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Chapter 12
Aggregate Demand and
Aggregate Supply
Aggregate Demand and Aggregate Supply
-- used to explain short-run fluctuations in
real GDP and price level
Aggregate Demand
-- Curve showing the quantity of real GDP
demanded by households, firms and
Gov’t at various price levels
Short-Run Aggregate Supply (SRAS)
-- Curve showing the quantity of real GDP
supplied by firms at various price levels
in short run
Intersection of SRAS and AD determine short run
real GDP and the price level in the economy
Derivation of Downward Slope
-- as P ↓, quantity demanded of real GDP ↑
Effect of ∆P on C, I and Xn (G is unaffected
by price level changes):
1) Wealth Effect (Influence on C)
-- when the price level ↑, real value of wealth
↓  ↓ in consumption
-- when the price level , real value of
wealth ↑  ↑ in consumption
2) Interest Rate Effect (Influence on I and to a
degree C)
-- when price level ↑, households & businesses
need more money to continue buying/selling.
-- increase demand for money leads to
increase in banking withdrawals, increase
borrowing and/or selling of financial assets 
rise in interest rates on loans and bonds
-- as r ↑, leads to less borrowing by firms for
capital expenditures (new buildings,
machinery, etc) and households will borrow
less for new homes. Also consumption is
affected with reduced purchases of durable
goods
3) International Trade Effect
-- if price level ↑ relative to other countries, U.S.
exports become more expensive and
imports become less expensive
 foreigners buy more domestic or nonU.S. goods and U.S. consumers purchase
more foreign goods
 Decrease in exports and increase in
imports
 Decrease in net exports
-- reverse effect if price level ↓
Movement Along Aggregate Demand
-- caused by changes in price level
Shifts in Aggregate Demand
Increase in AD
Decrease in AD
Price Level
Price Level
P
P
AD2
AD1
AD2
Real GDP (in
billions)
Q
AD1
Real GDP (in
billions)
Q
Shifts in Aggregate Demand
-- When variables other than price change
1) ∆ Government Policies
-- Influence of Monetary Policy (∆ in interest rates) and
Fiscal Policy (Gov’t purchases and taxes)
a) As r ↑, cost of borrowing ↑  C and I ↓  AD shifts
left
As r ↓, cost of borrowing ↓  C and I ↑  shifts AD
right
b) As Gov’t purchases ↑  AD shifts right
As Gov’t purchases ↓  AD shifts left
c) As taxes↑  disposable income ↓  C ↓  shifts
AD left
As taxes ↓  disposable income ↑  C ↑  shifts
AD right
2) ∆ Expectations of Firms/Households
-- If households are more optimistic about future incomes
 C ↑  shifts AD right
-- If households are more pessimistic  C ↓  AD shifts
left
-- If firms become more optimistic about future payoff of
investment spending  AD shifts right
-- If firms become more pessimistic  AD shifts left
3) ∆ Foreign Variables
-- If U.S. real GDP grows faster than real GDP in other
countries  increase in income for U.S. consumers is greater
than that of foreign consumers  Imports will increase faster
than exports  net exports ↓  AD shifts left (opposite occurs
when real GDP grows at a slower pace relative to other
countries)
-- Net Exports ↓ when exchange rates between U.S. dollar and
foreign currency ↑ (dollar increases in value) because prices in
foreign countries for U.S. goods ↑ (reduces exports) while
prices for foreign goods in U.S. ↓ (increases imports)  AD
shift left (opposite occurs when exchange rates between U.S.
and foreign currency ↓)
Note: ∆ in net exports from change in price level does not shift
AD
Aggregate Supply
-Composed of Long Run Aggregate Supply (LRAS) and Short Run
Aggregate Supply (SRAS)
I] Long Run Aggregate Supply (LRAS)
-- curve showing the quantity of real GDP supplied by firms at
various price levels in the long run
-- changes in the price level do not affect the level of real GDP
-- LRAS is a level of output known as potential output or full
employment output (some level of frictional and structural
unemployment)
Price Level
Long Run Aggregate
Supply (LRAS)
P
Firms operate at
normal capacity levels
Real GDP
(in billions)
QFE
I] Short Run Aggregate Supply (SRAS)
-- upward sloping because as price ↑, quantity
supplied of goods and services by firms ↑
Reasons for upward slope:
1) Increased Profits: Prices of inputs rise slower than
price of goods/services hence greater profits
2) Firms are slow to adjust prices:
-- As prices ↑, some firms are slow to increase their
prices and therefore experience an increase in
sales/increase in production.
