Aggregate demand and Aggregate
Supply (AD and AS)






notice the data: while potential GDP tends to move upward yr
after yr, due to economic growth, actual GDP tends to rise
above and fall below potential over shorter periods
Date reveals an important fact: Deviations from potential
output don’t last forever
In some of these episodes, government policy-either fiscal or
monetary-helped the economy to return to full employment
more quickly
But even without corrective policies-such as during long parts
of Great Ds of the 1930s-the economy shows a remarkable
tendency to begin moving back towards potential output
What is the mechanism behind?
We will study the behavior of a new variable that we have put
aside for several chapters: the price level
1
Actual and Potential Real GDP
(Billions of 1996 Dollars)
Figure 1a: Potential and Actual
Real GDP, 1960-2001
9,000
8,000
The orange line shows fullemployment or potential output.
7,000
6,000
5,000
4,000
3,000
The green line shows
actual output.
During recessions,
output declines.
During expansions, output
rises—sometimes rapidly.
2,000
2
Figure 1: The Two-Way Relationship
Between Output and the Price Level
Aggregate Demand Curve
Price
Level
Real
GDP
Aggregate Supply
Curve
3
AD and AS
 There exist a two-way relationship
between price level and output (see
diagram 1)
 Changes in price level cause changes
in real GDP – illustrated by Aggregate
Demand curve
 Changes in real GDP cause changes in
price level – illustrated by Aggregate
Supply curve
4
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 (because purchases become more expensive)
 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 5
GDP
Figure 2a: Deriving the Aggregate
Demand Curve
(a)
Interest Rate
9%
6%
Ms
H
As the price level rises, money
demand increases and interest
rate rises.
E
M1d
500
M2d
Money ($ Billions)
6
Figure 2b/c: Deriving the
Aggregate Demand Curve
(c)
Aggregate Expenditure
($ Trillions)
(b)
Price
Level
E
The rise in the
interest rate
causes real
GDP to fall.
H
6
AEr = 6%
AEr = 9%
10
Real GDP
($ Trillions)
140
H
100
On the AD curve,
a higher price
level is associated
with a lower real
GDP.
E
AD
6
10 Real GDP
($ Trillions)
7
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
8
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
9
name
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
10
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
Autonomous consumption spending
Investment spending
Net exports
Taxes
Money supply
11
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 $2 trillion
and ask what happens if price level remains at 100
 An increase in government purchases shifts entire AD
curve rightward
 AD curve shifts rightward when government
purchases, investment spending, autonomous
consumption spending, or net exports increase, or
when taxes decrease
 Analysis also applies in the other direction
 AD curve shifts leftward when government
purchases, investment spending, autonomous
consumption spending, or net exports decrease, or
when taxes increase
12
Figure 3: A Spending Shock Shifts
the AD Curve
Real Aggregate Expenditure
($ Trillions)
(a)
(b)
At any given price level, an
increase in government
purchases shifts the AE line
upward, raising real GDP.
H
Since real GDP is
higher at the given
price level, the AD
curve shifts rightward.
Price
Level
AE2
AE1
100
E
H
E
10 13.5
AD1 AD2
Real GDP
($ Trillions)
10 13.5
Real GDP
($ Trillions)
13
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
14
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
15
relationship between GDP and price level
Figure 4a: Effects of Key Changes
on the Aggregate Demand Curve
(a)
Price Level
Price level ↑ moves
us leftward along
the AD curve
P3
Price level ↓ moves
us rightward along
the AD curve
P1
P2
AD
Q3
Q1
Q2
Real GDP
16
Figure 4b: Effects of Key Changes
on the Aggregate Demand Curve
(b)
Price Level
Entire AD curve shifts rightward if:
• a, IP, G, or NX increases
• Net taxes decrease
• The money supply increases
AD2
AD1
Real GDP
17
Figure 4c: Effects of Key Changes
on the Aggregate Demand Curve
(c)
Price Level
decreases
Entire AD curve
shifts leftward if:
• a, IP, G, or NX decreases
• Net taxes increase
• The money supply decreases
AD1
AD2
Real GDP
18
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 – what interest us in macroeconomics
 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
19
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
20
GDP, Costs, and the Price Level
 Primary concern here: impact of real GDP on
unit costs and, therefore, on 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
21
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
22
stable wages
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
23
level
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-outputlevel” curve
24
Figure 5: The Aggregate Supply
Curve
Price Level
AS
130
B
100
80
Starting at point A, an
increase in output
raises unit costs.
Firms raise prices,
and the overall price
level rises.
A
C
Starting at point A, a decrease
in output lowers unit costs.
Firms cut prices, and the
overall price level falls.
6
10
13.5
Real GDP ($ Trillions)
25
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
26
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.
27
Figure 6: Shifts of the Aggregate
Supply Curve
AS2
Price Level
140
100
AS1
L
A
10
When unit costs rise at any
given real GDP, the AS curve
shifts upward–e.g., an increase
in world oil prices or bad
weather for farm production.
Real GDP ($ Trillions)
28
Figure 7a: Effects of Key Changes
on the Aggregate Supply Curve
(a)
Price Level
AS
Real GDP ↑ moves
us rightward along
the AS curve
P3
Real GDP ↓ moves
us leftward along
the AS curve
P1
P2
Q2
Q1
Q3
Real GDP
29
Figure 7b: Effects of Key Changes
on the Aggregate Supply Curve
(b)
Price Level
AS2
AS1
Entire AS curve shifts
upward if unit costs ↑ for
any reason besides an
increase in real GDP
Real GDP
30
Figure 7c: Effects of Key Changes
on the Aggregate Supply Curve
(c)
Price Level
AS1
AS2
Entire AS curve shifts
downward if unit costs ↓
for any reason besides
an decrease in real GDP
Real GDP
31
AD and AS Together: Short-Run
Equilibrium
 Where will the economy settle in shortrun?
 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
32
Figure 8: Short-Run
Macroeconomic Equilibrium
AS
Price Level
B
140
E
100
F
AD
6
10
14
Real GDP ($ Trillions)
33
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
34
An Increase in Government
Purchases
 Shifts AD curve rightward
 Can see how it affects economy in short-run:
increases output and rises interest rate in
the money market
 Process 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
35
Figure 9: The Effect of a Demand
Shock
AS
Price Level
130
115
100
H
J
E
AD1
10
13.5
12.5
AD2
Real GDP($ Trillions)
36
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
37
An Decrease in Government
Purchases
38
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
39
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
40
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
41
Demand Shocks: Adjusting to the
Long-Run
 In Figure 9, point H shows new equilibrium
after a positive demand shock in shortrun—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
42
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 full-employment output
43
Figure 10: The Long-Run
Adjustment Process
Price Level
AS2
AS1
P4
K
J
P3
P2
P1
H
E
AD2
AD1
YFE Y3 Y2
Real GDP
44
Demand Shocks: Adjusting to the
Long Run
 For a positive demand shock that shifts
AD curve rightward, self-correcting
mechanism works like this
45
Figure 11: Long-Run Adjustment
After A Negative Demand Shock
Price Level
AS1
AS2
P1
P2
E
N
P3
M
AD1
AD2
Y2
YFE
Real GDP
46