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Aggregate demand and Aggregate Supply (AD and AS) notice the data: while potential GDP tends to move upward yr
after yr, due to economic growth, actual GDP tends to rise above and fall below potential over shorter periods
Date reveals an important fact: Deviations from potential output don’t last forever
In some of these episodes, government policy-either fiscal or monetary-helped the economy to return to full employment more quickly
But even without corrective policies-such as during long parts of Great Ds of the 1930s-the economy shows a remarkable tendency to begin moving back towards potential output
What is the mechanism behind? We will study the behavior of a new variable that we have put
aside for several chapters: the price level
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Figure 1a: Potential and Actual Real GDP, 1960-2001
Act
ual
an
d P
ote
nti
al R
eal
GD
P
(Bil
lio
ns
of
1996
Do
llar
s)
2,000
3,000
4,000
5,000
6,000
7,000
8,000
9,000
1960
1965
1970
1975
1980
1985
1990
1995
2000
2003
The orange line shows full-employment or potential output.
The green line shows actual output. During recessions,
output declines.
During expansions, output rises—sometimes rapidly.
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Figure 1: The Two-Way Relationship Between Output and the Price Level
PriceLevel
RealGDP
Aggregate Demand Curve
Aggregate Supply Curve
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AD and AS
There exist a two-way relationship between price level and output (see diagram 1)
Changes in price level cause changes in real GDP – illustrated by Aggregate Demand curve
Changes in real GDP cause changes in price level – illustrated by Aggregate Supply curve
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The Aggregate Demand Curve First step in understanding how price level affects
economy is an important fact When price level rises, money demand curve shifts
rightward (because purchases become more expensive) Shift in money demand, and its impact on the economy,
is illustrated in Figure 2 Imagine a rather substantial rise in price level—from
100 to 140 Compared with our initial position, this new equilibrium
has the following characteristics Money demand curve has shifted rightward Interest rate is higher Aggregate expenditure line has shifted downward Equilibrium GDP is lower
All of these changes are caused by a rise in price level A rise in price level causes a decrease in equilibrium
GDP
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Figure 2a: Deriving the Aggregate Demand Curve
(a)
E
H
500 Money ($ Billions)
Interest Rate
6%
9%
Ms
As the price level rises, money demand increases and interest rate rises.
d1M
d2M
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Figure 2b/c: Deriving the Aggregate Demand Curve
(b) (c)
The rise in the interest rate causes real GDP to fall.
Real GDP($ Trillions)
Ag
gre
gat
e E
xpen
dit
ure
($ T
rill
ion
s)
6 10
E
AEr = 6%
AEr = 9%
H
140
100
Price Level
H
AD
E
On the AD curve, a higher price level is associated with a lower real GDP.
106 Real GDP($ Trillions)
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Deriving the Aggregate Demand Curve
Panel (c) of Figure 2 shows a new curve Shows negative relationship
between price level and equilibrium GDP
Call aggregate demand curve Tells us equilibrium real GDP at
any price level
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Understanding the AD Curve AD curve is unlike any other curve you’ve encountered in
this text In all other cases, our curves have represented simple
behavioral relationships But AD curve represents more than just a behavioral
relationship between two variables Each point on curve represents a short-run equilibrium
in economy A better name for AD curve would be “equilibrium output
at each price level” curve—not a very catchy name AD curve gets its name because it resembles demand
curve for an individual product AD curve is not a demand curve at all, in spite of its
name
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Movements Along the AD Curve As you will see later in this chapter, a variety of
events can cause price level to change, and move us along AD curve Suppose price level rises, and we move from point
E to point H along this curve Following sequence of events occurs
Opposite sequence of events will occur if price level falls, moving us rightward along AD curve
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Shifts of the AD Curve When we move along AD curve in Figure 2, we assume that
price level changes But that other influences on equilibrium GDP are constant Keep following rule in mind
When a change in price level causes equilibrium GDP to change, we move along AD curve
Whenever anything other than price level causes equilibrium GDP to change, AD curve itself shifts
Equilibrium GDP will change whenever there is a change in any of the following Government purchases Autonomous consumption spending Investment spending Net exports Taxes Money supply
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An Increase in Government Purchases Spending shocks initially affect economy by shifting
aggregate expenditure line In Figure 3, we assume economy begins at a price level of
100 Let’s increase government purchases by $2 trillion and ask
what happens if price level remains at 100 An increase in government purchases shifts entire AD
curve rightward AD curve shifts rightward when government purchases,
investment spending, autonomous consumption spending, or net exports increase, or when taxes decrease
Analysis also applies in the other direction AD curve shifts leftward when government purchases,
investment spending, autonomous consumption spending, or net exports decrease, or when taxes increase
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Figure 3: A Spending Shock Shifts the AD Curve
(a) (b)
H
10 13.5
E
AE1
AE2
At any given price level, an increase in government purchases shifts the AE line upward, raising real GDP.
