Aggregate Demand and Aggregate
Supply
SLIDES PREPARED BY JUDITH SKUCE, GEORGIAN COLLEGE
©2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 8
1
In this chapter you will learn
8.1 What determines the shape of the aggregate
demand curve and what factors shift the entire
curve
8.2 What determines the shape of the aggregate
supply curve, and what factors shift the entire
curve
8.3 How the equilibrium price level and real GDP
are determined
8.4 How the economy arrives at its long run
equilibrium
8.5 Equilibrium vs. full-employment GDP
©2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 8
2
Chapter 8 Topics
8.1 Aggregate Demand
8.2 Aggregate Supply
8.3 Equilibrium GDP & Changes in
Equilibrium
8.4 From the Short Run to the Long Run
8.5 Equilibrium Versus Full-Employment
GDP
©2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 8
3
Aggregate Demand (AD)
• The amounts of real output that buyers
collectively desire to purchase at each
possible price level
©2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 8
4
Aggregate Demand (AD)
• Aggregate Quantity Demanded (Real GDP) and
the Price Level are inversely related as follows:
Price Level
Figure 8 - 1
AD
Real GDP
©2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 8
5
Aggregate Demand (AD)
•
slopes downward because of the
following effects of a change in price
level:
1. Real-balances Effect
2. Interest-rate Effect
3. Foreign Trade Effect
Remember: these effects are caused
by price level changes
©2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 8
6
Changes in Aggregate Demand
Figure 8 - 2
Price level
AD Can Increase
AD1
Real domestic output, GDP
©2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 8
7
Changes in Aggregate Demand
Figure 8 - 2
Price level
AD Can Increase
shift RIGHT
AD1
AD2
Real domestic output, GDP
©2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 8
8
Changes in Aggregate Demand
Figure 8 - 2
Price level
AD Can Decrease
AD1
Real domestic output, GDP
©2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 8
9
Changes in Aggregate Demand
Figure 8 - 2
Price level
AD Can Decrease
shift LEFT
AD3
AD1
Real domestic output, GDP
©2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 8
10
Determinants of Aggregate Demand
• Consumer Spending
– Consumer wealth
– Consumer expectations
– Taxes
– Household indebtedness
©2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 8
11
Determinants of Aggregate Demand
• Investment Spending
– Real Interest Rates
– Expected Returns
•
•
•
•
Expectations about future business conditions
Technology
Degree of excess capacity
Business taxes
©2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 8
12
Determinants of Aggregate Demand
• Government Spending
• Net Export Spending
– National Income Abroad
– Exchange Rates
©2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 8
13
Chapter 8 Topics
8.1 Aggregate Demand
8.2 Aggregate Supply
8.3 Equilibrium GDP & Changes in
Equilibrium
8.4 From the Short Run to the Long Run
8.5 Equilibrium Versus Full-Employment
GDP
©2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 8
14
Aggregate Supply
• The level of real domestic output that will
be produced at each price level
• Production responses to price level
changes differ in the long run & the short
run
©2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 8
15
Aggregate Supply in the Long Run
• in the long run, the aggregate supply curve
is vertical at the economy’s fullemployment output (potential GDP)
Price level
ASLR
GDPf
©2005 McGraw-Hill Ryerson Ltd.
Real domestic
output, GDP
Macroeconomics, Chapter 8
16
Aggregate Supply in the Long Run
• in the long run, wages & other input prices
rise or fall to match changes in the price
level
• changes in the price level do not change
real profit & there is no change in real
output
©2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 8
17
Aggregate Supply in the Short Run
Price level
• in reality, nominal wages adjust only slowly to
changes in the price level
• short-run aggregate supply curve is upwardsloping
AS
GDPf
©2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 8
Real domestic
output, GDP
18
Aggregate Supply in the Short Run
• as the economy expands in the short run, perunit production costs generally rise
• the extent of the rise depends on where the
economy isunless
operating,
relative
to its capacity
stated
otherwise,
– an economy “aggregate
operating below
its full-employment
supply”
output has idle capital & labourlittle upward
refers
to AS costs
in the short
pressure on
production
– when the economy is run
operating beyond its fullemployment output, most available resources are
already employedper-unit production costs increase
as economy expands
©2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 8
19
Determinants of Aggregate Supply
1. Change in input prices
a. Domestic resource price
b. Price of imported resources
c. Market power
2. Change in productivity
3. Change in legal-institutional environment
a. Business taxes & subsidies
b. Government regulation
©2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 8
20
Chapter 8 Topics
8.1 Aggregate Demand
8.2 Aggregate Supply
8.3 Equilibrium GDP & Changes in
Equilibrium
8.4 From the Short Run to the Long Run
8.5 Equilibrium Versus Full-Employment
GDP
©2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 8
21
Equilibrium GDP
• Equilibrium occurs at the price level that
equalizes the amount of real output
demanded & supplied
• A price level too low would mean AD>AS,
putting upward pressure on prices across
the economy
©2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 8
22
Price Level Too Low
Figure 8-6
Price
Level
AS
AD
upward
pressure
PL1
AS1
©2005 McGraw-Hill Ryerson Ltd.
