Ch. 10: Aggregate Supply and Demand
 Derive AS/AD model
 Understand cause & consequences of change in AS/AD
• Short run vs Long run
• Effects on economic growth, prices, unemployment.
 Different schools of thought in macroeconomics
Macroeconomic Long Run and Short Run
The Macroeconomic LR
 a time frame that is sufficiently long for the real wage rate
to have adjusted to achieve full employment:




Real GDP = potential GDP.
Unemployment=natural unemployment rate.
Price level determined by quantity of money (equation of exchange)
Inflation rate =money growth rate minus the real GDP growth rate.
The Macroeconomic SR
 a period during which some prices or wages are sticky so
 Real GDP might be below, above, or at potential GDP.
 The unemployment rate might be above, below, or at the natural
unemployment rate
Aggregate Supply
The quantity of real GDP supplied is the total quantity
that firms plan to produce during a given period. It depends
on
 The quantity of the labor employed
 The quantity of physical and human capital
 State of technology
Two time frames associated with different states of the
labor market:
 Long-run aggregate supply
 Short-run
aggregate supply
Aggregate Supply
Long-Run Aggregate Supply (LAS)
the relationship between the quantity of real GDP
supplied and the price level when real GDP equals
potential GDP.
Potential GDP is determined by
•Production function
•Labor market
•Independent of price level
LR aggregate supply curve (LAS) is vertical at potential
GDP.
Determinants of LAS
Real Wage
Labor market
Price Level
LAS
Labor hours
Real GDP
Production function
Real GDP
Labor hours
Determinants of LAS
Change in labor supply
• immigration
• taxes on employees
• transfers (UI, SS)
• population growth
• retirement
Change in labor demand
• worker productivity (also affects PF)
• taxes on employer payroll
 Shifts in Production Function
• capital/technology (also affects LD)
• human capital
Graphic analysis of changes in LAS
(Change in Labor Supply)
Effect on
•Real wage
•Employment
•productivity
Graphic analysis of changes in LAS
(increase in labor productivity)
Effect on
•Real wage
•Employment
•Productivity
Aggregate Supply
Short-Run Aggregate Supply (SAS)
Shows relationship between real GDP supplied and the
price level, ceteris paribus
A rise in the price level with no change in the money
wage rate and other factor prices increases the quantity of
real GDP supplied.
• as P rises, real wage declines, firms want to hire
more employees (movement along labor demand
curve)
The short-run aggregate supply curve (SAS) is upward
sloping.
Short Run Aggregate Supply
Labor market
SAS
Production function
As P rises, RW falls, L rises;
RGDP rises
Aggregate Supply
Along the SAS
curve, real GDP
supplied might be
above potential
GDP…
or below potential
GDP.
Aggregate Supply
An increase in
potential GDP shifts
the LAS curve and the
SAS curve shifts along
with the LAS curve.
Aggregate Supply
A rise in the money
wage rate
 Decreases short-run
aggregate supply and
shifts the SAS curve
leftward.
 Has no effect on longrun aggregate supply.
Aggregate Demand
AD is the total amount of final goods and services
produced in the United States that people, businesses,
governments, and foreigners plan to buy.
AD= C + I + G + (X – M.)
AD depends on
 The price level
 Expectations about future
 Changes in wealth
 Fiscal and monetary policy
 The world economy
Aggregate Demand
The Aggregate Demand
Curve
plots the quantity of real
GDP demanded against P.
slopes downward for 2
reasons:
 Wealth effect
 Substitution effects
Aggregate Demand
Wealth Effect
P increases
 real wealth decr  C decr  AD decr
Substitution Effects
•Intertemporal
P incr
 int rate incr  C & I decr  AD decr
• International
P incr
 imports incr, exports decr  AD decr
Shifts in Aggregate Demand
Expectations about future
• Increases in expected future income
 increases C today
 increases AD.
• Increase in expected future inflation
 buying goods cheaper today
 increases AD.
• Increase in expected future profits
investment increases
 increases AD
Shifts in Aggregate Demand
Fiscal Policy
setting and changing taxes, transfer payments, and
purchasing goods and services.
An income tax cut or increase in transfers
 increases disposable income (income-taxes+
transfers)
 increases C
 increases AD
An increase in government spending
 increases G
 increases AD
Shifts in Aggregate Demand
Monetary policy
changes in interest rates and the quantity of money in the
economy.
An increase in the money supply reduces interest rates
and increases aggregate demand.
Shifts in Aggregate Demand
Summary:
Fiscal policy
Monetary policy
Value of $
Foreign income
Macroeconomic Equilibrium
SR Equilibrium:
SAS=AD
GDP can be above, below, or at potential GDP
LR equilibrium
LAS=SAS=AD
Macroeconomic Equilibrium
Graphical illustration of SR equilibria with
1. GDP>potential GDP (inflationary gap)
2. GDP<potential GDP (recessionary gap)
3. GDP=potential GDP (LR equilibrium)
•Transition from GDP>potential GDP to LR equilibrium
(inflationary gap)
•Initially:
• empl > equil. Empl
• unempl < natural rate
• R-wage < equil. R-wage
• upward pressure on R-waqes
• SAS shifts left until GDP=potential GDP
•As economy moves to LR Equilibrium:
Employment falls, Unemployment rises,
Real wage rises, Real GDP falls
•Transition from GDP<potential GDP to LR equilibrium
(recessionary gap)
•Initially:
• empl < equil. Empl
• unempl > natural rate
• R-wage > equil. R-wage
• downward pressure on R-waqes
• SAS shifts left until GDP=potential GDP
•As economy moves to LR Equilibrium:
Employment rises
Unemployment falls
Real wage falls
Real GDP rises
SR/LR effect of changes in AD
Effect of Increase in AD on real wage, prices, real GDP
unemployment and employment.
Macroeconomic Schools of Thought
Three broad schools of thought:
 Classical
believes the economy is self-regulating and always at full
employment.
 Keynesian
Due to sticky wages/prices, the economy would rarely operate at full
employment.
To achieve and maintain full employment, active help from fiscal
policy and monetary policy is required
 Monetarist
economy is self-regulating and that it will normally operate at full
employment, provided that monetary policy is not erratic and that the
pace of money growth is kept steady