Aggregate Demand and Aggregate Supply

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Aggregate Demand & Aggregate Supply
“The construction of an economic model...consists of
snatching…key points which, when put together in some cunning
way, become …a substitute for reality itself.”
~Evsey Domar

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Why does the economy ‘wobble’?
In studying business cycles, we discovered that the
economy wobbles from hot to cold and from inflation
to unemployment.
Why?
And more importantly, what can be done to prevent
or minimize these impacts?
We’ll answer these questions using the Aggregate
Demand – Aggregate Supply (AD-AS) model!

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First, some background
The word Aggregate means “the collection of
units”. In this module, we will be ‘aggregating’
all supply and all demand. That means we
will look at everything we buy and everything
we sell.
To do so, we will build a model. Don’t be
intimidated by this idea. This model is much
like a model airplane – it is designed to
approximate the real thing – our
macroeconomy.
Economists routinely build models to explore
what might happen in the real world.

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The AS-AD model is simple, but powerful
The AD AS model will
compare only two
variables.
The general level of
price as measured by
a price index
(such as the Consumer
Price Index (CPI))…
…and the total value
of output – as
measured by Real
GDP.

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Just so we are clear…
Any upward movement
means that prices are
going up.
The Y-axis measures the
price level.
To keep things simple, we’ll
call these prices P1, P2,
P3 etc…
P3
P1
P2

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Just so we are clear (part 2)…
Any rightward movement means
that output is going up…the
economy is getting bigger.
The X-axis measures Real GDP –
the total value of our output.
We’ll assume this hypothetical
economy is smaller than
ours…perhaps in the $200 billion
dollar range.
$100b $300b$200b

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We’ll develop three ‘curves’
In exploring the model, the relationships
between these variables will be examined:
AD – Aggregate Demand: the amount of “stuff” (i.e. goods
and services) consumer’s want to buy
SRAS - Short Run Aggregate Supply – the amount of ‘stuff’
producers are willing or able to produce given current conditions
LRAS - Long Run Aggregate Supply – the amount of ‘stuff’
producers are willing or able to produce given ideal conditions
such as a natural rate of unemployment

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Bare with me!
The initial part of this module will be
theoretical as we build the model.
Please bare with me – you will find that this model
is a simple but powerful tool that will help you
answer many questions…like:
What happens to prices if my taxes are lowered?
What does a housing boom or stock market boom
do to the economy?
What if Europe goes into recession…how does
that affect us?
And many more!!

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Let’s start with
aggregate demand
Aggregate demand
shows the
relationship between
prices…
And the amount of
goods and services
that are purchased in
an economy.
Those purchases can come
from any of our primary
source: Consumers (C),
Investors (I),
Government (G)
or foreign countries (Xn)

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AD is downward sloped
As you might expect, the AD
Curve is downward sloped.
At high prices (P3), aggregate
demand may be low…perhaps
only $100 billion worth of
goods and services are
demanded.
P3
P1
P3 – prices are high
P1 – prices are low
$100b $300b
At low prices (P1), aggregate
demand may be
high…perhaps $300 billion
worth of goods and services
are wanted.
Connecting these points gives
us our Aggregate Demand
curve.
AD

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Let’s turn to short run
aggregate supply
Short run aggregate
supply shows the
relationship between
prices…
And the amount of
goods and services
that are produced in
an economy.
That production comes from
our domestic businesses.

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SRAS is upward sloped
As you might expect, the
SRAS Curve is upward sloped.
At high prices (P3), SRAS may
be high…producers are
excited to make stuff at these
high prices and make $300
billion worth of goods and
services.
P3
P1
P3 – prices are high
P1 – prices are low
$100b $300b
At low prices (P1), SRAS may
be low…low prices squeeze
profits and discourage
producers. Here, they only
want to make $100 billion
worth of goods and services.
Connecting these points gives
us our Short Run Aggregate
Supply curve.
SRAS

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Putting these curves together gives us
Macroeconomic equilibrium
P2
$200b
SRAS
AD
In the short run, the economy
will find the point where AD
intersects with SRAS.
It is at that point where the
level of all of our demand
equals the level of all
producer’s supply.
As a result, this economy will
reach this point – what we will
call “macroeconomic
equilibrium”.
And at that point, The price
level will be at P2 and Real
GDP will be $200b.

