1. Aggregate demand and Aggregate Supply (AD and AS)
notice the data: while potential GDP tends to move upward yr after yr, due to economic growth, actual GDP tends to rise above and fall below potential over shorter periods
Date reveals an important fact: Deviations from potential output don’t last forever
In some of these episodes, government policy-either fiscal or monetary-helped the economy to return to full employment more quickly
But even without corrective policies-such as during long parts of Great Ds of the 1930s-the economy shows a remarkable tendency to begin moving back towards potential output
What is the mechanism behind?
We will study the behavior of a new variable that we have put aside for several chapters: the price level

2. Figure 1a: Potential and Actual Real GDP, 1960-2001
Actual and Potential Real GDP (Billions of 1996 Dollars)
2,000
3,000
4,000
5,000
6,000
7,000
8,000
9,000
1960
1965
1970
1975
1980
1985
1990
1995
2000
2003
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.

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

4. AD and AS
There exist a two-way relationship between price level and output (see diagram 1)
Changes in price level cause changes in real GDP – illustrated by Aggregate Demand curve
Changes in real GDP cause changes in price level – illustrated by Aggregate Supply curve

5. The Aggregate Demand Curve
First step in understanding how price level affects economy is an important fact
When price level rises, money demand curve shifts rightward (because purchases become more expensive)
Shift in money demand, and its impact on the economy, is illustrated in Figure 2
Imagine a rather substantial rise in price level—from 100 to 140
Compared with our initial position, this new equilibrium has the following characteristics
Money demand curve has shifted rightward
Interest rate is higher
Aggregate expenditure line has shifted downward
Equilibrium GDP is lower
All of these changes are caused by a rise in price level
A rise in price level causes a decrease in equilibrium GDP

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

7. Figure 2b/c: Deriving the Aggregate Demand Curve
Price
Level
On the AD curve, a higher price level is associated with a lower real GDP.
AEr = 6% H
AEr = 9%
140 E
Aggregate Expenditure
($ Trillions) E
The rise in the interest rate causes real GDP to fall.
100 H AD
Real GDP
($ Trillions)
Real GDP
($ Trillions) 6 10 6 10

8. Deriving the Aggregate Demand Curve
Panel (c) of Figure 2 shows a new curve
Shows negative relationship between price level and equilibrium GDP
Call aggregate demand curve
Tells us equilibrium real GDP at any price level

9. Understanding the AD Curve
AD curve is unlike any other curve you’ve encountered in this text
In all other cases, our curves have represented simple behavioral relationships
But AD curve represents more than just a behavioral relationship between two variables
Each point on curve represents a short-run equilibrium in economy
A better name for AD curve would be “equilibrium output at each price level” curve—not a very catchy name
AD curve gets its name because it resembles demand curve for an individual product
AD curve is not a demand curve at all, in spite of its name

10. Movements Along the AD Curve
As you will see later in this chapter, a variety of events can cause price level to change, and move us along AD curve
Suppose price level rises, and we move from point E to point H along this curve
Following sequence of events occurs
Opposite sequence of events will occur if price level falls, moving us rightward along AD curve

11. Shifts of the AD Curve
When we move along AD curve in Figure 2, we assume that price level changes
But that other influences on equilibrium GDP are constant
Keep following rule in mind
When a change in price level causes equilibrium GDP to change, we move along AD curve
Whenever anything other than price level causes equilibrium GDP to change, AD curve itself shifts
Equilibrium GDP will change whenever there is a change in any of the following
Government purchases
Autonomous consumption spending
Investment spending
Net exports
Taxes
Money supply

12. An Increase in Government Purchases
Spending shocks initially affect economy by shifting aggregate expenditure line
In Figure 3, we assume economy begins at a price level of 100
Let’s increase government purchases by $2 trillion and ask what happens if price level remains at 100
An increase in government purchases shifts entire AD curve rightward
AD curve shifts rightward when government purchases, investment spending, autonomous consumption spending, or net exports increase, or when taxes decrease
Analysis also applies in the other direction
AD curve shifts leftward when government purchases, investment spending, autonomous consumption spending, or net exports decrease, or when taxes increase

13. Figure 3: A Spending Shock Shifts the AD Curve
(b)
At any given price level, an increase in government purchases shifts the AE line upward, raising real GDP.
Since real GDP is higher at the given price level, the AD curve shifts rightward.
Price
Level
AE2
AE1
Real Aggregate Expenditure
($ Trillions) H
100 H E E
AD1
AD2
Real GDP
($ Trillions)
Real GDP
($ Trillions) 10
13.5 10
13.5

