CHAPTER SIX

Aggregate Demand & Aggregate Supply

1. Introduction

In chapters four and five we looked at the determinants of macroeconomic variables in the
long run. In macroeconomics, there are two major differences between the short run and the long
run. Firstly, in the long run we assume that there is a separation of real (adjusted for price level
changes) and nominal (not adjusted for price level changes) variables. This separation of real and
nominal variables is a concept that is formally called the classical dichotomy. Secondly, in the long
run, the money supply affects only nominal variables and not real variables. This is demonstrated in
chapter five’s figure 5-2, where a change in the money supply by the Federal Reserve strictly causes
the price level to change, i.e., it causes inflation or deflation, and it has no effect on the real value
people place on goods and services. This second idea is formally called monetary neutrality.

However, when we look at year-to-year changes in the economy, the assumption of monetary
neutrality is no longer appropriate. In this chapter, we will drop the assumption of monetary
neutrality and develop a model of aggregate demand and aggregate supply that deals with short run
economic fluctuations.

In this model, the first variable is real gross domestic product (real GDP) and the second
variable is the overall price level (P) which is measured by the consumer price index or some
other index of prices in the economy.1 Notice, that this short run model reflects a breakdown of
the classical dichotomy because it uses a nominal variable, the price level, and a real variable, real
GDP, at the same time.

Key concepts introduced in this chapter include: classical dichotomy, monetary neutrality,
aggregate demand, the interest rate effect, the wealth effect, the open economy effect, the real
exchange rate, the short run aggregate supply, the profit effect, the misperceptions effect, the menu
costs effect, long run aggregate supply, potential real GDP, the natural rate of unemployment,
inflationary gap, deflationary gap, fiscal policy, automatic stabilizer, and monetary policy.

________________
1
See chapter 4 for definitions of the consumer price index and the producer price index

87
 2. Aggregate Demand

The aggregate demand curve reflects the real gross domestic product demanded by all
groups in the economy at any given price level. Recall that nominal GDP is calculated by summing
up consumption spending, investment spending, government purchases, and net exports. And that
real GDP is equal to the nominal GDP adjusted for changes in the price level. That is,

NOMINAL GDP = C + I + G + NX, and

NOMINAL GDP
REAL GDP = *100
PRICE LEVEL INDEX
It is important to realize that the aggregate demand curve is very different from an individual
market demand curve (individual market demand curves were discussed in chapter two). The
aggregate demand curve is literally an aggregation of all real market activity at each price level.
An economy, therefore, has just one aggregate demand curve. The substitution that takes place in
individual markets because of changes in the prices of independent variables absolutely does not
take place with an aggregate demand curve.

Figure 6-1 illustrates the downward sloping aggregate demand curve (AD). Real GDP is
located on the horizontal axis and price level (P) is on the vertical axis. Suppose the economy moves
from point A to point B on the aggregate demand curve because of a change in some exogenous
factor. In this case, a decrease in the price level causes an increase in the real GDP demanded by
all groups in the economy. On the other hand, suppose the economy moved from point B to point
A. Here an increase in the price level causes a decrease in the real GDP demanded by all groups in
the economy.

Figure 6-1
Aggregate Demand

Price Level
(P)

PA A

PB B

AD

Real GDPA Real GDPB Real GDP/time

88
 To understand why the aggregate demand is negatively sloped we need to find out how the
price level affects the quantity of goods and services demanded. The three general explanations
for the negative slope of the aggregate demand curve are: the interest rate effect, real wealth effect,
and the open economy effect.

Firstly, the interest rate effect tells us that a reduction in the price level causes people to
convert cash to interest bearing assets. Interest bearing assets include assets such as bonds and
certificates of deposit. Interest bearing assets are commonly called loanable funds1, and this is the
term we’ll use for our discussion. Figure 6-2 illustrates an increase in the supply of loanable funds
with a south-east shift of the supply of loanable funds curve from S1 to S2. The result of this south-
east shift is a decrease in the interest rate and an increase in the quantity demanded of loanable
funds. Because the interest rate is equal to the price of investment goods, a decrease in the interest
rate causes an increase in spending on investment goods (I), which by definition increases REAL
GDP.

Figure 6-2
The Loanable Funds Market
S1
Interest rate
( i) S2

iA
A
B
iB

D1

LA LB Quantity of loanable
funds/time

Secondly, a decrease in the price level makes consumers feel wealthier because each nominal
dollar can purchase more goods and services, relative to before the price level decrease. This is
known as the wealth effect. It also operates in the opposite direction. For example, if the price
level increases, each nominal dollar purchases fewer goods and services, decreasing real wealth.
Subsequently, this causes a decrease in real GDP demanded by all groups in the economy.