Rea
l A
gg
reg
ate
Exp
end
itu
re($
Tri
llio
ns)
Real GDP($ Trillions)
100
10 13.5
AD1 AD2
EH
Since real GDP is higher at the given price level, the AD curve shifts rightward.
Real GDP($ Trillions)
Price Level
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Changes in the Money Supply
Changes in money supply will also shift aggregate demand curve Imagine that Fed conducts open market
operations to increase money supply AD curve shifts rightward
A decrease in money supply would have the opposite effect
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Shifts vs. Movements Along the AD Curve: A Summary
Figure 4 summarizes how some events in economy cause a movement along AD curve, and other events shift AD curve
Panels (b) and (c) of Figure 4 tell us how a variety of events affect AD curve, but not how they affect real GDP
Where will price level end up? First step in answering that question is to
understand the other side of the relationship between GDP and price level
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Figure 4a: Effects of Key Changes on the Aggregate Demand Curve
(a)
Real GDP
Price Level
P3
Q3 Q1 Q2
AD
P1
P2
Price level ↑ moves us leftward along the AD curve
Price level ↓ moves us rightward along the AD curve
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Figure 4b: Effects of Key Changes on the Aggregate Demand Curve
Entire AD curve shifts rightward if:• a, IP, G, or NX increases• Net taxes decrease• The money supply increases
AD2
AD1
(b)
Real GDP
Price Level
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Figure 4c: Effects of Key Changes on the Aggregate Demand Curve
AD2
decreasesEntire AD curve shifts leftward if:• a, IP, G, or NX decreases• Net taxes increase• The money supply decreases
(c)
Real GDP
Price Level
AD1
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Costs and Prices Price level in economy results from pricing
behavior of millions of individual business firms In any given year, some of these firms will raise
their prices, and some will lower them But often, all firms in the economy are
affected by the same macroeconomic event Causing prices to rise or fall throughout the
economy – what interest us in macroeconomics To understand how macroeconomic events
affect the price level, we begin with a very simple assumption A firm sets price of its products as a markup over
cost per unit
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Costs and Prices Percentage markup in any particular industry will depend
on degree of competition there In macroeconomics, we are not concerned with how the
markup differs in different industries But rather with average percentage markup in economy
Determined by competitive conditions Competitive structure changes very slowly, so average
percentage markup should be somewhat stable from year-to-year
But a stable markup does not necessarily mean a stable price level, because unit costs can change In short-run, price level rises when there is an economy-
wide increase in unit costs Price level falls when there is an economy-wide decrease in
unit costs
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GDP, Costs, and the Price Level Primary concern here: impact of real GDP on
unit costs and, therefore, on the price level Why should a change in output affect unit
costs and price level? As total output increases
Greater amounts of inputs may be needed to produce a unit of output
Price of non-labor inputs rise Nominal wage rate rises
A decrease in output affects unit costs through the same three forces, but with opposite result
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The Short Run All three of our reasons are important in explaining why a change
in output affects price level However, they operate within different time frames
But our third explanation—changes in nominal wage rate—is a different story
For a year or more after a change in output, changes in average nominal wage are less important than other forces that change unit costs
Some of the more important reasons why wages in many industries respond so slowly to changes in output Many firms have union contracts that specify wages for up to
three years Wages in many large corporations are set by slow-moving
bureaucracies Wage changes in either direction can be costly to firms Firms may benefit from developing reputations for paying stable
wages
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The Short Run Nominal wage rate is fixed in short-run
We assume that changes in output have no effect on nominal wage rate in short-run
Since we assume a constant nominal wage in short-run, a change in output will affect unit costs through the other two factors In short-run, a rise (fall) in real GDP, by
causing unit costs to increase (decrease), will also cause a rise (decrease) in price level
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Deriving the Aggregate Supply Curve Figure 5 summarizes discussion about effect of
output on price level in short-run Each time we change level of output, there will
be a new price level in short-run Giving us another point on the figure If we connect all of these points, we obtain
economy’s aggregate supply curve Tells us price level consistent with firms’ unit costs
and their percentage markup at any level of output over short-run
A more accurate name for AS curve would be “short-run-price-level-at-each-output-level” curve
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Figure 5: The Aggregate Supply Curve
Price Level
Real GDP ($ Trillions)
130
100
80C
AS
13.5106
A
B
Starting at point A, an increase in output raises unit costs. Firms raise prices, and the overall price level rises.
Starting at point A, a decrease in output lowers unit costs. Firms cut prices, and the overall price level falls.
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Movements Along the AS Curve When a change in output causes price
level to change, we move along economy’s AS curve What happens in economy as we make such
a move? As we move upward along AS curve, we can
represent what happens as follows
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Shifts of the AS Curve Figure 5 assumed that a number of important variables
remained unchanged But in real world, unit costs sometimes change for
reasons other than a change in output In general, we distinguish between a movement along
AS curve, and a shift of curve itself, as follows When a change in real GDP causes the price level to
change, we move along AS curve When anything other than a change in real GDP causes
price level to change, AS curve itself shifts What can cause unit costs to change at any given level
of output? Changes in world oil prices Changes in the weather Technological change Nominal wage, etc.
