Chapter 28 - Aggregate demand and aggregate supply. After studying this chapter you will be able to understand: What the components of aggregate demand (AD) are and why the AD curve slopes downward? What the components of aggregate supply (AS) are and why the AS curve slopes upward? What factors shift AD and AS? What differences exist between the short and long run?
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Chapter 28
Aggregate Demand and Aggregate Supply
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are and why the AD curve slopes downward
are and why the AS curve slopes upward.
long run
• What the short‐ and long‐run effects of shifts in
AD and AS are
shocks
What will you learn in this chapter?
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on three features of the economy:
1 Output (GDP)
2 Prices
3 Unemployment
macroeconomy would be useful
employment are all tied together as part of a
single economic equilibrium
Tying it all together
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Aggregate demand
• Aggregate demand is equal to GDP, or AD = GDP = C + I + G + NX.
• The aggregate demand curveshows the relationship between the
overall price level in the economy and output.
Aggregate demand
Price level
Output
1
P
Y1
1 A decrease
in the price
level…
P2
Y2
2 …increases the amount of goods and services demanded.
• We are interested in what happens when the prices
of all goods go up or down
• Price changes are measured by the price index or inflation
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• Why the AD curve slopes downward is due to
each component of AD.
1 Consumption (C):
because their real wealth decreases
– This is called the wealth effect.
2 Investment (I):
• As prices rise, interest rates rise
in a decrease in investment spending
Why does the AD curve slope downward?
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3 Government spending (G):
the price level
downward sloping AD
4 Net exports (NX):
relatively more expensive compared to other
countries’ goods
• As price levels increase, net exports decrease
Why does the AD curve slope downward?
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level and three of the national expenditure
components:
price level and aggregate expenditures
Why does the AD curve slope downward?
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The entire aggregate demand curve can also shift in response to non‐
price changes in any of the four components of aggregate demand.
Shifting the aggregate demand curve
1 Price level
Output
AD
A rightward shift of aggregate demand
Price level
A leftward shift of aggregate demand
AD1
Output AD2 AD2
• When a non‐price factor increases a
component of AD, the entire AD curve
shifts to the right.
• GDP is higher at every price level.
• When a non‐price factor decreases a component of AD, the entire AD curve shifts to the left.
• GDP is lower at every price level.
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Consumption
• High expectations about future income
increase consumer spending.
• Tax cuts increase consumer spending.
• Low expectations about future income lead to greater saving and less spending.
• Higher interest rates discourage borrowing.
Investment
• Confidence in the future of the economy
leads firms to expand their businesses.
• A tax credit for small businesses inspires
firms to buy new company cars.
• Firms cut back on spending in order to weather a recession.
• Taxes on capital increase, leaving less money for investment.
Government spending
• Increase in government spending spurs
spending after a recession.
• Decrease in government spending in response to concerns about increasing debt leads to less spending.
Net exports
• A new free trade agreement with Europe
reduces most tariffs and other restrictions
on U.S. goods.
• Economic growth abroad in China
increases demand for U.S. goods and
services.
• Other countries increase their tariffs on U.S. goods, making the goods more expensive.
• The dollar strengthens, making U.S. goods and services more expensive for international consumers, decreasing demand.
The main non‐price factors are as follows:
Shifting the aggregate demand curve
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Indicate whether each of the following situations results in
an increase or decrease in aggregate demand
Active Learning: AD shifts
1 Consumers feel confident that incomes will
increase significantly in the next year
2 The government is concerned about
increasing its debt and thus reduces
government spending
3 China increases the tariffs on U.S. goods
4 The government awards small factories a
tax credit, which many use to build new
manufacturing plants
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• Aggregate supply is the sum total of the production of all
the firms in the economy
• The aggregate supply curveshows the relationship
between the overall price level in the economy and total
production by firms
• The AS curve represents production in the economy as a
whole, not just of one good or service. It describes how
much firms decide to produce
• The economy operates differently in the short run and
long run, so there are two different AS curves
•Thelong‐run aggregate supply curve (LRAS).
•The short‐run aggregate supply curve (SRAS).
Aggregate supply
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In the short run, the AS curve slopes upward.
Short‐run aggregate supply (SRAS)
P1
P2
Price level
Output
Short-run aggregate
supply (SRAS)
• Prices of final goods increase more quickly than input prices
• An increase in the final goods’ price level
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• The long run is not a set amount of time.
– It is the time required for input prices to fully adjust to economic
conditions.
• When input costs adjust, firms no longer earn positive economic
profits.
• The economy returns to where it started.
