Chapter 10
Aggregate
Demand and
Aggregate Supply:
The Basic Model
The Basics of Aggregate Demand
• Aggregate demand refers the real value
of all new, final, domestically produced
goods and services that households,
firms, governments, and the foreign
sector are willing and able to purchase at
a given set of price levels, ceteris paribus.
The Basics of Aggregate Demand (cont’d)
• AD equals:

Consumption Spending by Households, plus

Investment Expenditures by Firms, plus

Government Expenditures, plus

Net Exports
• AD  C  I  G  (X  M )
The Price Level and Aggregate Demand
• The overall price level is the major determinant
of total spending in the economy.
• Aggregate demand curve shows relationship
between the price level and total spending

What is the relationship??
Figure 10.1
The Aggregate Demand Curve
Why the Aggregate Demand Curve
Slopes Downward
• There are three basic reasons:

The Wealth Effect
• As prices decrease you feel wealthier because you can buy
more

The Interest Rate Effect
• As prices fall don’t have to spend as much  save more
interest rates fall encourage borrowing changes AD

The International Trade Effect
• As prices fall buy more US good imports fall  other
countries see that our goods are cheaper exports
increase
Basic Movements in Aggregate Demand
• Change in aggregate quantity demanded

Caused by a change in the overall price level.

Shown by a movement along the aggregate demand
curve
Basic Movements in
Aggregate Demand (cont’d)
• A change in aggregate demand is caused by
changes in forces other than the price level:

Macroeconomic policy influences
• Changing interest rates, changing taxes, changes in
government spending

Expectations
• Consumer confidence

Global influences
• Purchasing power of the dollar
• Represented by a shift of the aggregate
demand curve
Table 10.1 Key Influences on Changes in
Aggregate Demand
Figure 10.2
Change in Aggregate Demand
Can we do it??
• Let’s try number 2…
• How will the following actions of
macroeconomic policy affect the US aggregate
demand curve?

Social Security taxes are increased to extend the life
of the Social Security system
• AD shift to the left

The federal government expends its spending on
prescription drug benefits under Medicare
• AD shift to the right

Consumers expect more disposal income in the
future as temporary tax cuts are made permanent
• AD shift to the right
The Basics of Aggregate Supply
• Aggregate supply is the real value of all final,
domestically produced goods and services that
firms are willing to offer for sale at various price
levels, ceteris paribus.
• There are two different aggregate
supply curves:

The Short-Run AS Curve

The Long-Run AS Curve
Aggregate Supply in the Short Run
• The short run is a period of time that is too
short for firms to adjust fully to changes in the
price level.

Workers face sticky wages.
• Can’t change nominal wages easily when prices change

Firms face sticky prices.
• Can’t always increase the price of your product

Firms and workers may have mistaken estimates of
nominal prices.
• May not have all the information right  OOPS
The Price Level and
Short-Run Aggregate Supply
• In the short run, a higher price level will cause
firms to produce more goods and services.

The short-run aggregate supply curve is
upward-sloping.
Why the Short-Run Aggregate Supply
Curve Slopes Upward
• A higher price level provides an incentive for
firms to increase output.

Based on the process of profit maximization
Profit per Unit Product
Production Cost


of Output
Price
per Unit of Output

Note: If price rises faster than costs,
profitability increases.
Why the Short-Run Aggregate Supply
Curve Slopes Upward (cont’d)
• Resource prices (such as nominal wages)
are sticky.

They change more slowly than output prices.
• As price levels rise faster than production
costs, profit per unit increases, and firms
have an incentive to increase output.
Basic Movements in Short-Run
Aggregate Supply (cont’d)
• A change in the price level is represented by a
movement along a short-run aggregate supply
curve.

This is called a change in aggregate quantity
supplied.
Figure 10.3
The Short-Run Aggregate Supply Curve
Changes in Short-Run Aggregate Supply
• Changes in other factors other than price can
affect profitability at a given price level:

Nominal resource prices, especially nominal wages
• Wages account for 2/3 of total production costs

Productivity
• Workers become more efficient and produce more

Producers’ expectations
• What do firms think will happen in the future?

These changes will shift the entire aggregate supply
curve.
Figure 10.4
Change in Short-Run Aggregate Supply
Can we do it??
• Let’s try number 6…
• For a given industry, let the product price per unit = $5 and the
production cost per unit = $3

Based on this information, what is the profit per unit for this producer?
• $2 * number of units sold

Now let the product price increase to $6 per unit, and the production
cost per unit increase to $3.50 per unit. What is the profit per unit now
for this producer?
• $2.50 * number of units sold

How should this producer change his production plans in the face of
the changing profit per unit?
• Should increase production

If many producers faced the same situation, how would this affect the
AS curve?
• Because it is a PRICE change AS will not shift  change in Aggregate
Quantity Supplied