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Chapter 12 - Aggregate Demand and Aggregate Supply
CHAPTER TWELVE
AGGREGATE DEMAND AND AGGREGATE SUPPLY
CHAPTER OVERVIEW
The aggregate expenditures model developed in Chapter 12 is a fixed-price-level model. Its focus is on
changes in real GDP, not on changes in the price level. This chapter introduces a variable-price model
in which it is possible to simultaneously analyze changes in real GDP and the price level. This
distinction should be made explicit for those students who have covered Chapter 12. What students learn
in this chapter will help organize their thoughts about equilibrium GDP, the price level, and government
macroeconomic policies. The tools learned will be applied in later chapters.
The present chapter introduces the concepts of aggregate demand and aggregate supply, explaining the
shapes of the aggregate demand and aggregate supply curves and the forces causing them to shift. The
equilibrium levels of prices and real GDP are considered. Finally, the chapter analyzes the effects of
shifts in the aggregate demand and/or aggregate supply curves on the price level and size of real GDP.
WHAT’S NEW
There is a new Last Word on the slowness of the recovery from the 2007-2009 recession despite all the
stimulus spending and extremely low interest rates.
There is a major revision to the Learning Objectives in this chapter.
All of the relevant tables and data have been updated.
INSTRUCTIONAL OBJECTIVES
After completing this chapter, students should be able to:
1. Define aggregate demand and aggregate supply.
2. Give three reasons why the aggregate demand curve slopes downward.
3. State the determinants of the aggregate demand curve’s location, and explain how the curve will
shift when one of these determinants changes.
4. Distinguish between an initial shift in aggregate demand and the full shift after multiplier effects
have been incorporated.
5. Explain the shape of the long-run aggregate supply curve.
6. Explain the shape of the short-run aggregate supply curve.
7. Indicate the determinants of the aggregate supply curve’s location, and explain how the curve will
shift when one of those determinants changes.
8. Find an economy’s equilibrium price level and real domestic output using AD-AS.
9. Explain how the multiplier effect is weakened when there is demand-pull inflation.
10. Demonstrate and explain how a decrease in aggregate demand can cause a recession without a drop
in the price level.
11. Demonstrate and explain the effects of shifts in aggregates supply on the equilibrium price level
and real domestic output of an economy.
12-1
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Chapter 12 - Aggregate Demand and Aggregate Supply
12. Explain how an economy can maintain full employment and stable prices under conditions of
rising aggregate demand.
13. Explain how the impact of oil price fluctuations has changed for the U.S. economy over the past
couple decades.
14. Define and identify terms and concepts at the end of the chapter and in the appendix.
COMMENTS AND TEACHING SUGGESTIONS
1. The aggregate demand-aggregate supply model will be used repeatedly for discussion of
unemployment, inflation, and economic growth in other chapters. It is important for students to
understand the basics in this chapter.
2. While it is helpful to show the similarities between the aggregate model and single-product supply
and demand markets explained in Chapter 3, you need to highlight the differences between the two
models.
3. The concepts of demand-pull and cost-push inflation, which were introduced earlier, can be
analyzed graphically by using the aggregate demand-aggregate supply model (see Figures 12.8 and
12.9).
4. If you have a number of students in your class who are business majors or pursuing careers in
business, you may wish to emphasize the section on productivity. The relationship between
productivity growth and lower per unit cost of output is important.
5. As you revisit the multiplier and explain how movement up the aggregate supply curve dampens
the effect, you may want to demonstrate how the multiplier determines the size of the shift in
aggregate demand. Emphasize that the full multiplier effect still occurs in terms of the size of the
shift in aggregate demand at a given price level, but because the price level can now change, the
final effect on output will be reduced. It is also useful for students to see how the effect gets even
weaker as the aggregate supply curve gets steeper near or beyond the full-employment level of
output.
STUDENT STUMBLING BLOCKS
1. The difference between aggregate demand-aggregate supply (AD-AS) model and the demand-
supply analysis for a single product market is difficult for students to grasp. The similarities are so
great that students often don’t focus on the important differences between the two models.
