Chapter 5
Aggregate Supply and Demand
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McGraw-Hill/Irwin
Macroeconomics, 10e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Introduction
• The last few chapters have detailed models of long run
economic growth now turn to short run fluctuations in
the economy that constitute the business cycle
• The AS/AD model is the basic macroeconomic tool for
studying output fluctuations and the determination of the
price level and the inflation rate
• Can be used to explain how the economy deviates from a path of
smooth growth over time, and to explore the consequences of
government policies intended to reduce unemployment and
output fluctuations, and maintain stable prices
3
AS and AD
• Aggregate supply curve describes, for each given price
level, the quantity of output firms are willing to supply
• Upward sloping since firms are willing to supply more output at
higher prices
• Aggregate demand curve shows the combinations of the
price level and the level of output at which the goods and
money markets are simultaneously in equilibrium
• Downward sloping since higher prices reduce the value of the
money supply, which reduces the demand for output
• Intersection of AS and AD curves determines the
equilibrium level of output and price level
4
AS, AD, and Equilibrium
• AS and AD intersect at point E
in Figure 5-1
Equilibrium: AS = AD
• Equilibrium output is Y0
• Observed level of output in
the economy at particular
point in time
• Equilibrium price level is P0
• Observed price level in the
economy at particular point in
time
[Insert Figure 5-1 here]
5
AS, AD, and Equilibrium
• Shifts in either the AS or AD
schedule results in a change in
the equilibrium level of prices
and output
• Increase in AD increase in P
and Y
• Decrease in AD decrease in P
and Y
• Increase in AS decrease in P
and increase in Y
• Decrease in AS increase in P
and decrease in Y
[Insert Figure 5-2 here]
Figure 5-2 illustrates an increase
in AD resulting from an increase
in money supply.
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AS, AD, and Equilibrium
The amount of the
increase/decrease in P and Y
after a shift in either
aggregate supply or
aggregate demand depends
on:
1. The slope of the AS curve
2. The slope of the AD curve
3. The extent of the shift of AS/AD
[Insert Figure 5-3 here]
Figure 5-3 shows the result of an
adverse AS shock:
AS Y, P
7
Classical Supply Curve
• The classical supply curve is
vertical, indicating that the
same amount of goods will be
supplied, regardless of price
[Figure 5-4 (b)]
• Based upon the assumption that
the labor market is in equilibrium
with full employment of the labor
force
• The level of output corresponding
to full employment of the labor
force = potential GDP, Y*
[Insert Figure 5-4 here]
Long run version of the AS curve
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Classical Supply Curve
• Y* grows over time as the
economy accumulates
resources and technology
improves AS curve moves
to the right
• The growth theory models
described in earlier chapters
explain the level of Y* in a
particular period
• Y* is “exogenous with respect
to the price level”
illustrated as a vertical line
since graphed in terms of the
price level
[Insert Figure 5-5 here]
9
Keynesian Supply Curve
• The Keynesian supply curve is
horizontal, indicating firms
will supply whatever amount
of goods is demanded at the
existing price level [Figure 5-4
(a)]
• Since unemployment exists, firms
can obtain any amount of labor at
the going wage rate
• Since average cost of production
does not change as output
changes, firms willing to supply
as much as is demanded at the
existing price level
[Insert Figure 5-4 here, again]
10
Keynesian Supply Curve
• Intellectual genesis of the Keynesian AS curve is found in
the Great Depression, when it seemed firms could
increase production without increasing P by putting idle
K and N to work
• Additionally, prices are viewed as “sticky” in the short
run, or firms are reluctant to change prices and wages
when demand shifts
• Instead firms increase/decrease output in response to demand
shift = flat AS curve in the short run
ShortShort run version of the AS curverun version of the AS curve
11
Frictional Unemployment and the
Natural Rate of Unemployment
• Taken literally, the classical model implies that there is
no involuntary unemployment everyone who wants to
work is employed
• In reality there is some unemployment due to frictions in the
labor market (Ex. Someone is always moving and looking for a
new job)
• The unemployment rate associated with the full
employment level of output is the natural rate of
unemployment
• Natural rate of unemployment is the rate of unemployment
arising from normal labor market frictions that exist when the
labor market is in equilibrium
12
AS and the Price Adjustment
Mechanism
• AS curve describes the price
adjustment mechanism within
the economy
• Figure 5-6 shows the SRAS curve
in black and the LRAS in green,
and the adjustment from the SR to
the LR
• The AS curve is defined by the
equation: (1)
where
• Pt-1 is the price level next period
• Pt is the price level today
• Y* is potential output
[Insert Figure 5-6 here]
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AS and the Price Adjustment
Mechanism
(1)
• If output is above potential (Y>Y*),
prices will increase and be higher
next period
• If output is below potential (Y<Y*),
prices will fall and be lower next
period
• Prices will continue to rise/fall over
time until Y=Y*
• Today’s price equals tomorrow’s iif
output equals potential (ignoring price
expectations)
• The difference between GDP and
potential GDP, Y-Y*, is called the
output gap
[Insert Figure 5-6 here]
14
AS and the Price Adjustment
Mechanism
(1)
• The upward shifting horizontal
lines in Figure 5-6 (b)
correspond to successive
snapshots of equation (1)
• Beginning with the horizontal
black line at time t=0, at Y>Y*,
price will be higher (AS
shifting up) by t=1
• Process continues until Y=Y*
[Insert Figure 5-6 here]
15
AS and the Price Adjustment
Mechanism
(1)
• The speed of the price adjustment
mechanism is controlled by the
parameter
• If is large, AS moves quickly (the
counter clock-wise rotations in Figure
5-6 (a))
• If is small, prices adjust slowly
• is of importance to policy makers:
• If is large, the AS mechanism will
return the economy to Y* relatively
quickly
• If is small, might want to use AD
policy to speed up the adjustment
process
[Insert Figure 5-6 here]
16
AD Curve and Shifts in AD
• AD shows the combination
of the price level and level of
output at which the goods
and money markets are
simultaneously in
equilibrium
• Shifts in AD due to:
1. Policy measures
• Changes in G, T, and MS
2. Consumer and investor
confidence
[Insert Figure 5-8 here]
Figure 5-8 shows an outward shift in
AD resulting from an increase in the
money supply.
