ECONOMICS

Twelfth Edition, Global Edition

Chapter 27
Aggregate Supply
and Aggregate
Demand

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 Chapter Outline and Learning Objectives

27.1 Explain what determines

aggregate supply in the long
run and in the short run
27.2 Explain what determines
aggregate demand
27.3 Explain how real GDP
and the price level are
determined and what causes
growth, inflation, and cycles
27.4 Explain the main schools
of thought in macroeconomics
today

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 Aggregate Supply (1 of 11)

• Quantity Supplied and Supply

‒ The quantity of real GDP supplied is the total quantity that firms
plan to produce during a given period.
‒ Aggregate supply is the relationship between the quantity of real
GDP supplied and the price level.
‒ We distinguish two time frames associated with different states of
the labor market:
▪ Long-run aggregate supply
▪ Short-run aggregate supply

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 Aggregate Supply (2 of 11)

• Long-Run Aggregate Supply

‒ Long-run aggregate supply is the relationship between the
quantity of real GDP supplied and the price level when real GDP
equals potential GDP.
‒ Potential GDP is independent of the price level.
‒ So the long-run aggregate supply curve (LAS) is vertical at
potential GDP.

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 Aggregate Supply (3 of 11)

• Short-Run Aggregate Supply

‒ Short-run aggregate supply is the relationship between the
quantity of real GDP supplied and the price level when the money
wage rate, the prices of other resources, and potential GDP
remain constant.
‒ A rise in the price level with no change in the money wage rate
and other factor prices increases the quantity of real GDP
supplied.
‒ The short-run aggregate supply curve (SAS) is upward sloping.

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 Aggregate Supply (4 of 11)

• Figure 27.1 shows the

LAS curve.
• In the long run, the
quantity of real GDP
supplied is potential GDP.
• As the price level rises
and the money wage rate
changes by the same
percentage, the quantity
of real GDP supplied
remains at potential GDP.

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 Aggregate Supply (5 of 11)

• In the short run, the

quantity of real GDP
supplied increases if the
price level rises.
• The SAS curve slopes
upward.
• A rise in the price level
with no change in the
money wage rate induces
firms to increase
production.

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 Aggregate Supply (6 of 11)

• With a given money wage

rate, the SAS curve cuts
the LAS curve at potential
GDP.
• The price level is 110.
• With the given money
wage rate, as the price
level falls below 110 ...
• the quantity of real GDP
supplied decreases along
the SAS curve.

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 Aggregate Supply (7 of 11)

• With the given money

wage rate, as the price
level rises above 110 …
• the quantity of real GDP
supplied increases
along the SAS curve.
• Real GDP exceeds
potential GDP.

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 Aggregate Supply (8 of 11)

• Changes in Aggregate Supply

‒ Aggregate supply changes if an influence on production plans
other than the price level changes.
‒ These influences include
▪ Changes in potential GDP
▪ Changes in money wage rate (and other factor prices)

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 Aggregate Supply (9 of 11)

• Changes in Potential GDP

‒ When potential GDP increases, both the LAS and SAS curves
shift rightward.
‒ Potential GDP changes for three reasons:
▪ An increase in the full-employment quantity of labor
▪ An increase in the quantity of capital (physical or human)
▪ An advance in technology

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 Aggregate Supply (10 of 11)

• Figure 27.2 shows the

effect of an increase in
potential GDP.
• The LAS curve shifts
rightward and the SAS
curve shifts along with the
LAS curve.

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 Aggregate Supply (11 of 11)

• Changes in the Money

Wage Rate
• Figure 27.3 shows the
effect of a rise in the money
wage rate.
• Short-run aggregate supply
decreases and the SAS
curve shifts leftward.
• Long-run aggregate supply
does not change.

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 Aggregate Demand (1 of 13)

• The quantity of real GDP demanded, Y, is the total amount

of final goods and services produced in the United States
that people, businesses, governments, and foreigners plan
to buy.
• This quantity is the sum of consumption expenditures, C,
investment, I, government expenditure, G, and net exports,
X – M.
• That is,
Y = C + I + G + X – M.

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 Aggregate Demand (2 of 13)

• Buying plans depend on many factors and some of the

main ones are
‒ The price level
‒ Expectations
‒ Fiscal policy and monetary policy
‒ The world economy

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 Aggregate Demand (3 of 13)

• The Aggregate Demand Curve

‒ Aggregate demand is the relationship between the quantity of
real GDP demanded and the price level.
‒ The aggregate demand curve (AD) plots the quantity of real GDP
demanded against the price level.

