McGraw-Hill/Irwin Chapter 29: Aggregate Demand and Aggregate Supply Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved

Aggregate Demand – Aggregate Supply Model  The AD-AS model enables us to analyze changes in real GDP and price level simultaneously.  The AD-AS model provides keen insights on inflation, recession, unemployment, and economic growth. LO: 14-1 Aggregate Demand – Aggregate Supply (AD-AS) model is the macroeconomic model that uses aggregate demand and aggregate supply to determine and explain the price level and level of real domestic output. 14-2

Aggregate Demand and Aggregate Demand Curve LO: 14-1  Aggregate demand curve is a schedule that shows the total quantity of goods and services demanded at difference price levels.  There is an inverse relationship between the price level (as measured by the GDP price index) and real output demanded (real GDP). Real Domestic Output, GDP Price Level AD Aggregate Demand 14-3

Changes in Aggregate Demand LO: 14-1 Determinant:Factor(s) of Determinant:AD shifts: Consumer Spending Consumer wealth increases Consumers’ real incomes rise Household indebtedness rises Tax increases RIGHT LEFT Investment Spending Increases in real interest rate Higher expected returns LEFT RIGHT Government Spending Increase in government spendingRIGHT Net export Spending Rising national income abroad Depreciation of the dollar RIGHT 14-4

Shifts in Aggregate Demand Curve Real Domestic Output, GDP Price Level AD 1 Increase in Aggregate Demand AD 3 AD 2 Decrease in Aggregate Demand LO:

Aggregate Supply LO: 14-2  Aggregate supply curve is a schedule that shows the total quantity of goods and services supplied at difference price levels.  The aggregate supply curve in the short run and in the long run vary by degrees of wage adjustment  In the immediate short run, output and input prices are fixed, and the AS curve is horizontal  In the short run, output prices are flexible while input prices are sticky, thus the AS curve is positively sloped  In the long run, all prices are flexible, economy is at the full employment (output is equal to potential), the AS curve is vertical 14-6

Immediate Short Run Aggregate Supply Real Domestic Output, GDP Price Level AS ISR Immediate Short Run Aggregate Supply LO:

Short Run Aggregate Supply Real Domestic Output, GDP Price Level 0 QfQf Aggregate Supply (Short Run) LO:

Long Run Aggregate Supply Real Domestic Output, GDP Price Level AS LR Long Run Aggregate Supply LO:

Changes in Aggregate Supply LO: 14-2 Determinant:Factor(s) of Determinant:AS shifts: Input Prices Domestic resource prices rise Prices of imported resources rise Increased market power LEFT ProductivityIncreases in productivityRIGHT Legal- Institutional Environment Higher business taxes More government regulation LEFT 14-10

Shifts in Aggregate Supply Curve Real Domestic Output, GDP Price Level AS 1 Increase in Aggregate Supply AS 3 AS 2 Decrease in Aggregate Supply LO:

Equilibrium Price Level and Real GDP  Equilibrium occurs at the price level that equalizes the amount of real output demanded and supplied.  Equilibrium point is the intersection of the aggregate demand curve and aggregate supply curve.  This intersection determines the equilibrium price level and equilibrium real output. LO:

Equilibrium Real Output Demanded (Billions) Price Level (Index Number) Real Output Supplied (Billions) $ $ Equilibrium Price Level and Equilibrium Real GDP LO:

Equilibrium Real Domestic Output, GDP (Billions of Dollars) Price Level AD AS Equilibrium LO:

Using AD-AS Model to Explain Inflation and Recession  When aggregate supply and aggregate demand change, inflation and recession can occur in the short run.  Demand-pull inflation occurs when aggregate demand increases (AD curve shifts to the right).  Cost-push inflation occurs when costs of production rise (AS curve shifts to the left).  Recession occurs when aggregate demand falls (AD curve shifts to the left) and prices are sticky downwards. LO:

Demand-Pull Inflation Real Domestic Output, GDP Price Level AD AS P1P1 P2P2 Q1Q1 QfQf AD 1 Increase in Aggregate Demand Demand-Pull Inflation LO:

Cost-Push Inflation Real Domestic Output, GDP Price Level AD AS P1P1 P2P2 Q1Q1 QfQf Decrease in Aggregate Supply Cost-Push Inflation AS 1 a b LO:

Recession Real Domestic Output, GDP Price Level AD 1 AS P1P1 Q2Q2 QfQf AD 2 Decrease in Aggregate Demand Creates a Recession a b LO: