Chapter 10: Aggregate Supply and Aggregate

Demand

Demand and Supply of Everything

- We’ve become experts on demand and supply of all kinds of things
o Apples
o Labor
o Dollars
- The quantity of apples demanded depends on the price of an apple.
- Chapter 10: We’ll consider the demand and supply of real GDP
o Value of everything produced in a country in one year.
- The quantity of real GDP demanded will depend on the price of
everything.
- What do we use to measure the price of everything?
o The price level!
- A note:
o You can go to the store and buy an apple.
 So the supply and demand for apples makes sense.
o That’s okay. This is a useful model to analyze the economy.
o “AS-AD model”
o When we graph the supply or demand of real GDP,
 …we’ll put real GDP (in dollars) on the X axis.
o Dollars change in value over time.
o So, we need to specify the base year.
 Current choice: 2012.
- When we graph the supply and demand of real GDP,
o We’ll put the price level on the Y axis
- Our favorite measure of the price level so far? CPI.
- But now we’ll work with a different measure of the price level…
o …the GDP deflator.
- The quantity of real GDP supplied is the total quantity of goods and
services that firms plan to produce in a given period.

Quantity Supplied of Everything

- Quick reminder from Chapter 5:
 o Potential GDP = target value of Real GDP
o Natural unemployment rate = target value of unemployment rate

Supply of Everything
- Aggregate supply is the relationship between the quantity of real GDP
supplied and the price level.
- We want to draw an aggregate supply curve,
o …but there are actually two aggregate supply curves.
- Short-run aggregate supply and long-run aggregate supply
- Short-run aggregate supply (SAS) is the relationship between the
quantity of real GDP supplied and the price level when the following
things all remain constant:
o The money wage rate
o The prices of other resources
o Potential GDP
- When we hold the money wage rate constant,
o …there is only one price level at which the real wage rate is at full-
employment equilibrium level.
o Let’s call this specific price level the “full employment price level.”
 o When we are at that one specific price level (whatever that is),
 …then real GDP must be exactly equal to potential GDP.
o So (full employment price level) and (potential GDP) together define
one point on our short-run aggregate supply curve.
- As we continue to hold the money wage rate constant,
o …if the price level rises above the full employment price level,
o …then firms see that they can sell their stuff for more money than
they could before,
o …without having to pay their workers more!
o They choose to produce more stuff and make more profits!
o Quantity of real GDP supplied goes up.
o The opposite happens if the price level falls.
- As the price level goes up, quantity of real GDP supplied goes up in the
short run.
- This means that the short-run aggregate supply curve is upward sloping.
- IF the price level changes, and nothing else changes, then in the short
run, we move along the short-run aggregate supply curve.
- Now, let’s think about the long run.
- Short run: Price level can change while the money wage rate stayed the
same.
- Long run: any % change in the price level must induce a matching %
change in the money wage rate.
- Result: In the long we are always at full employment, and the real GDP is
always equal to potential GDP.
- Long-run aggregate supply (LAS) is the relationship between the
quantity of real GDP supplied and the price level when the two previous
bullet points are true.
- In the long run, we are assuming that a 10% increase in the price level
will be matched by a 10% increase in the money wage rate.
- If prices go up by 10% and your paycheck does too,
o …then you real wage hasn’t changed.
- You can still buy exactly the same amount of stuff as before.
- And firms plan to produce exactly the same amount of stuff.
- So even if the price level changes, the long-run quantity of real GDP
supplied remains at potential GDP. Nothing real changed.
- So what does the LAS curve look like?
- Vertical line right through the amount that represents potential GDP.
- In the long run, real GDP always = potential GDP regardless of the price
level
 o …which means that the LAS curve intersects the SAS curve at a point
represented by (full-employment price level) and (potential GDP).
- What causes a change in aggregate supply, and therefore a shift of the
aggregate supply curves?

1. Changes in Potential GDP

- Potential GDP is how much stuff we will produce if we are exactly at full
employment.
- An increase in potential GDP increases both LAS and SAS.
- We assume that an increase in potential GDP does not change the full-
employment price level.
- Result: When potential GDP goes up, SAS and LAS both shift the same
distance to teh right.

2. Changes in the Money Wage Rate

- In the short run, the money wage rate might go up while the price level
stays the same.
- Result: Increase in firms’ costs.
- They have to pay workers more per hour.
- They respond by cutting back on production, and SAS shifts to the left.
- What about long run effect of a rise in money wage rate?
- In the long run, due a rise in the money wage rate…
o There is a matching rise in the price level.
o So there is no change in how much profit a firm makes per hour of
labor.
o So firms have no incentive to change production levels.
- A change in the money wage rate has no effect on LAS.