14. Changes in the Money Supply
Changes in money supply will also shift aggregate demand curve
Imagine that Fed conducts open market operations to increase money supply
AD curve shifts rightward
A decrease in money supply would have the opposite effect

15. Shifts vs. Movements Along the AD Curve: A Summary
Figure 4 summarizes how some events in economy cause a movement along AD curve, and other events shift AD curve
Panels (b) and (c) of Figure 4 tell us how a variety of events affect AD curve, but not how they affect real GDP
Where will price level end up?
First step in answering that question is to understand the other side of the relationship between GDP and price level

16. Figure 4a: Effects of Key Changes on the Aggregate Demand Curve
Price Level
Price level ↑ moves us leftward along the AD curve P3
Price level ↓ moves us rightward along the AD curve P1 P2 AD Q3 Q1 Q2
Real GDP

17. 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
Price Level
AD2
AD1
Real GDP

18. Figure 4c: Effects of Key Changes on the Aggregate Demand Curve
Price Level
Entire AD curve shifts leftward if:
a, IP, G, or NX decreases
Net taxes increase
The money supply decreases
decreases
AD1
AD2
Real GDP

19. Costs and Prices
Price level in economy results from pricing behavior of millions of individual business firms
In any given year, some of these firms will raise their prices, and some will lower them
But often, all firms in the economy are affected by the same macroeconomic event
Causing prices to rise or fall throughout the economy – what interest us in macroeconomics
To understand how macroeconomic events affect the price level, we begin with a very simple assumption
A firm sets price of its products as a markup over cost per unit

20. Costs and Prices
Percentage markup in any particular industry will depend on degree of competition there
In macroeconomics, we are not concerned with how the markup differs in different industries
But rather with average percentage markup in economy
Determined by competitive conditions
Competitive structure changes very slowly, so average percentage markup should be somewhat stable from year-to-year
But a stable markup does not necessarily mean a stable price level, because unit costs can change
In short-run, price level rises when there is an economy-wide increase in unit costs
Price level falls when there is an economy-wide decrease in unit costs

21. GDP, Costs, and the Price Level
Primary concern here: impact of real GDP on unit costs and, therefore, on the price level
Why should a change in output affect unit costs and price level?
As total output increases
Greater amounts of inputs may be needed to produce a unit of output
Price of non-labor inputs rise
Nominal wage rate rises
A decrease in output affects unit costs through the same three forces, but with opposite result

22. The Short Run
All three of our reasons are important in explaining why a change in output affects price level
However, they operate within different time frames
But our third explanation—changes in nominal wage rate—is a different story
For a year or more after a change in output, changes in average nominal wage are less important than other forces that change unit costs
Some of the more important reasons why wages in many industries respond so slowly to changes in output
Many firms have union contracts that specify wages for up to three years
Wages in many large corporations are set by slow-moving bureaucracies
Wage changes in either direction can be costly to firms
Firms may benefit from developing reputations for paying stable wages

23. The Short Run Nominal wage rate is fixed in short-run
We assume that changes in output have no effect on nominal wage rate in short-run
Since we assume a constant nominal wage in short-run, a change in output will affect unit costs through the other two factors
In short-run, a rise (fall) in real GDP, by causing unit costs to increase (decrease), will also cause a rise (decrease) in price level

24. Deriving the Aggregate Supply Curve
Figure 5 summarizes discussion about effect of output on price level in short-run
Each time we change level of output, there will be a new price level in short-run
Giving us another point on the figure
If we connect all of these points, we obtain economy’s aggregate supply curve
Tells us price level consistent with firms’ unit costs and their percentage markup at any level of output over short-run
A more accurate name for AS curve would be “short-run-price-level-at-each-output-level” curve

25. Figure 5: The Aggregate Supply Curve
Price Level AS
Starting at point A, an increase in output raises unit costs. Firms raise prices, and the overall price level rises.
130 B
100 A 80 C
Starting at point A, a decrease in output lowers unit costs. Firms cut prices, and the overall price level falls. 6 10
13.5
Real GDP ($ Trillions)

26. 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

27. Shifts of the AS Curve
Figure 5 assumed that a number of important variables remained unchanged
But in real world, unit costs sometimes change for reasons other than a change in output
In general, we distinguish between a movement along AS curve, and a shift of curve itself, as follows
When a change in real GDP causes the price level to change, we move along AS curve
When anything other than a change in real GDP causes price level to change, AS curve itself shifts
What can cause unit costs to change at any given level of output?
Changes in world oil prices
Changes in the weather
Technological change
Nominal wage, etc.