AD1
Macroeconomics, Chapter 8
Real
GDP
23
Equilibrium GDP
• similarly, a price level too high would mean
AD<AS, putting downward pressure on
prices across the economy
©2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 8
24
Price Level Too High
Figure 8-6
Price
Level
AS
AD
PL2
downwar
d
pressure
AD2
©2005 McGraw-Hill Ryerson Ltd.
AS2
Macroeconomics, Chapter 8
Real
GDP
25
Changes in Equilibrium
• Are caused by changes (shifts) in AD
and/or AS
©2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 8
26
Increases in AD
• for any initial increase in aggregate
demand, the resulting increase in real
output will be smaller the greater is the
increase in the price level
• demand-pull inflation…
©2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 8
27
Increases in AD
Figure 8-7
Price level
AS
P2
output does not
increase all the way
to GDP1 because of
inflation
P1
AD2
GDPf GDP2
©2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 8
AD1
Real GDP
GDP1
28
Decreases in AD
• Deflation is a rarity in the Canadian economy
• Real output takes the full brunt of the decline in
AD because product prices are “sticky” in the
short run
–
–
–
–
–
wage contracts
morale, effort, & productivity
minimum wage
menu costs
fear of price wars
©2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 8
29
Decreases in AD
Figure 8-8
Price level
prices are sticky
downwards
AS
P1
AD2
GDP1 GDPf
©2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 8
AD1
Real GDP
30
Decreases in AS: Cost-Push Inflation
• effects of a leftward shift in AS are doubly
bad
– output decreases
– price level increases
©2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 8
31
Decreases in AS
Figure 8-9
AS2
Price level
AS1
P2
P1
GDP2 GDPf
©2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 8
AD1
Real GDP
32
Increases in AS
• increases in AD should normally lead to
inflation
• recently, productivity growth has shifted
the long-run AS curve to the right
©2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 8
33
Increases in AS
Figure 8-10
AS1
Price level
AS2
P3
P2
P1
AD2
AD1
GDP1GDP2GDP3
©2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 8
Real GDP
34
Chapter 8 Topics
8.1 Aggregate Demand
8.2 Aggregate Supply
8.3 Equilibrium GDP & Changes in
Equilibrium
8.4 From the Short Run to the Long Run
8.5 Equilibrium Versus Full-Employment
GDP
©2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 8
35
From the Short Run to the Long Run
• nominal wages & other input prices may
remain constant in the short run, even
though the price level has changed
• once contracts have expired & nominal
wage adjustments have been made, the
economy enters the long run
©2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 8
36
Short-Run Aggregate Supply
Price level
Figure 8-11
a2
P2
P1
a1
GDPf
©2005 McGraw-Hill Ryerson Ltd.
AS1
GDP2
Macroeconomics, Chapter 8
an increase in
price level
increases
profits &
output,
moving the
economy from
a1 to a2
Real domestic output
37
Short-Run Aggregate Supply
Figure 8-11
Price level
AS1
a1
P1
P3
a3
GDP3
©2005 McGraw-Hill Ryerson Ltd.
