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                 AGGREGATE DEMAND
                  AGGREGATE SUPPLY
                   (AD-AS MODEL)
                  (Sloman 5e pages 411-414, 588-595)
                  (Sloman 6e pages 405-407, 574-581)

Level of prices in an economy determined by interaction of aggregate
demand and aggregate supply

Variable-price-level-model: enables us to analyze changes in both real
GDP and the price level simultaneously (AD/AS Model)

Fixed-price-level-model: emphasizes changes in real GDP; doesn‟t say
anything about price levels (and inflation as an extension) (AE Model)


Aggregate Demand – a schedule or curve that shows the amounts of real
output that buyers collectively desire to purchase at each possible price
level; total level of spending in an economy

                            AD = C + Ig + G + Xn

       Inverse relationship between real GDP and Price Level

              Price Level          Real GDP Demanded                

              Price Level          Real GDP Demanded                

Demand curve for a single product slopes downward basically due to
Income Effect and Substitution Effect.

       Income Effect for S/D        If Price of individual product
                                    decreases, nominal income allows
                                    greater purchases (Demand
                                    increases); reverse is also true

       Substitution Effect for S/D          If the Price of an individual
                                            product decreases, more of the
                                            product is demanded as it
                                            becomes relatively less
                                            expensive than other goods

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In Aggregates, as an economy moves down the Aggregate Demand curve,
it moves to a general lower price level.

       1. A decline in price level need not produce an income effect
          since wages, rents, interest, and profits (nominal income) would

       2. Also, there is NO overall substitution effect among
          domestically produced goods when the price level falls (as the
          general price level falls for all goods and services

A Price Level change causes consumers to reduce or increase spending due to:

1. Real-Balances Effect (real money balances effect): A higher price
      level means less consumption spending; a higher price level reduces
      the real value (or purchasing power) of the public‟s accumulated
      saving balances; purchases (especially for „big ticket‟ items) may
      be deferred (since they feel poorer)

2. Interest-Rate Effect: Assuming the supply of money is fixed, a
      higher price level increases the demand for money and,
      consequently, the interest rate increases, reducing the amount of
      real output demanded since higher interest rates curtail
      investment spending (I) and interest-sensitive consumption

     (see following graphs on loanable funds, i/r and I relationship)

3. Foreign-Purchase Effect (international substitution effect): A rise in
      the price level reduces the quantity of domestically produced
      goods demanded as exports when domestic price level relative to
      foreign price level increases and cheaper imports may be
      substituted domestically (more imports – less exports)


Other things being equal, a change in the price level will change the
amount of aggregate spending and therefore change the amount of real
GDP demanded by the economy. These are movements along a fixed
aggregate demand curve.

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                                                     Money Supply

                Interest Rate

                                O                                                                        $
                                                 Money (billions of $)

                                Investment Demand                                               Investment Demand
Interest Rate

                                                                Rate of Return

                                Investment ($ billions)                                         Investment ($ billions)

                                Loanable Funds                                                  Investment Demand
                                                               Interest Rate & Rate of Return
Interest Rate

                                Investment ($ billions)                                         Investment ($ billions)

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Determinants of Aggregate Demand (AD shifters)

If one or more of the following items change, the aggregate demand
curve will shift. These conditions are the determinants of aggregate
demand and are:

1. Change in consumer spending (C)

      a. Consumer wealth (financial and physical assets) – a sharp
             increase in the real value of consumer wealth prompts
             people to save less and buy more products, known as wealth
      b. Consumer expectations – expectations as to future real
             incomes or the direction of inflation may shift AD curve
             left or right
      c. Household indebtedness – when debt level is higher than
             normal, people cut back on expenditures and vice versa
      d. Personal Taxes – tax cuts increase DI shifting AD to the right
             and rises in taxes decrease DI shifting AD to the left

2. Change in Investment spending (Ig) – this depends on the real
     interest rate (i) in relation to loanable funds and the expected
     rate of return (r)

      a. Interest rates – increase in i decreases AD and a decrease
             in i increases AD (relate to increase/decrease in money
      b. Expected returns – higher expected returns causes an
         increase in Ig and shifts AD curve right
                   i. Future business conditions
                  ii. Technology – new & improved may enhance r
                 iii. Degree of excess capacity – operating well below
                      capacity is not an incentive to build new factories
                 iv. Business taxes – an increase would cause AD curve
                      to shift left

3. Changes in government spending (G) – as long as tax collections and
     interest rates do not change as well

4. Net export spending (Xn) – a rise in net exports (higher exports
     than imports) shifts AD curve to the right

      a. National Income Abroad – rising national income abroad
            encourages foreigners to buy more goods from other

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       b. Exchange rates
             1. Depreciation of $ increases Xn and AD curve shifts right
             2. Appreciation of $ decreases Xn and AD curve shifts left

       Depreciation of the dollar means that it takes less of another
       currency to buy a dollar or one gets more dollars for the same old
       value of foreign currency.


