C h a p t e r 7 AGGREGATE

SUPPLY AND
AGGREGATE
DEMAND**

C h a p t e r Key I d e a s
Production and Prices
A. What forces bring persistent and rapid expansion of real GDP?
B. What leads to inflation?
C. Why do we have business cycles?
D. Research on these issues divides economists into schools of thought.
E. The AS-AD model provides a framework for understanding economic growth, inflation, business
cycles, and the different schools of economic thought.

Outline
I. Aggregate Supply
A. Aggregate Supply Fundamentals
1. The aggregate quantity of goods and services supplied depends on three factors:
a) The quantity of labor (L )
b) The quantity of capital (K )
c) The state of technology (T )
2. The aggregate production function, Y = F(L, K, T ), shows how quantity of real GDP
supplied, Y, depends on labor, capital, and technology.
3. At any given time, the quantity of capital and the state of technology are fixed but the
quantity of labor can vary.
4. The wage rate that makes the quantity of labor demanded equal to the quantity supplied is
the equilibrium wage rate. At that wage rate, the level of employment full employment. At
full employment, the unemployment rate is called the natural rate of unemployment.
5. Over the business cycle, employment fluctuates around full employment.

*
* This is Chapter 23 in Economics.
145
146 CHAPTER 7

6.To study aggregate supply in different sates of the labor market, we distinguish two time
frames:
a) Long-run aggregate supply
b) Short-run aggregate supply
B. Long-Run Aggregate Supply
1. The macroeconomic long run is a
time frame that is sufficiently long for all
adjustments to be made so that real
GDP equals potential GDP and there is
full employment.
2. The long-run aggregate supply
curve (LAS ) is the relationship
between the quantity of real GDP
supplied and the price level when real
GDP equals potential GDP. Figure 7.1
shows an LAS curve with potential GDP
of $10 trillion.
3. The LAS curve is vertical because
potential GDP is independent of the
price level. Along the LAS curve all
prices and wage rates vary by the same
percentage so that relative prices and the real wage rate remain constant.
C. Short-Run Aggregate Supply
1. The macroeconomic short run is
a period during which some money
prices are sticky and real GDP might
be below, above, or at potential GDP
and the unemployment rate might be
above, below, or at the natural rate of
unemployment.
2. The short-run aggregate supply
curve (SAS) is the relationship
between the quantity of real GDP
supplied and the price level in the short
run when the money wage rate and
other resource prices are constant and
potential GDP does not change. Figure
7.2 shows a short-run aggregate supply
curve.
3. Along the SAS curve, a rise in the price
level with no change in the money
wage rate and other input prices
increases the quantity of real GDP
supplied—the SAS curve is upward
sloping.
4. The SAS curve is upward sloping
because a rise in the price level with no
AGGREGATE SUPPLY AND AGGREGATE DEMAND 147

change in costs induces firms to increase production; and a fall in the price level with no
change in costs induces firms to decrease production.
D. Movements along the LAS and SAS Curves
1. A change in the price level with an
equal percentage change in the
money wage rate brings a movement
along the LAS curve.
2.
A change in the price level with no
change in the money wage rate results
in a movement along the SAS curve.
Figure 7.3 illustrates both
movements.
E. Changes in Aggregate Supply
1. When potential GDP increases, both
the LAS and SAS curves shift
rightward.
a) Potential GDP changes, as
shown in Figure 7.4 for three
reasons:

i) Change in the full-

employment quantity of
labor.
ii) Change in the quantity
of capital, either in the
capital stock or in the
quantity of human
capital.
iii) Advance in technology.
b) All the factors that shift the
long-run aggregate supply
curve have the same effect on
the short-run aggregate supply
curve.
2. One additional factor influences
the short-run aggregate supply but not the long-run aggregate supply—a changes in
resource prices, such as the money wage rate.
a) An increase in resource prices decreases short-run aggregate supply, so an increase in
the money wage rate shifts the SAS curve leftward.

II. Aggregate Demand

A. The quantity of real GDP demanded, Y, is the total amount of final goods and services produced
in the United States that people, businesses, governments, and foreigners plan to buy.
1. This quantity is the sum of consumption expenditures, C, investment, I, government
purchases, G, and net exports), X – M. That is,
Y = C + I + G + X – M.
148 CHAPTER 7

2. Buying plans depend on many factors and some of the main ones are
a) The price level
b) Expectations
c) Fiscal and monetary policy
d) The world economy
B. The Aggregate Demand Curve
1. Aggregate demand is the relationship between the quantity of real GDP demanded and
the price level.
2. The aggregate demand (AD) curve
plots the quantity of real GDP
demanded against the price level.
Figure 7.6 shows an AD curve.
3. The AD curve slopes downward for
two reasons: a wealth effect and
two substitution effects.
a) Wealth effect: A rise in the
price level, other things
remaining the same, decreases
the quantity of real wealth. To
restore their real wealth,
people increase saving and
decrease spending, so the
quantity of real GDP
demanded decreases.
Similarly, a fall in the price
level, other things remaining
the same, increases the
quantity of real wealth. With
more real wealth, people
decrease saving and increase
spending, so the quantity of
real GDP demanded increases.
b) Intertemporal substitution
effect: A rise in the price level, other things remaining the same, decreases the real value
of money and raises the interest rate. Faced with a higher interest rate, people borrow
less and spend less so the quantity of real GDP demanded decreases. Similarly, a fall in
the price level increases the real value of money and lowers the interest rate. Faced with
a lower interest rate, people borrow more and spend more so the quantity of real GDP
demanded increases.
c) International substitution effect: A rise in the price level, other things remaining the
same, increases the price of domestic goods relative to foreign goods, so imports
increase and exports decrease, which decreases the quantity of real GDP demanded.
Similarly, a fall in the price level, other things remaining the same, decreases the price
of domestic goods relative to foreign goods, so imports decrease and exports increase,
which increases the quantity of real GDP demanded.
3. A change in the price level changes the quantity of real GDP demanded and there is a
movement along the aggregate demand curve.
AGGREGATE SUPPLY AND AGGREGATE DEMAND 149

C. Changes in Aggregate Demand

1. A change in any influence on buying plans other than the price level changes aggregate
demand.
2. The main influences are: expectations, fiscal and monetary policy, and the world economy.
a) Expectations about future income, future inflation, and future profits change aggregate
demand.
i) Increases in expected future income increase peoples’ consumption today, and
increases aggregate demand.
ii) An increase in the expected inflation rate makes buying goods cheaper today and
increases aggregate demand.
iii) An increase in expected future profits boosts firms’ investment, which increases
aggregate demand.
b) Fiscal policy is the government’s attempt to influence the economy by setting and
changing taxes, making transfer payments, and purchasing goods and services.
i) Disposable income is aggregate income minus taxes plus transfer payments. A
tax cut or an increase in transfer payments increases households’ disposable
income. An increase in disposable income increases consumption expenditure
and increases aggregate demand.
ii) Because government purchases of goods and services are one component of
aggregate demand, an increase in government purchases increases aggregate
demand.
150 CHAPTER 7

c) Monetary policy is changes in the interest rate and quantity of money in the
economy.
i) An increase in the
quantity of money
increases buying power
and increases aggregate
demand.
ii) A cut in the interest rate
increases expenditure and
increases aggregate
demand.
d) The world economy influences
aggregate demand in two ways:
i) A fall in the foreign
exchange rate lowers the
price of domestic goods
and services relative to
foreign goods and services
and so increases exports
and decreases imports,
thereby increasing
aggregate demand.
ii) An increase in foreign
income increases the
demand for U.S. exports
and increases aggregate
demand.
3. When aggregate demand increases,
the AD curve shifts rightward and
when aggregate demand decreases,
the AD curve shifts leftward. Figure
7.7 illustrates an increase and a
decrease in aggregate demand.

III. Macroeconomic Equilibrium

A. Short-Run Macroeconomic Equilibrium
1. Short-run macroeconomic equilibrium occurs when the quantity of real GDP
demanded equals the quantity of real GDP supplied. Short-run macroeconomic
equilibrium occurs at the point of intersection of the AD curve and the SAS curve.
AGGREGATE SUPPLY AND AGGREGATE DEMAND 151

2. Figure 7.8 illustrates a short-run

equilibrium.
a) If real GDP is below
equilibrium GDP, firms
increase production and raise
prices; and if real GDP is
above equilibrium GDP, firms
decrease production and lower
prices.
b) These changes bring a
movement along the SAS
curve toward equilibrium.
3. In short-run equilibrium, real GDP
can be greater than or less than
potential GDP.
B. Long-Run Macroeconomic Equilibrium
1. Long-run macroeconomic
equilibrium occurs when real
GDP equals potential GDP—when
the economy is on its LAS curve.
2. Figure 7.9 illustrates long-run
equilibrium.
3. Long-run equilibrium occurs where
the AD and LAS curves intersect. It
results when the money wage has
adjusted so that the SAS curve goes
through the long-run equilibrium
point.

