Aggregate Demand (AD)
 Shows the amount of Real GDP that
the private, public and foreign sector
collectively desire to purchase at
each possible price level
 The relationship between the price
level and the level of Real GDP is
inverse
Three Reasons AD is downward
sloping -- 1
Aggregate Spending
Constraint
There is a fixed amount of
money in the market.
This is the key to understanding
why although both D and AD
slope downward, they do so
for very different reasons!
Three Reasons AD is downward
sloping -- 2
Real-Balances Effect
When the price-level is high
households and businesses
cannot afford to purchase
as much output.
When the price-level is low
households and businesses
can afford to purchase more
output.
Three Reasons AD is downward
sloping -- 3
Interest-Rate Effect
A higher price-level
increases the interest rate
which tends to discourage
investment
A lower price-level
decreases the interest rate
which tends to encourage
investment
Three Reasons AD is downward
sloping -- 4
Foreign Purchases Effect
A higher price-level
increases the demand for
relatively cheaper imports
A lower price-level
increases the foreign
demand for relatively
cheaper U.S. exports
Long-Run v. Short-Run
 Long-Run
 Period of time where
input prices are
completely flexible
and adjust to
changes in the pricelevel
 In the long-run, the
level of Real GDP
supplied is
independent of the
price-level
 Short-Run
 Period of time where
input prices are sticky
and do not adjust to
changes in the pricelevel
 In the short-run, the
level of Real GDP
supplied is directly
related to the price
level
Long-Run Aggregate Supply
(LRAS)
The Long-Run Aggregate Supply or LRAS
marks the level of full employment in the
economy (analogous to PPC)
Because input prices are completely
flexible in the long-run, changes in
price-level do not change firms’ real
profits and therefore do not change
firms’ level of output. This means that
the LRAS is vertical at the economy’s
level of full employment
Short-Run Aggregate Supply
(SRAS)
Because input prices are sticky in
the short-run, the SRAS is upward
sloping. This reflects the fact that in
the short-run, increases in the
price-level increase firm’s profits
and create incentives to increase
output. As the price-level falls,
firm’s profits drop and this creates
an incentive to reduce output.
The AS/AD Model
The equilibrium of AS
& AD determines
current output (GDPR)
and the price level
(PL)
Full Employment
Full Employment
equilibrium exists where
AD intersects SRAS &
LRAS at the same point.
Recessionary Gap
A recessionary gap exists when
equilibrium occurs below full
employment output.
An inflationary gap
exists when equilibrium
occurs beyond full
employment output.