Chapter 13:

Aggregate Demand and

Aggregate Supply
 The Aggregate-Demand-
Aggregate-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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 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: AD shifts:
Consumer wealth increases
RIGHT
Consumer Consumers’ real incomes rise

Spending Household indebtedness rises

LEFT
Tax increases

Investment Increases in real interest rate LEFT

Spending Higher expected returns RIGHT

Government Increase in government spending RIGHT

Spending
Net export Risingnational income abroad
RIGHT
Spending Depreciation of the dollar

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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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 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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 Aggregate Supply
in the Short Run

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 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 legal-
institutional 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: AS shifts:

Input Prices Domestic resource prices rise
LEFT
Prices of imported resources rise

Increased market power

Productivity Increases in productivity RIGHT

Legal- Higher business taxes
Institutional LEFT
Environment
More government regulation

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 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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 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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