Demand for Everything

- The quantity of real GEDP demanded is the total amount of final
goods and services produced in the US that people, businesses,
government, and foreigners plan to buy.
- The relationship between the quantity of real GDP demanded and the
price level is called aggregate demand.
- Unlike aggregate supply, there is only one aggregate demand curve.
- When the price level goes up, the quantity of real GDP demanded goes
down, vice versa.
- So aggregate demand curve is downward sloping.
- Two reasons for this.

2 Reasons Why the AD Curve is Downward-Sloping

1. Wealth Effect
- When the price level goes up and everything else stays the same,
o …then your wealth in terms of dollars is exactly the same as before.
(nominal wealth: pieces of paper)
o But your wealth in terms of how much stuff you can buy has gone
down. (real wealth: stuff)
- When people’s real wealth decreases, they try to save more in order to
restore their wealth.
- In order to save more, they have to consume less stuff today.
- This means that the quantity of real GDP demanded decreases in
response to an increase in the price level.
- This means that the quantity of real GDP demanded decreases in
response to an increase in the price level.

2. Substitution Effects
2a. Intertemporal Substitution Effect

- Increase in the price level  Quantity of real money has decreased.

- Recall from Chapter 8: Decrease in quantity of real money supplied 
Increase in the interest rate.
- Price level up  Interest rate up  People respond how?
- Interest rates go up  People are less likely to borrow in order to buy stuff
today, more likely to delay those purchases until later instead.
- Price level up  Interest rate up  Today’s quantity of real GDP
demanded falls.

2b. International Substitution Effect

- When we think about quantity of real GDP demanded, we are measuring

US-made goods and services only.
- When the US price level rises while other countries’ price levels remain
the same,
o …US-made goods become more expensive relative to foreign-made
goods.
o How do people respond when US-made stuff is expensive?
o Buy less US-made stuff and more non-US-made stuff!
o US GDP decreases.
o US price level up  People buy less US made stuff  Today’s quantity
of real GDP demanded falls.
- When the price level changes and everything else remains the same,
o …we move along the aggregate demand curve to a new point that
goes with the new price level.
o There are three main factors that can cause a change in aggregate
demand a shift of the aggregate demand curve.

3 Factors That Cause a Change in AD

1. A Change in expectations
- An increase in any of the following causes an increase in aggregate
demand.
1a. Expected future income
1b. Expected future inflation rate
1c. Expected future profits.
- People’s overall expectations about the future of the economy are often
summed up by the phrase “ consumer confidence.”

2. Monetary Policy and Fiscal Policy

2a. Monetary policy means that the Fed’s attempt to influence the
economy by changing interest rates and the quantity of money.

- An increase in the quantity of money results in

o Lower interest rates, and
o Easier access to loans
- Increase in quantity of money  Increase in aggregate demand
- Decrease in quantity of money  Decrease in aggregate demand
2b. Fiscal Policy: Government’s attempt to influence the economy through
taxes, transfer payments, and purchases.

- The government can increase people’s disposable income by either

o Decreasing taxes, or
o Increasing transfer payments
- Increase in disposable income  Increase in aggregate demand.
- An increase in government expenditure also increases AD.
- (And also vice versa to all of the above)

3. The World Economy

3a. The Exchange Rate

- A rise in the exchange rate decreases aggregate demand

- Higer exchange rate? Americans buy more Jaguars instead of Cadillacs.
- Fewer people buying Cadillacs  Lower US aggregate demand

3b. Foreign Income

- When people in other countries start earning more income,
o …they buy more stuff,
o …including more US exports (like Cadillacs).
- A Cadillac bought by a foreigner count toward US aggregate demand.
- So an increase in foreign income results in an increase in US aggregate
demand.

