McConnell 22nd Edition

1. CHAPTER 32
Aggregate Demand and Aggregate Supply

2. ©2021 McGraw Hill Education. All rights reserved. No reproduction or further distribution without the prior written consent of McGraw Hill Education.
Aggregate Demand
Changes in Aggregate Demand
Aggregate Supply
Changes in Aggregate Supply
Equilibrium in the AD-AS Model
Changes in Equilibrium
32-2
Chapter Contents

3. Review of Business Cycle
• Business Cycle
• alternating increases and
decreases in economic
activity over time.
14-3
Levelofrealoutput
Time
Peak
Trough
Trough
Peak
Peak
• Four phases of business cycle

4. Overview of AD-AS Model
• Aggregate Demand and Aggregate Supply Model
• The aggregate demand (AD) and aggregate supply (AS) model shows a
relationship between the price level in an economy and the real GDP
of the economy.
• Three components of the AD-AS model
• Aggregate demand
• Aggregate supply
• Potential GDP (Long-run Aggregate supply)
14-4

5. Overview of AD-AS Model
• Potential GDP is determined by the economy’s production
capacity.
• Aggregate supply comes from the economy’s production decisions
by firms.
• Aggregate demand comes from the economy’s expenditure
decisions by households, firms, governments, and foreigners.
• These three components determine a macroeconomic
equilibrium.
14-5

6. Quantity of Real GDP Demanded
• The quantity of real GDP demanded (a.k.a. Real output
demanded, Amount of Real GDP demanded) is the total amount
of final goods and services produced in the United States that
people, businesses, governments, and foreigners plan to buy.
• This quantity is the sum of the consumption spending (C),
investment (I), government purchases on goods and services (G),
and net exports (NX).
Y = C + I + G + NX
14-6

7. Aggregate Demand
• Aggregate demand is the relationship between the quantity of real
GDP demanded and the price level when all other influences on
expenditure plans remain the same.
LO32.1
32-7
• When the price level rises
(falls), the quantity of real
GDP demanded decreases
(increases).
• Aggregate demand curve is
downward-sloping.
Real domestic output, GDPPricelevel
AD
0
Aggregate
demand

8. Downward Sloping Aggregate Demand Curve
• The price level influences the quantity of real GDP
demanded because a change in the price level brings
changes in
• Purchasing power of money (Real balances effect)
• Real interest rate (Interest-rate effect)
• Real prices of exports and imports (Foreign purchases effect)
LO32.1
32-8

9. Real Balance Effect
• A rise in the price level lowers the purchasing power of
money and decreases the quantity of real GDP demanded.
• If the price level rises and other things (e.g. nominal income
and wealth) remain the same, a given quantity of money will
buy less goods and services, so people cannot afford to
purchase the same amount as before.
• So the quantity of real GDP demanded decreases.
14-9

10. Interest-Rate effect
• When the price level rises, consumers need more money to
purchase the same quantity of goods and services as before.
• With fixed incomes, they have to borrow money. With
higher demand for loans, the real interest rate rises.
• Faced with a higher real interest rate, businesses and
consumers delay plans to buy new capital goods and
consumer durable goods and cut back on spending.
• So the quantity of real GDP demanded decreases.
14-10

11. Foreign Purchases Effect
• When the U.S. price level rises, but the prices in other
countries remain the same, a rise in the U.S. price level
makes U.S.-made goods and services more expensive
relative to foreign-made goods and services.
• This discourages people (both U.S. households and
foreigners) to purchase U.S.-made items and encourage to
purchase foreign-made items.
• So the quantity of real GDP demanded for U.S.-made goods
and services decreases.
14-11

12. Changes in Aggregate Demand
• A change in any factor that influences expenditure plans
other than the price level brings a change in aggregate
demand.
• Aggregate expenditure changes when its components change
(C, I, G, NX)
• A change in its component has two effects on Aggregate
demand
• Direct effect of its change on aggregate expenditure
• Multiplier effect
LO32.2
32-12