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How do we know macroeconomic
equilibrium will be reached?
$150b
SRAS
AD
Perhaps you do not believe that
macro economic equilibrium will be
at that point.
We can easily test that idea.
What if prices were higher than
P2…say P3?
P3
$250b
At those prices, consumers would
be reluctant to buy things…they
would demand only $150 billion in
goods and services.
Yet producers are excited about the
high prices and make $250 billion
worth of goods and services.

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$150b
SRAS
AD
At those high prices…producers
overproduce and wind up with a
surplus of $100b worth of goods
and services.
How do you think they get rid of
that surplus?
P3
$250b
They lower prices…pushing the
economy toward macro economic
equilibrium.
This process will continue until AD
equals SRAS (in theory).
$100b

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$150b
SRAS
AD
Let’s look at it from the other
side…What if prices were too low?
At these low prices…consumers
are excited to buy stuff! They want
$250 worth of goods and services.
P1
$250b
Yet producers are not willing to
make that much stuff at those low
prices.

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$150b
SRAS
AD
At those low prices, shortages
occur…consumers cannot get
everything they want. Specifically,
a shortage of $100b worth of goods
and services occurs..
How do you think consumer’s
respond?
$250b
They bid up prices…offering more
to make sure it is not them that is
left without. That pushes the
economy toward macro economic
equilibrium.
This process will continue until AD
equals SRAS (in theory).
$100b
P1

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So now we know, that in the short run,
macroeconomic equilibrium will be reached
SRAS
AD
The forces and desires of buyer
and seller will ensure that
macroeconomic equilibrium is
reached.
For this model economy, that
means the price level will be at P2
and Real GDP will be at $200.
That does not mean we will “like”
those levels – just that the
economy will tend to move there.
We’ll spend much of the rest of the
semester learning what can be
done when we do not “like” that
outcome.
P2
$200b

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Everything we’ve done so far looks at one
point in time…what about OVER time?
We’ll now turn our attention to
CHANGES in Aggregate Demand
and Short Run Aggregate Supply

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Let’s make our first change
SRAS
AD
Perhaps we start here…prices are
at P2 and Real GDP is $200b.
Then something happens…
perhaps stock prices increase a lot
(called “a stock market boom”) and
people feel richer. That’s called a
Wealth Effect.
With all this new wealth,
consumption goes up. You’ve
always wanted that new swimming
pool…right?
We show that in the model as a
rightward movement (i.e. an
increase) in the AD curve.
P2
$200b
If Consumption increases (C↑) that
means we demand more goods
and services at each price level.

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With a new AD curve, a new
macroeconomic equilibrium is established
SRAS
AD
With this new AD curve, P2 is no
longer the equilibrium price.
As a result of this increase in AD,
prices rise to P3.
And Real GDP increases to $250b
This should make sense to you: A
stock market boom has caused us
all to feel richer. As we buy more
goods, the economy accelerates
and Real GDP increases. But
prices also rise along with it!
P2
$200b
P3
$250b

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We’ve conducted our first analysis!
We analyzed an impact: Stock
prices rose dramatically.
We then showed, based on the AD-
AS model, that we would expect
prices to rise and Real GDP to
increase as a result.
That led to a wealth effect where
people felt richer and spent more.

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Let’s make our second change
SRAS
AD
Then something
happens…perhaps housing prices
fall a lot and everyone feels poorer.
This would probably scare people
causing them to cut back on
spending.
We show that in the model as a
leftward movement (i.e. an
decrease) in the AD curve.
P2
$200b
If Consumption decreases (C↓) that
means we demand fewer goods
and services at each price level.
Sound familiar?

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With a new AD curve, a new
macroeconomic equilibrium is established
SRAS
AD
With this new AD curve, P2 is not
longer the equilibrium price.
As a result of this decrease in AD,
prices fall to P1.
And Real GDP drops to $150b
This should make sense to you: A
“housing bust” has caused us all to
feel poorer. As we cut back on
spending, the economy slows down
and Real GDP drops. Prices also
fall along with it!
P2
$200b
P1
$150b

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We’ve conducted our second analysis!
We analyzed another impact:
House prices fell precipitously.
We then showed, based on the AD-
AS model, that we would expect
prices to fall and Real GDP to
decrease as a result.
That scared people, causing them to
cut back on their spending.

