AggregateDemand and Supply

Aggregate Demand Curveshows the level of real GDP purchased by everyone at different price levels during a time period, ceteris paribus

The horizontal axis measures the value of final goods and services included in real GDP measured in base year dollars

The vertical axis measure is an index of the overall price level, such as the GDP deflator or the CPI

Aggregate Demand Curve slopes downward to the right• Real balance wealth effect• Interest rate effect• Net exports effect

Interest Rate EffectAssuming fixed credit, an increase in the price level translates through higher interest rates into a lower real GDP

Net Exports EffectA higher domestic price level makes U.S. goods more expensive compared to foreign goods, exports decrease, imports increase, decreasing real GDP

Real Balance EffectConsumers spend more on goods and services because lower prices make their dollars more valuable

Aggregate Demand Downward Slope

$200

$150

$100

$50

2 4 6 8

B

A

1210

AD

Aggregate Demand CurveP

rice

Lev

el

Real GDP

Shifts in Aggregate Demand Curve• Consumption, • Investments, • Government spending and • Net exports can change

200

150

100

50

2 4 6 8

BA

1210

AD2

AD1

Shift in Aggregate Demand CurveP

rice

Lev

el (

CP

I)

Real GDP

Increases in C,I, G, (X-M)

Increases (shifts) in the aggregate demand curve

lead to

Aggregate Supply CurveShows the level of real GDP produced at different price levels during a time period, ceteris paribus

Keynes assumes fixed product prices and wagesDuring a deep recession or depression, there are many idle resources in the economyProducers are willing to sell additional output at current prices because there is plenty of resources to go around for everyone who wants themIdle resources mean fixed wages: Unemployed workers willing to work for the prevailing wage diminishes the power of workers to increase their wages

What kind of supply curve would explain fixed prices and wages?A horizontal supply curve

200

150

100

50

2 4 6 8Real GDP

Pri

ce L

evel

(C

PI)

12

AS

AD2

AD1

Keynesian Horizontal Aggregate Supply Curve

full employment

10

Government spending (G)

increases

Aggregate demand increases and the

economy moves from E1 to E2

Price level remains constant, while real GDP

and employment rise

Keynesians believe what a shift in aggregate demand will restore a depressed economy to full employment

Classical view of the aggregate supply curvea vertical line at the full employment output

Classical economists believe

Understanding the Different Theories

the economy normally operates at its full employment levelthe price level of products and production costs change by the same percentage in order to maintain full employment

200

150

100

50

2 4 6 8 10 12 14 16Real GDP

Full employment

Classical Aggregate Supply Curve

AS

Pri

ce L

evel

(C

PI)

17

AD1

AD2

Surplus

Aggregate demand decreases at full

employment

Unemployment causes a decrease in prices

The economy moves to a level of full employment

YK Real GDP

Keynesian Range

Ranges of the Aggregate Supply Curve

ASP

rice

Lev

el

Inte

rmed

iate

Range

Cla

ssic

al

Ran

ge

YF

Full Employment

2 4 6 8 10 12

AS

0

$50

$100

$150

$200

Full Employment

AD1

AD3

AD4

Increasing Demand

AD6

AD5

AD2

200

150

100

50

2 4 6 8 10 12 14 16full

employment

Rightward Shift in the Aggregate Supply CurveP

rice

Lev

el

17

AS1

AD

AS2

Real GDP

Types of Inflation• Cost push• Demand pull

Cost Push InflationA rise in the general price level resulting from an increase in the cost of production

Demand Pull InflationA rise in the general price level resulting from an excess of total spending

200

150

100

50

2 4 6 8 10 12 14 16

Pri

ce L

evel

17

AD

AS1

Real GDP

AS2

Cost Push Inflation

200

150

100

50

2 4 6 8 10 12 14 16

Pri

ce L

evel

17

AD1

AS

Real GDP

AD2

Demand Pull Inflation

StagflationHigh unemployment and rapid inflation exist simultaneously

The business cycleShifts in the aggregate demand and aggregate supply curves

Other Shifts in AD & AS

200

150

100

50

2 4 6 8 10 12 14 16 17

AD1

AS1

Real GDP

AD2

AS2

Rightward Shift in Demand and SupplyP

rice

Lev

el

Increase in aggregate demand and supply

Increase in real GDP

Increase in price level