13. Changes in Aggregate Demand Graphed
Real domestic output, GDP
Pricelevel AD1
AD3
AD2
0
LO32.2
Decrease in
aggregate
demand
Increase in
aggregate
demand
32-13
• When aggregate expenditure
increases, the aggregate
demand curve shifts rightward.
• When aggregate expenditure
decreases, the aggregate
demand curve shifts leftward.
• When one of expenditure
component changes, it
changes GDP directly (Direct
effect). Then, through
multiplier process GDP will
increases further (multiplier
effect).
Direct effect
Multiplier effect

14. Consumer Spending
• Consumption is affected by
• Consumer wealth Consumption AD
• Household borrowing Consumption AD
• Nominal interest rate affects household borrowing.
• Consumer expectations
• Expected future income Consumption AD
• Expected inflation Consumption AD
• Personal taxes Disposable income   Consumption  AD
LO32.2
32-14

15. Investment Spending
• Investment spending is affected by
• Real interest rates Investment AD
• Expected returns Investment AD
• Expected returns  when
• Expectations about future business conditions 
• Technology 
• Degree of excess capacity
• Business taxes 
LO32.2
32-15

16. Government Spending
• Aggregate demand increases when
• Government spending increases
• Increased spending on infrastructure (highways, ports, public utility),
military, and education
• Transfer payments increases
• Extended unemployment benefits, increased welfare benefits,
increased social security
• Taxes decreases (through consumption and investment)
• Income tax return, payroll tax reduction
LO32.2
32-16

17. Net Export Spending
• Aggregate demand increases when
• Exports increases
• National income and wealth abroad increases
• Imports decreases
• Buy-America campaign/requirement
• U.S. Dollar depreciation (Value of U.S. dollar decreases
relative to foreign currencies)
• Foreign prices of U.S. goods decreases
• U.S. dollar prices of foreign goods increases
LO32.2
32-17

18. Quantity of Real GDP Supplied
• The quantity of real GDP supplied (a.k.a. Real output
supplied, Amount of Real GDP supplied) is the total amount
of final goods and services that firms in the United States
plan to produce.
• The quantity of real GDP supplied depends on
• Quantity of resources employed (labor, capital, land,
entrepreneur)
• State of technology and productivity of resources
• Prices of resources (wage rate, interest rate)
• Price level (Prices of outputs) 14-18

19. Aggregate Supply
• Aggregate supply is the relationship between the quantity
of real GDP supplied and the price level when all other
influences on production plans remain the same.
• Along the aggregate supply curve, the only influence on
production plans that changes is the price level.
• Slope of aggregate supply curve depends on time horizon
• Immediate short run
• Short run
• Long run
LO32.3
32-19

20. Input and Output Prices and
Aggregate Supply Curves
• Depending on time horizon, input prices and output prices
may be fixed or flexible.
• Immediate short run: Both input prices are output prices are fixed.
• Short run: Input prices are fixed, but output prices are flexible.
• Long run: Both input prices are output prices are flexible.
• Most analysis are done in short-run case where aggregate supply
curve is upward-sloping.
• When the price level rises (falls), the quantity of real GDP supplied
increases (decreases). 14-20

21. Aggregate Supply in Different Time Horizons
Real domestic output, GDP
Pricelevel
ASISR
Qf
Immediate-short-run
aggregate supply
P1
0
LO32.3
32-21
Real domestic output, GDP
Pricelevel
0 Qf
AS
Aggregate supply
(short run)
Real domestic output, GDP
Pricelevel
ASLR
Qf
0
Long-run
aggregate
supply
• Immediate short run • Short run • Long run

22. Firms’ Response to Changes in Demand
• Immediate Short run (Perfectly elastic)
• Firms can change quantities of resources employed, so as output
quantities. But, they cannot change output prices.
• Short run (Upward-sloping)
• Firms can change quantities of resources employed
• Quantity of real GDP supplied increases as the price level increases.
• Long run (Perfectly inelastic)
• Total production of economy is bounded by its production capacity –
Quantities of resources and state of technology.
• Full employment level of real GDP (Potential GDP).
14-22

23. Short-Run Aggregate Supply
• Short-run Aggregate supply curve is upward-sloping.
• In short run the input prices (wage rate) are assumed
constant.
• When the price level increases,
• Profit per unit of output increases
• Firms’ production increases by employing more resources
14-23