Aggregate Supply – the level of real domestic output that firms will
            produce at each price level; direct relationship between the
            price level and the amount of real output that firms offer
            for sale

Aggregate Supply Curve – shape of the AS curve reflects what happens
            to the per unit production cost (average cost of output) as
            GDP expands or contracts

                              Total Input Cost
Per Unit Production Cost = ------------------------ = Average Total Cost
                                 Total Output

Average cost of output establishes that output‟s price level because the
price level must cover all the costs of production including normal profit

Assuming wage rates and other input prices, technology and the total
supply of factors of production remain constant, the higher the level of
prices the more will be produced.

AS curve is upward sloping due to:

   1) Diminishing returns – diminishing marginal physical product and
      hence an upward sloping marginal cost curve. In macro, we are
      adding all the MC curves, hence the AS curve slopes upward

   2) Growing shortages of certain variable factors – as firms
      collectively produce more, even inputs that can be varied may
      increasingly come in short supply

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                      3 Distinct Segments or Ranges of the AS Curve

                  0                     Qu                       Qfe     Qc

                           Real Domestic Output (Real GDP)

1. Horizontal Range (ab) – Keynesian range

   Levels of real output less than full employment output (Qf)

   Economy in a recession or depression; large amounts of unused
   machinery & equipment; large amounts of unemployed workers

   Producers can acquire labor & other inputs at stable prices

   AC (average costs) will stay constant as firms expand up to Qu

   Firms have no reason to raise prices

2. Intermediate (up-sloping) Range (bc)

   Expansion of real output accompanied by a rising price level

   Per unit production costs increase – shortage of raw materials, use of
   inefficient machinery, less capable workers may be hired, perhaps
   shortage of skilled workers

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   Increase in AC and boost in price levels as some industries pay more
   for resources or are working near plant capacity; higher product
   prices are needed to be profitable

   Once Qf (full-employment level of GDP) is reached, further price level
   increases may bring about increases in real GDP (output) for a time

   Rising price level accompanies rising real output

   Full capacity real output reached at „c‟; physical limit of economy (PPC)

3. Vertical Range (cd) – Classical range

   Since economy is already operating at full capacity, increases in the
   price level will produce no additional real output

   Bidding for resources will raise resource prices (costs) and ultimately
   boost product prices, but real output will remain unchanged; one
   firm‟s gain is at the expense (loss) of another firm

Determinates of Aggregate Supply
(shifters, changes in aggregate supply)

       An existing AS curve identifies the relationship between the price
       level and real output, other things equal.

       When other things are not equal, determinants come into play,
       cause per unit production costs to be higher or lower than before
       at each price level, and shift the curve itself

1. Change in input prices – higher input prices increase per unit
   production costs and reduce aggregate supply

   a. Domestic Resource Availability – increase in supply of these will
      lower resource prices and AC and shift AS curve right (and vice

       1. Land – new deposits, irrigation, new tech, or depletion of water
       2. Labor – 75-80% of all business costs, influx of women in labor
          force past 20 yrs put downward pressure on wages as did
          immigrants; AIDS has the opposite effect and reduces GDP
       3. Capital – when society improves or adds to its stock of capital,
          AS increases
       4. Entrepreneurial Ability – more would cause shift to right

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   b. Prices of Imported Resources – a decrease in price of imported
             resources increases AS and an increase in their price
             decreases AS; exchange rate fluctuations come into play

   c. Market Power – ability to set above-competitive prices by sellers
            of major inputs (such as OPEC, de Beers)

2. Change in Productivity

   Productivity – a measure of the relationship between a nation‟s level
         of real output and the amount of resources used to produce it;
         measure of real output per unit of input (average real output)

                                    Total Output
                  Productivity = ---------------------
                                    Total Input

                                    Total Input Cost
      Per Unit Production Cost = ---------------------------
                                       Total Output

                                    Example A                  Example B
   Total Output                       10                           20

   Total Input                           5                            5

   Price of each Input                   2 Bt/input                   2 Bt/input

            Increase in Productivity shifts AS curve to right

   Main source of productivity advance is improved production
   technology. Other sources of productivity increases:

             1. better educated and trained workforce
             2. improved forms of business enterprises
             3. reallocation of labor resources from less to more
                productive uses

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              3.   Changes in Legal-Institutional Environment

                   a. Indirect Business taxes (sales, excise, payroll) – an increase raises
                             AC and reduces AS (shift left)

                   b. Subsidies (payment or tax break) – decreases AC and increases
                            AS (shift right)

                   c. Government Regulation – more regulation increases AC and
                            decreases AS

                             (Supply-siders argue that by deregulating, AC
                             will decrease and AS will increase – shift right)


              Intersection of AD & AS curves determines an economy‟s equilibrium
              price level and equilibrium real output

                   AD in Horizontal Range                         AD in Intermediate Range
                                                PRICE LEVEL

              0            Q1 Qe       Q2                     0    Q1         Qe     Q2

                      Real GDP                                       Real GDP

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AD in horizontal range

                  Producers would not be willing to supply Q2 as inventories would
                  build up; nor would producers supply at Q1 as inventories would
                  become depleted

AD in intermediate range

                  At P1, AD = Q2 but as producers supply more the price level rises
                  from competition among buyers to purchase the lesser available
                  real output of Q1, pulling up price level to Pe, encouraging
                  producers to increase supply to Qe and buyers to scale back
                  purchases to Qe.