_______________________
1
The term “loanable funds” is a catch-all term that includes all resources available to finance investment
spending and capital accumulation.

89
 Thirdly, when the price level falls, it causes the real exchange rate to depreciate. This
is called the open economy effect. The real exchange rate is the rate at which foreign made
goods can be bought or sold for domestic made goods. The depreciation of the real exchange rate
increases the quantity of exports and decreases the quantity of imports and therefore it increases
net exports (NX) or exports minus imports. Because of the increase in net exports, the quantity
demanded of real GDP increases.

The aggregate demand curve may shift to the north-east and to the south-west. Holding the
price level constant, if there is a change in consumption spending, investment spending, government
purchases, or in net exports, then the aggregate demand curve will shift. If we hold the price level
constant and increase any one of the four components of real GDP, then the aggregate demand
curve will shift to the north-east. And if we hold the price level constant and decrease any one of
the four components of real GDP, then the aggregate demand curve will shift to the south-west.
Table 6-1 contains examples of the variables that cause the aggregate demand curve to shift.

Table 6-1
Exogenous Variables that Shift Aggregate Demand

Increases in Aggregate Demand Decreases in Aggregate Demand

(north-east shift)
Consumption (C)
 lower personal taxes
 a rise in consumer confidence
 greater stock market wealth
Investment (I)
 lower real interest rates
 optimistic business forecasts
 lower business taxes
Government purchases (G)
 an increase in government
purchases
 an increase in transfer payments1
New Exports (NX)
 income increases abroad, which
will likely increase exports
(south-west shift)
Consumption (C)
 higher personal taxes
 a fall in consumer confidence
 reduced stock market wealth
Investment (I)
 higher real interest rates
 pessimistic business forecasts
 higher business taxes
Government purchases (G)
 a decrease in government
purchases
 a decrease in transfer
payments
New Exports (NX)
 income decreases abroad,
which will likely decrease
exports

_____________
1
See chapter four for a definition of a transfer payment.

90
 3. Aggregate Supply

The aggregate supply curve reflects the total quantity of goods and services that producers
in the economy are willing and able to produce at any given price level. In the short run, the
aggregate supply curve is upward sloping. In the long run, the aggregate supply curve is a vertical
line located at the economy’s potential real GDP.

The short run aggregate supply curve is upward sloping because of the profit effect, the
misperception effect, and the menu costs effect. Firstly, consider the profit effect. Salaried workers
frequently sign one year, or multiple year, labor contracts. Because such nominal wage (w) contracts,
do not automatically adjust (by definition) to the ebb and flow of real-time labor market prices, they
are considered sticky in the short run. In an environment with a lot of long term labor contracts, if
the price level (P) increases, employment and production become more profitable because real wage
expenditures (nominal wage/ the price level, or w/P), which are adjusted for changes in the price
level, actually decrease. If businesses observe real wage expenditures decreasing, they are more
likely to increase the production of their goods and services in an effort to increase real profits.

In summary, ceteris paribus, sticky wages in the short run 1) induce firms to increase the
production of goods and services when the price level increases and 2) induce firms to decrease
their production of goods and services when the price level decreases.

Secondly, the misperceptions effect argues that in the short run producers are temporarily
fooled about what is really causing price changes in the markets in which they sell their products.
Because of these misperceptions, producers respond to changes in the price level despite no change
in a product’s real price, and this response leads to an upward-sloping supply curve.

For example, suppose the owner of a lobster boat business sees the price of lobster increasing.
The owner believes that the real price of lobsters is increasing. That is, the owner believes that the
marketplace is increasing the value it assigns to lobsters. Because of this belief, the owner decides
to gather and sell more lobsters than before. However, if all nominal market prices increase and all
market prices remained constant relative to one another, then the increase in the price of lobsters is
because of inflation and not because the marketplace changed its valuation of lobster. In this case,
the lobster owner was fooled into increasing his lobster production because of a misperception
about the price level.

91
 Lastly, the menu cost effect argues that because it can be expensive to change menus
and pricing boards and because business owners don’t want to constantly tell their customers that
they’ve changed their prices, they don’t do it often. This implies that when there is a change in
the price level because of a contraction in the economy, for example, producers keep their prices
unchanged. In this case, the real price charged by a producer actually increases, and customers
subsequently demand a smaller quantity because of these higher real prices. This behavior forces
the business to then cut back on production and employment. In the short run, when the price level
decreases and menu changing costs are high, real GDP declines.

At the end of the day, the best way to think about the short run aggregate supply curve is as
a composite of all three effects, because in reality they are all at work out there in the real world.

Figure 6-3 depicts a representative short run aggregate supply curve (SRAS). In the
figure, real GDP is on the horizontal axis and the price level in on the vertical axis. As the
price level increases from price level A (PA) to price level B (PB) real GDP increases from Real
GDPA to Real GDPB because of one or a combination of the three effects mentioned above.

Figure 6-3
Short Run Aggregate Supply
Price Level SRAS
(P)

PB
B

PA A

Real GDPA Real GDPB Real GDP/time

In the long run, every thing in the economy is variable. Prices, wages, interest rates, and
rents all fluctuate with market conditions. The long run provides enough of a time horizon for
producers to figure out whether a market price fluctuation is due to a change in consumer valuation
or a change in the price level. Therefore, in the long run, the aggregate supply curve is at potential
real GDP, which is the economy’s maximum sustainable output level given the supply of the
factors of production, the state of technology, and formal and informal institutions supporting the
economy.

92
 Figure 6-4 depicts the long run aggregate supply curve (LRAS). Again, real GDP is on the
horizontal axis and the price level is on the vertical axis. The aggregate supply curve is vertical in
the long-run. The location of the LRAS depends on the economy’s supply of land, capital, labor, and
entrepreneurial ability and the productivity of these resources, and not the price level.

An important point to emphasize is that unemployment exists when the real GDP is equal
to potential real GDP. The unemployment that exists when the economy is operating at potential
real GDP is called the natural rate of unemployment. This level of unemployment includes
structural and frictional unemployment, but excludes cyclical unemployment.1 The natural rate of
unemployment moves slowly over time but it is currently estimated to be between 4 and 5 percent.

Figure 6-4
Long Run Aggregate Supply

Price Level LRAS

(P)

Potential Real GDP Real GDP/time

The short run and long run aggregate supply curves shift when there is a change in any
one of the factors of production. If there is a permanent increase in a factor of production, then the
short run aggregate supply curve shifts to the south-east and the long run aggregate supply curve
shifts to the right. And if there is a permanent decrease in a factor of production, then the short run
aggregate supply curve shifts to the north-west and the long run aggregate supply curve shifts to
the left.

__________
1
See chapter 4 for an explanation of structural, frictional, and cyclical unemployment.

93
 Some other factors exclusively shift the short run aggregate supply curve. For example, a
change in the price of a factor of production will only affect the short run aggregate supply curve if
it does not reflect a permanent change in the supply of that factor of production. For example, figure
6-5 depicts the effect of a decrease in the price of electricity. Businesses that use electricity increase
their production to a new (higher) profit maximizing quantity supplied, at any given price level,
because the price of electricity has decreased. Thus, cheaper input costs cause a south-east shift
of the short run aggregate supply curve from SRAS1 to SRAS2. However, the long run aggregate
supply curve does not shift so long as the capacity to produce electricity has not been increased.

A second type of exogenous change that only affects the short run aggregate supply curve
is a temporary supply shock. Examples include an expected terrorist threat that never materializes
but causes workers to stay home for a period of time; a hurricane that hit, but did not alter the long
run productive capacity of the economy; and a labor union strike. Each of the above would cause
the short run aggregate supply curve to shift to the north-west for a temporary period of time. After
the event and with the passage of time the short run aggregate demand curve would shift back to its
original location, ceteris paribus.

Figure 6-5
Short and Long Run Aggregate Supply

Price Level LRAS SRAS1

(P)
SRAS2

Potential Real GDP Real GDP/time

94
 Table 6-2 contains examples of the factors that cause the short run aggregate supply and the
long run aggregate supply curve to shift. Again, these factors shift both the long run and short run
aggregate supply only if the effect is permanent. If the effect is not permanent, then only the short
run aggregate supply curve will shift.

Table 6-2
Exogenous Variables that Shift Aggregate Supply

An increase in Aggregate Supply A decrease in Aggregate Supply

(SRAS: south-east shift) (SRAS: north-west shift)
(LRAS: rightward shift) (LRAS: leftward shift)
Lower costs Higher costs
 lower wages  higher wages
 other input prices fall  other input prices rise
Government Policy  higher oil prices
 tax cuts Government Policy
 deregulation  tax increases
 lower trade barriers  overregulation
Economic growth  higher trade barriers
 improvements in technology  A decline in labor productivity
 productivity advances Terrorist Attacks
 an increase in labor Natural Disasters
Favorable weather Unfavorable weather

95
 4. Aggregate Demand & Aggregate Supply

In this section we will put aggregate demand, short run aggregate supply, and long run
aggregate supply together in one diagram and then analyze two shocks to the macroeconomic
economy.

Consider the economy depicted in figure 6-6. This economy is in long run equilibrium
at point A, where the price level is PA and aggregate output is equal to potential real GDP. Now
suppose that there is a wave of optimism in the economy because of a boom in the stock market
or because of a feeling that the economy is on the right track. Such an event induces people to
positively alter the consumption and investment plans. The net effect of a wave of optimism is
for people to increase their consumption of goods and services at any given price level. Thus, the
wave of optimism causes AD1 to shift to the north-east to AD2. As a result of the shift in aggregate
demand, the price level increases to PB and aggregate output increases to real GDPB.

Figure 6-6
Shifts in Aggregate Demand and Aggregate Supply
Price Level LRAS
(P)
SRAS2
C SRAS1
PC
B
PB
A
PA
AD2

AD1

Potential Real GDPB Real GDP/time

Real GDP

The difference between potential real GDP and real GDPB in figure 6-6 is called an
inflationary gap. When an economy experiences an inflationary gap such as this, the actual price
level is higher than what workers expected. Workers eventually figure out the actual price level
and realize that their real wage, adjusted for inflation, is lower than they expected and they demand
higher real wages. In the aggregate, businesses react to the increase in labor costs by decreasing
the quantity that they are willing and able to produce at any given price level. This reaction by the
business community causes the short run aggregate supply curve to shift north-west from SRAS1
to SRAS2. At point C, the inflationary gap is eliminated and the economy is back at its sustainable
level of output. However, the price level has increased to PC.

96
Now consider figure 6-7, which is an economy in long run equilibrium at point C with a price
level equal to PC and aggregate output equal to potential real GDP. Suppose a wave of pessimism
washes over the economy, lowering consumer confidence and decreasing the quantity of goods and
services that consumers demand at any given price level. As a result, AD1 shifts south-west to AD2.
The short run equilibrium is now at point B, where the price level is PB and aggregate output is at
real GDPB.

The difference between potential real GDP and real GDPB in figure 6-7 is called a deflationary
gap. An economy that is in a deflationary gap experiences an unemployment rate that is higher
than the natural rate of unemployment. This is the case because cyclical unemployment1 is now
added to the natural rate of unemployment.

The economy will eventually self-correct and eliminate a deflationary gap. For example,
because of the higher than natural rates of unemployment, workers are willing to accept lower
wages in an effort to get a job. In the aggregate, businesses experience lower input costs and as
a result they increase their profit maximizing quantity supplied at every given price level. This
is demonstrated in figure 6-7 with a south-east shift of the short run aggregate supply curve from
SRAS1 to SRAS2. Long run equilibrium is again reached at point A. At this point, the price level
equals PA, the recessionary gap is eliminated, and the economy is again operating at potential real
GDP.

Figure 6-7
Shifts in Aggregate Demand and Aggregate Supply
Price Level LRAS
(P)
SRAS1

C
PC SRAS2
B
PB

PA A
AD1

AD2

Real GDPB Potential Real GDP/time

Real GDP

_____________
1
See Chapter 4 for a definition of cyclical unemployment.

97
 5. Fiscal Policy & Short Run Economic Fluctuations

The government’s fiscal policy is its plan for managing aggregate demand through
government’s power to tax individuals and businesses and its power to spend and transfer the tax
revenues that it collects. Fiscal policy can be used 1) to stimulate aggregate demand when the
economy is in a deflationary gap and 2) to slow the economy down when it is in an unsustainable
inflationary gap.

Suppose the economy is in a deflationary gap. The short run equilibrium point A, in figure
6-8, depicts this scenario because the actual real GDPA is below the economy’s potential real GDP.
In this case, the government could use fiscal policy to increase aggregate purchases of goods and
services, to increase transfer payments to its citizens, or to decrease taxes, ceteris paribus. Each of
these changes will cause the aggregate demand curve to shift to the north-east from AD1 to AD2. If
the fiscal policy were implemented precisely, then the economy would be in equilibrium at point B,
where output is equal to potential real GDP and the price level is PB.

Figure 6-8
Fiscal Policy and a Deflationary Gap
Price Level
LRAS
(P)
SRAS1

B
PB
A
PA

AD2

AD1

Real GDPA Potential Real GDP/time

Real GDP

98
 On the other hand, suppose the economy is in an inflationary gap, which is depicted in
figure 6-9. In this scenario, a fiscal policy that decreases government purchases, decreases transfer
payments, or increases taxes would slow the economy down and cause the aggregate demand curve
to shift to the south-west from AD1 to AD2. Again, if done precisely, fiscal policy of this type would
cool the economy off and bring it back to equilibrium point A, where aggregate quantity demanded
equals potential real GDP and the price level equals PA.