24. Shape of Short-Run Aggregate Supply Curve
• Short-run Aggregate supply curve is relatively
flat below the full-employment GDP
• When the economy is producing below the full-
employment GDP, many resources are
unemployed, and firms can easily employ/utilize
them
• Short-run Aggregate supply curve is relatively
steep above the full-employment GDP
• When the economy is producing above the full-
employment GDP, few unemployed resources are
available, and firms cannot expand beyond its
capacity easily
14-24
Real domestic output, GDP
Pricelevel
0 Qf
AS
Aggregate supply
(short run)
Flat AS
Steep AS
Potential GDP

25. Long-Run Aggregate Supply
• Long-run Aggregate supply curve is vertical at the full-
employment GDP.
• In long-run the input prices (wage rate) are assumed flexible.
• When the price level increases,
• Labor and other resources demand proportional increases in
wage rate to maintain real wage.
• Real profit per unit of output does not change and firms have
no incentive to change production.
14-25

26. Changes in Short-Run Aggregate Supply
• Short-run Aggregate supply changes when the cost per unit of
production changes.
• Given the price level, a change in cost per unit of production affects its
profit per unit production.
• Higher production cost per unit, lower the profit per unit of production.
• Lower profits, lower the quantity firms produce, given increasing costs.
• Firm’s supply and the short-run aggregate supply decrease.
• Any factors affecting firm’s cost will affect the short-run
aggregate supply .
LO32.4
32-26

27. Factors Affecting Production Cost
• Factors affecting firm’s production cost (determinants
of short-run aggregate supply)
• Input prices (wage, natural resource prices) – Domestic
and imported resources
• Productivity (state of technology)
• Legal-Institutional environment (tax, subsidy,
regulation)
• Quantity of available resources can affect the input
prices, and then the short-run aggregate supply.LO32.4
32-27

28. Productivity
• Real output per unit of input
• Increases in productivity reduce costs
• Decreases in productivity increase costs
Per-unit production cost =
total input cost
total output
Productivity =
total output
total inputs
LO32.4
32-28

29. Legal-Institutional Environment
• Legal changes alter per-unit costs of output
• Taxes and subsidies
• Taxes on outputs or inputs raise per-unit costs of output. Ex.
Excise taxes.
• Subsidies on outputs or inputs lower per-unit costs of output.
• Extent of government regulation
• Government regulation tends to raise per-unit costs of
output. Ex. Environmental regulation & safety requirement.
LO32.4
32-29

30. Changes in Aggregate Supply Graphed
Real domestic output, GDPPricelevel
AS1
AS3
AS2
0
LO32.4
Decrease in
aggregate supply
Increase in
aggregate supply
32-30
• When the per-unit costs of output
decreases (e.g. input prices fall,
productivity increase), the short-run
aggregate supply curve shifts
rightward.
• When the per-unit costs of output
increases (e.g. input prices rise,
productivity decrease), the short-run
aggregate supply curve shifts leftward.

31. Changes in Long-Run Aggregate Supply
• Factors affecting the full-employment GDP (potential GDP)
shift the long-run aggregate supply curve
• Productivity (state of technology)
• Quantity of available resources
14-31
Real GDP
ASLR1
Qf1
0
ASLR2
Qf2
• When the more resources
become available or technology
advances (productivity increases),
the long-run aggregate supply
curve shifts rightward.

32. SR Aggregate Supply and LR Aggregate Supply
• Factors which affect short-run and/or long-run supply curve
14-32
Changes in
Long-run
Aggregate Supply
(Potential GDP)
Short-run
Aggregate Supply
Price Level No Change
Movement along the
short-run AS curve
Resource Prices No Change Shift
Resource Supply Shift* Shift*
Productivity Shift* Shift*
* The long-run aggregate supply (potential GDP) and the short-run
aggregate supply shift to the same direction.

