The Model of Aggregate Demand and

Aggregate Supply “Short-Run

P Aggregate
The price Supply”
level
SRAS
AGGREGATE DEMAND
AND AGGREGATE The model
determines the
P1
“Aggregate
SUPPLY eq’m price level Demand”
AD

and the eq’m Y

Y1
level of output
(real GDP). Real GDP, the
quantity of output
0 1

The Aggregate-Demand (AD) Curve Why the AD Curve Slopes Downward

The AD P
Y = C + I + G + NX P
curve C, I, G, NX are
shows the P2 the components P2
quantity of of agg. demand.
all G&S Assume G fixed
demanded P1 by govt policy. P1

in the AD To understand AD

economy at Y
the slope of AD, Y
any given Y2 Y1 must determine Y2 Y1
how a change in P
price level.
affects C, I, & NX.
2 3

The Slope of the AD Curve Why the AD Curve Might Shift

An increase in P
P Any event that
reduces the P
quantity of g&s changes C, I, G, or
P2 NX – except a change
demanded b/c:
in P – will shift the
• the wealth AD curve. P1
effect (C falls)
P1 Example:
• the interest-
AD A stock market boom AD2
rate effect (I
makes households AD1
falls) Y
Y2 Y1 feel wealthier, C Y
• the exchange- rises, the AD curve
Y1 Y2
rate effect (NX shifts right.
falls) 4 5

1
 Policy Effects in the Goods and
Policy Effects in the Goods and
Money Markets
Money Markets
 Expansionary Policy Effects  Expansionary fiscal policy: an increase
in government spending (G) or a
 Any government policy aimed at reduction in net taxes (T) aimed at
stimulating aggregate output (income)
increasing aggregate output (income)
(Y) is said to be expansionary.
(Y).
 Expansionary monetary policy: an
increase in the money supply aimed at
increasing aggregate output (income)
6
(Y). 7

Policy Effects in the Goods and Money

Markets
The Effect of an Increase in Government
Purchases or a Decrease in Net Taxes on
the AD Curve
Policy Effects in the Goods and
Money Markets
 Contractionary Policy Effects
 Any government policy that is aimed at
reducing aggregate output (income) (Y)
is said to be contractionary.
 Where expansionary policy is used to
boost the economy, contractionary
The Effect of an Increase in policy is used to slow the economy.
Money Supply on the AD Curve
8 9

Policy Effects in the Goods and The Aggregate-Supply (AS) Curves

Money Markets The AS curve P LRAS
 Contractionary fiscal policy: A shows the total
decrease in government spending or an quantity of SRAS

increase in net taxes aimed at g&s firms produce

decreasing aggregate output (income) and sell at any
given price level.
(Y).
In the short run,
 Contractionary monetary policy: A AS is
decrease in the money supply aimed at upward-sloping. Y
decreasing aggregate output (income) In the long run,
(Y). AS is vertical.
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2
The Long-Run Aggregate-Supply Curve Why LRAS Is Vertical
(LRAS)
P YN depends on the P
The natural rate of LRAS LRAS
economy’s stocks
output (YN) is the
of labor, capital, and
amount of output natural resources,
the economy and on the level of P2
produces when technology.
unemployment P1
An increase in P
is at its natural rate. does not affect
YN is also called any of these,
Y so it does not Y
potential output YN YN
or full-employment affect YN.
output.
12 13

Why the LRAS Curve Might Shift Using AD & AS to Depict LR Growth
Any event that
and Inflation
P LRAS1 LRAS2 Over the long run, LRAS2000
changes any of the LRAS1990
tech. progress P
LRAS1980
determinants of YN
will shift LRAS. shifts LRAS to the
right
Example: 1) and growth in P2000
Immigration
the money P1990
increases L,
supply shifts AD AD2000
causing YN to rise. P1980
to the right.
2) Changes in AD1990
government policy Y Result:
YN Y’ AD1980
(Incentives to work):
N ongoing inflation Y
Y1980 Y1990 Y2000
Tax rates and welfare and growth in
benefits 14
output. 15

Short Run Aggregate Supply (SRAS) Why the Slope of SRAS Matters
LRAS
The SRAS curve P P
If AS is vertical,
is upward
SRAS fluctuations in AD Phi SRAS
sloping:
do not cause Phi
P2
Over the period fluctuations in
of 1-2 years, output or
P1 ADhi
an increase in P employment. Plo
causes an AD1
If AS slopes up, Plo
increase in the ADlo
Y then shifts in AD Y
quantity of Y1 Y2 Ylo Y1 Yhi
do affect output
G&S supplied. and employment.
16 17

3
 Why the SRAS Curve Might Shift Why the SRAS Curve Might Shift

SAS1 SAS2 Also, PE shifts SRAS:

General LAS1 LAS2
If PE rises, P LRAS
Price level Increase in SRAS2
short-run AS workers & firms set SRAS1
Everything
higher wages.
that shifts PE2
LRAS shifts At each P,
SRAS, too. P1 Increase in
long-run AS production is less PE1
profitable, Y falls,
Suggest
factors that SRAS shifts left.
cause both Y
LAS and SAS YP1 YP2 YN
Real GDP
to increase
18 18 19

The Long-Run Equilibrium The Effects of a Shift in AD

Event: stock market
In the long-run P LRAS crash
P LRAS
equilibrium, SRAS
1. affects C, AD curve
SRAS1
2. C falls, so AD shifts
PE = P,
left
PE P1 A
Y = YN , 3. SR eq’m at B. SRAS2
P and Y lower, P2 B
and
unemp higher AD1
unemployment AD P3 C
4. Over time, PE falls, AD2
is at its natural Y
YN SRAS shifts right, Y
Y2 YN
rate. until LR eq’m at C.
Y and unemp back
20 at initial levels. 21

The Effects of a Shift in SRAS Accommodating an Adverse Shift in

Event: oil prices rise If policymakers do
SRAS
1. increases costs, P nothing, P
LRAS LRAS
shifts SRAS 4. Low employment
(assume LRAS SRAS2 SRAS2
causes wages to fall,
constant) P3
SRAS1 SRAS shifts right, C SRAS1
2. SRAS shifts left B B
P2 until LR eq’m at A. P 2
3. SR eq’m at point B.
P higher, Y lower, P1 A Or, policymakers could P A
1 AD2
unemp higher use fiscal or monetary
From A to B, policy to increase AD
AD1 AD1
stagflation, a period of Y
and accommodate the Y
falling output Y2 YN AS shift: Y2 YN
and rising prices. Y back to YN, but
22
P permanently higher. 23

4
 John Maynard Keynes, 1883-1946 Check Your Understanding

• The General Theory of Employment, The level of long run aggregate supply is NOT
Interest, and Money, 1936 affected by
• Argued recessions and depressions
can result from inadequate demand; a. changes in the price level.
policymakers should shift AD. b. changes in the number size of the labour force.
• Famous critique of classical theory:
c. changes in the capital stock.
The long run is a misleading guide to
current affairs. In the long run, we d. changes in technology.
are all dead. Economists set themselves
too easy, too useless a task if in tempestuous
seasons they can only tell us when the storm is
long past, the ocean will be flat.
24 25