28. Figure 6: Shifts of the Aggregate Supply Curve
AS2
Price Level
AS1 L
140
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.
100 A 10
Real GDP ($ Trillions)

29. Figure 7a: Effects of Key Changes on the Aggregate Supply Curve
Price Level AS
Real GDP ↑ moves us rightward along the AS curve P3
Real GDP ↓ moves us leftward along the AS curve P1 P2
Real GDP Q2 Q1 Q3

30. Figure 7b: Effects of Key Changes on the Aggregate Supply Curve
AS2
Price Level
AS1
Entire AS curve shifts upward if unit costs ↑ for any reason besides an increase in real GDP
Real GDP

31. Figure 7c: Effects of Key Changes on the Aggregate Supply Curve
Price Level
AS1
AS2
Entire AS curve shifts downward if unit costs ↓ for any reason besides an decrease in real GDP
Real GDP

32. AD and AS Together: Short-Run Equilibrium
Where will the economy settle in short-run?
Where is our short-run macroeconomic equilibrium?
We know that in equilibrium, economy must be at some point on AD curve
Short-run equilibrium requires economy be operating on its AS curve
Only when economy is at point E—on both curves—will we have reached a sustainable level of real GDP and the price level

33. Figure 8: Short-Run Macroeconomic Equilibrium
Price Level AS B
140 E
100 F AD
Real GDP ($ Trillions) 6 10 14

34. What Happens When Things Change?
Now that we know how short-run equilibrium is determined, and armed with our knowledge of AD and AS curves, we are ready to put model through its paces
Our short-run equilibrium will change when either AD curve, AS curve, or both, shift
An event that causes AD curve to shift is called a demand shock
An event that causes AS curve to shift is called a supply shock
In earlier chapters, we’ve used phrase spending shock
A change in spending by one or more sectors that ultimately affects entire economy
Demand shocks and supply shocks are just two different categories of spending shocks

35. An Increase in Government Purchases
Shifts AD curve rightward
Can see how it affects economy in short-run: increases output and rises interest rate in the money market
Process described is not entirely realistic
Assumes that when government purchases rise, first output increases, and then price level rises
In reality, output and price level tend to rise together

36. Figure 9: The Effect of a Demand Shock
Price Level AS
130 H
115 J
100 E
AD2
AD1 10
13.5
Real GDP($ Trillions)
12.5

37. 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

38. An Decrease in Government Purchases

39. 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

40. Other Demand Shocks A positive demand shock—shifts AD curve rightward
Increases both real GDP and price level in short-run
A negative demand shock—shifts AD curve leftward
Decreases both real GDP and price level in short-run

41. An Example: The Great Depression
U.S. economy collapsed far more seriously during 1929 through 1933—the onset of the Great Depression—than it did at any other time
What do we know about demand shocks that caused Great Depression?
Fall of 1929, bubble of optimism burst
Stock market crashed, and investment and consumption spending plummeted
Demand for products exported by United States fell
Fed reacted by cutting money supply sharply
Each of these events contributed to a leftward shift of AD curve
Causing both output and price level to fall

42. Demand Shocks: Adjusting to the Long-Run
In Figure 9, point H shows new equilibrium after a positive demand shock in short-run—a year or so after the shock
But point H is not necessarily where economy will end up in long-run
In short-run, we treat wage rate as given
But in long-run, wage rate can change
When output is above full employment, wage rate will rise, shifting AS curve upward
When output is below full employment, wage rate will fall, shifting AS curve downward

43. Demand Shocks: Adjusting to the Long Run
Increase in government purchases has no effect on equilibrium GDP in long-run
Economy returns to full employment, which is just where it started
This is why long-run adjustment process is often called economy’s self-correcting mechanism
If a demand shock pulls economy away from full employment
Change in wage rate and price level will eventually cause economy to correct itself and return to full-employment output

44. Figure 10: The Long-Run Adjustment Process
Price Level
AS2
AS1 P4 K P3 J P2 H P1 E
AD2
AD1
YFE Y3 Y2
Real GDP

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

46. Figure 11: Long-Run Adjustment After A Negative Demand Shock
Price Level
AS1
AS2 P1 E P2 N P3 M
AD1
AD2
Real GDP Y2
YFE