33. Equilibrium
• Aggregate supply (AS) and aggregate demand (AD)
determine real GDP and the price level.
• Macroeconomic equilibrium occurs
• when the quantity of real GDP demanded equals the quantity
of real GDP supplied.
• at the point of intersection of the AD curve and the AS curve.
• Macroeconomic equilibrium not necessarily occurs at the
potential GDP.
14-33

34. The Equilibrium Price Level and Equilibrium Real GDP
Real domestic output, GDP
(billions of dollars)
Pricelevel(indexnumbers)
100
502 510 514
a b
AD
AS
Real Output
Demanded
(Billions)
Price Level
(Index Number)
Real Output
Supplied
(Billions)
$506 108 $513
508 104 512
510 100 510
512 96 507
514 92 502
0
LO32.5
92
32-34
Equilibrium

35. Changes in AD and AS
• A change in aggregate supply or aggregate demand affects
the equilibrium real GDP and the equilibrium price level.
• Changes in the equilibrium real GDP
• Expansion when the equilibrium GDP increases ()
• Recession when the equilibrium GDP decreases ()
• Changes in the equilibrium price level
• Inflation when the price level increases ()
• Deflation when the price level decreases ()
14-35

36. Increase in Aggregate Demand
Real domestic output, GDP
Pricelevel
AD1
AS
P1
P2
Q2Q1Qf
AD2
0
LO32.6
32-36
• When the aggregate demand
increases,
• Real GDP   Expansion
• Price level   Inflation
• Demand-Pull Inflation: When
the inflation occurs due to
increased demand caused by
excess consumption &
government spending

37. Decrease in Aggregate Demand
Real domestic output, GDP
Pricelevel
AD1
AS
P1
P2
Q1 Q2 Qf
AD2
c
a
b
0
LO32.6
32-37
• When the aggregate
demand decreases,
• Real GDP   Recession
• Price level   Deflation
• Main cause of recession is a
decreased in the aggregate
demand

38. Downward Price Stickiness
• Below the full-employment GDP the aggregate supply curve is fairly flat
• When the aggregate demand decreases, the price level decreases little,
but the real GDP fall greatly, causing cyclical unemployment.
• Downward price stickiness: Prices are downwardly inflexible due to
• Fear of price wars
• Menu costs: Firms are reluctant to lower prices when such actions incur
large costs
• Firms cannot lower output prices because they cannot lower the cost of
production, in particular wage rate, due to
• Wage contracts
• Efficiency wages
• Minimum wage law
LO32.6
32-38

39. Decreases in Aggregate Supply
Real domestic output, GDP
Pricelevel
AD
AS1
P1
P2
Q1 Qf
AS2
a
b
0
LO32.6
32-39
• When the aggregate supply
decreases,
• Real GDP   Recession
• Price level   Inflation
• Cost-Push Inflation: When
the inflation occurs due to
decreased supply often
caused by Increased energy
(oil) price

40. Stagflation
• Stagflation = Stagnation + Inflation
• Inflation accompanied by recession and increase in
unemployment
• Cased by a decrease in aggregate supply
• Supply shocks: Sudden unexpected changes in aggregate supply
• Oil shocks in 1970s
14-40

41. Oil Price and Business Cycle
• Recessions
• 1973-1975
• 1980-1980
• 1981-1982
• 1990-1991
• 2001-2001
• 2007-2009
14-41

42. Increases in Aggregate Supply
• When the aggregate
supply increases,
• Real GDP   Expansion
• Price level   Deflation
14-42
Real GDP
Pricelevel
AS2
P2
Q1
AS1
a
AD
b
P1
Q20

43. Increase in Aggregate Demand and Aggregate Supply
Real domestic output, GDPPricelevel
AD1
AS2
P1
P2
Q2Q1
AS1
b
AD2
c
P3
Q3
a
0
LO32.6
32-43
• Simultaneous increase in
aggregate demand and aggregate
supply will result in
• Expansion
• Moderate inflation
• Economic growth in the late
1990s along with Information
technology revolution increased
• Productivity of labor
• Demand for innovative products

44. The Big Picture (Chapter 36)
Levels of
output,
employment,
income, and
prices
Aggregate
demand
Aggregate
supply
Input
prices
Productivity
Legal-
institutional
environment
Consumption
(Ca)
Investment
(Ig)
Net Export
Spending
(Xn)
Government
Spending
(G)
LO36.7
36-44