GDPf
Macroeconomics, Chapter 8
a decrease in
price level
decreases
profits &
output,
moving the
economy from
a1 to a3
Real domestic output
38
Long-Run Aggregate Supply
Figure 8-11
ASLR
Price level
b1
P2
P1
a1
GDPf
©2005 McGraw-Hill Ryerson Ltd.
an increase in
AS2
price level
leads to
AS1
increases in
a2
nominal
wages,
shifting shortrun AS
leftward
new
GDP2
Real domestic output
equilibrium at
b1
Macroeconomics, Chapter 8
39
Long-Run Aggregate Supply
Price level
Figure 8-11
P1
P3
a3
GDP3
©2005 McGraw-Hill Ryerson Ltd.
a decrease in
price level
ASLR
leads to
AS1
decreases in
nominal
AS3
wages,
a1
shifting shortrun AS
c1
rightward
new
GDPf GDP2
Real domestic output
equilibrium at
c1
Macroeconomics, Chapter 8
40
Equilibrium in the Long-Run AD-AS
Model
Figure 8-12
ASLR
Price level
AS1
P1
a
AD1
GDPf
©2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 8
41
Chapter 8 Topics
8.1 Aggregate Demand
8.2 Aggregate Supply
8.3 Equilibrium GDP & Changes in
Equilibrium
8.4 From the Short Run to the Long Run
8.5 Equilibrium Versus Full-Employment
GDP
©2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 8
42
Equilibrium Versus Full-Employment
GDP
• There is no guarantee, in the short run,
that equilibrium GDP will be fullemployment GDP
©2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 8
43
Recessionary Gap
• A recessionary gap occurs when AD is too
low, and equilibrium GDP is below
potential GDP
©2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 8
44
Recessionary Gap
Figure 8-13
Price level
ASLR
Potential GDP
AS
Recessionary
Gap = 20
P0
AD0
P1
AD1
490
©2005 McGraw-Hill Ryerson Ltd.
510
Macroeconomics, Chapter 8
Real GDP
45
Inflationary Gap
• An inflationary gap occurs when AD is too
high, and equilibrium GDP is above
potential GDP
©2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 8
46
Inflationary Gap
Figure 8-13
Price level
ASLR
Potential GDP
AS
Inflationary
Gap = 20
P1
AD2
P0
AD0
510
©2005 McGraw-Hill Ryerson Ltd.
530
Macroeconomics, Chapter 8
Real GDP
47
Chapter 8 Topics
8.1 Aggregate Demand
8.2 Aggregate Supply
8.3 Equilibrium GDP & Changes in
Equilibrium
8.4 From the Short Run to the Long Run
8.5 Equilibrium Versus Full-Employment
GDP
©2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 8
48
Chapter 8 Appendix
The Relationship of the Aggregate
Expenditures Model to the AD-AS
Model
©2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 8
49
Derivation of AD Curve
• AD can be derived from the Aggregate
Expenditures Model
illustrated…
©2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 8
50
Aggregate expenditures
(billions of dollars)
Figure A8 - 1
AE 1 at P 1
1
0
Price level
GDP1
P1
0
1'
GDP1
What if
prices go
Real GDP
up?
Real GDP at
price level 1
Real GDP
Price level
Aggregate expenditures
(billions of dollars)
Figure A8 - 1
AE1 at P 1
AE2 at P 2
1
2
0
P2
P1
0
GDP2 GDP1
What if
prices
go up
Real GDP
again?
2'
1'
GDP2 GDP1
A Lower Real
GDP at price
level 2
Real GDP
Aggregate expenditures
(billions of dollars)
Figure A8 - 1
AE1 at P 1
AE2 at P 2
1
AE3 at P 3
2
3
0
Real GDP
Price level
GDP3 GDP2 GDP1
P3
P2
P1
0
3'
2'
1'
GDP3GDP2 GDP1
A Still Lower
Real GDP Level
at price
Real GDP
level 3
Aggregate expenditures
(billions of dollars)
Figure A8 - 1
AE1 at P 1
AE2 at P 2
1
AE3 at P 3
2
3
0
Real GDP
Price level
GDP3 GDP2 GDP1
P3
P2
P1
0
3'
Aggregate Demand
can be derived from AE
2'
1'
GDP3GDP2 GDP1
Real GDP
Shifts in AD
• and shifts in Aggregate Expenditure
illustrated…
©2005 McGraw-Hill Ryerson Ltd.
Macroeconomics, Chapter 8
55
Price level
Aggregate expenditures
(billions of dollars)
Figure A8 - 2
AE2 at P 1
AE1 at P 1
An Increase
in Aggregate
Expenditures
0
GDP1 GDP2
Real GDP
An Increase in
Aggregate Demand
P1
AD2
AD1
0
GDP1 GDP2
Real GDP