The Aggregate Model of the
Macro Economy
Chapter 14
The Aggregate Demand Curve (AD)
• The AD curve shows the alternative
combinations of the price level (P) and real
income (Y ) that result in simultaneous
equilibrium in both the real goods and the
money markets.
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Deriving the Aggregate Demand Curve
r
RLMS1 RLMS2
r
E
B
E(Y2)
IRE = f(r)
r1
r2
A
r1
B
r2
A
A
B
RLMD
M/P1 M/P2
M/P
Change in the price level
and the effect on the
money market
E(Y1)
45o
IRE1 IRE2
IRE
Y1
Y2 Y
Interest-related expenditure and
equilibrium income
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Shape of the Aggregate Demand Curve
P
P1
P2
A
B
AD
Copyright
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Y1
Y2 Pearson Education,
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Y
4
Shifting the Aggregate Demand Curve
• Monetary policy
• Fiscal policy
• Other autonomous
spending changes
P
Effect of expansionary monetary
or fiscal policy or an autonomous
increase in spending
P1
AD 2
AD1
Y1
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Y2
Y
5
Household Consumption Spending and
Aggregate Demand
AD CURVE SHIFTS OUT TO THE RIGHT
AD CURVE SHIFTS BACK TO THE LEFT
Decrease in personal taxes (TP)
Increase in personal taxes (TP)
Increase in consumer confidence (CC )
Decrease in consumer confidence (CC)
Increase in consumer wealth (W)
Decrease in consumer wealth (W)
Increase in consumer credit (CR)
Decrease in consumer credit (CR)
Decrease in consumer debt (D)
Increase in consumer debt (D)
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Business Investment Spending and
Aggregate Demand
AD CURVE SHIFTS OUT TO THE RIGHT
AD CURVE SHIFTS BACK TO THE LEFT
Decrease in business taxes (TB)
Increase in business taxes (TB)
Increase in expected profits and business
confidence (PR)
Decrease in expected profits and business
confidence (PR)
Increase in capacity utilization (CU)
Decrease in capacity utilization (CU)
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Foreign Sector and Aggregate Demand
AD CURVE SHIFTS OUT TO THE RIGHT
AD CURVE SHIFTS BACK TO THE LEFT
Increase in the level of foreign GDP or real Decrease in the level of foreign GDP or
income (Y*)
real income (Y* )
Decrease in the currency exchange rate
(R)
Increase in the currency exchange rate (R)
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Implementation Issues and Fiscal
Policy
• Any changes in government expenditure or taxes meant to
stimulate or contract the economy may take weeks or months
to be approved by both the Senate and the House of
Representatives and then sent to the president for his
signature.
• Fiscal policy takes even longer to have an impact on the
economy after the changes are passed by Congress and
signed by the president.
• Some aspects of federal expenditures and taxes act as
automatic stabilizers for the economy.
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Implementation Issues and Monetary
Policy
• The Federal Open Market Committee (FOMC)
can enact policy changes very rapidly.
• Spending changes on real goods and services
that result from changes in monetary policy
may vary by sector and take time to move
through the economy.
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Interaction of Fiscal and Monetary
Policy
• The final level of interest rates and real
income in the economy typically depends on
the Federal Reserve’s reaction to fiscal policy
or other autonomous changes in spending.
• There might also be a concern about
crowding out, the decrease in interest-related
spending of consumers and businesses that
occurs when the interest rate rises from
increased government spending.
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The Aggregate Supply Curve (AS)
• The AS curve shows the relationship between
the price level at which firms in the economy
are willing to produce different levels of real
goods and services and the resulting level of
real income.
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Potential output (GDP)
• The maximum amounts of real goods and
services or real income (GDP) that can be
produced in the economy at any point in time
based on the economy’s aggregate production
function.
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Short-Run Aggregate Supply Curve
• An aggregate supply
curve that is either
horizontal or upward
sloping, depending on
whether the absolute
price level increases as
firms produce more
output.
P
SAS
Y
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Keynesian Model
• A model of the aggregate
economy, based on ideas
developed by John Maynard
Keynes, with a horizontal
short-run aggregate supply
curve in which all changes
in aggregate demand result
in changes in real output
and income.
P
SAS
P0
A
B
AD0
Y0
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AD1
Y
Y1
15
Upward Sloping Aggregate Supply
• The short-run aggregate
supply curve slopes
upward as real income
and output approach
the economy’s potential
output.
P
SAS
P2
P1
AD2
AD1
Y
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Long-Run Aggregate Supply Curve
(Vertical)
• A vertical aggregate
supply curve that defines
the level of full
employment or potential
output based on a given
amount of resources,
efficiency, and technology
in the economy.
P
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LAS
Yf
Y
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Shifting Aggregate Supply
• The short-sun aggregate
supply curve will shift as a
result of productivity
changes and changes in the
costs of the inputs of
production that are
independent of overall
demand changes.
• The long-run aggregate
supply curve can also shift
over time if there are
increases in the amount of
inputs (labor, land, capital,
and raw materials) in the
economy and increases in
technology and efficiency.
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Measuring Changes in Aggregate
Demand and Supply
• Leading indicators are economic variables, such as manufacturing,
employment, monetary, and consumer expectation statistics, that
generally turn down before a recession begins and turn back up before a
recovery starts.
• Coincident indicators are economic variables, including employment,
income, and business production statistics, that tend to move in tandem
with the overall phases of the business cycle.
• Lagging indicators are economic variables, including measures of inflation
and unemployment, labor costs, and consumer and business debt and
credit levels, that turn down after the beginning of a recession and turn up
after a recovery has begun.
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• 1. The following events have occurred at times
in the history of the United States:
• A deep recession hits the world economy.
• The world oil price rises sharply.
• U.S. businesses expect future profits to fall.
• a. Explain for each event whether it changes
short-run aggregate supply, long-run aggregate
supply, aggregate demand, or some combination
of them.
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• A deep recession in the world economy
decreases aggregate demand.
• A sharp rise in oil prices decreases short-run
aggregate supply.
• The expectation of lower future profits
decreases investment and decreases
aggregate demand.
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• b. Explain the separate effects of each event
on U.S. real GDP and the price level, starting
from a position of long-run equilibrium.
• c. Explain the combined effects of these
events on U.S. real GDP and the price level,
starting from a position of long-run
equilibrium.
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• A deep recession in the world economy
decreases aggregate demand, which
decreases real GDP and lowers the price level.
A sharp rise in oil prices decreases short-run
aggregate supply, which decreases real GDP
and raises the price level. The expectation of
lower future profits decreases investment and
decreases aggregate demand, which
decreases real GDP and lowers the price level.
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• The combined effect of a deep recession in
the world economy, a sharp rise in oil prices,
and the expectation of lower future profits
decreases both aggregate demand and shortrun aggregate supply, which decreases real
GDP and the price level rises, falls, or remains
the same.
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