2. Students will confuse changes in demand and changes in supply. For example, if asked about an
increase in export sales of wheat, some students will inevitably view this as a decrease in supply,
because wheat leaves the country. Repetition of the determinants of demand and supply can help
clarify the distinction.
LECTURE NOTES
I. Introduction
A. Learning objectives – After reading this chapter, students should be able to:
1. Define aggregate demand (AD) and explain how its downward slope is the result of the
real-balances effect, the interest-rate effect, and the foreign purchases effect.
2. Explain the factors that cause changes (shifts) in AD.
3. Define aggregate supply (AS) and explain how it differs in the immediate short run, the
short run, and the long run.
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Chapter 12 - Aggregate Demand and Aggregate Supply
4. Explain the factors that cause changes (shifts) in AS.
5. Discuss how AD and AS determine an economy’s equilibrium price level and level of real
GDP.
6. Describe how the AD-AS model explains periods of demand-pull inflation, cost-push
inflation, and recession.
7. (Appendix) Identify how the aggregate demand curve relates to the aggregate
expenditures model.
B. AD-AS model is a variable price model. The aggregate expenditures model in Chapter 12
assumed constant price.
C. AD-AS model provides insights on inflation, unemployment and economic growth.
II. Aggregate Demand
A. A schedule or curve that shows the various amounts of real domestic output that domestic and
foreign buyers will desire to purchase at each possible price level.
B. The aggregate demand curve is shown in Figure 12.1.
1. It shows an inverse relationship between price level and real domestic output.
2. The explanation of the inverse relationship is not the same as for demand for a single
product, which centered on substitution and income effects.
a. Substitution effect doesn’t apply within the scope of domestically produced goods,
since there is no substitute for “everything.”
b. Income effect also doesn’t apply in the aggregate case, since income now varies with
aggregate output.
3. What is the explanation of the inverse relationship between price level and real output in
aggregate demand?
a. Real balances effect: When price level falls, the purchasing power of existing
financial balances rises, which can increase spending.
b. Interest-rate effect: A decline in price level means lower interest rates that can
increase levels of certain types of spending.
c. Foreign purchases effect: When price level falls, other things being equal, U.S.
prices will fall relative to foreign prices, which will tend to increase spending on U.S.
exports and also decrease import spending in favor of U.S. products that compete
with imports. (Similar to the substitution effect.)
C. Changes in aggregate demand: Determinants are the “other things” (besides price level) that
can cause a shift or change in demand (see Figure 12.2 in text). Effects of the following
determinants are discussed in more detail in the text.
1. Changes in consumer spending, which can be caused by changes in several factors.
a. Consumer wealth
b. Household borrowing
c. Consumer expectations
d. Personal taxes
12-3
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Chapter 12 - Aggregate Demand and Aggregate Supply
2. Changes in investment spending, which can be caused by changes in several factors.
a. Real interest rates
b. Expected returns, which are a function of
Expected future business conditions
Technology
Degree of excess capacity
Business taxes
3. Changes in government spending.
4. Changes in net export spending unrelated to price level, which may be caused by changes
in other factors such as:
a. National income abroad, and
b. Exchange rates: Depreciation of the dollar encourages U.S. exports since U.S.
products become less expensive when foreign buyers can obtain more dollars for
their currency. Conversely, dollar depreciation discourages import buying in the U.S.
because our dollars can’t be exchanged for as much foreign currency.
III. Aggregate Supply
A. A schedule or curve showing the level of real domestic output available at each possible price
level.
B. Aggregate supply in the immediate short-run (Figure 12.3)
1. The aggregate supply curve is horizontal at a given price level due to the rigidity of prices
C. Aggregate supply in the short run (Figure 12.4)
1. The short run aggregate supply curve is upward sloping.
2. The lag between product prices and resource prices makes it profitable for firms to
increase output when the price level rises.
3. To the left of full-employment output, the curve is relatively flat. The relative abundance
of idle inputs means that firms can increase output without substantial increases in
production costs.
