Chapter 13:
Aggregate Demand and
Aggregate Supply
The Aggregate-DemandAggregate-Supply Model

The aggregate-demand-aggregate-supply
model (AD-AS model) is a graphical model
that allows us to analyze changes in real
GDP and the price level simultaneously.

The AD-AS model provides insights on
inflation, unemployment, economic growth,
and recession.
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Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Aggregate Demand

Aggregate demand is a schedule or curve
that shows the total quantity of goods and
services demanded at difference price
levels.

There is an inverse relationship between the
price level (as measured by the GDP price
index) and real output demanded (real GDP).
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Aggregate Demand
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Changes in Aggregate Demand

Other things equal, a change in the price
level will cause a movement along a fixed
aggregate demand curve.

As the price level rises, the amount of real
output purchased falls, and vice versa.
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Changes in Aggregate Demand

The determinants of aggregate demand
will cause the entire aggregate demand
curve to shift.

These include changes in consumer spending,
investment spending, government spending,
and net export spending.
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How AD Shifters Affect the
Aggregate Demand Curve
Determinant:
Factor(s) of Determinant:
Consumer
Consumer
Spending
Investment
Spending
Government
Spending
Net export
Spending
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wealth increases
Consumers’ real incomes rise
Household indebtedness rises
Tax increases
AD shifts:
RIGHT
LEFT
Increases
in real interest rate
Higher expected returns
LEFT
RIGHT
Increase
RIGHT
Rising
in government spending
national income abroad
Depreciation of the dollar
RIGHT
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Aggregate Supply

Aggregate supply is a schedule or curve
that shows the total quantity of goods and
services supplied at difference price
levels.

The aggregate supply curve in the short run
and in the long run vary by degree of wage
adjustment; in the long run, the AS curve is
vertical while in the short run, the AS curve is
positively sloped.
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Aggregate Supply
in the Long Run

In the long run, aggregate supply is
vertical at the economy’s full-employment
output.



Changes in wages and other input prices
respond completely to changes in the price
level.
Price-level changes do not affect firms’ profits,
and thus they create no incentive for firms to
alter their output.
This is the long-run aggregate supply curve.
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Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Aggregate Supply
in the Long Run
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Aggregate Supply
in the Short Run

In the short run, nominal wages and input
prices adjust slowly to changes in the price
level.


A rise in the price level increases real output;
a fall in the price level reduces real output.
The short-run aggregate supply curve is an
aggregate supply curve relevant to a time
period in which wages and other input prices
do not change in response to changes in the
price level.
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Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Aggregate Supply
in the Short Run
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Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Changes in Aggregate Supply

Other things equal, a change in the price
level will cause a movement along a fixed
aggregate supply curve.
McGraw-Hill/Irwin
Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Changes in Aggregate Supply

The determinants of aggregate supply will
cause the entire aggregate supply curve to
shift.


These include changes input prices, changes
in productivity, and changes in legalinstitutional environment.
Changes in the determinants raise or
lower per-unit production costs at each
price level (or each level of output).
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How AS Shifters Affect the
Aggregate Supply Curve
Determinant:
Factor(s) of Determinant:
Input Prices
Domestic
Productivity
Increases
LegalInstitutional
Environment
McGraw-Hill/Irwin
resource prices rise
Prices of imported resources rise
Increased market power
Higher
More
in productivity
business taxes
government regulation
AS shifts:
LEFT
RIGHT
LEFT
Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Equilibrium Price Level
and Real GDP

Equilibrium occurs at the price level that
equalizes the amount of real output
demanded and supplied.

This occurs at the intersection of the
aggregate demand curve and aggregate
supply curve which establish the equilibrium
price level and equilibrium real output
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Equilibrium Price Level
and Real GDP
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Changes in the Price Level
and Real GDP

From period to period, aggregate demand
and aggregate supply typical change.

For example: if investment and government
spending rises in an economy operating at its
full-employment, aggregate demand will shift
to the right, causing the price level and real
output to rise (inflation and a positive output
gap)  this is demand-pull inflation.
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Changes in the Price Level
and Real GDP
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Downward Price-Level
Inflexibility


The price level in the U.S. economy is
readily flexible upward. However, the
price level is “sticky” on the downside.
Several possible reasons for downward
price-level inflexibility include:





Fear of price wars
Menu costs
Wage concerns
Morale, effort, and productivity
Minimum wage
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An Important Caution

This is some evidence that the price level
and average level of wages are becoming
more flexible downward in the U.S..

Intense international competition and declining
union power seem to be undermining the ability
of firms and workers to resist price and wage
cuts when faced with falling aggregate demand.
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Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved.
An Important Caution


In theory, full flexible downward prices and
wages would automatically “self-correct” a
recession.
In reality, the government, rather than wait
for these slow and uncertain “corrections”,
focus on trying to move the aggregate
demand curve to its pre-recession location.
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Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved.