AP Macroeconomics

Class 3
 • Use the aggregate demand curve to illustrate the
relationship between the aggregate price level and
the quantity of aggregate output demanded in the
economy
• Explain how the wealth effect and interest rate
What You Will effect give the aggregate demand curve a negative
slope
Learn in this • Identify the factors that can shift the aggregate
demand curve
Module

Section 4 | Module 17
 Aggregate Demand

• The aggregate demand curve shows the relationship between the

aggregate price level and the quantity of aggregate output
demanded by households, businesses, the government and the
rest of the world.

• It also shows a country’s ability to consume.

AD = C + I + G + (X – M)

Section 4 | Module 17
 The Aggregate Demand Curve
Aggregate price
level (GDP deflator,
2005 = 100)

A movement down the

AD curve leads to a lower
aggregate price level and
1933 higher aggregate output.
7.9

5.0

Aggregate demand
curve, AD
0 $716 950
Real GDP (billions of
2005 dollars) Section 4 | Module 17
 Why Is the Aggregate Demand Curve Downward
Sloping?

• When considering the aggregate demand curve, we consider a

simultaneous change in the prices of all final goods and services.
• It is downward-sloping for two reasons:
– The first is the wealth effect of a change in the aggregate price level—a
higher aggregate price level reduces the purchasing power of households’
wealth and reduces consumer spending.
– The second is the interest rate effect of a change in aggregate the price
level—a higher aggregate price level leads to a rise in nominal interest rates
and a fall in investment spending and consumer spending.

Section 4 | Module 17
 Shifts of the Aggregate Demand Curve

• The aggregate demand curve shifts because of:

– Changes in C, I, G, (X - M)
– Money supply
– Government policies
➢ Fiscal policy
➢ Monetary policy

Section 4 | Module 17
 Shifts of the Aggregate Demand Curve

(a) Rightward Shift (b) Leftward Shift

Decrease in
Aggregate Aggregate Demand
Aggregate price level
price level

Increase in
Aggregate Demand

AD AD AD AD
1 2 2 1

Real GDP Real GDP

Section 4 | Module 17
Factors that Shifts the Aggregate Demand Curve

Section 4 | Module 17
Factors that Shifts the Aggregate Demand Curve

Section 4 | Module 17
 Check Point

Which of the following would shift the aggregate demand curve to the left?
A. An increase in consumer confidence
B. Business firms reduce spending on plant and equipment
C. Foreigners develop a preference for our products
D. Government increases its level of spending
E. An increase in the money supply

Section 4 | Module 17
Summary
1. The aggregate demand curve shows the relationship between the
aggregate price level and the quantity of aggregate output demanded.
2. The aggregate demand curve is downward sloping for two reasons: the
wealth effect of a change in the aggregate price level and the interest rate
effect of a change in the aggregate price level.
3. The aggregate demand curve shifts because of
changes in expectations, changes in wealth not
due to changes in the aggregate price level, and
the effect of the size of the existing stock of
physical capital.
4. Policy makers can use fiscal policy and monetary
policy to shift the aggregate demand curve.
Section 4 | Module 17
 • Use the aggregate supply curve to illustrate the
relationship between the aggregate price level and
the quantity of aggregate output supplied in the
economy
• Identify the factors can shift the aggregate supply
What You Will curve
• Explain why the aggregate supply curve is different
Learn in this in the short run from in the long run
Module

Section 4 | Module 18
 Aggregate Supply

• The aggregate supply curve shows the

relationship between the aggregate
price level and the quantity of
aggregate output in the economy.
• It also shows the country’s ability to
produce.
• The short-run aggregate supply curve
is upward-sloping
– a higher aggregate price level leads to
higher profits and increased aggregate
output in the short run.

Section 4 | Module 18
 The Short-Run Aggregate Supply Curve
Aggregate price
level (GDP deflator,
2005 = 100) Short-run aggregate
supply curve, SRAS

10.6
1929

7.9 A movement down

1933 the SRAS curve leads
to deflation and lower
aggregate output.

0 $716 977 Real GDP (billions of

2005 dollars) Section 4 | Module 18
 Shifts of the Short-Run Aggregate Supply Curve

(a) Leftward Shift (b) Rightward Shift

Aggregate Aggregate
price level SRAS 2 SRAS 1
SRAS 1 price level SRAS 2

Decrease in Short-Run Increase in Short-Run

Aggregate Supply Aggregate Supply

Real GDP Real GDP

Section 4 | Module 18
Shifts of the Short-Run Aggregate Supply Curve

Changes in expected inflation, commodity prices,

nominal wages, or productivity lead to changes in
producers’ profits and shift the short-run
aggregate supply curve.

– A commodity is a standardized input bought

and sold in bulk quantities, such as oil, coffee,
or copper.

Section 4 | Module 18
Factors that Shift Short-Run Aggregate Supply

Section 4 | Module 18
 Long-Run Aggregate Supply Curve

• The long-run aggregate supply curve shows the relationship

between the aggregate price level and the quantity of aggregate
output supplied that would exist if all prices, including nominal
wages, were fully flexible.
• LRAS curve is not affected by policies or business cycle. It is only
determined by the availability of resources and technological
advancement. An increase in investment will also increase LRAS
because it will increase capital stock.
• If LRAS shift to the right, PPC will shift outward.

Section 4 | Module 18
 Long-Run Aggregate Supply Curve
Aggregate price Long-run aggregate
level (GDP deflator, supply curve, LRAS
2005 = 100)
15.0
…leaves the quantity
A fall in the of aggregate output
aggregate supplied unchanged
price level in the long run.

7.5

0 Potential $800 Real GDP (billions of

output, YP 2005 dollars)
Section 4 | Module 18
Actual and Potential Output from 1989 to 2013

Section 4 | Module 18
 Check Point

Which of the following would NOT shift the aggregate supply curve?
A. An increase in the price level
B. A decrease in the amount of resources in the economy
C. An increase in the amount of resources in the economy
D. An improvement in technology
E. A decrease in productivity

Section 4 | Module 17
Summary
1. The aggregate supply curve shows the relationship between the aggregate
price level and the quantity of aggregate output supplied.
2. The short-run aggregate supply curve is upward sloping because nominal
wages are sticky in the short run.
3. Changes in commodity prices, nominal wages, and productivity lead to
changes in producers’ profits and shift the short-run aggregate supply
curve.
4. In the long run, all prices are flexible and the economy produces at its
potential output, and the long-run aggregate supply curve is vertical at
potential output.

Section 4 | Module 18
 • Explain the difference between short-run and
long-run macroeconomic equilibrium
• Describe the causes and effects of demand
shocks and supply shocks
• Determine if an economy is experiencing a
What You Will recessionary or an inflationary gap and explain
how to calculate the size of an output gap
Learn in this
Module

Section 4 | Module 19
 Short-Run Macroeconomic Equilibrium

• The AS-AD model uses the aggregate supply curve and the aggregate
demand curve together to analyze economic fluctuations.
• The economy is in short-run macroeconomic equilibrium when the
quantity of aggregate output supplied is equal to the quantity demanded.
• The short-run equilibrium aggregate price level is the aggregate price
level in the short-run macroeconomic equilibrium.
• Short-run equilibrium aggregate output is the quantity of aggregate
output produced in the short-run macroeconomic equilibrium.

Section 4 | Module 19
 The AS–AD Model

Aggregate price S R AS
level

Short-run
P E macroeconomic
E SR
equilibrium

AD

Y Real GDP
E
Section 4 | Module 19
 Demand Shocks
(a) A Negative Demand Shock (b) A Positive Demand Shock

Aggregate Aggregate A positive

price level A negative
price level demand shock...
demand shock...

SRAS SRAS

P1 ...leads to a higher
E P E
1 2 2 aggregate price
...leads to a lower level and higher
P2 aggregate price level P E
E 1 1 aggregate output.
2 and lower aggregate
AD output. AD
1 2
AD AD
2 1
Y2 Y1 Y1 Y2
Real GDP Real GDP

Section 4 | Module 19
 Supply Shocks
(a) A Negative Supply Shock (b) A Positive Supply Shock

Aggregate Aggregate A positive supply

price level A negative
price level shock...
supply shock...

SRAS SRAS
2 SRAS 1 1 SRAS 2
E2 E
1
P P
2 1
...leads to a higher
…leads to a lower aggregate output
P E1 aggregate output and P E2
1 2 and lower
a higher aggregate aggregate price
price level. level.
AD AD

Y Y1 Y Y
2 Real GDP 1 2 Real GDP

Section 4 | Module 19
 Demand-pull inflation
• When AD shift to right, PL
increases and real GDP
increases. This is called a
Aggregate
demand-pull inflation. This price level
A positive
demand shock...
type of inflation is caused by
people’s increasing demand SRAS

to spend. Cyclical P E ...leads to a higher

2 2 aggregate price
unemployment will decrease level and higher
P E
with demand-pull inflation. 1 1 aggregate output.
AD
• When C, I, G, (X – M) or AD
2

1
money supply increases Y1 Y2
Real GDP

Section 4 | Module 19
 Cost-push inflation

• When AS shift to left, PL increases

and real GDP decrease. This is
Aggregate called a cost-push inflation or
price level A negative
supply shock... stagflation. This type of inflation is
SRAS caused by country’s decreased
2 SRAS 1
E2
ability to produce. Cyclical
P
2
unemployment will increase with
…leads to a lower
P
1
E1 aggregate output and cost-push inflation.
a higher aggregate
AD
price level.
• When cost of production
becomes more expensive.
Y Y1
2 Real GDP

Section 4 | Module 19
 Long-Run Macroeconomic Equilibrium

• The economy is in long-run macroeconomic equilibrium when the point of

short-run macroeconomic equilibrium is on the long-run aggregate supply
curve.

• If an economy is in long-run macroeconomic equilibrium, it is also

producing on its PPC.

Section 4 | Module 19
 Long-Run Macroeconomic Equilibrium
Aggregate
price level L R AS • The economy is in
S R AS equilibrium when
actual GDP equals
potential GDP

P E Long-run
E LR Macroeconomic • There is no cyclical
equilibrium
unemployment.
Unemployment
rate = natural rate
AD
of unemployment.
Y Real GDP
P
Potential output
Section 4 | Module 19
 Recessionary gap
Aggregate
price level L R AS

S R AS
• There is a
recessionary gap
when actual
output is below
P
E potential output.
E

• Yp – Y is the
Recessionary gap
inflationary gap
AD
Y Y Real GDP
P
Actual output Potential output
Section 4 | Module 19
 Inflationary gap
Aggregate
price level L R AS

S R AS
• There is an
inflationary gap
when aggregate
P E
output is above
E
potential output.

• Y – Yp is the
AD
inflationary gap
Inflationary gap

Y Y Real GDP
P
Potential output Actual output
Section 4 | Module 19
 Long-Run Macroeconomic Equilibrium

• According to Classical economists, the economy is self-correcting when

shocks to aggregate demand affect aggregate output in the short run.

• There are three school of thoughts we will learn in macroeconomics.

• Classical – believes in economy’s self correcting mechanism
• Keynesians – believe in government intervention
• Fiscal policy
• Monetarists – believe in central bank intervention
• Monetary policy

Section 4 | Module 19
 Short-Run Versus Long-Run Effects of a Negative
Demand Shock
2. …reduces the aggregate
Aggregate price level and aggregate
price level output and leads to higher
unemployment in the short run…
LRAS
SRAS
1

SRAS
2

P E
1 1
1. An initial
P2 negative 3. …until an eventual
demand shock… E fall in nominal wages
2
in the long run increases
P3 short-run aggregate
E
3 AD supply and moves the
1 economy back to
AD potential output.
2
Y Y
2 1 Potential Real GDP
output
Recessionary gap
35 of 17 Section 4 | Module 19
Short-Run Versus Long-Run Effects of a Positive
Demand Shock

Section 4 | Module 19
 Check Point

a) Draw an aggregate supply/aggregate demand diagram. Label the axes of

your diagram. Make the aggregate supply curve upward sloping.

b) Show which curve shifts when foreigners suddenly develop a distaste for
our products. What will happen to equilibrium output and the
equilibrium price level in the short run?

Section 4 | Module 17
 Check Point

c) Would you expect the same thing to happen to equilibrium output and
the equilibrium price level in the long run? Redraw the aggregate
supply/aggregate demand diagram using a long-run aggregate supply
curve.

d) Now what happens when foreigners develop a distaste for our

products?

Section 4 | Module 17
Summary
1. In the AD–AS model, the intersection of the short-run aggregate supply curve and
the aggregate demand curve is the point of short-run macroeconomic
equilibrium. It determines the short-run equilibrium aggregate price level and
the level of short-run equilibrium aggregate output.
2. A demand shock causes the aggregate price level and aggregate output to move in
the same direction as the economy moves a long the short-run aggregate supply
curve.
3. A supply shock causes them to move in opposite directions as the economy moves
along the aggregate demand curve.
4. Stagflation is inflation and falling aggregate output and is caused by a negative
supply shock.
Section 4 | Module 19
Summary
5. Demand shocks have only short-run effects on aggregate output because the
economy is self-correcting in the long run.
6. In a recessionary gap, an eventual fall in nominal wages moves the economy to
long-run macroeconomic equilibrium, where aggregate output is equal to
potential output.
7. In an inflationary gap, an eventual rise in nominal wages moves the economy to
long-run macroeconomic equilibrium.
8. The output gap is the percentage difference between actual aggregate output and
potential output

Section 4 | Module 19