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The AS-AD model is simple, but powerful
Using the AD-AS Model, we can
get a good idea of how this
economy is doing after an impact
such as the second impact.
Prices are falling…that is
deflation.
Real GDP is also falling…that
means our incomes are falling!
This sounds a lot like a recession
to me…and an uncomfortable
economy to live in!

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So what causes the AD
curve to move?
We’ve explored two scenarios, both
of which affected consumption.
As consumption changes, so does
Aggregate demand…It is after all the sum
of spending by our four components.
It is important that you consider the determinants
(as listed on the next two slides) and the possible
impacts that they may have on Aggregate
demand.
Any factor that can affect the AD curve is called a
“Determinant of Aggregate Demand”

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The determinants of AD (increasing)
Any of the changes could cause an
increase in AD
– Consumption
• A wealth effect such as a stock boom
increases consumption
• Reduced individual taxes increases
consumption
– Investment
• Lower interest rates encourage investment
• Reduced taxes encourage investment
– Government spending
• War increases government spending
• Social programs are enacted causing more
government spending
– Net exports
• Prosperity in foreign nations increases their
income and causes them to buy more U.S.
goods.
• Exchange rates: a cheaper dollar makes U.S.
goods more attractive to foreign consumers.
Price
Level

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More determinants of AD (decreasing)
Any of the changes could cause a
decrease in AD
– Consumption
• A housing or stock bust decreases
consumption
• Higher taxes decreases consumption
– Investment
• Higher interest rates discourage investment
• Higher taxes discourage investment
– Government spending
• Government spending cutbacks
• Social programs are ended reducing
government spending
– Net exports
• Recessions in foreign nations decreases their
income and causes them to buy fewer U.S.
goods.
• Exchange rates: a more valuable dollar
makes U.S. goods less attractive to foreign
consumers.

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Let’s turn our attention to the Short
Run Aggregate Supply Curve
SRAS
AD
Then something happens…
perhaps business costs fall
because health care costs go
down.
This allows employers to make
more goods and services with the
same amount of resources.
P2
That is illustrated by a rightward (or
outward) shift in the SRAS curve.
The SRAS curve also moves.
$100b

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Let’s turn our attention to the Short
Run Aggregate Supply Curve
SRAS
AD
As a result, prices are lower and
Real GDP is higher.
P1
$200b
With this new SRAS curve, a new
established.
P2
$100b

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What about a decline in
Aggregate Supply?
SRAS
AD
What if oil prices went a lot
higher…not tough to imagine,
right?
Many businesses use oil to make
their goods and services – if for no
other reasons then they have to
transport them.P1
$200b
These higher resource costs could
cause employers to reduce the
amount of goods and services they
make…a leftward shift in SRAS.
Alternatively, the SRAS curve can
fall as well.

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Here the SRAS curve has shifted left
SRAS
AD
P2
$150b
With the reduced SRAS curve, a
new macroeconomic equilibrium is
established.
As a result, prices are higher (P2)
and Real GDP is lower.
P1
$200b

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So what causes the AS
curve to move?
We’ve explored two scenarios,
health care costs and oil prices.
Factors that affect the AS curve are
business related and include things like
business taxes and costs of resources.
It is important that you consider the determinants
(as listed on the next two slides) and the possible
impacts that they may have on Aggregate
Supply.
Any factor that can affect the AS curve is called a
“Determinant of Aggregate Supply”

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SRAS1
Determinants of AS (increases)
Any of the changes could cause an
increase in the AS curve
– A decrease in input prices
• A fall in wages would encourage employers to
produce more
• Lower oil costs would encourage producers to
produce more
– An increase in productivity
• Higher productivity allows more output to be
produced at the same cost
– Favorable taxation and regulation
• A lowering of business taxes lowers costs and
encourages businesses to produce more
• Less regulation (typically) encourages more
output
SRAS2

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SRAS2
SRAS1
Determinants of AS (decreases)
Any of the changes could cause a
decrease in AS
– An increase in input prices
• A rise in wages would discourage employers
from increasing production
• Higher oil costs would encourage producers
to produce less
– A decrease in productivity
• lower productivity causes output to cost more
per unit
– Unfavorable taxation and regulation
• Higher taxes raise business costs and
discourages business from producing more
• More regulation (typically) forbids more output

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Let’s try some examples
Let’s run through some scenarios to make
sure you understand the model!
The next five slides will give you these
scenarios and ask that you answer a
simple question.
Once you click, the answer will be given. If
you get them all right, your understanding
of this material is solid. If not, you should
review the text and presentation more.

