Aggregate Supply and
D em a n d
Chapter #5
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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
5-2
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
5-3
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
5-4
AS, AD, and Equilibrium
• Shifts in either the AS or
AD schedule result 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
Figure 5-2 illustrates an
increase in AD resulting
from an increase in 5-5
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
Figure 5-3 shows the result of
an adverse AS shock:
AS Y, P
5-6
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*
5-7
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
5-8
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
5-9
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 firms 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
5-10
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
5-11
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 blue, and the
adjustment from the SR to the LR Pt 1 Pt [1 (Y Y * )]
• 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
5-12
AS and the Price Adjustment
Mechanism
Pt 1 Pt [1 (Y Y * )] (1)
• If output is above potential (Y>Y*), prices increase, higher next
period
• If output is below potential (Y<Y*), prices fall, lower next period
• Prices continue to rise/fall over time until Y=Y*
– Today’s price equals tomorrow’s if output equals potential (ignoring
price expectations)
The difference between GDP and potential GDP, Y-Y*, is called the output gap
5-13
AS and the Price Adjustment
Mechanism
Pt 1 Pt [1 (Y Y * )] (1)
• 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
higher (AS shifting up) by t=1
• Process continues until Y=Y*
5-14
AS and the Price Adjustment
Mechanism
Pt 1 Pt [1 (Y Y * )] (1)
• Speed of the price adjustment mechanism 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
5-15
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
• Figure 5-8 shows an
outward shift in AD
resulting from an increase
in the money supply
5-16
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
M
– Real money supply is written as , whereM is the nominal
P
money supply, and P is the price level
– AND M
M r I AD
r I AD P
P
M
M P
• 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
5-17
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 underlyingMtheV P Y
quantity
theory of money is the quantity equation:
(2)
5-18
AD and the Money Market
M V P Y (2)
• If the velocity of money is assumed constant,
equation (2)Mbecomes
V P Y , 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
5-19
Changes in the Money Stock
and AD
• An increase in the
nominal money stock
shifts the AD schedule up
in proportion to the
increase in nominal
money M0
– Suppose corresponds
to AD and the economy is
operating at P0 and Y0
– If moneyM stock
1.1M 0 increases
by 10% to , AD
shifts to AD’ the value
of P corresponding
M 1.1M 0 M 0 to Y0
must be P’P= 11.1P.1P0 P00
– Therefore
real
money balances and Y
are unchanged
5-20
AD Policy & 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
G, T , M S
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)
5-21
AD Policy & 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’
– Spending increases to E’
BUT firms can not obtain
the N required to meet the
increased demand
– Firms hire more workers &
wages and costs of
production rise firms
must charge higher price
– Move up AS and AD curves
to E’’ where AS = AD’
5-22
AD Policy & the Classical Supply
Curve
• The increase in price from
the increase in AD reduces
M
the real money
stock,
P
, 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
5-23
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
5-24
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, move to E’: GDP
increases, tax revenues fall
proportionately less than tax
cut (AD effect)
• In the LR, moves to E’’: GDP is
higher, but by a small amount,
tax collections fall as the
deficit rises, and prices rise
(AS effect)
5-25
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
5-26
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/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
5-27
