The document discusses aggregate demand and aggregate supply, and their role in explaining short-run economic fluctuations. It notes that economic activity fluctuates from year to year, with recessions representing periods of declining incomes and rising unemployment. The aggregate demand-aggregate supply model is used to analyze these fluctuations by showing the relationship between price levels, output, and the demand and supply of goods and services. Shifts in components of aggregate demand, like government purchases, can cause the aggregate demand curve to shift and impact price levels and output in the short run.

1. Aggregate Demand
and Aggregate Supply
PowerPoint Slides prepared by:
Andreea CHIRITESCU
Eastern Illinois University
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2. Economic Fluctuations
• Economic activity
– Fluctuates from year to year
• Recession
– Economic contraction
– Period of declining real incomes and rising
unemployment
• Depression
– Severe recession
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3. Economic Fluctuations
• Key facts about economic fluctuations
1. Economic fluctuations are irregular and
unpredictable
• The business cycle
1. Most macroeconomic variables fluctuate
together
• Recessions – economy-wide phenomena
• As output falls, income falls and
unemployment rises
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4. Figure 9
U.S. Real GDP Growth since 1900
Over the course of U.S. economic history, two fluctuations stand out as especially large. During
the early 1930s, the economy went through the Great Depression, when the production of goods
and services plummeted. During the early 1940s, the United States entered World War II, and the
economy experienced rapidly rising production. Both of these events are usually explained by
large shifts in aggregate demand.
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5. Figure 1
A Look at Short-Run Economic Fluctuations (c)
This figure shows real GDP in panel (a), investment spending in panel (b), and unemployment in
panel (c) for the U.S. economy using quarterly data since 1965. Recessions are shown as the
shaded areas. Notice that real GDP and investment spending decline during recessions, while
unemployment rises.
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6. Short-Run Economic Fluctuations
• AD-AS model
– Model of aggregate demand (AD) &
aggregate supply (AS)
– Most economists use it to explain short-
run fluctuations in economic activity
• Around its long-run trend
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7. Short-Run Economic Fluctuations
• Aggregate-demand curve
– Shows the quantity of goods and
services
– That households, firms, the government,
and customers abroad
– Want to buy at each price level
– Downward sloping
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8. Short-Run Economic Fluctuations
• Aggregate-supply curve
– Shows the quantity of goods and services
– That firms choose to produce and sell
– At each price level
– Upward sloping
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9. Figure 2
Aggregate Demand and Aggregate Supply
Price
Level
Aggregate supply
Equilibrium
price level
Aggregate demand
Equilibrium Quantity of
output Output
Economists use the model of aggregate demand and aggregate supply to analyze
economic fluctuations. On the vertical axis is the overall level of prices. On the
horizontal axis is the economy’s total output of goods and services. Output and the
price level adjust to the point at which the aggregate-supply and aggregate-demand
curves intersect.
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10. Figure 3
The Aggregate-Demand Curve
Price
Level 1. A decrease in
the price level . . .
P1
2. . . . increases the quantity of
P2 goods and services demanded
Aggregate demand
Y1 Y2 Quantity of Output
A fall in the price level from P1 to P2 increases the quantity of goods and services
demanded from Y1 to Y2. There are three reasons for this negative relationship. As the
price level falls, real wealth rises, interest rates fall, and the exchange rate depreciates.
These effects stimulate spending on consumption, investment, and net exports.
Increased spending on any or all of these components of output means a larger
quantity of goods and services demanded.
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11. Aggregate-Demand Curve
• The AD curve might shift:
– Changes in consumption
– Changes in investment
– Changes in government purchases
– Changes in net exports
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12. Aggregate-Demand Curve
• Changes in government purchases, G
– Policymakers – change government
spending at a given price level
• Build new roads
– Increase in government purchases
• Aggregate demand - shifts right
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13. Aggregate Supply Curve
• Short run
– Aggregate-supply curve is upward sloping
– A higher price raises the quantity of goods
and services supplied
• Long run aggregate supply
– Recall Chapter 17
• Price level does not affect the long-run
determinants of GDP:
– Supplies of labor, capital, and natural resources
– Available technology
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14. Figure 6
The Short-Run Aggregate-Supply Curve
Price Short-run
Level aggregate
1. A decrease in
supply
the price level . . .
P1
P2 2. . . . reduces the quantity of
goods and services supplied
in the short run
Y2 Y1 Quantity of Output
In the short run, a fall in the price level from P1 to P2 reduces the quantity of output
supplied from Y1 to Y2. This positive relationship could be due to sticky wages, sticky
prices, or misperceptions. Over time, wages, prices, and perceptions adjust, so this
positive relationship is only temporary.
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15. Causes of Economic Fluctuations
• Assumption
– Economy begins in long-run equilibrium
• Long-run equilibrium:
– Intersection of AD and LRAS curves
• Output - natural rate
• Actual price level
– Intersection of AD and short-run AS curve
• Expected price level = Actual price level
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16. Exhibit 7
The Long-Run Equilibrium
Price Long- run
Level aggregate
supply Short-run
aggregate
supply
Equilibrium A
price
Aggregate
demand
Quantity of Output
The long-run equilibrium of the economy is found where the aggregate-demand curve
crosses the aggregate-supply curve (point A).
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17. Causes of Economic Fluctuations
• Shift in aggregate demand
– Wave of pessimism (stock market crash)
– Aggregate demand shifts left
– Short-run
• Output falls
• Price level falls
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18. Exhibit 8
A Contraction in Aggregate Demand
Price Short-run aggregate
Level supply, AS1
P1 A
B
P2
1. A decrease in aggregate
demand . . .
AD2 Aggregate demand, AD1
Y2 Y1 Quantity of Output
2. . . . causes output to fall in the short run . . .
A fall in aggregate demand is represented with a leftward shift in the aggregate-demand curve
from AD1 to AD2. In the short run, the economy moves from point A to point B. Output falls from Y1
to Y2, and the price level falls from P1 to P2.
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19. The Recession of 2008–2009
• 2008-2009, financial crisis, severe
downturn in economic activity
– Worst macroeconomic event in more
than half a century
• 2006-2008: housing prices began to fall
– Substantial rise in mortgage defaults and
home foreclosures
– Financial institutions that owned
mortgage-backed securities
• Huge losses
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20. The Recession of 2008–2009
• Three policy actions to shift AD rightward
– The Fed
• Cut its target for the federal funds rate from 5.25% in
September 2007 to about zero in December 2008
• Started open market operations
– Treasury
• Lent loans to banks and became part owner
• Government – temporarily became a part owner of
these banks
– January 2009, Barack Obama
• $787 billion stimulus bill of government
spending & tax cuts
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21. Exhibit 8b
Effect of Policy Actions
Price Short-run aggregate
Level supply, AS1
P1 A
B
P2 3. Policy aims at return
aggregate demand to AD1 . . .
1. A decrease in aggregate
demand . . .
AD2 Aggregate demand, AD1
Y2 Y1 Quantity of Output
2. . . . causes output to fall in the short run . . .
A fall in aggregate demand is represented with a leftward shift in the aggregate-demand curve
from AD1 to AD2. In the short run, the economy moves from point A to point B. Output falls from Y1
to Y2, and the price level falls from P1 to P2.
© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 21
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.