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Scenario #1
Imagine you live in this hypothetical
economy.
SRAS
AD1
$200b
P1
$150b
AD2
P2
You’ve watched as aggregate
demand has increased from AD1 to
AD2 in response to a reduction in
personal taxes.
Which of the following is most
accurate:
A) Prices
increased.
B) Real GDP
decreased.
C) Prices
decreased.
D) Real GDP is
unchanged.
Note that the new AD curve causes prices to rise from P1 to P2. That
is inflation!

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Scenario #2
economy.
SRAS
AD2
$200b
P1
$150b
AD1
P2
demand has fallen from AD1 to AD2
in response to a recession in a major
trading partner country.
accurate:
A) Prices
increased.
B) Real GDP
increased.
C) Prices
decreased.
D) Real GDP is
unchanged.
Note that the new AD curve causes prices to fall from P2 to P1. That is
deflation!

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Scenario #3
economy.SRAS1
AD1
$75b
P1
$150b
P2
You’ve watched as aggregate supply
has fallen from SRAS1 to SRAS2 in
response to an increase in business
taxes.
accurate:
A) Prices
increased.
B) Real GDP
decreased.
C)Real GDP fell to
$75 billion.
D) All the above
are likely.
SRAS2
Note that macroeconomic equilibrium suggests higher prices, and
lower Real GDP, falling to $75 billion. Ouch!

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Scenario #4
economy.SRAS1
AD1
$200b
P2
$150b
P1
has increased from SRAS1 to
SRAS2 in response to an reduction
in business taxes.
accurate:
A) Prices
increased.
B) Real GDP
decreased.
C) Prices
decreased.
D) Real GDP is
unchanged.
SRAS2
Note that the new SRAS curve causes prices to fall from P2 to P1. But
Real GDP is growing!

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Scenario #5
economy.SRAS1
AD1
$200b
P1
$150b
P2
has increased from SRAS1 to
SRAS2 and AD has shifts from AD1
to AD2.
accurate:
A) Prices
increased.
B) Real GDP
decreased.
C) Prices
decreased.
D) Prices are
unchanged.
SRAS2
AD2
$250b
With these simultaneous changes, prices are pretty stable. But Real
GDP is higher!

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Finally…let’s look at Long
Run Aggregate Supply (LRAS)
We know our economy goes through
ups and downs as it moves through
the business cycle.
In the short run, economic factors may not
move quickly enough to fully adjust for
these ups and downs.
As a good example, think of wages. When
the economy contracts, our wages do not
move quickly downward in response.

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More on sticky prices
In the long run however, prices and wages
are not sticky – they do fluctuate based on
economic conditions.
Economists refer to this idea as “sticky wages”.
Over short periods of time, wages do not respond
quickly to changes – they are sticky. Prices of
goods and services can also be sticky.
And our theory will tell us that they will do
so until all resources are fully employed: In
other words we will reach our potential
GDP and full employment in the long run.

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The LRAS gives us one key piece of
information: Potential Output
The LRAS curve shows us the potential
output we would have if we used all our
resources. In particular, we are referring to
the resource of labor.
When our macro economy is using
labor to fullest extent, we call that
“Full Employment”.
It occurs when our unemployment rate is at
the “natural rate”.
In this class, we are calling that 5%.

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LRAS, in graphical form
If our economy were at 5%
unemployment, we would be
producing our potential GDP.
LRAS
P1
$200b
Imagine that if that were true in this
hypothetical economy, potential GDP
would be $200 billion.
If true, then the LRAS would be a
vertical line at $200.
It is this economy’s potential supply
of goods, regardless of price…since
prices are flexible in the long run.
P2

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Here is where LRAS become useful
If the SRAS and AD curve intersect
on the LRAS curve, then
macroeconomic equilibrium is at the
potential.
LRAS
$200b
That means that we are producing at
a ‘full employment rate’.
And that suggests that the
unemployment rate is at the natural
rate.
In other words, unemployment in this
economy is at 5%.
P2
SRAS1
AD1

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This economy has fallen
below its potential
What if something happens and AD
shifts left from AD1 to AD2?LRAS
$200b
This economy is no longer producing
at its potential. It is instead
producing $150 billion worth of
goods and services.
unemployment rate is higher than the
natural rate.
economy is above 5%.
P2
SRAS1
AD2
$150b
After all, if you are going to produce
fewer goods and services, you likely
don’t need as many employees!
AD1

