Chapter 33 – Aggregate Demand and Aggregate Supply
Business Cycles
•
Business Cycles have consistent indicators, but are unpredictable in
nature
•
Expansionary periods
• Business is good, large amounts of customers, profits grow
•
Contractionary periods
• Business is bad, GDP falls, declining sales, dwindling profits
GDP
Three Key Facts About Economic Fluctuations
Real GDP
• Real GDP is the most commonly used economic indicator to
measure short-run changes in the economy
•Fall in real GDP, fall in personal income, corporate profits,
consumer spending, investment spending, retail sales, home
sales, auto sales, etc.
Three Key Facts About Economic Fluctuations
GDP and Unemployment
•Real GDP declines, unemployment rises
•Contraction/Recession begins, unemployment rises
•Recession ends, recovery/expansion, unemployment rates fall
GDP
Explaining Short-Run Economic Fluctuations

Monetary Neutrality does not apply in the short run
(6 months, 1 year)
◦ Real and nominal variables are highly intertwined in the short run
◦ Changes in the money supply can temporarily push real GDP
away from its long-run trend
 “Economic Stimulus Package”
Who Can Prevent A Recession From Becoming A Depression?
Monetary Policy
of the Fed
Fiscal Policy of the
Federal
Government
Model of aggregate demand & aggregate supply



Model used to explain short-run fluctuations in economic activity
around its long-run trend
Aggregate – a sum, gross amount, of all supply and demand in an
economy
Two axes:
 Economy’s output of goods and services (Real GDP)
 Average level of prices (CPI or GDP Deflator)
Price
Level
Aggregate supply (AS)
Equilibrium
price level (PL)
Aggregate demand (AD)
Equilibrium
Output (Y)
Real GDP
7
Aggregate Demand

Aggregate demand curve
◦ Sum of C+I+G+NX (real GDP) at each price level
◦ Downward sloping
◦ Low price levels increase the quantity of goods and services demanded, vice versa
Price
Level
P
P2
1. A decrease
in the price
level . . .
0
Aggregate
demand
Y
Y2
2. . . . increases the quantity of
goods and services demanded.
Quantity of
Output
Why the AD Curve Might Shift?

C - Shifts arising from changes in consumption
◦ Increases in spending – people have more disposable income
◦ Decreases in spending – people become more concerned with saving for
retirement

I - Shifts arising from changes in investment
◦ Change in firm investing – tax policy, pessimism about the economy in
future, high interest rates

G - Shifts arising from changes in government purchases
◦ Congress increases/decreases spending

NX - Shift arising from changes in net exports
◦ Global recessions would cause a decrease in demand for U.S. products
What Shifts the Aggregate Demand Curve?
Price
Level
A
B
C
Quantity of Output
Situation
Change in AD
New AD Curve
Congress cuts taxes
C
Business spending decreases
A
Government spending increases; no new taxes
C
Survey shows consumer confidence jumps
C
Stock collapses; investors lose billions
A
President cuts defense spending by 20%; no increase
in domestic spending
A
The Aggregate Supply Curve