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AD Relationship Between
Output and Prices
• Key to the AD relationship between output and prices is
the dependency of AD on real money supply
• Real money supply = value of money provided by the central
bank and the banking system
• Real money supply is written as , where is the nominal
money supply, and P is the price level
• AND
• For a given level of , high prices result in low OR
high prices mean that the value of the number of available
dollars is low and thus a high P = low level of AD
Inverse relationship between P and Y downward sloping AD curve
18
AD and the Money Market
• For the moment, ignore the goods market and focus on
the money market and the determination of AD
• The quantity theory of money offers a simple explanation
of the link between the money market and AD
• The total number of dollars spent in a year, NGDP, is P*Y
• The total number of times the average dollar changes hands in a
year is the velocity of money, V
• The central bank provides M dollars
The fundamental equation underlying the quantity theory of
money is the quantity equation: (2)
19
AD and the Money Market
(2)
• If the velocity of money is assumed constant, equation (2)
becomes , and is an equation for the AD
curve
• For a given level of M, an increase in Y must be offset by
a decrease in P, and vice versa
• Inverse relationship between Y and P as illustrated by
downward sloping AD curve
• An increase in M shifts the AD curve upward for any
value of Y
• Illustrated in Figure 5-8
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Changes in the Money Stock and AD
• An increase in the nominal
money stock shifts the AD
schedule up exactly in
proportion to the increase in
nominal money
• Suppose corresponds to AD
and the economy is operating at
P0 and Y0
• If money stock increases by 10%
to , AD shifts to AD’
the value of P corresponding to
Y0 must be P’ =
• Therefore real
money balances and Y are
unchanged
[Insert Figure 5-8 here, again]
21
AD policy and the
Keynesian Supply Curve
• Figure 5-9 shows the AD
schedule and the Keynesian
supply schedule
• Initial equilibrium is at point E
(AS = AD)
• Suppose an aggregate demand
policy increases AD
to AD’
• The new equilibrium point, E’,
corresponds to the same price
level, and a higher level of
output (employment is also
likely to increase)
[Insert Figure 5-9 here]
22
AD policy and the
Classical Supply Curve
• In the classical case, AS schedule is
vertical at FE level of output
• Unlike the Keynesian case, the price
level is not given, but depends upon
the interaction between AS and AD
• Suppose AD increases to AD’:
• At the original price level, spending
would increase to E’ BUT firms can
not obtain the N required to meet the
increased demand
• As firms hire more workers, wages
and costs of production increase, and
firms must charge higher price
• Move up AS and AD curves to E’’
where AS = AD’
[Insert Figure 5-10 here]
RESULT: Increase in AD results
in higher prices, but not output
23
AD policy and the
Classical Supply Curve
• The increase in price from the
increase in AD reduces the real
money stock, , and
leads to a reduction in
spending
• The economy only moves up AD
until prices have risen enough,
and M/P has fallen enough, to
reduce total spending to a level
consistent with full employment
this is true at E’’, where
AD = AS
[Insert Figure 5-10 here]
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Supply Side Economics
• Supply side economics focuses on AS as the driver in the
economy
• Supply side policies are those that encourage growth in
potential output shift AS to right
• Such policy measures include:
• Removing unnecessary regulation
• Maintaining efficient legal system
• Encouraging technological progress
• Politicians use the term supply side economics in
reference to the idea that cutting taxes will increase AS
enough that tax collections will actually increase, rather
than fall
25
Supply Side Economics
• Cutting tax rates has an impact on
both AS and AD
• AD shifts to AD’ due to increase in
disposable income
• Shift is relatively large compared
to that of the AS
• AS shifts to AS’ as the incentive to
work increases
• In short run, economy moves from E
to E’: GDP increases, tax revenues
fall proportionately less than tax cut
(AD effect)
• In the LR, economy moves to E’’ as
AS curve shifts to right: GDP is
higher, but by a small amount, tax
collections fall as the deficit rises
[Insert Figure 5-11 here]
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Supply Side Economics
• Supply side policies are useful, despite previous example
• Only supply side policies can permanently increase output
• Demand side policies are useful for short run results
• Many economists support cutting taxes for the incentive
effect, but with a simultaneous reduction in government
spending
• tax collections fall, but the reduction in government spending
minimizes the impact on the deficit
The deficit is the excess of government expenditures over tax revenues.
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AS and AD in the Long Run
• In the LR, AS curve moves to the
right at a slow, but steady pace
• Movements in AD over long periods
can be large or small, depending
largely on movements in money
supply
• Figure 5-12 shows a set of AS and
AD curves for the period 1970-2000
• Movements in AS slightly higher
after 1990
• Big shifts in AD between 1970 and
1980
• Prices increase when AD moves out
more than AS
• Output determined by AS, while
prices determined by the relative
shifts in AS and AD
[Insert Figure 5-12 here]
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