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 Aggregate Demand (4 of 13)

• Figure 27.4 shows an AD

curve.
• The AD curve slopes
downward for two
reasons:
‒ Wealth effect
‒ Substitution effects

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 Aggregate Demand (5 of 13)

• Wealth Effect
‒ A rise in the price level, other things remaining the same,
decreases the quantity of real wealth (money, stocks, etc.).
‒ To restore their real wealth, people increase saving and decrease
spending.
‒ The quantity of real GDP demanded decreases.
‒ Similarly, a fall in the price level, other things remaining the same,
increases the quantity of real wealth, which increases the quantity
of real GDP demanded.

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 Aggregate Demand (6 of 13)

• Substitution Effects
‒ Intertemporal substitution effect:
‒ A rise in the price level, other things remaining the same,
decreases the real value of money and raises the interest rate.
‒ When the interest rate rises, people borrow and spend less, so the
quantity of real GDP demanded decreases.
‒ Similarly, a fall in the price level increases the real value of money
and lowers the interest rate.
‒ When the interest rate falls, people borrow and spend more, so
the quantity of real GDP demanded increases.

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 Aggregate Demand (7 of 13)

• International substitution effect:

‒ A rise in the price level, other things remaining the same,
increases the price of domestic goods relative to foreign goods.
‒ So imports increase and exports decrease, which decreases the
quantity of real GDP demanded.
‒ Similarly, a fall in the price level, other things remaining the same,
increases the quantity of real GDP demanded.

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 Aggregate Demand (8 of 13)

• Changes in Aggregate Demand

‒ A change in any influence on buying plans other than the price
level changes aggregate demand.
‒ The main influences on aggregate demand are
▪ Expectations
▪ Fiscal policy and monetary policy
▪ The world economy

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 Aggregate Demand (9 of 13)

• Expectations
‒ Expectations about future income, future inflation, and future
profits change aggregate demand.
‒ Increases in expected future income increase people’s
consumption today and increases aggregate demand.
‒ A rise in the expected inflation rate makes buying goods cheaper
today and increases aggregate demand.
‒ An increase in expected future profits boosts firms’ investment,
which increases aggregate demand.

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 Aggregate Demand (10 of 13)

• Fiscal Policy and Monetary Policy

‒ Fiscal policy is the government’s attempt to influence the
economy by setting and changing taxes, making transfer
payments, and purchasing goods and services.
‒ A tax cut or an increase in transfer payments increases
households’ disposable income—aggregate income minus taxes
plus transfer payments.
‒ An increase in disposable income increases consumption
expenditure and increases aggregate demand.

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 Aggregate Demand (11 of 13)

• Because government expenditure on goods and services

is one component of aggregate demand, an increase in
government expenditure increases aggregate demand.
• The Fed’s attempt to influence the economy by changing
the interest rate and adjusting the quantity of money is
called monetary policy.
• An increase in the quantity of money increases buying
power and increases aggregate demand.
• A cut in interest rates increases expenditure and increases
aggregate demand.

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 Aggregate Demand (12 of 13)

• The World Economy

‒ The world economy influences aggregate demand in two ways:
‒ A fall in the foreign exchange rate lowers the price of domestic
goods and services relative to foreign goods and services, which
increases exports, decreases imports, and increases aggregate
demand.
‒ An increase in foreign income increases the demand for U.S.
exports and increases aggregate demand.

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 Aggregate Demand (13 of 13)

• Figure 27.5 illustrates

changes in aggregate
demand.
• When aggregate
demand increases, the
AD curve shifts
rightward…
• … and when aggregate
demand decreases, the
AD curve shifts leftward.

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 Explaining Macroeconomic Trends and
Fluctuations (1 of 14)
• Short-Run Macroeconomic Equilibrium
‒ Short-run macroeconomic equilibrium occurs when the
quantity of real GDP demanded equals the quantity of real GDP
supplied at the point of intersection of the AD curve and the SAS
curve.

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 Explaining Macroeconomic Trends and
Fluctuations (2 of 14)
• Figure 27.6 illustrates a
short-run equilibrium.
• If real GDP is below
equilibrium GDP, firms
increase production and
raise prices…
• … and if real GDP is
above equilibrium GDP,
firms decrease production
and lower prices.

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 Explaining Macroeconomic Trends and
Fluctuations (3 of 14)
• These changes bring a
movement along the SAS
curve towards equilibrium.
• In short-run equilibrium,
real GDP can be greater
than or less than potential
GDP.

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 Explaining Macroeconomic Trends and
Fluctuations (4 of 14)
• Long-Run Macroeconomic Equilibrium
‒ Long-run macroeconomic equilibrium occurs when real GDP
equals potential GDP—when the economy is on its LAS curve.
‒ Long-run equilibrium occurs at the intersection of the AD and LAS
curves.

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 Explaining Macroeconomic Trends and
Fluctuations (5 of 14)
• Figure 27.7 illustrates the
adjustment to long-run
equilibrium.

• Initially, the economy is at

below-full employment
equilibrium.