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With the LRAS, we can really summarize
an economy’s health
Note that AD fell. Now macroeconomic
equilibrium is below the full employment rate
of output and Real GDP has fallen to $150b.
Given these conditions, we’ll assume the
unemployment rate has risen above 5%.
After all, if we are making less stuff, we need
fewer workers!
We can now take a good, broad look at this
macroeconomy.
Real GDP has decreased.
Prices have fallen (that is deflation).
And unemployment is above the natural rate.
That sounds a lot like an recession!.

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A recessionary gap!
With this change in AD, Real GDP
has fallen to $150 billion
Yet this economy is capable of
producing $200 billion in goods and
services.
Therefore, a “Recessionary Gap” of
$50 has occurred.
“Recessionary Gap”

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This economy has accelerated
beyond its potential
What if SRAS shifts from SRAS1 to
SRAS2 and macroeconomic
equilibrium occurred to the right of
LRAS
LRAS
$200b
This economy is no longer producing
at its potential. It is instead
producing $250 billion worth of
goods and services.
unemployment rate is below the
natural rate.
economy is less than 5%.
P2
SRAS2
AD1
$250b
SRAS1

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Again, we can really summarize this
economy’s health
Note that SRAS increased. Now
above the full employment rate of
output and Real GDP has
increased to $250b. Given these
conditions, we’ll assume the
unemployment rate is below 5%.
After all, if we are making more
stuff, we need more workers!
Let’s take a broad look at this
macroeconomy.
Real GDP has increased.
And unemployment is low…below 5%.
That sounds a lot like an expansion!

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LRAS
$200b
P2
SRAS1
AD1
$250b
An Inflationary gap!
With this macroeconomic
equilibrium, Real GDP is $250 billion
Yet this economy is capable of
producing only $200 billion in goods
and services in “normal times”.
This can only happen if
unemployment is very low.
“Inflationary Gap”
Therefore, an “Inflationary Gap” of
$50 billion has occurred.

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Let’s try some more examples
Let’s run through some scenarios with the
LRAS curve
The next three slides will give you these
scenarios and ask that you answer a
simple question.
Once you click, the answer will be given. If
you get them all right, your understanding
of this material is solid. If not, you should
review the text and presentation more.

of 58
Scenario #6
economy.
SRAS
AD1
$200b
P1
$150b
AD2
P2
demand has increased from AD1 to
AD2 in response to a reduction in
personal taxes.
accurate:
A) Prices
decreased.
B) The
unemployment
rate decreased.
C) Prices are
unchanged.
D) The
unemployment
rate increased.
Real GDP has increased…more is being produced. And an inflationary gap exists. These
observations suggest that the unemployment rate is low…below the natural rate of 5%.
LRAS
$175b

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Scenario #7
economy.
SRAS
AD2
$200b
P1
$150b
AD1
P2
demand has fallen from AD1 to AD2
in response to a recession in a major
trading partner country.
Which of the following is the best
estimate of the unemployment rate?
A) 3% B) 4%
C) 5% D) 6%
Note that the new AD curve shows a recessionary gap. That suggests unemployment is
above the natural rate of 5%. Only one choice gives us that option.
LRAS

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Scenario #8
economy.SRAS1
AD1
$75b
P1
$150b
P2
has fallen from SRAS1 to SRAS2 in
response to an increase in business
taxes.
accurate:
A) a recessionary
gap has occurred.
B) An inflationary
gap has occurred.
C) Unemployment
is below 5%.
D) All the above
are likely.
SRAS2
Note that macroeconomic equilibrium suggests higher prices, lower
Real GDP, and high unemployment. Ouch!
LRAS

of 58Slide 58 of 58
In summary
The AD-AS Model allows us to explore potential
changes in a macroeconomy.
We can also use the model to get an idea about
unemployment.
One we understand which curve (SRAS or AD) any
impact will affect, we can then speculate on potential
changes in prices and Real GDP.
When macroeconomic equilibrium occurs on the
LRAS, we are at the natural rate of unemployment.
If it occurs somewhere else, then we have either a
recessionary of inflationary gap!
Slide 58 of 58

Aggregate Demand and Aggregate Supply

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Aggregate Demand and Aggregate Supply