Combining Aggregate Supply and Aggregate Demand

- Now that we are experts in aggregate demand and aggregate supply,
o …we can put them together!
o “AS-AD model”
o There were two types of aggregate supply: short run and long run.
o And so there are two types of equilibrium in the AS-AD model.
- Short-run macroeconomic equilibrium occurs when Quantity of real
GDP demanded = Quantity of real GDP supplied.
- On our graph, this is the point where the AD curve and SAS curve
intersect.
- Based on our assumptions about the short run,
 o …the money wage rate is fixed.
- In the short run, GDP can be different from potential GDP.
- Fed can use monetary policy to increase short-run real GDP!
o Increase money supply, lower real interest rates.
- Long-run macroeconomic equilibrium occurs when Real GDP =
Potential GDP
- On our graph, this is true when we are at a point on the LAS curve.
- Based on our assumptions about the long run,
o …the money wage rate always adjusts to keep us exactly at
employment = full employment,
o …and therefore keep us exactly at GDP = potential GDP.
- Fed has no control over potential GDP.
- If the SAS, LAS, and AD curve all intersect at the same spot,
o …then we are at both long run and short run equilibrium.
- The puzzle pieces of the economy are all fitting together perfectly.
- If the SAS curve intersects the AD curve at one spot,
o …but the Las curve intersects the AD curve at another spot,
o …then we are at a short run equilibrium which doesn’t work in the long
run.
o Something needs to happen that causes the SAS curve to shift until
both of the equilibria are aligned again.
o Question: What factor could cause the SAS curve to shift in order to
achieve this alignment?
o Answer: The money wage rate could change!
- Recall that a change in the money wage rate does affect SAS but doesn’t
affect LAS.
- IF the SAS curve is “too far” to the left,
o …that means that the money wage rate is too high to achieve full
employment.
o Money wage rate will fall until the SAS curve has shifted rightward
back into the sweet spot,
 …where the short-run equilibrium once again matches the long-run
equilibrium.
- If the SAS is “too far” to the right,
o …that means that the money wage rate is too low to achieve full
employment.
o Money wage rate will rise until the SAS curve has shifted leftward back
into the sweet spot,
  …where the short-run equilibrium once again matches the long-run
equilibrium.

Economic Growth and Inflation in the AS-AD Model

- Remember:
o LAS is always equal to potential GDP.
o An increase in potential GDP results from an increase in either
1. The supply of labor, or
2. Labor productivity
- So, an increase in either of these two factors results in an increase of LAS.
- Let’s focus on long-run equilibrium for a moment.
- When LAS increases while AD stays unchanged,
o …then real GDP grows, and the price level falls. Deflation!
- When AD increases while LAS stays unchanged,
o …then real GDP stays the same, and the price level goes up. Inflation!
- When both LAS and AD increase at the same pace, real GDP grows with
no inflation.
- If AD increases faster than LAS does, then real GDP grows with inflation.
- Which policies fight inflation? Ones that slow down AD:
o Fiscal policy: DEDCRASE government spending/ INCREASE taxes
o Monetary policy: DECREASE the money supply / INCREASE interest
rates

The Business Cycle in the AS-AD Model

- Our term for describing the pattern. In which real GDP fluctuates around
potential GDP: “business cycle”
- If we were always at long-run equilibrium, then real GDP would always
equal potential GDP.
o There would be no fluctuations and no business cycle!
- Recall from Chapter 5: Real GDP – Potential GDP = Output gap
- When the short-run equilibrium puts real GDP above potential GDP, then
we call it an above full-employment equilibrium.
- In this case, the output gap is positive, and we call it an inflationary
gap.
- When the short-run equilibrium puts real GDP below potential GDP, then
we call it a below full-employment equilibrium.
- In this case, the output gap is negative, and we call it a recessionary
gap.

Macroeconomic Schools of Thought

- Different economists generally agree about the basics of the AS-AD model
we just learned.
- But different economists have different beliefs about some of the key
details.
- Those details are important for determining which economic policies are a
good idea or a bad idea.
- Let’s consider three different macroeconomic “schools of thought.”

1. Classical macroeconomics believe that the economy does a perfect

job of regulating itself.
- If we ever move away from a full-employment equilibrium,
o …then the money wage rate adjusts instantly to bring us back to full
employment.
o So as a result, we are always at full employment.
- Based on this view, classical economists are less worried about what
governments should do.
o …and more worried about governments shouldn’t do.
o Governments shouldn’t charge high taxes.
 Taxes create disincentives that harm the economy.

2. Keynesian macroeconomists believe that the economy is rarely at

full employment.
- In order to move from a below full-employment equilibrium back to full
employment, the money wage rate must fall.
- A Keynesian believes that this process happens to slowly on its own.
- The government should help fix the economy more quickly!
o Recession happening? Use aggressive monetary policy and fiscal policy
to fix it.

3. Monetarist macroeconomics believe that the economy is self-

regulating and will normally operate at full employment.
- …as long as monetary policy is not erratic
- …and the pace of money growth is kept steady.
- A monetarist agrees with a Keynesian that careful monetary policy is
important
- A monetarist agrees with a classical macroeconomist that taxes should be
kept low.