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Economics: Principles and Applications, 2e by Robert E. Hall & Marc Lieberman © 2001 South-Western, a division of Thomson Learning Aggregate Demand and Aggregate Supply © 2001 South-Western, a division of Thomson Learning The Aggregate Demand Curve •The Price Level and the Money Market •Deriving the Aggregate Demand Curve •Understanding the AD Curve •Movements Along the AD Curve •Shifts of the AD Curve © 2001 South-Western, a division of Thomson Learning The Aggregate Demand Curve A rise in the price level causes a decrease in equilibrium GDP. © 2001 South-Western, a division of Thomson Learning The Aggregate Demand Curve Aggregate Demand (AD) Curve A curve indicating equilibrium GDP at each price level. © 2001 South-Western, a division of Thomson Learning The Aggregate Demand Curve The AD curve represents more than just a behavioral relationship between two variables. Each point on the curve represents a shortrun equilibrium in the economy. © 2001 South-Western, a division of Thomson Learning The Aggregate Demand Curve When a change in the price level causes equilibrium GDP to change, we move along the AD curve. Whenever anything other than the price level causes equilibrium GDP to change, the AD curve itself shifts. © 2001 South-Western, a division of Thomson Learning The Aggregate Demand Curve The AD curve shifts rightward when government purchases, investment spending, autonomous consumption spending, or net exports increase, or when taxes decrease. © 2001 South-Western, a division of Thomson Learning The Aggregate Demand Curve The AD curve shifts leftward when government purchases, investment spending, autonomous consumption spending, or net exports decrease, or when taxes increase. © 2001 South-Western, a division of Thomson Learning The Aggregate Demand Curve An increase in the money supply shifts the AD curve rightward. A decrease in the money supply shifts the AD curve leftward. © 2001 South-Western, a division of Thomson Learning The Aggregate Supply Curve •Prices and Costs in the Short Run •Deriving the Aggregate Supply Curve •Movements Along the AS Curve •Shifts of the AS Curve © 2001 South-Western, a division of Thomson Learning The Aggregate Supply Curve A firm sets the price of its products as a markup over cost per unit. © 2001 South-Western, a division of Thomson Learning The Aggregate Supply Curve The average percentage markup in the economy is determined by competitive conditions in the economy. The competitive structure of the economy changes very slowly, so the average percentage markup should be somewhat stable from year to year. © 2001 South-Western, a division of Thomson Learning The Aggregate Supply Curve In the short run, the price level rises when there is an economy-wide increase in unit costs, and the price level falls when there is an economy-wide decrease in unit costs. © 2001 South-Western, a division of Thomson Learning The Aggregate Supply Curve As total output increases … •Greater amounts of inputs may be needed to produce a unit of output. •The prices of non-labor inputs rise. •The nominal wage rate rises. © 2001 South-Western, a division of Thomson Learning The Aggregate Supply Curve For a year or so after a change in output, changes in the average nominal wage are less important than other forces that change unit costs. © 2001 South-Western, a division of Thomson Learning The Aggregate Supply Curve Assume that changes in output have no effect on the nominal wage rate in the short run. © 2001 South-Western, a division of Thomson Learning The Aggregate Supply Curve In the short run, a rise in real GDP, by causing unit costs to increase, will also cause a rise in the price level. A fall in real GDP, by causing unit costs to decrease, will also cause a decrease in the price level. © 2001 South-Western, a division of Thomson Learning The Aggregate Supply Curve Aggregate Supply (AS) Curve A curve indicating the price level consistent with firms’ unit costs and markups for any level of output over the short run. © 2001 South-Western, a division of Thomson Learning The Aggregate Supply Curve When a change in real GDP causes the price level to change, we move along the AS curve. When anything other than a change in real GDP causes the price level to change, the AS curve itself shifts. © 2001 South-Western, a division of Thomson Learning The Aggregate Supply Curve Examples of Changes That Shift AS •Changes in world oil prices •Changes in the weather •Technological change •Adjustment to the long run © 2001 South-Western, a division of Thomson Learning AD and AS Together: Short-Run Equilibrium Short-Run Macroeconomic Equilibrium A combination of price level and GDP consistent with both the AD and AS curves. © 2001 South-Western, a division of Thomson Learning What Happens When Things Change? •Demand Shocks in the Short Run •Demand Shocks: Adjusting to the Long Run •The Long-Run Aggregate Supply Curve •Supply Shocks © 2001 South-Western, a division of Thomson Learning What Happens When Things Change? Demand Shock Any event that causes the AD curve to shift. Supply Shock Any event that causes the AS curve to shift. © 2001 South-Western, a division of Thomson Learning What Happens When Things Change? When government purchases increase, the horizontal shift of the AD curve measures how much real GDP would increase if the price level remained constant. But because the price level does rise, real GDP rises by less than the horizontal shift in the AD curve. © 2001 South-Western, a division of Thomson Learning What Happens When Things Change? A positive demand shock--one that shifts the AD curve rightward--increases both real GDP and the price level in the short run. A negative demand shock--one that shifts the AD curve leftward--decreases both real GDP and the price level in the short run. © 2001 South-Western, a division of Thomson Learning What Happens When Things Change? In the short run, we treat the wage rate as given. But in the long run, the wage rate can change. When output is above full employment, the wage rate will rise, shifting the AS curve upward. When output is below full employment, the wage rate will fall, shifting the AS curve downward. © 2001 South-Western, a division of Thomson Learning What Happens When Things Change? Self-Correcting Mechanism The adjustment process through which price and wage changes return the economy to fullemployment output in the long run. © 2001 South-Western, a division of Thomson Learning What Happens When Things Change? When output exceeds its full-employment level, wages will eventually rise, causing a rise in the price level and a drop in GDP until full employment is restored. When output is less than its full-employment level, wages will eventually fall, causing a drop in the price level and a rise in GDP until full employment is restored. © 2001 South-Western, a division of Thomson Learning What Happens When Things Change? Long-Run Aggregate Supply Curve A vertical line indicating all possible output and price-level combinations at which the economy could end up in the long run. © 2001 South-Western, a division of Thomson Learning What Happens When Things Change? The self-correcting mechanism shows us that, in the long run, the economy will eventually behave as the classical model predicts. © 2001 South-Western, a division of Thomson Learning What Happens When Things Change? In the short run, a negative supply shock shifts the AS curve upward, decreasing output and increasing the price level. © 2001 South-Western, a division of Thomson Learning What Happens When Things Change? Stagflation The combination of falling output and rising prices. © 2001 South-Western, a division of Thomson Learning What Happens When Things Change? A negative supply shock causes stagflation in the short run. © 2001 South-Western, a division of Thomson Learning What Happens When Things Change? A positive supply shock shifts the AS curve downward, increasing output and decreasing the price level. © 2001 South-Western, a division of Thomson Learning What Happens When Things Change? In the long run, the economy self-corrects after a supply shock, just as it does after a demand shock. When output differs from its full-employment level, the wage rate changes, and the AS curve shifts until full employment is restored. © 2001 South-Western, a division of Thomson Learning Some Important Provisos About the AS Curve •Some prices take time to adjust. •In some industries, wages respond quickly. •There is more to the process of recovering from a shock than the adjustment of prices and wages. © 2001 South-Western, a division of Thomson Learning