C. Economic Growth and Inflation

1. Figure 7.10 illustrates economic
growth and inflation.
2. Economic growth occurs because the
quantity of labor grows, capital is
accumulated, and technology
advances, all of which increase
potential GDP and bring a
rightward shift of the LAS curve.
3. Inflation occurs because the quantity
of money grows more rapidly than
potential GDP, so that aggregate
demand increases by more than
long-run aggregate supply. The AD
curve shifts rightward faster than the
rightward shift of the LAS curve and
the price level rises.
152 CHAPTER 7

D. The Business Cycle

1. The business cycle occurs because aggregate demand and the short-run aggregate supply
fluctuate but the money wage does not change rapidly enough to keep real GDP at
potential GDP.
2. A below full-employment equilibrium is a macroeconomic equilibrium in which
potential GDP exceeds real GDP. Figure 7.11a illustrates below full-employment
equilibrium. The amount by which potential GDP exceeds real GDP is called a
recessionary gap, which is the same as the Okun gap discussed in Chapter 4.
3. A long-run equilibrium is a macroeconomic equilibrium in which potential GDP equals real
GDP. Figure 7.11b illustrates long-run equilibrium.
4. An above full-employment equilibrium is a macroeconomic equilibrium in which
real GDP exceeds potential GDP. Figure 7.11c illustrates above full-employment
equilibrium. The amount by which real GDP exceeds potential GDP is called an
inflationary gap.
5. Figure 7.11d shows how, as the economy moves from one type of short-run equilibrium to
another, real GDP fluctuates around potential GDP in a business cycle.
AGGREGATE SUPPLY AND AGGREGATE DEMAND 153

E. Fluctuations in Aggregate Demand

1. Figure 7.12 shows the effects of an increase in aggregate demand. Part (a) shows the short-
run effects and part (b) shows the long-run effects.

2. Starting at long-run equilibrium, an increase in aggregate demand shifts the AD curve

rightward.
3. With real GDP less than equilibrium GDP, firms increase production and rise prices—a
movement along the SAS curve.
4. Real GDP increases, the price level rises, and in the new short-run equilibrium, with real
GDP equal to $10.5 trillion, there is an inflationary gap.
5. The money wage rate begins to rise and short-run aggregate supply begins to decrease. The
SAS curve shifts leftward.
6. The price level rises and real GDP decreases until it has returned to potential GDP.
F. Fluctuations in Aggregate Supply
1. Figure 7.13 shows the effects of a
decrease in aggregate supply.
2. Starting at long-run equilibrium, a
rise in the price of oil decreases
short-run aggregate supply and
the SAS curve shifts leftward.
3. Real GDP decreases and the price
level rises. The combination of
recession combined with inflation
is called stagflation.
154 CHAPTER 7

IV. U.S. Economic Growth, Inflation, and Cycles

A. Figure 7.14 is a scatter diagram of real GDP and the price level each year from 1963 to 2003.
The figure also interprets the data in terms of shifting AD, SAS, and LAS curves. The data show
economic growth, inflation, and the business cycle between 1963 and 2003.

1. Real GDP and potential GDP grew from $2.8 trillion to $10.3 trillion.
2. The price level rose from 22 to 105.
3. Business cycle expansions alternated with recessions.
B. Economic Growth
Real GDP growth was rapid during the 1960s and 1990s and slower during the 1970s and
1980s.
C. Inflation
Inflation was the most rapid during the 1970s.
D. Business Cycles
Recessions occurred during the mid-1970s, 1982, 1991–1992, and 2001.

V. Macroeconomic Schools of Thought

A. Macroeconomics is an active field of research in which there is much consensus, but also some
differing viewpoints, especially about the business cycle.
B. The Keynesian View
1. A Keynesian macroeconomist believes that left alone, the economy would rarely operate at
full employment and that to achieve and maintain full employment, active help from fiscal
policy and monetary policy is required.
AGGREGATE SUPPLY AND AGGREGATE DEMAND 155

2.Keynesians believe that expectations (“animal spirits”) are the most significant influence on
aggregate demand and business cycle fluctuations.
3. Keynesians believe that the money wage rate is extremely sticky, especially in the downward
direction. A new Keynesian believes that not only is the money wage rate sticky but that
prices of goods and services are also sticky.
4. The Keynesian view calls for fiscal policy and monetary policy to actively offset changes in
aggregate demand.
C. The Classical View
1.A classical macroeconomist believes that the economy is self-regulating and that it is
always at full employment.
2. Classical macroeconomists believe that technological change is the most significant
influence on both aggregate demand and aggregate supply. They believe fluctuations in
potential GDP are responsible for business cycle fluctuations.
3. Classical macroeconomists believe that the money wage rate is flexible and that the
economy adjusts to long-run aggregate supply very quickly.
4. The classical view emphasizes the potential for taxes to stunt incentives and create
inefficiency.
D. The Monetarist View
1. A monetarist macroeconomist believes that the economy is self-regulating and that it will
normally operate at full employment provided that monetary policy is not erratic and that
the pace of money growth is kept steady.
2. Monetarists believe that the quantity of money is the most significant influence on aggregate
demand and business cycle fluctuations.
3. Monetarists believe that the money wage rate is sticky, leading to a distinction between
short-run and long-run aggregate supply.
4. The monetarist view is that, provided that the quantity of money is kept on a steady growth
path, no active stabilization is needed to offset changes in aggregate demand.

Reading Between the Lines

A news article discusses the fast growth in the third quarter of 2003 and effect on the price level. While
real GDP grew quickly, there was little effect on the price level and little sense of inflationary pressures.
So, using the AS-AD model, the increase in aggregate demand appears to have been matched by an
increase in long-run aggregate supply.

New in the Seventh Edition

The discussion of U.S. growth, inflation, and cycles has been updated. All the data are updated through
2003. The last section on “Macroeconomic Schools of Thought” is new and helps prepare the students
for the differences among macroeconomists. The Reading Between the Lines is new and discusses the
expansion of 2002–2003 in terms of the AS-AD model.
156 CHAPTER 7

Te a c h i n g S u g g e s t i o n s
1. Economists as a group are ambivalent about the aggregate supply-aggregate demand (AS-AD) model.
Real business cycle theorists, who like to build their models from the base of production functions
and preferences, don’t use the model because the AS and AD curves are not independent.
Technological change shifts both the AS and AD curves simultaneously and in complicated ways.
New Keynesian economists have dropped the model in favor of a dynamic variant that places the
inflation rate on the y-axis and the output gap (real GDP minus potential GDP as a percentage of
potential GDP) on the x-axis.
Despite attacks on the model from both sides of the doctrinal spectrum, those of us who spend a good
part of our professional lives teaching the principles course recognize the AS-AD model as the key
macroeconomic model. For us, the model plays a similar role in the organization of the
macroeconomics to that played by the demand and supply model in microeconomics. That is the
view taken in this textbook.
The AS-AD model is the best model currently available for introducing students to macroeconomics.
It enables them to gain insights into the way the economy works, to organize their study of the
subject, and to understand the debates surrounding the effects of policies designed to improve
macroeconomic performance.
Devoting about a week of lecture time to the AS-AD model is worthwhile. At this point the students
don’t yet have the background to appreciate all the details that go into the aggregate demand and
aggregate supply curves. But they are able to grasp the basic purpose of the model. Your goal at this
point in the course is to help them understand the components of the model intuitively and to put the
model to work using some of its more simple and obvious features. (The situation is very similar to
that at the beginning of the microeconomics sequence when you teach demand and supply At that
stage, the students don’t know about the consumer problem that lies behind the demand curve and
the model of perfect competition that lies behind the supply curve when they study demand and
supply at the beginning of their microeconomics course. But they can appreciate the intuition on the
demand and supply curves and use the model to generate predictions.)
2. Aggregate Supply
The flavor of the Classical-Keynesian controversy. If you want to convey the flavor of one of the biggest
controversies in macroeconomics, you can do so at this early stage of the course by using only the
aggregate supply curves. The difference between the upward-sloping SAS and the vertical LAS lies at
the core of the disagreement between Classical economists who believe that wages and prices are
highly flexible and adjust rapidly and Keynesian economists who believe that the money wage rate in
particular adjusts very slowly.
Along the LAS curve—two things happening. Students seem comfortable with the idea that the SAS
curve has a positive slope; but they seem less at ease with the vertical LAS curve. Emphasize (as the
textbook does) the crucial idea that along the LAS curve two sets of prices are changing — the prices
of output and the prices of resources, especially the money wage rate. Once they get this point,
students quickly catch on to the result that firms won’t be motivated to change their production levels
along the LAS curve. The vertical LAS curve is both vital and difficult and class time spent on this
concept is well justified.
One LAS curve-many SAS curves. Another way of reinforcing the distinction between the two AS
curves is to point out to students that at any given time, there is just one LAS curve, corresponding to
potential GDP. But there is an infinite number of possible SAS curves, each corresponding to a
different money wage rate.
2. Aggregate Demand
Keep it simple. You know that the AD curve is a subtle object—an equilibrium relationship derived
from simultaneous equilibrium in the goods market and the money market. This description of the
AGGREGATE SUPPLY AND AGGREGATE DEMAND 157

AD curve is not helpful to students in the principles course and is a topic for the intermediate macro
course. At the same time that we want to simplify the aggregate demand story, we also want to avoid
being misleading. The textbook walks that fine line, and we suggest that you stick closely to the
textbook treatment and don’t try to convey the more subtle aspects of aggregate demand.
A major problem with the AD curve is that a change in the price level that brings a movement along
the curve is not a strict ceteris paribus event. A change in the price level changes the quantity of real
money, which changes the interest rate. Indeed, this chain of events is one of the reasons for the
negative slope of the AD curve. In telling this story, we must be sensitive to the fact that the student
doesn’t yet know about the demand for money. We must provide intuition with stories (like the
Maria stories in the textbook) without referring to the demand for money.
Income equals expenditure on the AD curve. Some instructors want to emphasize a second and more
subtle violation of ceteris paribus, that along the AD curve, aggregate planned expenditure equals real
GDP. That is, the AD curve is not drawn for a given level of income but for the varying level of
income that equals the level of planned expenditure. If you want to make this point when you first
introduce the AD curve, you must cover the AE model of Chapter 29 (Chapter 13 in Macroeconomics)
before you cover this chapter. (The material is written in a way that permits this change of order.) If
you do not want to derive the AD curve from the equilibrium of the AE model, don’t even mention
what’s going on with income along the AD curve. Silence is vastly better than confusion. You can pull
this rabbit out of the hat when you get to Chapter 29 (Chapter 13 in Macroeconomics) if you’re
covering the material in the order presented in the textbook.
3. Macroeconomic Equilibrium
Short-run macroeconomic equilibrium. Emphasize that in short-run macroeconomic equilibrium, firms
are producing the quantities that maximize profit and everyone is spending the amount that they
want to spend. Describe the convergence process using the mechanism laid out on page 530 (page
158 in Macroeconomics) of the textbook. In that process, firms always produce the profit-maximizing
quantities—the economy is on the SAS curve. If they can’t sell everything they produce, firms lower
prices and cut production. Similarly, they can’t keep up with sales and inventories are falling, firms
raise prices and increase production. These adjustment processes continues until firms are selling their
profit-maximizing output. Emphasize also that with a fixed (sticky) money wage rate, this short-run
equilibrium can be at, below, or above potential GDP.
Long-run macroeconomic equilibrium. You can use the idea that there is only one LAS curve-but many
SAS curves to explain long-run equilibrium. In long-run equilibrium, real GDP equals potential GDP
on the one LAS curve. The money wage rate is at the level that makes the SAS curve the one of the
infinite number of possible SAS curves that passes through the intersection of AD and LAS.
From the short run to the long run. Explain that market forces move the money wage rate to the long-
run equilibrium level. At money wage rates below the long-run equilibrium level, there is a shortage
of labor, so the money wage rate rises. At money wage rates above the long-run equilibrium level,
there is a surplus of labor, so the money wage rate falls. At the long-run equilibrium money wage rate,
there is neither a shortage nor a surplus of labor and the money wage rate remains constant.
Shifting the SAS curve. Reinforce the movement toward long-run equilibrium with a curve-shifting
exercise. Take the case where the AD curve shifts rightward. The fact that the initial equilibrium
occurs where the new AD curve intersects the SAS curve is not difficult. But the notion that the SAS
curve shifts leftward as time passes is difficult for many students. The trick to making this idea clear is
to spend enough time when initially discussing the SAS so that the students realize that wages and
other input prices remain constant along an SAS curve. Once the students see this point, they can
understand that, as input prices increase in response to the higher level of (output) prices, the SAS
curve shifts leftward.
158 CHAPTER 7

