1 Figure 1a: Potential and Actual Real GDP, Actual and Potential Real GDP (Billions of 1996 Dollars) 2,000 3,000 4,000 5,000 6,000 7,000 8,000 9, The orange line shows full- employment or potential output. The green line shows actual output. During recessions, output declines. During expansions, output rises—sometimes rapidly.

2 Figure 1: The Two-Way Relationship Between Output and the Price Level Price Level Real GDP Aggregate Demand Curve Aggregate Supply Curve

3 Figure 2a: Deriving the Aggregate Demand Curve (a) E H 500 Money ($ Billions) Interest Rate 6% 9% MsMs As the price level rises, money demand increases and interest rate rises.

4 Figure 2b/c: Deriving the Aggregate Demand Curve (b) (c) The rise in the interest rate causes real GDP to fall. Real GDP ($ Trillions) Aggregate Expenditure ($ Trillions) 610 E AE r = 6% AE r = 9% H Price Level H AD E On the AD curve, a higher price level is associated with a lower real GDP. 106 Real GDP ($ Trillions)

5 Figure 3: A Spending Shock Shifts the AD Curve (a)(b) H E AE 1 AE 2 At any given price level, an increase in government purchases shifts the AE line upward, raising real GDP. Real Aggregate Expenditure ($ Trillions) Real GDP ($ Trillions) AD 1 AD 2 E H Since real GDP is higher at the given price level, the AD curve shifts rightward. Real GDP ($ Trillions) Price Level

6 Figure 4a: Effects of Key Changes on the Aggregate Demand Curve (a) Real GDP Price Level P3P3 Q3Q3 Q1Q1 Q2Q2 AD P1P1 P2P2 Price level ↑ moves us leftward along the AD curve Price level ↓ moves us rightward along the AD curve

7 Figure 4b: Effects of Key Changes on the Aggregate Demand Curve Entire AD curve shifts rightward if: a, IP, G, or NX increases Net taxes decrease The money supply increases AD 2 AD 1 (b) Real GDP Price Level

8 Figure 4c: Effects of Key Changes on the Aggregate Demand Curve AD 2 decreases Entire AD curve shifts leftward if: a, IP, G, or NX decreases Net taxes increase The money supply decreases (c) Real GDP Price Level AD 1

9 Figure 5: The Aggregate Supply Curve Price Level Real GDP ($ Trillions) C AS A B Starting at point A, an increase in output raises unit costs. Firms raise prices, and the overall price level rises. Starting at point A, a decrease in output lowers unit costs. Firms cut prices, and the overall price level falls.

10 Movements Along the AS Curve  When a change in output causes price level to change, we move along economy’s AS curve What happens in economy as we make such a move? As we move upward along AS curve, we can represent what happens as follows

11 Figure 6: Shifts of the Aggregate Supply Curve Price Level Real GDP ($ Trillions) 100 AS 1 A When unit costs rise at any given real GDP, the AS curve shifts upward–e.g., an increase in world oil prices or bad weather for farm production AS 2 L

12 Figure 7a: Effects of Key Changes on the Aggregate Supply Curve (a) Real GDP Price Level P3P3 Q2Q2 Q1Q1 Q3Q3 P1P1 P2P2 AS Real GDP ↑ moves us rightward along the AS curve Real GDP ↓ moves us leftward along the AS curve

13 Figure 7b: Effects of Key Changes on the Aggregate Supply Curve Real GDP Price Level (b) AS 1 AS 2 Entire AS curve shifts upward if unit costs ↑ for any reason besides an increase in real GDP

14 Figure 7c: Effects of Key Changes on the Aggregate Supply Curve Real GDP Price Level (c) AS 1 AS 2 Entire AS curve shifts downward if unit costs ↓ for any reason besides an decrease in real GDP

15 Figure 8: Short-Run Macroeconomic Equilibrium Price Level Real GDP ($ Trillions) AS E B AD F

16 Figure 9: The Effect of a Demand Shock Price Level Real GDP($ Trillions) AS E J H AD 1 AD 2 115

17 An Increase in Government Purchases  Can summarize impact of price-level changes When government purchases increase, horizontal shift of AD curve measures how much real GDP would increase if price level remained constant  But because price level rises, real GDP rises by less than horizontal shift in AD curve

18 An Decrease in Government Purchases

19 An Increase in the Money Supply  Although monetary policy stimulates economy through a different channel than fiscal policy Once we arrive at AD and AS diagram, two look very much alike Can represent situation as follows

20 Figure 10: The Long-Run Adjustment Process Price Level Real GDP P2P2 P3P3 P4P4 P1P1 Y FE Y3Y3 Y2Y2 H E AS 2 AS 1 AD 2 AD 1 J K

21 Demand Shocks: Adjusting to the Long Run  For a positive demand shock that shifts AD curve rightward, self-correcting mechanism works like this

22 Figure 11: Long-Run Adjustment After A Negative Demand Shock Price Level Real GDP P2P2 AS 1 P1P1 P3P3 Y FE Y2Y2 AS 2 AD 2 AD 1 E M N