4. To the right of full-employment output the curve is relatively steep. Shortages of inputs
and production bottlenecks will require substantially higher prices to induce firms to
produce.
D. Aggregate supply in the long run (Figure 12.5)
1. In the long run the aggregate supply curve is vertical at the economy’s full-employment
output.
2. The curve is vertical because in the long run resources prices adjust to changes in the
price level, leaving no incentive for firms to change their output.
E. References to “aggregate supply” in the remainder of the chapter apply to the short run
curve unless otherwise noted.
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Chapter 12 - Aggregate Demand and Aggregate Supply
F. Changes in aggregate supply: Determinants are the “other things” besides price level that
cause changes or shifts in aggregate supply (see Figure 12.6 in text). The following
determinants are discussed in more detail in the text.
1. A change in input prices, which can be caused by changes in several factors.
a. Domestic resource prices
b. Prices of imported resources
2. Changes in productivity (productivity = real output / input) can cause changes in per-unit
production cost (production cost per unit = total input cost / units of output). If
productivity rises, unit production costs will fall. This can shift aggregate supply to the
right and lower prices. The reverse is true when productivity falls. Productivity
improvement is very important in business efforts to reduce costs.
3. Change in legal-institutional environment, which can be caused by changes in other
factors.
a. Business taxes and/or subsidies, and
b. Government regulation.
IV. Equilibrium in the AD-AS Model
A. Equilibrium price and quantity are found where the aggregate demand and supply curves
intersect. (See Key Graph 12.7 for illustration of why quantity will seek equilibrium where
curves intersect.)
B. Try Quick Quiz 12.7.
C. Increases in aggregate demand cause demand-pull inflation (Figure 12.8).
1. Increases in aggregate demand increase real output and create upward pressure on prices,
especially when the economy operates at or above its full employment level of output.
2. The multiplier effect weakens the further right the aggregate demand curve moves along
the aggregate supply curve. More of the increase in spending is absorbed into price
increases instead of generating greater real output.
D. Decreases in AD: If AD decreases, recession and cyclical unemployment may result. See
Figure 12.9. Prices don’t fall easily.
1. Fear of price wars keeps prices from being reduced.
2. Menu costs discourage repeated price changes.
3. Wage contracts are not flexible so businesses can’t afford to reduce prices.
4. Employers are reluctant to cut wages because of impact on employee effort, etc.
Employers seek to pay efficiency wages – wages that maximize work effort and
productivity, minimizing cost.
5. Minimum wage laws keep wages above that level.
6. Consider This … Ratchet Effect
12-5
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Chapter 12 - Aggregate Demand and Aggregate Supply
E. Shifting aggregate supply occurs when a supply determinant changes.
1. Leftward shift in curve illustrates cost-push inflation (see Figure 12.10).
2. Rightward shift in curve will cause a decline in price level (see Figure 12.11). See text
for discussion of this desirable outcome.
3. In the late 1990s, despite strong increases in aggregate demand, prices remained
relatively stable (low inflation) as aggregate supply shifted right (productivity gains).
V. LAST WORD: Stimulus and the Great Recession
A. Aggregate Demand stimulus helped to prevent the 2007-2009 downturn from becoming
another great depression. But why was the stimulus-fueled recovery substantially weaker
than expected?
B. One explanation for the disappointing unemployment and GDP numbers was that it was
hard for the stimulus to be very effective given the high debt levels that were built up
during the bubble years.
1. Low interest rates failed to induce additional borrowing by firms and households
already in debt.
2. Expenditures by the government increased output but failed to have a large
multiplier effect because households were saving (or paying off debt) any additional
income.
C. Another issue was that the stimulus was spread out over many sectors of the economy
and there were specific sectors that needed the stimulus more than others.
D. The stimulus in some sectors may have resulted in price increases rather than output
changes as a result of steep supply schedules.
APPENDIX TO CHAPTER 12
I. The Relationship of the Aggregate Demand Curve to the Aggregate
Expenditures Model
A. Deriving AD-curve from aggregate expenditures model. (See Appendix Figure
1)
1. Both models measure real GDP on horizontal axis.
2. Suppose initial price level is P1 and aggregate expenditures AE1 as shown in Appendix
Figure 1a. Equilibrium real domestic output is Q1. There will be a corresponding point
on the aggregate demand curve (Point 1 on Appendix Figure 1b).
