S E C T I O N 8 A G G R E G A T E D E M A N D A N D A G G R E G A T E S U P P L Y

29

27 Aggregate Demand

28 Aggregate Supply

29 The AD-AS Model

The AS–AD Model • The AS-AD model uses the AS curve and the AD

curve together to analyze economic fluctuations.

Slide 2

Short-Run Macroeconomic Equilibrium • 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.

Slide 3

The AS–AD Model

Slide 4

Y E

P E E SR

S R AS

AD

Real GDP

Short-run macroeconomic

equilibrium

Aggregate price level

Macroeconomic Shocks

• If a demand or supply shock hits the economy, AD or AS shifts and moves the economy to a new equilibrium.

Slide 5

Demand Shocks

Slide 6

Y 2

2 P 2

AD 2

A negative demand shock...

Y 1

E 1

E

S R AS

AD 1

Y 1

2

E 1

S R AS

AD 1

P 1

P 1

Real GDP

Aggregate price level

Real GDP

Aggregate price level

...leads to a higher aggregate price level and higher

aggregate output.

(a) A Negative Demand Shock (b) A Positive Demand Shock

E P 2

Y 2

AD 2

A positive demand shock...

...leads to a lower aggregate price level and lower aggregate

output.

Supply Shocks

Slide 7

P 1

AD

Y 1

E 1

Real GDP

Aggregate price level

(a) A Negative Supply Shock

SRAS 1 SRAS

Y 2

2 E

P 2

2

Y 1

1

AD

E 2

E

SRAS

P 1

Real GDP

Aggregate price level

(b) A Positive Supply Shock

P 2

Y 2

SRAS 2 1

A negative supply shock...

…leads to a lower aggregate output

and a higher aggregate price

level.

...leads to a higher aggregate output

and lower aggregate price

level.

A positive supply shock...

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.

Slide 8

Long-Run Macroeconomic Equilibrium

Slide 9

Y P

P E

S R AS

L R AS

AD

E LR

Real GDP

Aggregate price level

Long-run macroeconomic equilibrium

Potential output

SR vs LR Effects of a Negative Demand Shock

Slide 10

Y 1

P E 1

2

S R AS 1 L R AS

AD 1

Real GDP

Aggregate price level

Potential output

E 3 P 3

SRAS 2

3. …until an eventual fall in nominal wages

in the long run increases short-run aggregate

supply and moves the economy back to potential output.

2

2. …reduces the aggregate price level and aggregate

output and leads to higher unemployment in the short run…

AD 2

Recessionary gap

Y 2

E

1. An initial negative

demand shock…

1

P

SR vs LR Effects of a Positive Demand Shock

Slide 11

Y 1

P 3

E 3

E1

P 1

P

S R AS 1

L R AS

AD

Real GDP Potential

output

AD 2

1.An initial positive demand shock…

Inflationary gap

Y 2

2 E 2 2. …increases the

aggregate price level and aggregate output

and reduces unemployment

in the short run… 1

Aggregate price level

Long-Run Macroeconomic Equilibrium • The economy is self-correcting when shocks to AD affect aggregate output in the short run, but not the long run.

• Stabilization policy is the use of government policy to reduce the severity of recessions and rein in excessively strong expansions.

• If policy makers react quickly to a fall in aggregate demand, they can use monetary or fiscal policy to shift the AD curve back to the right.

• Unlike demand shocks, there are no government policies that can easily react to shocks an AS shock.

Slide 12