1

Aggregate demand and Aggregate Supply (AD and AS) notice the data: while potential GDP tends to move upward yr

after yr, due to economic growth, actual GDP tends to rise above and fall below potential over shorter periods

Date reveals an important fact: Deviations from potential output don’t last forever

In some of these episodes, government policy-either fiscal or monetary-helped the economy to return to full employment more quickly

But even without corrective policies-such as during long parts of Great Ds of the 1930s-the economy shows a remarkable tendency to begin moving back towards potential output

What is the mechanism behind? We will study the behavior of a new variable that we have put

aside for several chapters: the price level

2

Figure 1a: Potential and Actual Real GDP, 1960-2001

Act

ual

an

d P

ote

nti

al R

eal

GD

P

(Bil

lio

ns

of

1996

Do

llar

s)

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9,000

1960

1965

1970

1975

1980

1985

1990

1995

2000

2003

The orange line shows full-employment or potential output.

The green line shows actual output. During recessions,

output declines.

During expansions, output rises—sometimes rapidly.

3

Figure 1: The Two-Way Relationship Between Output and the Price Level

PriceLevel

RealGDP

Aggregate Demand Curve

Aggregate Supply Curve

4

AD and AS

There exist a two-way relationship between price level and output (see diagram 1)

Changes in price level cause changes in real GDP – illustrated by Aggregate Demand curve

Changes in real GDP cause changes in price level – illustrated by Aggregate Supply curve

5

The Aggregate Demand Curve First step in understanding how price level affects

economy is an important fact When price level rises, money demand curve shifts

rightward (because purchases become more expensive) Shift in money demand, and its impact on the economy,

is illustrated in Figure 2 Imagine a rather substantial rise in price level—from

100 to 140 Compared with our initial position, this new equilibrium

has the following characteristics Money demand curve has shifted rightward Interest rate is higher Aggregate expenditure line has shifted downward Equilibrium GDP is lower

All of these changes are caused by a rise in price level A rise in price level causes a decrease in equilibrium

GDP

6

Figure 2a: Deriving the Aggregate Demand Curve

(a)

E

H

500 Money ($ Billions)

Interest Rate

6%

9%

Ms

As the price level rises, money demand increases and interest rate rises.

d1M

d2M

7

Figure 2b/c: Deriving the Aggregate Demand Curve

(b) (c)

The rise in the interest rate causes real GDP to fall.

Real GDP($ Trillions)

Ag

gre

gat

e E

xpen

dit

ure

($ T

rill

ion

s)

6 10

E

AEr = 6%

AEr = 9%

H

140

100

Price Level

H

AD

E

On the AD curve, a higher price level is associated with a lower real GDP.

106 Real GDP($ Trillions)

8

Deriving the Aggregate Demand Curve

Panel (c) of Figure 2 shows a new curve Shows negative relationship

between price level and equilibrium GDP

Call aggregate demand curve Tells us equilibrium real GDP at

any price level

9

Understanding the AD Curve AD curve is unlike any other curve you’ve encountered in

this text In all other cases, our curves have represented simple

behavioral relationships But AD curve represents more than just a behavioral

relationship between two variables Each point on curve represents a short-run equilibrium

in economy A better name for AD curve would be “equilibrium output

at each price level” curve—not a very catchy name AD curve gets its name because it resembles demand

curve for an individual product AD curve is not a demand curve at all, in spite of its

name

10

Movements Along the AD Curve As you will see later in this chapter, a variety of

events can cause price level to change, and move us along AD curve Suppose price level rises, and we move from point

E to point H along this curve Following sequence of events occurs

Opposite sequence of events will occur if price level falls, moving us rightward along AD curve

11

Shifts of the AD Curve When we move along AD curve in Figure 2, we assume that

price level changes But that other influences on equilibrium GDP are constant Keep following rule in mind

When a change in price level causes equilibrium GDP to change, we move along AD curve

Whenever anything other than price level causes equilibrium GDP to change, AD curve itself shifts

Equilibrium GDP will change whenever there is a change in any of the following Government purchases Autonomous consumption spending Investment spending Net exports Taxes Money supply

12

An Increase in Government Purchases Spending shocks initially affect economy by shifting

aggregate expenditure line In Figure 3, we assume economy begins at a price level of

100 Let’s increase government purchases by $2 trillion and ask

what happens if price level remains at 100 An increase in government purchases shifts entire AD

curve rightward AD curve shifts rightward when government purchases,

investment spending, autonomous consumption spending, or net exports increase, or when taxes decrease

Analysis also applies in the other direction AD curve shifts leftward when government purchases,

investment spending, autonomous consumption spending, or net exports decrease, or when taxes increase

13

Figure 3: A Spending Shock Shifts the AD Curve

(a) (b)

H

10 13.5

E

AE1

AE2

At any given price level, an increase in government purchases shifts the AE line upward, raising real GDP.

