McGraw-Hill/Irwin

Chapter 29: Aggregate Demand and Aggregate Supply

Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved

Aggregate Demand – Aggregate Supply Model

The AD-AS model enables us to analyze changes in real GDP and price level simultaneously.

The AD-AS model provides keen insights on inflation, recession, unemployment, and economic growth.

LO: 14-1

Aggregate Demand – Aggregate Supply (AD-AS) model is the macroeconomic model that uses aggregate demand and aggregate supply to determine and explain the price level and level of real domestic output.

14-2

Aggregate Demand and Aggregate Demand Curve

LO: 14-1

Aggregate demand curve is a schedule 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). Real Domestic Output, GDP

Pri

ce L

evel

AD

AggregateDemand

14-3

Changes in Aggregate Demand

LO: 14-1

Determinant: Factor(s) of Determinant: AD shifts:

Consumer Spending

Consumer wealth increases

Consumers’ real incomes rise

Household indebtedness rises

Tax increases

RIGHT

LEFT

Investment Spending

Increases in real interest rate

Higher expected returns

LEFT

RIGHT

Government Spending

Increase in government spending RIGHT

Net export Spending

Rising national income abroad

Depreciation of the dollarRIGHT

14-4

Shifts in Aggregate Demand Curve

Real Domestic Output, GDP

Pri

ce L

evel

AD1

Increase inAggregateDemand

AD3

AD2Decrease inAggregateDemand

LO: 14-1

14-5

Aggregate Supply

LO: 14-2

Aggregate supply curve is a schedule 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 degrees of wage adjustment In the immediate short run, output and input prices are

fixed, and the AS curve is horizontal In the short run, output prices are flexible while input prices

are sticky, thus the AS curve is positively sloped In the long run, all prices are flexible, economy is at the full

employment (output is equal to potential), the AS curve is vertical

14-6

Immediate Short Run Aggregate Supply

Real Domestic Output, GDP

Pri

ce L

evel ASISR

Immediate Short RunAggregate Supply

LO: 14-2

14-7

Short RunAggregate Supply

Real Domestic Output, GDP

Pri

ce L

evel

0 Qf

Aggregate Supply(Short Run)

LO: 14-2

14-8

Long Run Aggregate Supply

Real Domestic Output, GDP

Pri

ce L

evel

ASLR

Long RunAggregate

Supply

LO: 14-2

14-9

Changes in Aggregate Supply

LO: 14-2

Determinant: Factor(s) of Determinant: AS shifts:

Input Prices Domestic resource prices rise

Prices of imported resources rise

Increased market power

LEFT

Productivity Increases in productivity RIGHT

Legal-Institutional Environment

Higher business taxes

More government regulationLEFT

14-10

Shifts in Aggregate Supply Curve

Real Domestic Output, GDP

Pri

ce L

evel

AS1

Increase inAggregate

Supply

AS3

AS2Decrease inAggregate

Supply

LO: 14-2

14-11

Equilibrium Price Level and Real GDP

Equilibrium occurs at the price level that equalizes the amount of real output demanded and supplied.

Equilibrium point is the intersection of the aggregate demand curve and aggregate supply curve.

This intersection determines the equilibrium price level and equilibrium real output.

LO: 14-3

14-12

Equilibrium

Real OutputDemanded(Billions)

Price Level(Index Number)

Real OutputSupplied(Billions)

$506

508

510

512

514

108

104

100

96

92

$513

512

510

507

502Equilibrium Price Level and

Equilibrium Real GDPLO: 14-3

14-13

Equilibrium

Real Domestic Output, GDP (Billions of Dollars)

Pri

ce L

evel

100

510

AD

AS

Equilibrium

LO: 14-3

14-14

Using AD-AS Model to Explain Inflation and Recession

When aggregate supply and aggregate demand change, inflation and recession can occur in the short run.

Demand-pull inflation occurs when aggregate demand increases (AD curve shifts to the right).

Cost-push inflation occurs when costs of production rise (AS curve shifts to the left).

Recession occurs when aggregate demand falls (AD curve shifts to the left) and prices are sticky downwards.

LO: 14-4

14-15

Demand-Pull Inflation

Real Domestic Output, GDP

Pri

ce L

evel

AD

AS

P1

P2

Q1Qf

AD1

Increase in Aggregate Demand

Demand-PullInflation

LO: 14-4

14-16

Cost-Push Inflation

Real Domestic Output, GDP

Pri

ce L

evel

AD

AS

P1

P2

Q1 Qf

Decrease in Aggregate Supply

Cost-PushInflation

AS1

a

b

LO: 14-4

14-17

Recession

Real Domestic Output, GDP

Pri

ce L

evel

AD1

AS

P1

Q2 Qf

AD2

Decrease in Aggregate Demand

Creates aRecession

ab

LO: 14-4

14-18