MEDITERRANEAN SCHOOL OF BUSINESS
PROGRAM: CURRICULUM PRE-ENGINEERING
COURSE: ECO 172 Macroeconomics
PROFESSOR: Associate Prof Maleke Fourati
TERM: Spring 2026
1
Chapter 9
Aggregate Demand and Aggregate Supply
2
In this chapter, look for the answers to these questions:
• What are economic fluctuations? What are their characteristics?
• How does the model of aggregate demand and aggregate supply
explain economic fluctuations?
• Why does the Aggregate-Demand curve slope downward? What
shifts the AD curve?
• What is the slope of the Aggregate-Supply curve in the short run? In
the long run?
• What shifts the AS curve(s)?
Introduction
▪Over the long run, real GDP grows about 3% per year on average.
▪In the short run, GDP fluctuates around its trend.
✓Recessions: periods of falling real incomes and rising unemployment
✓Depressions: severe recessions (very rare)
▪Short-run economic fluctuations are often called business cycles.
▪Explaining these fluctuations is difficult, and the theory of
economic fluctuations is controversial.
▪Most economists use the model of aggregate demand and
aggregate supply to study fluctuations.
The Model of Aggregate Demand
and Aggregate Supply
P
The price
level
SRAS
“Short-Run
Aggregate
The model P1 Supply”
determines the
eq’m price level “Aggregate
Demand”
AD
and eq’m output Y
Y1
(real GDP).
Real GDP, the
quantity of output
The Aggregate-Demand (AD) Curve
P
The AD curve shows the
P2
quantity of all g&s
demanded in the
economy at any given
price level. P1
AD
Y
Y2 Y1
Why the AD Curve Slopes Downward
P
Y = C + I + G + NX
P2
▪Assume G fixed by govt
policy.
▪To understand the slope of
P1
AD, must determine how a
change in P affects C, I, AD
and NX.
Y
Y2 Y1
The Wealth Effect (P and C )
Suppose P rises.
▪The dollars people hold buy fewer g&s, so real wealth is lower.
▪People feel poorer.
Result: C falls.
The Interest-Rate Effect (P and I )
Suppose P rises.
▪Buying g&s requires more money.
▪To get this money, people sell bonds or other assets.
▪This drives up interest rates.
Result: I falls. (Recall, I depends negatively on interest rates.)
The Exchange-Rate Effect (P and NX )
Suppose P rises.
▪Tunisian interest rates rise (the interest-rate effect).
▪Foreign investors desire more Tunisian bonds.
▪Higher demand for Tunisian Dinar in foreign exchange market.
▪Tunisian exchange rate appreciates.
▪Tunisian exports more expensive to people abroad, imports
cheaper to Tunisian residents.
Result: NX falls.
The Slope of the AD Curve: Summary
An increase in P P
reduces the quantity
of g&s demanded
because: P2
▪ the wealth effect
(C falls)
P1
▪ the interest-rate
AD
effect (I falls)
▪ the exchange- Y
Y2 Y1
rate effect (NX
falls)
Why the AD Curve Might Shift
Any event that changes P
C, I, G, or NX—except
a change in P—will shift
the AD curve.
Example: P1
A stock market boom
makes households feel
AD2
wealthier, C rises,
AD1
the AD curve shifts right.
Y
Y1 Y2
Why the AD Curve Might Shift
▪Changes in C
✓Stock market boom/crash
✓Preferences consumption/saving tradeoff
✓Tax hikes/cuts
▪Changes in I
✓Firms buy new computers, equipment, factories
✓Expectations, optimism/pessimism
✓Interest rates, monetary policy
✓Investment Tax Credit or other tax incentives
Why the AD Curve Might Shift
▪Changes in G
✓Government spending, e.g., defense
✓Regional & local spending, e.g., roads, schools
▪Changes in NX
✓Booms/recessions in countries that buy our exports
✓Appreciation/depreciation resulting from international speculation in foreign
exchange market
ACTIVE LEARNING 1
The Aggregate-Demand curve
What happens to the AD curve in each of the
following scenarios?