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Figure 6: Shifts of the Aggregate Supply Curve
Price Level
Real GDP ($ Trillions)
100
AS1
A
When unit costs rise at any given real GDP, the AS curve shifts upward–e.g., an increase in world oil prices or bad weather for farm production.
140
10
AS2
L
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Figure 7a: Effects of Key Changes on the Aggregate Supply Curve
(a)
Real GDP
Price Level
P3
Q2 Q1 Q3
P1
P2
ASReal GDP ↑ moves us rightward along the AS curve
Real GDP ↓ moves us leftward along the AS curve
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Figure 7b: Effects of Key Changes on the Aggregate Supply Curve
Real GDP
Price Level(b)
AS1
AS2
Entire AS curve shifts upward if unit costs ↑ for any reason besides an increase in real GDP
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Figure 7c: Effects of Key Changes on the Aggregate Supply Curve
Real GDP
Price Level(c)
AS1AS2
Entire AS curve shifts downward if unit costs ↓ for any reason besides an decrease in real GDP
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AD and AS Together: Short-Run Equilibrium
Where will the economy settle in short-run? Where is our short-run macroeconomic equilibrium?
We know that in equilibrium, economy must be at some point on AD curve
Short-run equilibrium requires economy be operating on its AS curve
Only when economy is at point E—on both curves—will we have reached a sustainable level of real GDP and the price level
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Figure 8: Short-Run Macroeconomic Equilibrium
Price Level
Real GDP ($ Trillions)
140
100
AS
106 14
E
B
AD
F
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What Happens When Things Change? Now that we know how short-run equilibrium is
determined, and armed with our knowledge of AD and AS curves, we are ready to put model through its paces
Our short-run equilibrium will change when either AD curve, AS curve, or both, shift An event that causes AD curve to shift is called a
demand shock An event that causes AS curve to shift is called a supply
shock In earlier chapters, we’ve used phrase spending shock
A change in spending by one or more sectors that ultimately affects entire economy
Demand shocks and supply shocks are just two different categories of spending shocks
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An Increase in Government Purchases
Shifts AD curve rightward Can see how it affects economy in short-run:
increases output and rises interest rate in the money market
Process described is not entirely realistic Assumes that when government purchases
rise, first output increases, and then price level rises
In reality, output and price level tend to rise together
36
Figure 9: The Effect of a Demand Shock
Price Level
Real GDP($ Trillions)
100
130
AS
1012.5
13.5
E
J
H
AD1
AD2
115
37
An Increase in Government Purchases
Can summarize impact of price-level changes When government purchases increase, horizontal
shift of AD curve measures how much real GDP would increase if price level remained constant But because price level rises, real GDP rises by less
than horizontal shift in AD curve
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An Decrease in Government Purchases
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An Increase in the Money Supply
Although monetary policy stimulates economy through a different channel than fiscal policy Once we arrive at AD and AS diagram, two look
very much alike Can represent situation as follows
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Other Demand Shocks
A positive demand shock—shifts AD curve rightward Increases both real GDP and price level
in short-run A negative demand shock—shifts AD
curve leftward Decreases both real GDP and price level
in short-run
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An Example: The Great Depression U.S. economy collapsed far more seriously
during 1929 through 1933—the onset of the Great Depression—than it did at any other time
What do we know about demand shocks that caused Great Depression? Fall of 1929, bubble of optimism burst Stock market crashed, and investment and
consumption spending plummeted Demand for products exported by United States fell Fed reacted by cutting money supply sharply
Each of these events contributed to a leftward shift of AD curve Causing both output and price level to fall
42
Demand Shocks: Adjusting to the Long-Run In Figure 9, point H shows new equilibrium
after a positive demand shock in short-run—a year or so after the shock But point H is not necessarily where economy
will end up in long-run In short-run, we treat wage rate as given
But in long-run, wage rate can change When output is above full employment, wage
rate will rise, shifting AS curve upward When output is below full employment, wage
rate will fall, shifting AS curve downward
43
Demand Shocks: Adjusting to the Long Run
Increase in government purchases has no effect on equilibrium GDP in long-run Economy returns to full employment, which is
just where it started This is why long-run adjustment process is often
called economy’s self-correcting mechanism If a demand shock pulls economy away
from full employment Change in wage rate and price level will
eventually cause economy to correct itself and return to full-employment output
44
Figure 10: The Long-Run Adjustment Process
Price Level
Real GDP
P2
P3
P4
P1
YFE Y3 Y2
H
E
AS2
AS1
AD2
AD1
J
K
45
Demand Shocks: Adjusting to the Long Run
For a positive demand shock that shifts AD curve rightward, self-correcting mechanism works like this
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Figure 11: Long-Run Adjustment After A Negative Demand Shock
Price Level
Real GDP
P2
AS1
P1
P3
YFEY2
AS2
AD2
AD1
E
M
N