3. If price rises to P2, aggregate expenditures will fall to AE2 because purchasing power of
wealth falls, interest rates may rise, and net exports fall. (See Appendix Figure 1a.) Then
new equilibrium is at Q2. That generates a point (Point 2) up and to the left of Point 1 on
Appendix Figure 1b.
4. If price rises to P3, real asset balance value falls, interest rates rise again, net exports fall
and new equilibrium is at Q3. Again see Appendix Figures 1a and 1b.
5. Technically, the aggregate demand curve is found by drawing a line (or curve) through
Points 1, 2, and 3 on Appendix Figure 1b.
12-6
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Chapter 12 - Aggregate Demand and Aggregate Supply
B. Aggregate demand shifts and the aggregate expenditures model (Appendix Figure 2):
1. When there is a change in one of the determinants of aggregate demand, there will be a
change in the aggregate expenditures as well. Look at Appendix Figure 2a.
2. The change in aggregate expenditures is multiplied and aggregate demand shifts by more
than the initial change in spending (see Appendix Figure 2b). The text illustrates the
multiplier effect of a change in investment spending.
3. Shift of AD curve = initial change in spending x multiplier
4. The effect of the shift on real domestic output and the price level will depend on the
starting point relative to full-employment output, as well as the relative steepness of the
aggregate supply curve.
QUIZ
1. A rightward shift of the AD curve in the very steep upper part of the upsloping AS curve will:
A. increase real output by more than the price level.
B. increase the price level by more than real output.
C. reduce real output by more than the price level.
D. reduce the price level by more than real output.
2. The fear of unwanted price wars may explain why many firms are reluctant to:
A. reduce wages when a decline in aggregate demand occurs.
B. reduce prices when a decline in aggregate demand occurs.
C. expand production capacity when an increase in aggregate demand occurs.
D. provide wage increases when labor productivity rises.
3. The foreign purchases effect suggests that an increase in the U.S. price level relative to other
countries will:
A. increase the amount of U.S. real output purchased.
B. increase U.S. imports and decrease U.S. exports
C. increase both U.S. imports and U.S. exports.
D. decrease both U.S. imports and U.S. exports.
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Chapter 12 - Aggregate Demand and Aggregate Supply
4. Which set of events would most likely decrease aggregate demand?
A. A reduction in the excess capital of the existing capital stock
B. A reduction in business and personal tax rates
C. An increase in investment spending
D. An increase in personal income tax rates
5. The slope of the immediate-short-run aggregate supply curve is based on the assumption that:
A. Both input and output prices are fixed
B. Neither input nor output prices are fixed
C. Input prices are flexible but output prices are fixed
D. Input prices are fixed but output prices are flexible
6. A fall in the price of capital goods will shift the aggregate:
A. Demand curve leftward
B. Demand curve rightward
C. Supply curve rightward
D. Supply curve leftward
Answer: C
7. A decline in the quantity of real output demanded along the aggregate demand curve is a result of
a(n):
A. Decrease in the level of income
B. Increase in the price level
C. Increase in the level of income
D. Decrease in the price level
12-8
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Chapter 12 - Aggregate Demand and Aggregate Supply
8. Efficiency wages are associated with:
A. A price level that is inflexible upward
B. A price level that is inflexible downward
C. A domestic output that cannot be increased
D. A domestic output that cannot be decreased
9. The economy experiences an increase in the price level and a decrease in real domestic output.
Which is a likely explanation?
A. Productivity has increased
B. Input prices have increased
C. Excess capacity has decreased
D. Government regulations have been reduced
10. If at a particular price level, real domestic output from producers is greater than real domestic
output desired by purchasers, there will be a:
A. Surplus and the price level will rise
B. Surplus and the price level will fall
C. Shortage and the price level will rise
D. Shortage and the price level will fall
12-9
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