• Changes in the price‐level do not affect aggregate supply in the long
run.
Long‐run aggregate supply (LRAS)
Price level
Output
Long-run aggregate
supply (LRAS)
Yp
P1
P2
• In the long run, the aggregate supply curve is fixed.
• The long‐run aggregate supply curve is not affected by the price level, causing it to be vertical.
• The LRAS curve represents potential output in the economy.
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• Economies do not always produce to their potential output.
• Business cycles are fluctuations of output around the level of potential
output.
– When output is higher than potential output, the economy is in a boom.
– When output is below potential output, the economy is in a recession.
• The U.S. business cycle has occurred frequently over the last 50 years.
The business cycle
Long-run average growth
-4
-2
0
2
4
6
8
Year
Percent Annual growth rate of
real per capita GDP
The average real GDP per capita growth rate was around 3% between 1960 and 2010.
But notice that the yearly average fluctuated quite a bit.
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If inputs become more expensive, firms will want to
supply fewergoods at any price level in the short‐run
Shifts in the SRAS curve
SRAS 1 SRAS 2 Price level
LRAS
Output
shifts to the left
• Supply shocksare
significant events that directly affect production and the
AS curve in the short run
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In the long run, production decisions are influenced
Shifts in the LRAS curve
LRAS 2020
(2010)
Y
(2020)
LRAS
2010
Price level
Output
• The LRAS curve shifts outward if there is an increase in available inputs.
• Everything that shifts the LRAS also shifts the SRAS.
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Shifts in the LRAS curve
Factor Increases LRAS Decreases LRAS
Technology
Technological innovation allows
same amount of inputs.
A new law stripping away intellectual property rights reduces the incentive to innovate.
Capital
Foreign investment in factories
and machines increases available
capital.
Depreciation and wear breaks down capital.
Labor Immigration increases the availablesupply of labor. workers out of the labor force.Aging population takes
everyone a chance to go to school.
Reduction of federal college grants.
Natural resources
New energy sources allow factories
to produce more with the same
inputs.
Climate change permanently reduces the amount of land that can be farmed.
The main factors that shift LRAS are as follows.
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Equilibrium in the national economy is at the point
where AD = AS
Economic fluctuations
SRAS
AD LRAS
Y*
P*
Price level
Output
• Short‐run equilibrium occurs
at the intersection of the AD and SRAS
• The long‐run equilibrium occurs wherethe AD curve crosses both the LRAS and SRAS
– Prices are at expected levels.
– The short run level of output
is the same as the long run level of potential output
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Using the AD‐AS model, the short‐ and long‐run effects of a
rightward shift in AD can be predicted.
Effects of a shift in aggregate demand
Short run
Price level
Output
LRAS
AD1 SRAS
Y1
E1
P1
AD2
Y2
Long run Price level
Output LRAS
2
E E3 SRAS2
AD2 AD1
SRAS1
P1
Y
1 E2 P3
Y3
• The increase in AD causes wages and input prices to rise.
• SRAS decreases.
• Output returns to original level
• Prices increase again.
E2
• Increase in consumer confidence
causes AD to increase.
• Output is above long‐run
potential.
• Prices increase.
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• Decrease in consumer confidence
causes AD to decrease
• Output is below long run potential.
• Prices decrease.
Effects of a shift in aggregate demand
SRAS
AD1
LRAS
Short run
Price level
Output 2
AD2 P
Long run Price level
Output
AD1 AD2
LRAS SRAS1 E1 P1
• The decrease in AD causes wages and input prices to fall.
• SRAS increases.
• Output returns to original level.
• Prices decrease again.
E 1
Y1
P1
Y2
2
E
Y2
2 E
Y3
SRAS2 P3
E3
Using the AD‐AS model, the short‐ and long‐run effects of a
leftward shift in AD can be predicted.
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Changes in AD in the short and long run are
summarized as follows.
Effects of a shift in aggregate demand
Increase in AD Increase in governmentspending: increases G Output increases.Price increases.
Decrease in AD Reduction in consumerconfidence: reduces C Output decreases.Price decreases.
Shift Example Short run Long run
Output unchanged.
Price increases.
Output unchanged.
Price decreases.
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• Temporary supply side shock causes
the SRAS to decrease.
• Output falls below long run potential.
• Prices increase.
Effects of a shift in aggregate supply
Short run
Output SRAS2
2
Y
P2
Output
Long run Price level
LRAS SRAS1
AD Y2
P 2
SRAS2
Y1
E2
• The decrease in SRAS causes wages to
fall (price of labor decreases).
• SRAS increases.
