qe 
Unem 
AD2
AD1
O
Q
Price
Level
AS2
AS1
P2
b
a
P1
Q1
Qf
Q
Real domestic output, GDP
F.Decrease in AS: Cost-push Inflation
-- A decrease in AS that causes cost-push inflation.
Cost-Push Inflation:
 Supply shock causes increase in price level,
 Govt has a policy dilemma, either higher price level or lower
economic output.
Equilibrium and Changes in
Equilibrium
Decrease in Aggregate Supply
Price Level
AS1
Cost-Push
Inflation
P2
P1
AS
b
a
AD
Q1 Qf
Real Domestic Output, GDP
Increase in productivity, but not in
wages (sticky wages?!?)
PL
AS1
Q
PL 
Unem 
AS2

AD
O
Q
“Decrease in Int’l value of Dollar”
PL
AS
PL1

PL2
PL 
QL 
Unem 

AD2
AD1
O
Q1 Q2
Q
Price Level
PL
P3
P2
P1
AS1
AS2
b
a
c
AD2
AD1
O
Q1 Q2 Q3
Q
Real domestic output, GDP
G.
Increase in AS: full employment w/
price-level stability.
-- Growth, full-employment, and relative price stability.
Equilibrium and Changes in
Equilibrium
Increases in Aggregate Supply –
Full-Employment With Price-Level Stability
Price Level
AS1
P3
P2
P1
AS2
b
c
a
AD2
AD1
Q1
Q2Q3
Real Domestic Output, GDP
What’s happening here?


A significant decline in aggregate demand that causes a
recession,
An excessive increase in aggregate demand can cause
demand-pull inflation.