Rea

l A

gg

reg

ate

Exp

end

itu

re($

Tri

llio

ns)

Real GDP($ Trillions)

100

10 13.5

AD1 AD2

EH

Since real GDP is higher at the given price level, the AD curve shifts rightward.

Real GDP($ Trillions)

Price Level

14

Changes in the Money Supply

Changes in money supply will also shift aggregate demand curve Imagine that Fed conducts open market

operations to increase money supply AD curve shifts rightward

A decrease in money supply would have the opposite effect

15

Shifts vs. Movements Along the AD Curve: A Summary

Figure 4 summarizes how some events in economy cause a movement along AD curve, and other events shift AD curve

Panels (b) and (c) of Figure 4 tell us how a variety of events affect AD curve, but not how they affect real GDP

Where will price level end up? First step in answering that question is to

understand the other side of the relationship between GDP and price level

16

Figure 4a: Effects of Key Changes on the Aggregate Demand Curve

(a)

Real GDP

Price Level

P3

Q3 Q1 Q2

AD

P1

P2

Price level ↑ moves us leftward along the AD curve

Price level ↓ moves us rightward along the AD curve

17

Figure 4b: Effects of Key Changes on the Aggregate Demand Curve

Entire AD curve shifts rightward if:• a, IP, G, or NX increases• Net taxes decrease• The money supply increases

AD2

AD1

(b)

Real GDP

Price Level

18

Figure 4c: Effects of Key Changes on the Aggregate Demand Curve

AD2

decreasesEntire AD curve shifts leftward if:• a, IP, G, or NX decreases• Net taxes increase• The money supply decreases

(c)

Real GDP

Price Level

AD1

19

Costs and Prices Price level in economy results from pricing

behavior of millions of individual business firms In any given year, some of these firms will raise

their prices, and some will lower them But often, all firms in the economy are

affected by the same macroeconomic event Causing prices to rise or fall throughout the

economy – what interest us in macroeconomics To understand how macroeconomic events

affect the price level, we begin with a very simple assumption A firm sets price of its products as a markup over

cost per unit

20

Costs and Prices Percentage markup in any particular industry will depend

on degree of competition there In macroeconomics, we are not concerned with how the

markup differs in different industries But rather with average percentage markup in economy

Determined by competitive conditions Competitive structure changes very slowly, so average

percentage markup should be somewhat stable from year-to-year

But a stable markup does not necessarily mean a stable price level, because unit costs can change In short-run, price level rises when there is an economy-

wide increase in unit costs Price level falls when there is an economy-wide decrease in

unit costs

21

GDP, Costs, and the Price Level Primary concern here: impact of real GDP on

unit costs and, therefore, on the price level Why should a change in output affect unit

costs and price level? As total output increases

Greater amounts of inputs may be needed to produce a unit of output

Price of non-labor inputs rise Nominal wage rate rises

A decrease in output affects unit costs through the same three forces, but with opposite result

22

The Short Run All three of our reasons are important in explaining why a change

in output affects price level However, they operate within different time frames

But our third explanation—changes in nominal wage rate—is a different story

For a year or more after a change in output, changes in average nominal wage are less important than other forces that change unit costs

Some of the more important reasons why wages in many industries respond so slowly to changes in output Many firms have union contracts that specify wages for up to

three years Wages in many large corporations are set by slow-moving

bureaucracies Wage changes in either direction can be costly to firms Firms may benefit from developing reputations for paying stable

wages

23

The Short Run Nominal wage rate is fixed in short-run

We assume that changes in output have no effect on nominal wage rate in short-run

Since we assume a constant nominal wage in short-run, a change in output will affect unit costs through the other two factors In short-run, a rise (fall) in real GDP, by

causing unit costs to increase (decrease), will also cause a rise (decrease) in price level

24

Deriving the Aggregate Supply Curve Figure 5 summarizes discussion about effect of

output on price level in short-run Each time we change level of output, there will

be a new price level in short-run Giving us another point on the figure If we connect all of these points, we obtain

economy’s aggregate supply curve Tells us price level consistent with firms’ unit costs

and their percentage markup at any level of output over short-run

A more accurate name for AS curve would be “short-run-price-level-at-each-output-level” curve

25

Figure 5: The Aggregate Supply Curve

Price Level

Real GDP ($ Trillions)

130

100

80C

AS

13.5106

A

B

Starting at point A, an increase in output raises unit costs. Firms raise prices, and the overall price level rises.

Starting at point A, a decrease in output lowers unit costs. Firms cut prices, and the overall price level falls.

26

Movements Along the AS Curve When a change in output causes price

level to change, we move along economy’s AS curve What happens in economy as we make such

a move? As we move upward along AS curve, we can

represent what happens as follows

27

Shifts of the AS Curve Figure 5 assumed that a number of important variables

remained unchanged But in real world, unit costs sometimes change for

reasons other than a change in output In general, we distinguish between a movement along

AS curve, and a shift of curve itself, as follows When a change in real GDP causes the price level to

change, we move along AS curve When anything other than a change in real GDP causes

price level to change, AS curve itself shifts What can cause unit costs to change at any given level

of output? Changes in world oil prices Changes in the weather Technological change Nominal wage, etc.