A. A ten-year-old investment tax credit expires.
B. The domestic exchange rate falls.
C. A fall in prices increases the real value of consumers’ wealth.
D. Government replaces sales taxes with new taxes on interest, dividends,
and capital gains.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
ACTIVE LEARNING 1
Answers
A. A ten-year-old investment tax credit expires.
I falls, AD curve shifts left.
B. The domestic exchange rate falls (money depreciation)
NX rises, AD curve shifts right.
C. A fall in prices increases the real value of consumers’
wealth.
Move down along AD curve (wealth-effect).
D. Government replaces sales taxes with new taxes on
interest, dividends, and capital gains.
C rises, AD shifts right.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
The Aggregate-Supply (AS) Curves
P LRAS
The AS curve shows the
total quantity of g&s
firms produce and sell SRAS
at any given price level.
AS is:
▪ upward-sloping
in short run
Y
▪ vertical in
long run
The Long-Run Aggregate-Supply Curve (LRAS)
The natural rate of output P LRAS
(YN) is the amount of output
the economy produces when
unemployment is at its natural
rate.
YN is also called
full-employment output.
Y
YN
Why LRAS Is Vertical
YN determined by the P LRAS
economy’s stocks of
labor, capital, and
natural resources, and
on the level of P2
technology.
An increase in P does P1
not affect any of these,
so it does not affect YN.
Y
YN
Why the LRAS Curve Might Shift
P LRAS1 LRAS2
▪Any event that
changes any of the
determinants of YN
will shift LRAS.
▪Example: Immigration
increases L, causing
YN to rise.
Y
YN YN’
Why the LRAS Curve Might Shift
▪Changes in L or natural rate of unemployment
✓Immigration
✓Govt policies reduce natural unemployment rate
▪Changes in K or H
✓Investment in factories, equipment
✓More people get university degrees
✓Factories destroyed by a hurricane
Why the LRAS Curve Might Shift
▪Changes in natural resources
✓Discovery of new mineral deposits
✓Reduction in supply of imported oil
✓Changing weather patterns that affect agricultural production
▪Changes in technology
✓Productivity improvements from technological progress
Using AD & AS to Depict
Long-Run Growth and Inflation
Over the long run,
tech. progress shifts
LRAS to the right
and growth in the
money supply shifts
AD to the right.
Result: ongoing inflation
and growth in output.
Short Run Aggregate Supply (SRAS)
P
The SRAS curve is upward
sloping: over the period of SRAS
1–2 years, an increase in P
P2
causes an increase in the
quantity of g & s supplied. P1
Y
Y1 Y2
Why the Slope of SRAS Matters
LRAS
P
If AS is vertical,
Phi
fluctuations in AD SRAS
do not cause
fluctuations in output Phi
or employment.
ADhi
Plo
If AS slopes up, then shifts
AD1
in AD do affect output Plo
and employment. ADlo
Y
Ylo Y1 Yhi
Why the SRAS Curve Might Shift
Everything that shifts LRAS shifts SRAS,
too.
Also, PE (Expected Prices) shifts SRAS: P LRAS
If PE rises, workers & firms set higher SRAS
wages SRAS
(When workers and firms expect the price level to
be high, they are likely to reach a bargain with a PE
higher level of nominal wages. Higher wages
raise firms’ costs, and for any given actual price
level, higher costs reduce the quantity of goods
and services supplied. Thus, when the expected PE
price level rises, wages are higher, costs increase,
and firms produce a smaller quantity of goods
and services at any given actual price level.
Thus, the short-run aggregate-supply curve shifts
to the left)
At each P, production is less profitable, Y YN
Y
falls, SRAS shifts left.
The Long-Run Equilibrium
In the long-run equilibrium, P LRAS
PE = P, SRAS
Y = YN ,
and unemployment is at
its natural rate.
PE
AD
Y
YN
Economic Fluctuations
▪Caused by events that shift the AD and/or
AS curves.
▪Four steps to analyzing economic fluctuations:
1. Determine whether the event shifts AD or AS.
2. Determine whether curve shifts left or right.
3. Use AD–AS diagram to see how the shift changes Y and P in
the short run.
4. Use AD–AS diagram to see how economy
moves from new SR eq’m to new LR eq’m.