• Output increases to original level.
• Prices decrease to original level.
Price level
LRAS
SRAS1
AD Y1
E 2
Supply‐side shocks can also be analyzed. Suppose a temporary
supply‐side shock hits the economy
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• Permanent supply side shock causes
the LRAS to decrease.
• Input prices rise causing the SRAS to
decrease.
• Prices increase and output decreases.
Effects of a shift in aggregate supply
• As prices continue to rise, the SRAS
decreases until it reaches the long run equilibrium.
• Prices increase again.
• Output decreases to long‐run equilibrium.
P1
Y1
P2
LRAS2
SRAS2
P3 P1
Y1 Y3
LRAS1 LRAS2
SRAS1 Price level
AD
Long run
E1
SRAS3 LRAS1
SRAS1 Price level
Output
AD
Short run
E1
E3 E2
Suppose a permanent supply‐side shock hits the economy
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• The AD/AS model is a powerful tool for:
• It is important to distinguish between supply
and demand shocks.
Comparing demand and supply shocks
Event What kind of shock?
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Indicate what type of shock is caused by each of
the following situations.
Active Learning: Demand and supply shocks
Situation Type of Shock
Consumer confidence increases
A hurricane destroys many
factories on the east coast
There is a large surge in the
number of immigrants into the U.S.
The discovery of new oil reserves
causes a temporary decrease in
the price of oil
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• There are clear predictions about how different types of
shocks will affect prices and output
• These predictions give clues to what type of shock
occurred
Comparing demand and supply shocks
Supply or demand? Positive shock Negative shock
Demand side
Short-run:
Output increases Price increases Demand side
Long-run:
No change in output Price increases Temporary shock:
Supply side
Short-run:
Output increases Price decreases Temporary shock:
Supply side
Long-run:
No change in output
No change in price Permanent shock:
Supply side
Long-run:
Output increases Price decreases
Short-run:
Output decreases Price decreases
Long-run:
No change in output Price decreases
Short-run:
Output decreases Price increases
Long-run:
No change in output
No change in price
Long-run:
Output decreases Price increases
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For each of the following situations, indicate how the
AD/AS model predicts prices and output will change
Active Learning: Short‐ and long‐run predictions
Situation Short run Long run
An increase in consumption
positive AD shock.
Unusually high rainfall increases
current year wheat crop yields
negative SRAS shock.
The FED increases interest rates
negative AD shock.
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• It can take a long time for the economy to fully
adjust to demand and supply shocks.
• Waiting for adjustments is often difficult on
producers and consumers.
• Voters often call upon politicians to respond
during a recession.
• The government can try to boost the economy
out of a recession through government
spending.
The role of public policy
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• The government can try to counter this
negative demand shock by spending more to
cause aggregate demand to increase.
• Such policies are challenging to implement.
–It is difficult to gauge the overall effect of
government spending on AD
–It is rare to perfectly design policy to restore AD to
its original level
outcomes
The role of public policy
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The government may respond to a housing crisis as shown below
Government spending to counter negative
demand shocks
AD2 1
AD2 AD1 Price level
Output
LRAS
SRAS Government stimulus
Y3 P2
Y2
P2
AD3 P3
Y2
Price level
Output
LRAS
AD1 P
SRAS Housing-market crash
Y1
E1
E2
E3 E2
• Government spending increases AD.
• Equilibrium price level increases.
• Output increases , but is still lower than the original level.
• The crash of the housing market
causes AD to decrease.
• Short term price level falls.
• Short term output falls.
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• The drought causes SRAS to
decrease.
• Short term prices rise.
• Short term output falls.
Government spending to counter negative
supply shocks
• Government spending increases AD.
• New equilibrium prices are higher.
• Output increases to the original level.
P 1
Y1
SRAS1
AD
LRAS
Price level
Output
Drought shifts aggregate supply
P
2
Y2
SRAS2
1 Price level
Output
Government response
AD2 SRAS1 SRAS2
AD1
LRAS
P3
Y1
E2
E3 P
P2
Y2 E2
The government may respond to Midwestern drought as shown below
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• The long‐run result of government
intervention is higher prices , but output may
more quickly return to long‐run levels.
• Why would the government ever choose to
intervene?
and services
• Government spending is a short‐term policy
action used to address short‐term shocks.
Government spending summarized
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• The AD/AS model helps to understand what
drives prices, unemployment, and GDP in
context of the economy.
• AD shows the relationship between overall
prices and total demand in the economy.
• AD is downward‐sloping because consumption,
investment, and net exports all decrease when
prices rise.
Summary