Chapter 12

The Aggregate Supply (AS) Curve:

Aggregate supply is the total supply of goods and services in an economy.
The aggregate supply (AS) curve shows the relationship between the aggregate
quantity of output supplied by all the firms in an economy and the overall price level.
AS curve is not the sum of individual supply curves and it is not a market
supply curve.
Because many firms in the economy set prices as well as output, we can say
an “aggregate supply curve” is really a “price/output response” curve—a curve that
traces out the price decisions and output decisions of all firms in the economy under
a given set of circumstances.
Aggregate Supply in the Short Run:
The AS curve (or price-output response curve) shows how changes in
aggregate demand affect the price level and output in an economy.
At least for a period of time, an increase in aggregate demand will result in
an increase in both the price level and output. When aggregate demand is low,
curve is fairly flat but when the economy reaches maximum capacity, price keeps
on increasing and curve becomes vertical.
Upward Sloping:
The Aggregate Supply (AS) curve can slope upward or be vertical based on
how quickly wages adjust to changes in prices.
1. If wages and prices rise at the same pace, firms might not increase output
because they're paying more for workers and products equally. This scenario
would result in a vertical AS curve, as firms won't find it profitable to produce
more.
2. When wages respond more slowly than product prices to increased demand,
firms increase output as prices rise. In this case, the AS curve slopes upward
because firms can profit by producing more due to the lag in wage
adjustments.
In reality, wages often lag behind price changes. This lag causes the AS curve to
slope upward because firms see increased demand without immediate proportional
wage increases, allowing them to produce more at a profit.
Particular Shape:
1. Vertical Portion: At a certain level of economic activity (Y), the economy is
using all available capital and labor at the market wage. Here, increased
demand for output or labor can only be met by increasing prices or wages.
Wages and prices are less likely to be "sticky" at this level because the
economy is operating at full capacity.
2. Flat Portion: This part of the curve represents lower levels of output
compared to historical norms. Many firms operate below their maximum
capacity both in terms of equipment and workforce. With this excess capacity,
firms can increase output (from point A to B) without incurring substantial
additional costs. Small price increases can lead to relatively larger increases
in output. Additionally, wages might be relatively "sticky" upwards in this
phase if firms have retained excess workers during economic downturns to
maintain worker morale.
Shifts in Aggregate Supply curve:
A rightward shift says that society can get a larger aggregate output at a given
price level. What might cause such a shift? Clearly, if a society had an increase in
labor or capital, the AS curve would shift to the right, since the capacity of the
economy would increase. Also, technical changes that increased productivity would
shift the AS curve to the right by lowering marginal costs of production in the
economy.
Cost shock, or supply shock: A change in costs that shifts the short-run aggregate
supply (AS) curve.
The Long-Run AS Curve:
The Equilibrium Price Level:
The price level at which the aggregate demand and aggregate supply curves
intersect.

At each point along the AD curve, both the money market and the goods market are
in equilibrium.
Each point on the AS curve represents the price/ output decisions of all the firms in
the economy.
P0 and Y0 correspond to equilibrium in the goods market and the money market and
to a set of price/output decisions on the part of all the firms in the economy.
The Aggregate Demand (AD) Curve:
Planned Aggregate Expenditure and the Interest Rate:
We can summarize the effects of a change in the interest rate on the
equilibrium level of output in the goods market. The effects of a change in the
interest rate include:
■ A high interest rate ( r ) discourages planned investment ( I ).
■ Planned investment is a part of planned aggregate expenditure ( AE ).
■ Thus, when the interest rate rises, planned aggregate expenditure ( AE ) at every
level of income falls.
■ Finally, a decrease in planned aggregate expenditure lowers equilibrium output
(income) (Y) by a multiple of the initial decrease in planned investment.
Planned Investment:

Planned investment is the negative function of interest rate.

The Behavior of the Fed:
The IS curve shows the relationship between the interest rate and output.
When the interest rate is high, planned investment is low, so output is low. When the
interest rate is low, planned investment is high, so output is high.
Deriving the AD Curve:
Downward Sloping:
The Aggregate Demand (AD) curve shows the relationship between the overall
price level (P) and the aggregate output (Y) of an economy. Here's why the AD curve
slopes downward:
1. Effect of Price Increase on Fed Response: When the overall price level (P)
increases, according to the Fed's rule, the interest rate also increases. This
higher interest rate negatively impacts planned investment and aggregate
expenditure (AE), leading to a decrease in aggregate output (Y). The higher
price level prompts the Fed to raise interest rates, reducing investment and,
subsequently, output.
2. Government Spending and Aggregate Demand: An increase in
government spending (G) shifts the AD curve to the right. This happens
because higher government spending shifts the IS curve to the right, resulting
in a higher equilibrium output level.
3. Effect of Fed Policy (Z) on Aggregate Demand: An increase in the factor
represented by Z, which prompts the Fed to raise interest rates, shifts the AD
curve to the left. This is because a higher Z leads to a leftward shift of the
Fed's rule in Figure 12.7, causing higher interest rates and subsequently
reducing output.
The Final Equilibrium:
Every point on the AS curve is one in which firms make output and price
decisions to maximize their profits. Every point on the AD curve reflects equilibrium
in the goods market with the Fed behaving according to the Fed rule. The intersection
of these two curves is the final equilibrium. The equilibrium values of aggregate
output (Y) and the price level (P) are determined.
Other Reasons for a Downward-Sloping Aggregate Demand Curve:

The Consumption Link:

The consumption link provides another reason for the AD curve’s downward
slope.
An increase in the price level increases the demand for money, which leads to an
increase in the interest rate, which leads to a decrease in consumption (as well as
planned investment), which leads to a decrease in aggregate output (income).
The initial decrease in consumption (brought about by the increase in the interest
rate) contributes to the overall decrease in output.
The Real Wealth Effect:
The change in consumption brought about by a change in real wealth that
results from a change in the price level.
Shifts of the Aggregate Demand Curve from Policy Variables:
IS curve:
A curve illustrating the negative relationship between the equilibrium value
of aggregate output (income) (Y) and the interest rate in the goods market.
LM curve:
A curve illustrating the positive relationship between the equilibrium value of
the interest rate and aggregate output (income) (Y) in the money market.