Changes in Equilibrium

Increases in AD: Demand-Pull Inflation


                                                                             Increases real

                                                                             output but
                                                                             leaves price
                                                                             level unchanged

                  O                                                      Q

                                          Real GDP

                                AD ↑ in horizontal range

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                                                                   Increases both

                                                                   real output and
                                                                   price level

                  O                                           Q

                               Real GDP

                       AD ↑ in intermediate range

                                                                  Increases price
                                                                  level but cannot

                                                                  increase real
                                                                  output as full
                                                                  capacity has been

                  O                                           Q

                             Real GDP

                      AD ↑ in vertical range

Price level ↑ in intermediate & vertical ranges = demand-pull inflation

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Decreases in AD: Recession and Cyclical Unemployment

                  A decline in real output with no change in the price level (horizontal
                  range) constitutes a recession and since fewer workers are needed to
                  produce the lower output, cyclical unemployment arises.


                                                                          Idle production capacity

                                                                          Cyclical unemployment

                  O                                            Q

                                   Real GDP

                                     AD ↓

This economic condition exists due to downward price inflexibility
(“sticky” or inflexible in a downward direction for a considerable amount
of time) for resources and products for a considerable period of time
because of:

                  1. wage contracts – usually only adjust each yr (though 3 yr union
                                      contracts common)

                  2. impairment of morale, effort, productivity

                      efficiency wages = wages that elicit maximum work
                                         effort and minimize labor cost
                                         per unit of output

                  3. minimum wage – legal floor

                  4. menu costs – costs of determining new price structure,
                              re-pricing, printing & mailing catalogues,
                              communicating (via advertising)

                  5. fear of price wars

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Increase in AS: Full Employment & Price Stability


                  O                                            Q

                             Real GDP

First, AD  from AD1 to AD2

No increase from P1 to P2 due to increased productivity gains which shift
       the AS curve from AS1 to AS2 such that mild inflation would exist
       moving from P1 to P3

         (an example would be New Economy of US in 1990s and 2000s)

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Decreases in AS: Cost-Push Inflation

Increased costs and reduced supply


                  O                                                        Q

                                      Real GDP

   When AS  with no change in AD, price level  = cost-push inflation

Real output declines from Q1 to Q2

Price Level rises from P1 to P2

Recession comes about

Short-run AS is usually shown as intermediate range of the AD-AS Model

                      Short-run equilibrium is the normal state of the
                      economy as it fluctuates around potential GDP

                      Long-run equilibrium is the state
                      toward which the economy is headed

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Long-run Aggregate Supply

The Q of real GDP at the vertical region is the physical limit of the
economy (corresponding to PPF) which is different than FE (full

Real GDP, in turn, depends on the FE quantity of labor, the quantity
      of capital, and the state of technology

                      Long-run Aggregate Supply Curve


                                                                              LRAS curve is

                                                                              always vertical
                                                                              and is located at
                                                                              Real GDP at FE
                                                                              or as the
                                                                              vertical portion
                                                                              of the AS curve

                  O                                               Q

                                  Real GDP

LRAS is vertical because potential GDP is independent of the price level

Price level, the wage rate and other resource prices all change by the
same %, and relative prices and the real wage rate remain constant

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                                A change in potential GDP


                                                                                   When potential GDP
                                                                                   changes, both
                                                                                   LRAS and SRAS

                  O                                                            Q

                                              Real GDP

Reasons for change in Real GDPfe:

                  1. change in the full-employment quantity of labor
                  2. change in the quantity of capital (physical and human)
                  3. advance in technology

(differentiate between fluctuations around real GDPfe and changes in real

A change in the money wage rate does not change LRAS, because on the
LRAS curve, the change in the money wage rate is accompanied by an
equal percentage change in the price level.

                         However, the money wage rate (and other resource prices)
                         affect SRAS because they influence firms‟ costs

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                     A change in Resource Prices


                                                                    A change in
                                                                    resource prices
                                                                    affects the SRAS
                                                                    curve, not the LRAS

                 O                                            Q

                             Real GDP

Long-run AD-AS Equilibrium


                                                                  LR macroeconomic
                                                                  equilibrium exists
                                                                  where real GDP
                                                                  equals GDPfe

                 O                                            Q

                             Real GDP

 real GDPfe = LRAS and real GDP is where the AD curve intersects the
           LRAS and the SRAS curves, all at the same point

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Inflation – a rise in an economy‟s price level

Stagflation – the combination of stagnation (low growth and high
              unemployment) and high inflation; simultaneous increases in
              the price level and the unemployment rates

Deflation – decline in an economy‟s price level

Inflationary gap – the excess of national expenditure over income (and
              injections over withdrawals) at the full-employment level of
              national income

Deflationary gap – the shortfall of national expenditure below national
             income ( and injections below withdrawals) at the full-
             employment level of national income

Reflationary policy – fiscal or monetary policy designed to increase the
             rate of growth of aggregate demand

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