AS curve – total quantity of goods and services firms can produce and
sell at any given price level
Shape of AS curve depends on time horizon (short/long run)
Short run - Aggregate-supply curve is upward sloping
What shifts the curve?
http://www.usatoday.com/story/news/nation/2013/10/19/us-oilimports-opec-embargo/2997499/
◦ Temporary changes in Land, Labor, Capital
◦ 1973 Supply Shock
11
What Shifts the Aggregate Supply Curve?
Price
Level
A
B
C
Quantity of
Output
Situation
Unions grow more aggressive; wage rates increase
OPEC successfully increases oil prices
Labor productivity increases dramatically
Giant natural gas discovery decreases energy prices
Computer technology brings new efficiency
Research shows that improved schools have
increased the skills of American workers
Change in AS
New AS Curve
A
A
C
C
C
C
Aggregate Demand
Consumer Spending
Government Spending Investment Spending
Foreign Spending (x-m)
Corn Field
Pizza Joint
Aggregate Supply
Factory
Apple Store
Aggregate Demand or Supply?
Scenario
1. A factory
2. A printing press
3. A woman buys a hamburger for her child
AD or AS
AS
AS
4. A U.S. company sells a jet to a foreign country
AD
AD
5. A company builds a new factory
AD
6. Trees
AS
7. A corn field
AS
8. A coal mine
AS
9. Students purchase tickets for a football game
AD
AD
10. Two newlyweds buy a house
AD AS Scenarios
1.
A significant increase in world oil prices
2.
Government announces a large increase in spending on health and education
3.
Average wage rises way above inflation for the third month running
4.
Exchange rate appreciation knocks export hopes for manufacturing
5.
US productivity levels at their highest level for 10 years
6.
A booming stock market leads to highest rate of retail sales in a century
Price
Level
AS1
AS
Ple1
Ple
AD
Y1
Y
Real GDP
16
AD AS Scenarios
1.
A significant increase in world oil prices
2.
Government announces a large increase in spending on health and education
3.
Average wage rises way above inflation for the third month running
4.
Exchange rate appreciation knocks export hopes for manufacturing
5.
US productivity levels at their highest level for 10 years
6.
A booming stock market leads to highest rate of retail sales in a century
Price
Level
AS
Ple1
Ple
AD
Y
Y1
AD1
Real GDP
17
AD AS Scenarios
1.
A significant increase in world oil prices
2.
Government announces a large increase in spending on health and education
3.
Average wage rises way above inflation for the third month running
4.
Exchange rate appreciation knocks export hopes for manufacturing
5.
US productivity levels at their highest level for 10 years
6.
A booming stock market leads to highest rate of retail sales in a century
Price
Level
AS1
AS
Ple1
Ple
AD
Y1
Y
Real GDP
18
AD AS Scenarios
1.
A significant increase in world oil prices
2.
Government announces a large increase in spending on health and education
3.
Average wage rises way above inflation for the third month running
4.
Exchange rate appreciation knocks export hopes for manufacturing
5.
US productivity levels at their highest level for 10 years
6.
A booming stock market leads to highest rate of retail sales in a century
Price
Level
AS
Pe
Pe1
AD
Y1
Y
AD1
Real GDP
19
AD AS Scenarios
1.
A significant increase in world oil prices
2.
Government announces a large increase in spending on health and education
3.
Average wage rises way above inflation for the third month running
4.
Exchange rate appreciation knocks export hopes for manufacturing
5.
US productivity levels at their highest level for 10 years
6.
A booming stock market leads to highest rate of retail sales in a century
Price
Level
AS
AS1
Ple
Ple1
AD
Y
Y1
Real GDP
20
AD AS Scenarios
1.
A significant increase in world oil prices
2.
Government announces a large increase in spending on health and education
3.
Average wage rises way above inflation for the third month running
4.
Exchange rate appreciation knocks export hopes for manufacturing
5.
US productivity levels at their highest level for 10 years
6.
A booming stock market leads to highest rate of retail sales in a century
Price
Level
AS
Ple1
Ple
AD
Y
Y1
AD1
Real GDP
21
Videos
2010 AP® MACROECONOMICS FREE-RESPONSE
3. How does each of the following changes affect the real
gross domestic product and price level of an open
economy in the short run? Graph and explain each.
(a) An increase in the price of crude oil, an important
natural resource
(b) A technological change that increases the productivity
of labor
(c) An increase in spending by consumers
(d) A decrease in government spending to offset a deficit
• a) GDP will fall and the price level will rise, because the
increase in the price of oil raises input costs and causes the
short-run aggregate supply curve to shift to the left.
Price
Level
AS1
AS
Ple1
Ple
AD
Y1
Y
Real GDP
24
• b) Real GDP will rise and the price level will fall,
because the increase in labor productivity reduces unit
input costs and causes the short-run aggregate supply
curve to shift to the right.
Price
Level
AS
AS1
Ple
Ple1
AD
Y
Y1
Real GDP
25
• (c) Real GDP will rise and the price level will rise,
because the increase in spending causes the aggregate
demand curve to shift to the right.
Price
Level
AS
Ple1
Ple
AD1
AD
Y
Y1
Real GDP
26
• (d) Real GDP will fall and the price level will fall,
because the decrease in spending causes the
aggregate demand curve to shift to the left.
Price
Level
AS
Pe
Pe1
AD
Y1
Y
AD1
Real GDP
27
The Aggregate Supply Curve
In the Long-Run (LRAS) the supply is vertical
◦ Conceptually, the same as the Production Possibilities Curve
◦ An economy’s production of goods and services (real GDP) is based on
the factors of production not on price levels
 Land, Labor, Capital determine what is possible to produce
◦ LRAS – shows potential output/full employment/natural rate of output
◦ Shows what the economy produces when unemployment is at its
natural/normal rate (5-6%)
Price
Level
Long-run
Aggregate
Supply
(LRAS)
Capital Goods