-- As prices ↓, some firms are slow to adjust their
prices ↓ so they experience a reduction in
sales/decrease in production
Reasons Behind Reasons
i) Contracts make wages and prices “sticky”
-- “sticky” refers to the fact that wages and prices are slow to
react to changes in demand and supply
Example:
#1) Company X and union negotiate a multi-year wage contract.
The company’s sales begin to take off and therefore prices ↑ in
the midst of stable wages leading to increased profits
#2) Company X enters an agreement with a supplier to supply a
key input at a constant price for 2 yrs. If sales take off and
prices ↑, since price inputs remains constant, profits ↑
Note: Although examples reflect specific companies, pervasive
scenarios can influence entire economy.
Reasons Behind Reasons
ii) Firms adjust wages slowly
-- Many non-union wage adjustments occur once a year
when during the course of the year, prices can fluctuate
considerably. Also, wages are often more conservatively
adjusted after careful evaluation of the state of the
economy, historical increases, and financial condition of
the company. As a result, we say wages adjust slowly
compared to price levels in the marketplace.
iii) Menu costs make prices “sticky”
-- Many firms have menus or catalogs that contain a list of
their products’ prices. Prices are set after careful
evaluation of market conditions and demand.
-- As prices rise and fall, even though firms would want to
change their prices, there would be associated costs with
making any changes. These costs are known as menu
costs (costs to firms of changing prices)
Movement Along Short Run Aggregate Supply
-- Caused by changes in the price level
Shifts in Short Run Aggregate Supply:
Increase in SRAS
Decrease in SRAS
Shifts in Short Run Aggregate Supply:
-- When variables other than price change
1) Increase in Labor Force and in Capital Stock
-- firms will increase output at every price level if the #
workers increase or capital increase  SRAS shifts to
the right (more output can be produced at every price
level)
2)
Technological Change
-- with technological change, productivity of workers and
machines increase, meaning firms can increase output
w/o any adjustment in amount of labor and capital 
reduction in units costs and greater profitability as output
increases  SRAS shifts to the right
3) Expected Changes in Price Level
-- If prices are expected to rise by a certain level (say
2%), workers will attempt to adjust wages by 2% and
firms will adjust prices by 2%. If this permeates
throughout the economy, general costs will rise by 2%
 SRAS shifts left
-- any level of real GDP now has a price level that is 2%
higher
Price Level
(GDP Deflator;
2000=100
SRAS2
SRAS1
102
100
Real GDP (in
trillions)
$10
4)
Adjustment of Workers and Firms to Errors in Past
Expectations About Price Levels
-- If workers and firms make inaccurate predictions
about the price level, they will attempt to make it up in
the future (price and wage adjustments)
a) If, economy-wide, price level was higher than
expected (planned and set prices @ lower price
point), firms adjust prices ↑ & workers’ wages ↑ 
SRAS shifts left.
b) If, economy-wide, price level was lower than
expected (planned and set prices @ higher price
point), firms adjust prices ↓ & workers’ wages ↓ 
SRAS shifts right.
5) Unexpected Changes in Price of Critical Natural
Resource
-- Unexpected increases/decreases in critical natural
resources can cause firms’ costs to change. There are
some natural resources that can have an economy-wide
effect (e.g. oil—can effect utility costs, transportation
costs, raw material costs, etc, depending on industry of
firm)
-- Increase in cost of critical resource on output will
cause SRAS to shift left while a decrease in cost of
critical resource will cause SRAS to shift right.
