Chapter 13

Aggregate Demand and Supply

This outline is based on Cowen and Tabarrok (2011).

13.1 Business Cycle

Unemployment tends to rise when we have a recession and falls

once the economy has recovered.

“More generally, a recession is a time when all kinds of re-

sources, not just labor but also capital and land, are not fully

employed. During a recession, factories close, stores are boarded

up, and farmland is left fallow. We know that some unemploy-

ment is a natural or normal consequence of economic growthin

Chapter 12, we called this level of unemployment the natural

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Figure 13.1: U.S. Average Annual Real GDP Growth (Blue) and Civilian Un-

employment (Red). Recessions, which we defined in Chapter 6 as significant,

widespread declines in real income and employment, are shaded.

unemployment ratebut often unemployment exceeds the natu-

ral rate. More generally, when there are a lot of unemployed

resources, it suggests that resources are being wasted and the

economy is operating below its potential.” Cowen and Tabarrok

(2011)

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13.2 Aggregate Demand and Supply

The AS/AD model consists of three relationships, which we will

depict graphically and refer to as ‘curves.’

1. Dynamic Aggregate Demand

2. Long-Run Aggregate Supply – Solow Growth

3. Short-Run Aggregate Supply – which is caused by ‘Sticky’

Prices

13.2.1 Dynamic Aggregate Demand

Recall from the last chapter

−→M +−→v =

−→P +

−→YR

The arrow indicates rates of change.

This can be interpreted as

Spending growth = Inflation + Real GDP growth

Notice that spending growth (left-hand side) increases when

money supply growth increases or when velocity increases. These

can lead to either higher inflation or real GDP growth (right-

hand side).

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The aggregate demand (AD) is all combinations of π and

real GDP growth that are possible for a given rate of spend-

ing growth. So, if spending growth,−→M + −→v = 5%, then the

combinations of inflation and real GDP growth are:

Spending growth =−→M +−→v = 5%

Inflation GDP growth

0% 5%

1% 4%

2% 3%

3% 2%

4% 1%

5% 0%

6% -1%

7% -2%

When plotted with inflation on the vertical and real GDP on

the horizontal axes looks like this:

If spending increases (due to an increase in money growth or

velocity), then AD shifts to the right as shown with the dashed

red line.

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Figure 13.2: Aggregate Demand when spending increases at the rate of 5%.

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13.2.2 Long-run Aggregate Supply – Solow Growth

Economic growth depends on increases in the stocks of labor

and capital and on increases in productivity (driven by new and

better ideas and better institutions). It does not depend on in-

flation. So, the long-run growth rate (Solow Growth) is fixed

with respect to inflation. It is drawn as a vertical line at what-

ever long-run real GDP growth rate resources and technology

allow.

13.2.3 Shocks to Solow Growth

A shock is an unexpected (economic) event. These can be ben-

eficial or detrimental to the economy. When shocks affect real

economic activity, they shift the Solow curve to the right (a good

or positive shock) or left (bad or negative shock).

• Weather (good weather improves agricultural output or

tourism and bad weather makes both worse.)

• Energy shocks – bad ones include oil embargoes, or closing

of Suez canal. Fracking has been a positive shock to energy

production.

• Taxes (higher is bad, lower is good), regulations (can be

bad–sometimes good)

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Figure 13.3: Long-run growth does not depend on inflation. It depends on

resources, technology and ideas, and society’s institutions. Here it is shown

at 3%, which is close to its historical average in the U.S.

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Figure 13.4: Shocks to Solow Growth can cause changes in growth – Real

Business Cycle.

• political stability – can improve or deteriorate.

Shocks to our long-run ability to convert resources into output

cause real benefits or damage to growth. This is what some refer

to as the real business cycle. It is pictured below:

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13.2.4 Short-run AS – Sticky Wages and Prices

In the short-run, a period when wages and prices cannot adjust

very quickly, increases in inflation (unanticipated) will increase

real GDP.

Each SRAS curve is associated with a particular expected

rate of inflation. When actual inflation exceeds expected (π >

E(π)), firms and individuals will produce more, increasing growth.

Once people catch on to the fact that prices have risen and

are able to renegotiate wages accordingly, SRAS shifts up and

returns to the Solow level, albeit at a now higher rate of inflation.

In the long run, people will always come to expect the actual

inflation rate (you can’t fool people forever), and in the long

run, the inflation rate is found where the Solow curve intersects

the AD curve. Thus, the SRAS curve is always moving toward

the point where the Solow curve intersects the new AD curve

(point c in the figure 13.5).

13.2.5 Why are wages and prices sticky?

• Wages usually change once a year. Why? Not sure, but an-

nual evaluations are the norm and based on these and busi-

ness conditions, etc. determine your raise, if any. Union

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Figure 13.5: In the short-run, unanticipated increases in inflation increase

real GDP growth. Once workers and sellers realize that prices have risen, and

that a new higher level of inflation can be expected, they negotiate higher

prices. This shifts sras up as shown here.10

contracts are multi-year commitments and help make wages

sticky. In any event, workers are generally playing catch-up

when it comes to unanticipated increases in inflation. Dur-

ing deflationary recessions, wages may be fixed for the time

being, but workers are easy to send home when demand is

slack!

• Menu Costs – these are the costs associated with changing

prices. Customers don’t like frequent price changes–it com-

plicates planning. Firms have to communicate these new

prices to consumers and this can be expensive (print a new

menu each time the price of an egg changes?!)

• “Prices rise like rockets and fall like feathers.” Why

the SRAS is flat when AD/AS shocks are negative and steep

when AD/AS shocks are positive? Well, empirically it ap-

pears to be so. Several explanations have been put for-

ward. 1) people hate pay cuts (or in this case) reductions

in the rate of pay increases. It’s demoralizing since it is

easy to think that you got a crummy raise because man-

agement thinks you do crummy work. Demoralized workers

produce less. 2) a lot of wage contracts already have the

higher wage increased baked into the cake. Recall union

contracts (which are particularly hard to negotiate) extend

many years. 3) It is easier to reduce hours than wages. Re-

ducing hours reduces supply a lot without reducing wages

much.

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13.2.6 Quantity Theory in terms of changes

M × v = P × YR

Total change on the left must equal changes on the right:1 So,

if velocity and real GDP aren’t changing, then

−→M + 0 =

−→P + 0

This says that Money growth leads to equivalent growth in

prices. If money grows at 5%/year then so will prices.

1The total derivative: dM × v +M × dV = dP × YR + P × dYR.

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Figure 13.6: Spending growth falls and AD shifts left along the SRAS. GDP

Growth shrinks as inflation falls. Once wages start to adjust and fall, infla-

tionary expectations fall and SRAS will shift to the right, landing at point

c. This may take a while, though.

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Figure 13.7: Spending growth falls and AD shifts left along the SRAS. GDP

Growth shrinks as inflation falls. If the decline in −→v is temporary, then AD

should rebound in subsequent quarters and return to point a. If not, then

inflationary expectations may fall and lower wages.

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Figure 13.8: The Great Depression was not so great for most Americans. It

was downright awful.

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Bibliography

Cowen, Tyler and Alex Tabarrok (2011), Modern Principles of

Economics, 2nd edn, Worth, New York.

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