Figure 6-9
Fiscal Policy and an Inflationary Gap
Price Level
LRAS
(P)

SRAS1
B
PB

PA A
AD1

AD2

Potential Real GDPB Real GDP/time

Real GDP

Several caveats are in order. Generally speaking, the government is not able to precisely
estimate how much fiscal policy stimulus the economy needs when it is in deflationary gap. Nor
does the government know how much fiscal policy is needed to cool the economy off when it is in
an inflationary gap. Nevertheless, the direction is clear and a relative magnitude can be estimated
so that fiscal policy can be helpful in both cases.

A more important concern is the lag time associated with much fiscal policy. Tax and
spending changes must pass through the Congress, which takes time. Thus, it is possible that an
economic stimulus will arrive after the economy has already self-corrected. Or a fiscal policy that
is intended to cool off the economy arrives when the economy is slipping into a recession.

Automatic stabilizers exist because they help solve the problem of fiscal policy lags.
Automatic stabilizers automatically stimulate the economy when it enters a deflationary gap and
automatically cools the economy down when it enters an inflationary gap. Automatic stabilizers are
a just-in-time fiscal policy, because they operate without policymakers having to take any deliberate
action. Examples of automatic stabilizers include unemployment insurance, welfare benefits, and
income taxes.

99
 6. Monetary Policy & Short Run Economic Fluctuations

Monetary policy is any action that changes the supply of money and alters the interest
rate. In the United States, monetary policy is implemented by the Federal Reserve System.

Figure 6-10 depicts a new model of the money market (one that is different from the model
presented in chapter 5) that is helpful in showing the effects of monetary policy changes. In this
model, the interest rate is on the vertical axis and the quantity of money is on the horizontal axis.
The money supply curve (MS) is vertical because it is determined by the Federal Reserve. The
money demand curve (MD) is downward sloping. This is the case because as the interest rate
increases, the opportunity cost of holding money increases and the quantity demanded of money
decreases. Also, as the interest rate decreases, the opportunity cost of holding money decreases and
people choose to increase there quantity demanded of money. The equilibrium interest rate is the
interest rate that balances the quantity demanded and quantity supplied of money.

Figure 6-10
The Money Market
Interest Rate MS1 MS2
(i)

i1

i2

MD1

Q1 Q2 Quantity of Money/time

Assume that the money market is in equilibrium where the equilibrium interest rate is i1
and the equilibrium quantity of money is Q1. Suppose that the Federal Reserve increases the money
supply from MS1 to MS2 by implementing one or several of its three monetary tools (see chapter 5
for a discussion of monetary tools). An increase in the money supply would cause a decrease in the
interest rate from i1 to i2 and an increase in the equilibrium quantity of money from Q1 to Q2. If the
Federal Reserve subsequently decreased the money supply from MS2 to MS1, then the interest rate
would increase back to i1 and the equilibrium quantity of money would decrease back to Q1.

100
 Consider equilibrium point A in figure 6-11, which depicts the economy in a deflationary
gap. In this situation, the Federal Reserve could increase the money supply and reduce the interest
rate. A decrease in the interest rate reduces the cost of borrowing and induces consumption and
investment expenditures by consumers and businesses, which by definition stimulates real GDP
at every price level. If done precisely, aggregate demand will increase from AD1 to AD2 and the
economy will be in equilibrium at point B. In summary, a monetary policy injection by the Federal
Reserve can stimulate an economy and pull it out of a deflationary gap.
Figure 6-11
Monetary Policy and a Deflationary Gap
Price Level LRAS
(P)
SRAS1

B
PB
A
PA

AD2

AD1

Real GDPA Potential Real GDP/time

Real GDP
Alternatively, suppose the economy is at an unsustainable inflationary gap similar to point
B in figure 6-12. In this situation, the Federal Reserve could decrease the money supply and
thereby increase the interest rate. An increase in the interest rate increases the cost of borrowing
and causes a reduction in consumption and investment expenditures by consumers and businesses
at every price level. Therefore, a decrease in the money supply causes the aggregate demand
curve to shift to the south-west from AD1 to AD2 and returns the economy back to its long run
equilibrium.
Figure 6-12
Monetary Policy and an inflationary Gap
Price Level
LRAS
(P)

SRAS1
B
PB

PA A
AD1

AD2

Potential Real GDPB Real GDP/time

Real GDP

101