The Effects of a Shift in AD
Event: Stock market crash
1. Affects C, AD curve P LRAS
2. C falls, so AD shifts left
SRAS1
3. SR eq’m at B. P and Y lower,
unemp higher
P1 A
4. Over time, SRAS shifts right, SRAS2
until LR eq’m at C.Y and P2 B
unemp back at initial levels.
AD1
P3 C
AD2
Y
Y2 YN
30
ACTIVE LEARNING 2
Working with the model
▪Draw the AD-SRAS-LRAS diagram for the U.S. economy starting in a
long-run equilibrium.
▪A boom occurs in Canada.
Use your diagram to determine the SR and LR effects on U.S. GDP,
the price level, and unemployment.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
ACTIVE LEARNING 2
Answers
Event: Boom in Canada
P LRAS
1. Affects NX, AD curve SRAS2
2. Shifts AD right
3. SR eq’m at point B. P3 C SRAS1
P and Y higher,
unemp lower P2 B
4. Over time, PE rises, P1 A AD2
SRAS shifts left,
until LR eq’m at C. AD1
Y and unemp back Y
YN Y2
at initial levels.
CASE STUDY: The 2008–2009 Recession
▪From 12/2007 to 6/2009, real GDP fell about 4%
▪Unemployment rose from 4.4% in 5/2007 to 10.1% in 10/2009
▪The housing market played a central role in this recession…
John Maynard Keynes, 1883–1946
The General Theory of Employment,
Interest, and Money, 1936
Argued recessions and depressions
can result from inadequate demand;
policymakers should shift AD.
Famous critique of classical theory:
The long run is a misleading
guide to current affairs. In the
long run, we are all dead.
Economists set themselves too easy, too useless a task if in
tempestuous seasons they can only tell us when the storm is
long past, the ocean will be flat.
CONCLUSION
▪This chapter has introduced the model of aggregate demand and
aggregate supply, which helps explain economic fluctuations.
▪Keep in mind: these fluctuations are deviations from the long-run
trends explained by the models we learned in previous chapters.
▪In the next chapter, we will learn how policymakers can affect
aggregate demand with fiscal and monetary policy.
SUMMARY
•Short-run fluctuations in GDP and other macroeconomic
quantities are irregular and unpredictable. Recessions are
periods of falling real GDP and rising unemployment.
•Economists analyze fluctuations using the model of
aggregate demand and aggregate supply.
•The aggregate demand curve slopes downward because a
change in the price level has a wealth effect on
consumption, an interest-rate effect on investment, and an
exchange-rate effect on net exports.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
SUMMARY
•Anything that changes C, I, G, or NX—except a change in
the price level—will shift the aggregate demand curve.
•The long-run aggregate supply curve is vertical because
changes in the price level do not affect output in the long
run.
•In the long run, output is determined by labor, capital,
natural resources, and technology; changes in any of these
will shift the long-run aggregate supply curve.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
SUMMARY
•In the short run, output deviates from its natural rate when
the price level is different than expected, leading to an
upward-sloping short-run aggregate supply curve. The three
theories proposed to explain this upward slope are the sticky
wage theory, the sticky price theory, and the misperceptions
theory.
•The short-run aggregate-supply curve shifts in response to
changes in the expected price level and to anything that
shifts the long-run aggregate supply curve.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
SUMMARY
•Economic fluctuations are caused by shifts in aggregate
demand and aggregate supply.
•When aggregate demand falls, output and the price level
fall in the short run. Over time, a change in expectations
causes wages, prices, and perceptions to adjust, and the
short-run aggregate supply curve shifts rightward. In the long
run, the economy returns to the natural rates of output and
unemployment, but with a lower price level.
•A fall in aggregate supply results in stagflation—falling output
and rising prices. Wages, prices, and perceptions adjust over
time, and the economy recovers.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Go to Kahoot
1. The aggregate demand curve slopes downward because a fall in the price
level causes
a) real wealth to decrease.
b) the interest rate to decline.
c) the currency to appreciate.
d) all of the above.
2. A sudden increase in business pessimism shifts the aggregate ... curve, leading
to ... output.
a) supply; lower
b) supply; higher
c) demand; lower
d) demand; higher
40
41