Prepared by:
Fernando & Yvonn Quijano
© 2007 Worth Publishers Essentials of Economics Krugman • Wells • Olney
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In the late 1970s and early 1980s, energy price increases
arising from events in the Middle East led to recession
and inflation here at home.
What you will learn in
this chapter:
➤ How the aggregate supply curve
illustrates the relationship between the
aggregate price level and the quantity of
aggregate output supplied in the
economy
➤ Why the aggregate supply curve is
different in the short run compared to
the long run
➤ How the aggregate demand curve
illustrates the relationship between the
aggregate price level and the quantity of
aggregate output demanded in the
economy
➤ The importance of the multiplier, which
determines the total change in
aggregate output arising from a shift of
the aggregate demand curve
➤ How the AS–AD model is used to
analyze economic fluctuations
➤ How monetary policy and fiscal policy
can stabilize the economy
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Aggregate Supply
The aggregate supply curve shows
the relationship between the aggregate
price level and the quantity of aggregate
output supplied.
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Aggregate Supply
The Short-Run Aggregate Supply Curve
(16-1) Profit per unit output =
Price per unit output – Production cost per unit output
The nominal wage is the dollar amount
of the wage paid.
The short-run aggregate supply
curve shows the relationship between
the aggregate price level and the
quantity of aggregate output supplied
that exists in the short run, the time
period when many production costs can
be taken as fixed.
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Aggregate Supply
The Short-Run Aggregate Supply Curve
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Aggregate Supply
Shifts of the Short-Run Aggregate Supply Curve
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Aggregate Supply
Shifts of the Short-Run Aggregate Supply Curve
The following are important factors that
affect producers’ profit per unit and so can
lead to shifts of the short-run aggregate
supply curve:
Changes in Commodity Prices
Changes in Nominal Wages
Changes in Productivity
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Aggregate Supply
The Long-Run Aggregate Supply Curve
The long-run aggregate supply curve
shows the relationship between the
aggregate price level and the quantity of
aggregate output supplied that would
exist if all prices, including nominal
wages, were fully flexible.
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Aggregate Supply
The Long-Run Aggregate Supply Curve
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Aggregate Supply
The Long-Run Aggregate Supply Curve
Potential output is the level of real
GDP the economy would produce if all
prices, including nominal wages, were
fully flexible.
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Aggregate Supply
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Aggregate Supply
From the Short Run to the Long Run
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economics in action
Prices and Output During the Great Depression
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Aggregate Demand
The aggregate demand curve shows
the relationship between the aggregate
price level and the quantity of aggregate
output demanded by households,
businesses, the government, and the
rest of the world.
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Aggregate Demand
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Aggregate Demand
Why Is the Aggregate Demand Curve Downward
Sloping?
(16-2) GDP = C + I + G + X – IM
The Wealth Effect
The wealth effect of a change in the
aggregate price level is the effect on
consumer spending caused by the
effect of a change in the aggregate
price level on the purchasing power of
consumers’ assets.
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Aggregate Demand
Why Is the Aggregate Demand Curve Downward
Sloping?
The Interest Rate Effect
The interest rate is the price,
calculated as a percentage of the
amount borrowed, charged by the
lender to a borrower for the use of the
lender’s savings for one year.
The interest rate effect of a change in
the aggregate price level is the effect
on consumer spending and investment
spending caused by the effect of a
change in the aggregate price level on
the purchasing power of consumers’
and firms’ money holdings.
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Aggregate Demand
Shifts of the Aggregate Demand Curve
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Aggregate Demand
Shifts of the Aggregate Demand Curve
A number of factors can shift the aggregate
demand curve. Among the most important
factors are:
Changes in Expectations
Changes in Wealth
Changes in the Stock of Physical Capital
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Aggregate Demand
Government Policies and Aggregate Demand
One of the key insights of macroeconomics
is that the government can have a powerful
influence on aggregate demand and that, in
some circumstances, this influence can be
used to improve economic performance.
The two main ways the government can
influence the aggregate demand curve are
through:
Fiscal Policy
Monetary Policy
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The Multiplier
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The Multiplier
The marginal propensity to consume,
or MPC, is the increase in consumer
spending when disposable income rises
by $1.
(16-3)
MPC 
 Consumer spending
 Disposable income
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The Multiplier
The marginal propensity to save, or
MPS, is the increase in household
savings when disposable income rises
by $1.