Natural rate
Quantity of Output
of output (GDP) (GDP)
Full Employment 5-6%
Consumer Goods
Why the LRAS Curve Might Shift

Permanent changes in the following:

Changes in Labor
◦ Immigration increase quantity of labor, shift
right
◦ Emigration, workers leave for jobs abroad,
shift left

Changes in Capital
◦ Increase capital stock (machinery, factories,
operating equipment), shift right
◦ Decrease productivity (generational trend to
bypass college education), shift left

Changes in Natural Resources
◦ Discovery of oil, shift to right
◦ Cold weather destroys crops, shift to left

Changes in Technological Knowledge
◦ Innovations (computer, internet, handheld
devices), shift right
◦ Government policies (environmental concerns,
patents, workers safety), shift to left
Why The Short Run Aggregate-Supply Curve Slopes Upward

Key difference in the economy in the short and long run is behavior of AS
◦ Long run, price level does not affect economic output
◦ Short run, price level does affect economic output
 Period of a year or two, an increase in price levels raises output
 Price levels increase, suppliers want to supply more, vice versa
Price
Level
Short-run
aggregate
supply
P1
1. A decrease
in the price
P2
level . . .
Y2
Y1
Quantity of Output
2. . . . reduces the quantity of goods and
30 short run
services supplied in the
Why The Short Run Aggregate-Supply Curve Slopes Upward

Key difference in the economy in the short and long run is behavior of AS
◦ Long run, price level does not affect economic output
◦ Short run, price level does affect economic output
 Period of a year or two, an increase in price levels raises output
 Price levels increase, suppliers want to supply more, vice versa
Price
Level
Short-run
aggregate
supply
P1
1. An increase
in the price
P2
level . . .
Y2
Y1
Quantity of Output
2. . . . increases the quantity of goods
31 in the short run
and services supplied
Why the AS curve slopes upward in short-run

Sticky-wage theory - nominal wages are slow to adjust to
changing economic conditions
 Wages are “sticky” in short run
 Can affect long-term contracts: workers and firms (up to
3 years)
 Nominal wages are based on expected prices
 Don’t respond immediately when actual price level is
different from what was expected, causing input costs for
the firm to increase
32
Why the AS curve slopes upward in short-run

Sticky-price theory - prices of some goods &
services slow to adjust to changing economic
conditions
 Menu costs, firms’ costs of adjusting prices
33
Why the AS curve slopes upward in short-run

Misperceptions theory - changes in the overall price
level can temporarily mislead suppliers about changes in
individual markets
 Suppliers respond to changes in level of prices
change quantity supplied of goods and services
34
The Long-Run Equilibrium
Long-run
aggregate
Supply
(LRAS)
Price
Level
Equilibrium
Price (Ple)
Short-run
aggregate
Supply
(SRAS)
A
Aggregate
Demand (AD)
Natural rate
of output (Qfe, Y)
5-6% Unemployment
•
Quantity of Output
Long-Run-Equilibrium
• AD intersects with SRAS and LRAS(point A).
• Expected price level has adjusted to equal the actual price level.
• Full Employment (natural rate of output), wage Equilibrium
The Economy Compared to a Car

The economy is like a car…

You can drive 120mph but is not sustainable
◦ Extremely low unemployment, 2%

Driving 20mph is too slow; the car can go faster
◦ High unemployment, 10%

Some cars have the capacity to drive faster than
others
◦ Industrial nations vs. 3rd world nations

If the engine (technology) or gas mileage
(productivity) increase then the car can move at
even higher speeds
◦ Increase in LRAS/PPC

The government/Fed’s job is to brake or speed
up when needed; promote things that will
improve the engine
◦ Shift the LRAS/PPC left/outward
Recessionary and Inflationary Gaps
Price
Level
Price
Level
LRAS
LRAS
SRAS
SRAS
AD
Q1
(7.9%)
•
Qfe
(5-6%)
Recessionary Gap
•
•
•
•
Underperforming economy
(contraction/recession)
Not at full employment
Unused resources
Falling Prices
Quantity
of Output
(GDP)
AD
•
Qfe
Q1
(5-6%)
(2%)
Inflationary Gap
•
•
•
Overperforming economy
(expansion)
Above full employment
Quickly Rising Prices
Quantity
of Output
(GDP)
Four Step Process For Modeling AS&AD