Avoid confusing students by using ‘up’ to correspond to a decrease in SAS. But do point out that that
when the SAS curve shifts leftward it is moving vertically upward, as input prices rise to become
consistent with potential GDP and the new long-run equilibrium price level. Most students find it
easier to see why the SAS curve shifts leftward once they see that rising input prices shift the curve
vertically upward
4. Growth, inflation, and cycles
Putting the AS-AD model to work. Don’t neglect the predictions of the model. This is the payoff for
the student. With this simple model, we can now say quite a lot about growth, inflation, and the
cycle.
The price level doesn’t fall, and real GDP rarely falls. The AS-AD model predicts a fall in the price level
when either aggregate demand decreases or aggregate supply increases. And the model predicts that
real GDP decreases when either aggregate supply or aggregate demand decreases. Students are
sometimes bothered by this apparent mismatch between the predictions of the model and the
observed economy. The best way to handle this issue is to emphasize that in our actual economy,
aggregate supply and aggregate demand almost always are increasing. When we use the model to
simulate the effects of a decrease in either aggregate supply or aggregate demand, we’re studying what
happens relative to the trends in real GDP and the price level. A fall in the price level in the model
translates into a lower price level than would otherwise have occurred and a slowing of inflation. The
story is similar for real GDP.
5. Macroeconomic Schools of Thought
The flavor of the Classical-Keynesian controversy. If you want to convey the flavor of one of the biggest
controversies in macroeconomics, you can do so at this early stage of the course using only the
aggregate supply curves. The difference between the upward-sloping SAS and the vertical LAS lies at
the core of the disagreement between Classical economists who believe that wages and prices are
highly flexible and adjust rapidly and Keynesian economists who believe that the money wage rate in
particular adjusts very slowly.

The Big Picture

Where we have been
This chapter provides the first pass answers to the questions of macroeconomics . The chapter uses
the fact established in the first macroeconomic chapter, that expenditure equals C + I + G + (X – M),
to explain the forces that determine aggregate demand. It also draws on Chapter 3, demand and
supply, for the crucial concepts of equilibrium and the distinction between shifts and movements
along demand and supply curves.

Where we are going

This chapter provides a bare-bones description of the AS-AD model. The treatment parallels that of
the demand and supply model in Chapter 3. That is, the curves are defined and the reasons for their
slopes and the factors that shift them are explained. But the curves are not formally derived. The
chapter gives an overview of the entire macroeconomics sequence and serves as the foundation on
which the course is built. The next two chapters elaborate the supply side. The next chapter explains
how potential GDP is determined and what determines the quantity of capital and what makes it
grow. This chapter also explains how investment is determined (an interesting comment on the
interconnectedness of the demand and supply sides). Chapter 9(Chapter 16 in Economics) explores
the process of economic growth—the factors that shift the LAS curve steadily rightward. Starting
AGGREGATE SUPPLY AND AGGREGATE DEMAND 159

with Chapter 10 (Chapter 26 in Economics), the next block of chapters elaborates the demand side.
Chapters 10 and 11 (Chapters 26 and 27 in Economics) explain the role of money and provide the
detailed underpinning for the effects of money on aggregate demand. Chapter 12 (Chapter 28 in
Economics) uses the AS-AD model to examine inflation. Chapter 13 (Chapter 29 in Economics) lays
out the aggregate expenditure model, explains the multiplier effect of changes in investment,
describes the adjustment process that moves the economy toward the AD curve, and derives the AD
curve from the AE equilibrium. Chapter 14 (Chapter 30 in Economics) uses the AS-AD model to
study the sources of the business cycle. Chapters 15 and 16 (Chapters 31 and 32 in Economics) use
the AS-AD model to explain the effects of fiscal policy and monetary policy and to examine the
debates and alternative views on the appropriate use of fiscal policy and monetary policy.

O v e r h e a d Tr a n s p a r e n c i e s
Transparency Text Figure Transparency title
36 Figure 7.2 Short-Run Aggregate Supply
37 Figure 7.3 Movements Along the Aggregate Supply
Curves
38 Figure 7.6 Aggregate Demand
39 Figure 7.8 Short-Run Equilibrium
40 Figure 7.9 Long-Run Equilibrium
41 Figure 7.10 Economic Growth and Inflation
42 Figure 7.11 The Business Cycle
43 Figure 7.12 An Increase in Aggregate Demand
44 Figure 7.14 Aggregate Supply and Aggregate Demand:
1963–2003

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Additional Discussion Questions