28

Figure 6: Shifts of the Aggregate Supply Curve

Price Level

Real GDP ($ Trillions)

100

AS1

A

When unit costs rise at any given real GDP, the AS curve shifts upward–e.g., an increase in world oil prices or bad weather for farm production.

140

10

AS2

L

29

Figure 7a: Effects of Key Changes on the Aggregate Supply Curve

(a)

Real GDP

Price Level

P3

Q2 Q1 Q3

P1

P2

ASReal GDP ↑ moves us rightward along the AS curve

Real GDP ↓ moves us leftward along the AS curve

30

Figure 7b: Effects of Key Changes on the Aggregate Supply Curve

Real GDP

Price Level(b)

AS1

AS2

Entire AS curve shifts upward if unit costs ↑ for any reason besides an increase in real GDP

31

Figure 7c: Effects of Key Changes on the Aggregate Supply Curve

Real GDP

Price Level(c)

AS1AS2

Entire AS curve shifts downward if unit costs ↓ for any reason besides an decrease in real GDP

32

AD and AS Together: Short-Run Equilibrium

Where will the economy settle in short-run? Where is our short-run macroeconomic equilibrium?

We know that in equilibrium, economy must be at some point on AD curve

Short-run equilibrium requires economy be operating on its AS curve

Only when economy is at point E—on both curves—will we have reached a sustainable level of real GDP and the price level

33

Figure 8: Short-Run Macroeconomic Equilibrium

Price Level

Real GDP ($ Trillions)

140

100

AS

106 14

E

B

AD

F

34

What Happens When Things Change? Now that we know how short-run equilibrium is

determined, and armed with our knowledge of AD and AS curves, we are ready to put model through its paces

Our short-run equilibrium will change when either AD curve, AS curve, or both, shift An event that causes AD curve to shift is called a

demand shock An event that causes AS curve to shift is called a supply

shock In earlier chapters, we’ve used phrase spending shock

A change in spending by one or more sectors that ultimately affects entire economy

Demand shocks and supply shocks are just two different categories of spending shocks

35

An Increase in Government Purchases

Shifts AD curve rightward Can see how it affects economy in short-run:

increases output and rises interest rate in the money market

Process described is not entirely realistic Assumes that when government purchases

rise, first output increases, and then price level rises

In reality, output and price level tend to rise together

36

Figure 9: The Effect of a Demand Shock

Price Level

Real GDP($ Trillions)

100

130

AS

1012.5

13.5

E

J

H

AD1

AD2

115

37

An Increase in Government Purchases

Can summarize impact of price-level changes When government purchases increase, horizontal

shift of AD curve measures how much real GDP would increase if price level remained constant But because price level rises, real GDP rises by less

than horizontal shift in AD curve

38

An Decrease in Government Purchases

39

An Increase in the Money Supply

Although monetary policy stimulates economy through a different channel than fiscal policy Once we arrive at AD and AS diagram, two look

very much alike Can represent situation as follows

40

Other Demand Shocks

A positive demand shock—shifts AD curve rightward Increases both real GDP and price level

in short-run A negative demand shock—shifts AD

curve leftward Decreases both real GDP and price level

in short-run

41

An Example: The Great Depression U.S. economy collapsed far more seriously

during 1929 through 1933—the onset of the Great Depression—than it did at any other time

What do we know about demand shocks that caused Great Depression? Fall of 1929, bubble of optimism burst Stock market crashed, and investment and

consumption spending plummeted Demand for products exported by United States fell Fed reacted by cutting money supply sharply

Each of these events contributed to a leftward shift of AD curve Causing both output and price level to fall

42

Demand Shocks: Adjusting to the Long-Run In Figure 9, point H shows new equilibrium

after a positive demand shock in short-run—a year or so after the shock But point H is not necessarily where economy

will end up in long-run In short-run, we treat wage rate as given

But in long-run, wage rate can change When output is above full employment, wage

rate will rise, shifting AS curve upward When output is below full employment, wage

rate will fall, shifting AS curve downward

43

Demand Shocks: Adjusting to the Long Run

Increase in government purchases has no effect on equilibrium GDP in long-run Economy returns to full employment, which is

just where it started This is why long-run adjustment process is often

called economy’s self-correcting mechanism If a demand shock pulls economy away

from full employment Change in wage rate and price level will

eventually cause economy to correct itself and return to full-employment output

44

Figure 10: The Long-Run Adjustment Process

Price Level

Real GDP

P2

P3

P4

P1

YFE Y3 Y2

H

E

AS2

AS1

AD2

AD1

J

K

45

Demand Shocks: Adjusting to the Long Run

For a positive demand shock that shifts AD curve rightward, self-correcting mechanism works like this

46

Figure 11: Long-Run Adjustment After A Negative Demand Shock

Price Level

Real GDP

P2

AS1

P1

P3

YFEY2

AS2

AD2

AD1

E

M

N