45. Business Cycle Revisited
• Along the business cycle, we observe
• Expansion with high inflation
• Recession with low inflation or deflation
• These changes can be explained by aggregate demand
fluctuations
• Investment spending fluctuates erratically
• Initiates aggregate expenditure changes and magnify through
multiplier effects
14-45

46. Aggregate Demand Fluctuations
• An aggregate demand is at AD0
and the real GDP at A is below
the full-employment GDP in
part (a).
• Real GDP is $12.5 trillion and
the economy is in a trough at A
in part (c).
14-46

47. Aggregate Demand Fluctuations
• An aggregate demand
increases from AD0 to AD1, the
economy moves from a trough
at A to full-employment GDP
at B.
• An aggregate demand
continues to increase from
AD1 to AD2, the economy
moves from full-employment
GDP at B to real GDP at C
above full-employment GDP.
14-47

48. Aggregate Demand Fluctuations
• An aggregate demand
decreases from AD2 to AD3,
the economy moves from a
peak at C to full-employment
GDP at D.
• An aggregate demand
continues to decrease from
AD3 to AD4, the economy
moves from full-employment
GDP at D to real GDP at E
below full-employment GDP.
14-48

49. Three Possible Equilibriums
• The equilibrium GDP at equilibrium may be less than,
equal to, or more than the potential GDP.
• Full-employment equilibrium
• When equilibrium real GDP equals potential GDP.
• Above full-employment equilibrium
• When equilibrium real GDP exceeds potential GDP.
• Below full-employment equilibrium
• When potential GDP exceeds equilibrium real GDP.
14-49

50. GDP Gap Revisited
• When the economy is at above or below full employment
equilibrium, there is a gap between equilibrium real GDP
and potential GDP.
• Recessionary gap (Negative GDP gap): a gap that exists
when potential GDP exceeds real GDP (below full-
employment equilibrium).
• Inflationary gap (Positive GDP gap): a gap that exists when
real GDP exceeds potential GDP (above full-employment
equilibrium).
14-50

51. Full-Employment Equilibrium
• With real GDP equal to
potential GDP, the economy
is at full employment.
• No GDP gap
• Unemployment rate is equal
to the natural rate of
unemployment.
14-51

52. Below-Full-Employment Equilibrium
• With real GDP less than
potential GDP, the economy
is below full employment.
• A recessionary (negative
GDP) gap emerges.
• Unemployment rate is above
the natural rate of
unemployment.
14-52

53. Above-Full-Employment Equilibrium
• When real GDP exceeds
potential GDP, the economy
is above full employment.
• An inflationary (positive GDP)
gap emerges.
• Unemployment rate if below
the natural rate of
unemployment.
14-53

54. Global Perspective 32.1
Source: Organisation for Economic Co-operation and Development (OECD).
LO32.6
32-54

55. Changes in Real GDP Over Time
• The dots show real GDP and the price level
each year from 1970 to 2011.
• Rightward movement of the dots is
economic growth.
• Upward movement of the dots shows a
rising price level or inflation.
• With continuous technological
advancement and capital accumulation,
potential GDP moves to right steadily.
• Aggregate supply shifts to right most of
time except for supply shock years.
• Aggregate demand move mostly rightward,
but erratically. 14-55

56. Last Word: Stimulus and the Great Recession (1 of 2)
Housing collapse triggers bank failures which leads to
recession.
Federal Reserve intervenes: Lowers short-term
interest rates.
Federal government begins largest peacetime
program of spending.
32-56

57. Last Word: Stimulus and the Great Recession (2 of 2)
• GDP growth has been disappointing.
• High debt load due to low interest rates.
• High rate of savings.
• Unequal impact.
• Price increases rather than output gains.
32-57

58. Disclaimer
• Please do not copy, modify, or distribute this presentation
• without author’s consent.
• This presentation was created and owned by
• Dr. Ryoichi Sakano
• North Carolina A&T State University
• It includes copy-righted materials from
©2021 McGraw Hill Education. All rights reserved. No reproduction or further distribution without the prior written consent of McGraw Hill Education.