11. “The demand curves for all products have negative slopes. For instance, the demand curves for
milk, automobiles, personal computers, and shirts all have negative slopes. Therefore, because the
aggregate demand curve shows the demand for all products, it too must have a negative slope.”
Comment on this assertion.
12. Explain why the SAS curve slopes upward and the LAS curve is vertical.
13. Any factor that shifts the LAS curve also shifts the SAS curve. Why?
14. When the equilibrium real GDP is below potential GDP, how does the unemployment rate
compare with the natural rate? What is the result of this state of affairs?
15. How can the equilibrium real GDP possibly be greater than potential GDP?
16. Explain how an increase in money wages affects the SAS curve. Why does a change in money
wages affect only the SAS curve and not the LAS curve?
17. If the government spends more money by buying more goods and services, is this change an
example of fiscal policy or monetary policy?
18. What is a recessionary gap? How does the economy adjust to eliminate a recessionary gap?
19. How does a change in the money supply affect real GDP and the price level in the short run? In
the long run? How does the initial SAS curve compare with its new long-run position? Why does
this change occur?
10. A decrease in potential GDP also raises the price level. Why, then, is the cause of inflation only
persisting increases in aggregate demand rather than persisting decreases in potential GDP?
11. Was the 2001 recession started by a shift in AD or in SAS? Why?
12. Suggest an event that could cause stagflation.
AGGREGATE SUPPLY AND AGGREGATE DEMAND 161

Answers to the Review Quizzes

Page 154 (page 526 in Economics)
1. If the price level rises and the money wage rate also rises by the same percentage there is no change
in the quantity of real GDP and there is a movement along the LAS curve. Figure 7.3 illustrates.
2. If the price level rises and the money wage rate remains constant the quantity of real GDP
supplied increases and the economy moves along the SAS curve. Figure 7.3 illustrates.
3. If potential GDP increases both long-run aggregate supply and short-run aggregate supply increase
and the LAS curve and SAS curve shift rightward. Figure 7.4 illustrates.
4. If the money wage rate rises and potential GDP remains the same there is a decrease in short-run
aggregate supply and no change in long-run aggregate supply. The SAS curve shifts leftward and
the LAS curve is unchanged. Figure 7.5 illustrates.

Page 158 (page 530 in Economics)

1. The aggregate demand curve shows the relationship between the quantity of real GDP demanded
and the price level when other influences on expenditure plans remain the same. When there is a
movement along the aggregate demand curve, the price level changes and other factors such as
expectations, fiscal and monetary policy, and the world economy remain the same.
2. The aggregate demand curve slopes downward because of the wealth effect and two substitution
effects. A rise in the price level decreases real wealth, which brings an increase in saving and a
decrease in spending—the wealth effect; raises the interest rate, which decreases borrowing and
spending—an intertemporal substitution effect; and increases the price of domestic goods and
services relative to foreign goods and services, which decreases exports and increases imports—an
international substitution effect.
3. Aggregate demand increases and the AD curve shifts rightward if: expected future income, future
inflation, or future profits increase; government purchases increase or taxes are cut; the quantity of
money increases and the interest rate is cut; the foreign exchange rate falls; or foreigners’ income
increases.

Page 163 (page 535 in Economics)

1. Economic growth results from increases in long-run aggregate supply. Economic growth occurs
because the quantity of labor increases, capital is accumulated and there are technological advances
over time. All three of these factors result in increasing potential GDP and shift the LAS curve
rightward.
2. Inflation results from increases in aggregate demand that exceeds the increase in long-run aggregate
supply. As the aggregate demand curve shifts rightward the price level rises. Increases in AD that
exceed increases in LAS produce inflation.
3. Short-run macroeconomic equilibrium occurs when the quantity of real GDP demanded equals
the quantity supplied. There are three types of short-run equilibrium: below full-employment
equilibrium where a recessionary gap exists; above full-employment equilibrium where an
inflationary gap exists; full-employment equilibrium where no gap exists.
4. Fluctuations in aggregate demand with no change in short-run aggregate supply bring fluctuations
in real GDP around potential GDP. A decrease in short-run aggregate supply can bring a fall in
real GDP relative to potential GDP, a phenomenon called stagflation.
162 CHAPTER 7