Spending Shock: Unexpected event causing SRAS to
shift
•
Often the result of unexpected changes in a critical
resource
Macroeconomic Equilibrium
I] Short-Run Equilibrium:
-- level of output where AD intersects SRAS
-- Price level is in terms of GDP Deflator (could have chosen CPI)
GDP Deflator = Nominal GDP
X 100
Real GDP
Example: GDP Deflator value of 106 tells us that prices
were 6% higher than in base year
Price Level
(GDP Deflator;
2000=100)
SRAS
100
AD
Real GDP
(in trillions)
$5
Macroeconomic Equilibrium
II] Long Run Equilibrium:
-level of output where AD = SRAS = LRAS
-economy is at potential output or level of output @ full
employment
Price Level
(GDP Deflator;
2000=100)
LRAS
SRAS
100
AD
Real GDP (in
trillions)
$5
Impact of Recessions, Expansions and Spending
Shocks On Equilibrium
Assumptions: 1) Economy is not experiencing inflation
2) Economy is not experiencing avg long
run growth
A) Recessions
-- Households become pessimistic about future
incomes and firms become pessimistic about future
profitability of investments  AD Shifts left
Price Level
(GDP Deflator;
2000=100)
LRAS
SRAS
100
98
A
B
AD1
AD2
Real GDP (in
trillions)
$4.5
$5
-- AD shifts from AD1 to AD2 and short run equilibrium is now at pt B or a
decline of $.5 trillion to $4.5 trillion. The price level will also
decrease 2 pts or from 100 to 98
-- Output is now below potential GDP and will result in laid off workers
and reduced profits for firms leading to a recession
Adjustment Back to Potential Output
-- With drop in output, price level drops to 98.
Workers and firms adjust to the price level being
lower than expected by ↓ in wages (able to buy
more and unemployed workers willing to accept
lower wages to be able to work) and firms prices
↓ (firms accept lower price due to reduced
demand)  shifts SRAS to the right and over
time back to full employment level (pt C). Price
level decreases further to 96.
Price Level
(GDP Deflator;
2000=100)
LRAS
SRAS1
SRAS2
100
98
A
B
96
C
AD1
AD2
Real GDP (in
trillions)
$4.5
$5
Conclusion:
↓ in AD creates a recession in short run but economy returns
to full employment output in Long Run. Ultimately price level
decreases.
--
Adjustment back to potential output is known as selfcorrecting mechanism (occurs w/o actions by Gov’t)
B)
Expansion
-- Households become more optimistic about future income
and future income and firms become more optimistic about
future profitability of investments  shifts AD curve right
Price Level
(GDP Deflator;
2000=100)
LRAS
SRAS
102
100
B
A
AD2
AD1
Real GDP (in
trillions)
$5 $5.5
-- AD shifts from AD1 to AD2 and short run equilibrium is now
at pt B or an increase from $.5 trillion to $5.5 trillion. The
price level will also increases 2 pts or from 100 to 102
-- Output is now above potential GDP (beyond level of
normal capacity) and will result in an increase in amount of
workers employed and increased profits for firms leading to a
expansion.
Adjustment Back to Potential Output
-- Self correcting mechanism brings economy back to
potential output. Since price level ↑, workers and firms adjust
to the price level being higher than expected by ↑ in wages
(higher levels of employment will increase employees
bargaining power for higher wages) and firms prices ↑ (firms
increase price due to increased demand)  shifts SRAS to
the left and over time back to full employment level (pt C).
Price level increases further to 103.
Price Level
(GDP Deflator;
2000=100)
LRAS
SRAS2
SRAS1
103
C
102
100
B
A
AD2
AD1
Real GDP (in
trillions)
$5 $5.5
Conclusion:
↑ in AD creates an expansionary phase for the economy in
short run but economy returns to full employment output in
Long Run. Ultimately price level increases.
C) Supply Shock
-- If price of oil increases, firms costs increase  causes
SRAS curve to shift left to SRAS2
-- Output or amount of goods produced ↓ from $5.0 to $4.5
trillion and price level ↑ to 102
-- Result of increased price level (inflation) and reduced
output (recession) is called stagflation
Price Level
(GDP Deflator;
2000=100)
LRAS
SRAS2
SRAS1
B
102
100
A
AD
Real GDP (in
trillions)
$4.5
$5
Adjustment Back to Potential Output
-- Recession results in firms willing to accept lower prices and
workers willing to accept lower wages  causes SRAS2
curve to shift back to the right and over time back to SRAS1 or
to pt A.
Conclusion
Output returns to potential output and price level returns to
original level
Price Level
(GDP Deflator;
2000=100)
LRAS
SRAS2
SRAS1
B
102
100
A
AD
Real GDP (in
trillions)
$4.5
$5