(16-4)
Total increase in real GDP from $50 billion rise in I
= $50 billion ×
1
1  MPC
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The Multiplier
TABLE 16-1
Rounds of Increases of Real GDP
Increase in
real GDP
(billions of dollars)
First round
Total increase in
real GDP
(billions of dollars)
$50
$50
Second round
30
80
Third round
18
98
Fourth round
10.8
…
…
…
0
125
Final round
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The Multiplier
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The Multiplier
An autonomous change in aggregate
spending is an initial change in the desired
level of spending by firms, households, and
government at a given level of real GDP.
The multiplier is the ratio of the total
change in real GDP caused by an
autonomous change in aggregate
spending to the size of that autonomous
change.
(16-5) Multiplier 
(16-6) Y 
1
Y

1 - MPC
AAS
1
 AAS
1 - MPC
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The AS–AD Model
In the AS–AD model, the aggregate supply
curve and the aggregate demand curve are
used together to analyze economic
fluctuations.
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The AS–AD Model
Short-Run Macroeconomic Equilibrium
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The AS–AD Model
Short-Run Macroeconomic Equilibrium
The economy is in short-run
macroeconomic equilibrium when the
quantity of aggregate output supplied is
equal to the quantity demanded.
The short-run equilibrium aggregate
price level is the aggregate price level in
the short-run macroeconomic equilibrium.
Short-run equilibrium aggregate output
is the quantity of aggregate output
produced in the short-run macroeconomic
equilibrium.
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The AS–AD Model
Shifts of the SRAS Curve
An event that shifts the short-run aggregate
supply curve is a supply shock.
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The AS–AD Model
Shifts of the SRAS Curve
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The AS–AD Model
Shifts of the SRAS Curve
Stagflation is the combination of inflation
and falling aggregate output.
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The AS–AD Model
Shifts of Aggregate Demand: Short-Run Effects
An event that shifts the aggregate demand
curve is a demand shock.
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The AS–AD Model
Shifts of Aggregate Demand: Short-Run Effects
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The AS–AD Model
Long-Run Macroeconomic Equilibrium
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The AS–AD Model
Long-Run Macroeconomic Equilibrium
The economy is in long-run
macroeconomic equilibrium when the
point of short-run macroeconomic
equilibrium is on the long-run aggregate
supply curve.
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The AS–AD Model
Long-Run Macroeconomic Equilibrium
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The AS–AD Model
Long-Run Macroeconomic Equilibrium
There is a recessionary gap when
aggregate output is below potential output.
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The AS–AD Model
Long-Run Macroeconomic Equilibrium
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The AS–AD Model
Long-Run Macroeconomic Equilibrium
There is an inflationary gap when
aggregate output is above potential output.
In the long run the economy is selfcorrecting: shocks to aggregate demand
affect aggregate output in the short run but
not the long run.
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economics in action
Supply Shocks versus Demand Shocks in Practice
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Macroeconomic Policy
Policy in the Face of Demand Shocks
Some policy measures to increase aggregate demand,
especially those that increase budget deficits, may have
long-term costs in terms of lower long-run growth.
Furthermore, in the real world policy makers aren’t
perfectly informed, and the effects of their policies aren’t
perfectly predictable. This creates the danger that
stabilization policy will do more harm than good.
Despite these qualifications, most economists believe that
a good case can be made for using macroeconomic policy
to offset major negative shocks to the AD curve.
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Macroeconomic Policy
Responding to Supply Shocks
In contrast to the aggregate demand curve, there are no
easy policies that shift the short-run aggregate supply
curve.
Economically advanced nations suffering from the supply
shocks of the 1970s chose to stabilize prices.
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KEY TERMS
Aggregate supply curve
Nominal wage
Short-run aggregate supply curve
Long-run aggregate supply curve
Potential output
Aggregate demand curve
Wealth effect of a change in the
aggregate price level
Interest rate effect of a change in
the aggregate price level
Marginal propensity to consume
(MPC)
Marginal propensity to save (MPS)
Autonomous change in aggregate
spending
Multiplier
AS–AD model
Short-run macroeconomic equilibrium
Short-run equilibrium aggregate price
level
Short-run equilibrium aggregate
output
Supply shock
Stagflation
Demand shock
Long-run macroeconomic equilibrium
Recessionary gap
Inflationary gap
Self-correcting
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