• In the long run, the money

wage falls until the SAS
curve passes through the
long-run equilibrium point.

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 Explaining Macroeconomic Trends and
Fluctuations (6 of 14)
• Initially, the economy is at
an above-full
employment equilibrium.
• In the long run, the
money wage rate rises
until the SAS curve
passes through the long-
run equilibrium point

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 Explaining Macroeconomic Trends and
Fluctuations (7 of 14)
• Economic Growth and
Inflation in the AS-AD
Model
• Figure 27.8 illustrates
economic growth.
• Because the quantity of
labor grows, capital is
accumulated, and
technology advances,
potential GDP increases.
• The LAS curve shifts
rightward.

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 Explaining Macroeconomic Trends and
Fluctuations (8 of 14)
• Figure 27.8 also illustrates
inflation.
• If the quantity of money
grows faster than potential
GDP, aggregate demand
increases by more than
long-run aggregate
supply.
• The AD curve shifts
rightward faster than the
rightward shift of the LAS
curve.
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 Explaining Macroeconomic Trends and
Fluctuations (9 of 14)
• The Business Cycle in the AS-AD Model
‒ The business cycle occurs because aggregate demand and the
short-run aggregate supply fluctuate, but the money wage does
not change rapidly enough to keep real GDP at potential GDP.
‒ An above full-employment equilibrium is an equilibrium in which
real GDP exceeds potential GDP.
‒ A full-employment equilibrium is an equilibrium in which real
GDP equals potential GDP.
‒ A below full-employment equilibrium is an equilibrium in which
potential GDP exceeds real GDP.

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 Explaining Macroeconomic Trends and
Fluctuations (10 of 14)
• Figures 27.9(a) and (d)
illustrate above full-
employment equilibrium.
• The amount by which real
GDP exceeds potential GDP
is called an inflationary gap.
• Figures 27.9(b) and (d)
illustrate full-employment
equilibrium.

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 Explaining Macroeconomic Trends and
Fluctuations (11 of 14)
• Figures 27.9(c) and (d) illustrate
below full-employment
equilibrium.
• The amount by which real GDP
is less than potential GDP is
called a recessionary gap.
• Figure 27.9(d) shows how, as
the economy moves from one
type of short-run equilibrium to
another, real GDP fluctuates
around potential GDP in a
business cycle.

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 Explaining Macroeconomic Trends and
Fluctuations (12 of 14)
• Fluctuations in Aggregate
Demand
• Figure 27.10 shows the
effects of an increase in
aggregate demand.
• An increase in aggregate
demand shifts the AD curve
rightward.
• Firms increase production
and the price level rises in
the short run.

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 Explaining Macroeconomic Trends and
Fluctuations (13 of 14)
• At the short-run
equilibrium, there is an
inflationary gap.
• The money wage rate
begins to rise and the SAS
curve starts to shift
leftward.
• The price level continues
to rise and real GDP
continues to decrease until
it equals potential GDP.

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 Explaining Macroeconomic Trends and
Fluctuations (14 of 14)
• Fluctuations in Aggregate
Supply
• Figure 27.11 shows the
effects of a rise in the price of
oil.
• The SAS curve shifts
leftward.
• Real GDP decreases and the
price level rises.
• The economy experiences
stagflation.

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 Macroeconomic Schools of Thought (1 of 4)

• Macroeconomists can be divided into three broad schools

of thought:
‒ Classical
‒ Keynesian
‒ Monetarist

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 Macroeconomic Schools of Thought (2 of 4)

• The Classical View

‒ A classical macroeconomist believes that the economy is self-
regulating and always at full employment.
‒ The term “classical” derives from the name of the founding school
of economics that includes Adam Smith, David Ricardo, and John
Stuart Mill.
‒ A new classical view is that business cycle fluctuations are the
efficient responses of a well-functioning market economy that is
bombarded by shocks that arise from the uneven pace of
technological change.

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 Macroeconomic Schools of Thought (3 of 4)

• The Keynesian View

‒ A Keynesian macroeconomist believes that left alone, the
economy would rarely operate at full employment and that to
achieve and maintain full employment, active help from fiscal
policy and monetary policy is required.
‒ The term “Keynesian” derives from the name of one of the
twentieth century’s most famous economists, John Maynard
Keynes.
‒ A new Keynesian view holds that not only is the money wage rate
sticky but also are the prices of goods.

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 Macroeconomic Schools of Thought (4 of 4)

• The Monetarist View

‒ A monetarist is a macroeconomist who believes that the economy
is self-regulating and that it will normally operate at full
employment, provided that monetary policy is not erratic and that
the pace of money growth is kept steady.
‒ The term “monetarist” was coined by an outstanding twentieth-
century economist, Karl Brunner, to describe his own views and
those of Milton Friedman.

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