First, determine whether the event affects AD or AS
Second, determine which way the curve shifts
Third, use AD & AS to compare initial & new
equilibrium
Fourth, examine the transition between SRAS and LRAS
The Aggregate Demand and Aggregate Supply
Model at Long-Run Equilibrium
Effects of a Shift in AD

Scenario: The economy is experiencing a recession
*Assume long-run equilibrium*
◦ Step 1 – AD or AS affected? AD
◦ Step 2 – Which direction will the curve shift? Left
◦ Step 3 – Plot the new EP (B)
◦ Step 4 – Examine transition between SRAS and LRAS (C)
Price
Level
LRAS
3. . . . Over time, nominal wages
come down, price levels
decrease(cost of doing business),
and the short-run aggregate-supply
curve shifts, bringing us back to
long-run equilibrium. . .
SRAS1
SRAS2
Ple1
A
B
Ple2
C
4. . . . and output returns
to its natural rate.
Ple3
1. A decrease in
aggregate demand . . .
AD2
Y2
Y1
AD1
Quantity of Output
2. . . . causes output to fall in the short run, companies lay off workers,
unemployment will rise, cut back on production. . .
Effects of a Shift in Demand

Scenario: The economy experiences a boom in the stock market, people have more
disposable income to spend
*Assume long-run equilibrium*
◦ Step 1 – AD or AS affected? AD
◦ Step 2 – Which direction will the curve shift? Right
◦ Step 3 – Plot the new EP (B)
◦ Step 4 – Examine transition between SRAS and LRAS (C)
Price
Level
LRAS
SRAS2
SRAS1
Ple3
C
B
Ple2
A
Ple1
AD1
Y1
Y2
AD2
Quantity of Output
Important points about AD
Short run, shifts in AD cause fluctuations in short run output (real
GDP)
 Long run, shifts in AD affect overall price level, but output returns
to long run equilibrium
 Policymakers can affect AD/AS and reduce the short-run impact of
economic fluctuations

Effects of a Shift in AS

Scenario: A hurricane hits and reduces the availability of refineries to produce oil
*Assume long-run equilibrium*
◦ Step 1 – AD or AS affected? AS
◦ Step 2 – Which direction will the curve shift? Left
◦ Step 3 – Plot the new EP (B)
◦ Step 4 – Examine transition between SRAS and LRAS (C)
Price
Level
LRAS
SRAS2
1. An adverse shift in the short-run
AS curve. . .
SRAS1
Ple3
3. . . . and the Ple
2
price level
Ple1
to rise
(stagflation). . .
B
C
A
Policymakers affect AD
through monetary/fiscal policy. . .
AD2
AD1
Y2 Y1
2. . . . causes output to fall. . .
Quantity of Output
4. . . . but keeps output at its natural rate.
Important points about AS
Short run, shifts in AS can cause stagflation
 Long run, shifts in AS affect overall price level, but not
output
 Policymakers can reduce the impact of economic
fluctuations, but risk increasing price levels

Binder Check Chapter 33
An Introduction to Aggregate Supply and Demand
2. Short Run AD and AS
3. Youtube video - (Macro) Episode 24: AD & AS
4. Youtube video - (Macro) Episode 25: Macroeconomic
Viewpoints
5. Youtube video - (Macro) Episode 26: Macroeconomic
Viewpoints
6. Chapter 33 Mankiw Practice
7. Free Response
8. Daily Tens
9. Notes Chapter 33
10. Terms
1.
Extra Credit
1.
2.
3.
4.
How are the LRAS model and the PPC model similar?
Draw a properly labeled graph of each of the above models to show
an underperforming (below full employment) economy.
Identify each of the following as being either AS or AD.
a. Oil refineries
b. China imports US soybeans
c. A baseball stadium
d. A customer buys a hotdog at a baseball game
Each of the following are current event headlines in the news today.
List which of the following will most likely to be affected, AD, SRAS, or
LRAS.
a.
b.
US drought affects wheat and soybean yields
Despite No Fed Action, Interest Rates For Mortgages Drop To
Record Lows
c. Stock Market Hit Hard By Lack Of QE3 (quantitative easing 3)