Answers to the Problems

1. a A deep recession in the world economy decreases aggregate demand, which decreases real GDP
and lowers the price level. A sharp rise in oil prices decreases short-run aggregate supply, which
decreases real GDP and raises the price level. The expectation of huge losses in the future
decreases investment and decreases aggregate demand, which decreases real GDP and lowers the
price level.
b. The combined effect of a deep recession in the world economy, a sharp rise in oil prices, and the
expectation of huge losses in the future decreases both aggregate demand and short-run
aggregate supply, which decreases real GDP and might raise or lower the price level.
c. The Toughtimes government might try to increase aggregate demand by increasing its purchases
or by cutting taxes and the Toughtimes Fed might increase the quantity of money and lower
interest rates. These policies could increase real GDP, but they would also raise the price level.
2. a. The strong expansion in the world economy increases Coolland’s exports and increases aggregate
demand, which increases real GDP and raises the price level. The expectation of huge profits in
the future increases investment and increases aggregate demand, which increases real GDP and
raises the price level. A cut in government expenditures decreases aggregate demand, which
decreases real GDP and lowers the price level.
b. The combined effect of a strong expansion in the world economy, the expectation of huge
profits in the future, and a cut in government expenditures might increase of decrease aggregate
demand, and so might increase or decreases real GDP and raise or lower the price level.
c. Coolland’s policymakers may be concerned about the net effect on Coolland’s economy. If the
expansionary events dominate, Coolland’s government might want to take further
contractionary actions (such as decreasing government purchases even more and/or raising
taxes). Coolland’s Fed might want to decrease the quantity of money and raise interest rates. If
the contractionary events dominate, then Coolland’s government may want to undertake
expansionary policy (e.g., cut government spending less and/or cut taxes) and Coolland’s Fed
may want to increase the money supply and lower interest rates.
3. a. Make a graph with the price level on the y-axis and real GDP on the x-axis. Make the price level
values run from 80 to 150 in intervals of 10, and make the real GDP values run from 150 to
650 in intervals of 50. Plot the data in the table in the graph. The AD curve plots the price level
against the quantity of real GDP demanded. The SAS curve plots the price level against the
quantity of real GDP supplied in the short-run.
b. Equilibrium real GDP is $400 trillion and the price level is 100. Short-run macroeconomic
equilibrium occurs at the intersection of the aggregate demand curve and the short-run aggregate
supply curve.
c. The long-run aggregate supply curve is a vertical line in your graph at real GDP of $500 billion.
4. a. Make a graph with the price level on the y-axis and real GDP on the x-axis. Make the price level
values run from 80 to 150 in intervals of 10, and make the real GDP values run from 50 to 650
in intervals of 50. Plot the data in the table in the graph. The AD curve plots the price level
against the quantity of real GDP demanded. The SAS curve plots the price level against the
quantity of real GDP supplied in the short-run.
b. Equilibrium real GDP is $300 trillion and the price level is 120. Short-run macroeconomic
equilibrium occurs at the intersection of the aggregate demand curve and the short-run aggregate
supply curve.
c. The long-run aggregate supply curve is a vertical line in your graph at real GDP of $250 billion.
5. Make a new table based on that in problem 3. Add a column headed “New real GDP demanded.”
Enter values in this column that equal the value in the column headed “Real GDP demanded” plus
$100 billion. (For example, on the first row of your new column, you have $550 billion.) Now, using
AGGREGATE SUPPLY AND AGGREGATE DEMAND 163

the graph that you made to answer problem 3, add a new AD curve by plotting the price level against
“New quantity of real GDP demanded.” The new equilibrium level of real GDP is $450 billion, and
the price level is 110.
6. Make a new table based on that in problem 4. Add a column headed “New real GDP demanded.”
Enter values in this column that equal the value in the column headed “Real GDP demanded” minus
$150 billion. (For example, on the first row of your new column, you have $450 billion.) Now, using
the graph that you made to answer problem 4, add a new AD curve by plotting the price level against
“New quantity of real GDP demanded.” The new equilibrium level of real GDP is $250 billion, and
the price level is 110.
7. Make a new table based on that in problem 3. Add a column headed “New real GDP supplied in the
short run.” Enter values in this column that equal the value in the column headed “Real GDP
supplied in the short run” minus $100 billion. (For example, on the first row of your new column,
you have $250 billion.) Now, using the graph that you made to answer problem 3, add a new SAS
curve by plotting the price level against “New quantity of real GDP supplied in the short run.” The
new equilibrium level of real GDP is $350 billion, and the price level is 110.
8. Make a new table based on that in problem 4. Add a column headed “New real GDP supplied in the
short run.” Enter values in this column that equal the value in the column headed “New real GDP
supplied in the short run” plus $150 billion. (For example, on the first row of your new column, you
have $300 billion.) Now, using the graph that you made to answer problem 4, add a new SAS curve
by plotting the price level against “New quantity of real GDP supplied in the short run.” The new
equilibrium level of real GDP is $400 billion, and the price level is 110.
9. a. Point C. The aggregate demand curve is the red curve AD1. The short-run aggregate supply
curve is the blue curve SAS0. These curves intersect at point C.
b. Point D. The short-run aggregate supply curve is the red curve SAS1. The aggregate demand
curve is now the red curve AD1. These curves intersect at point D.
c. Aggregate demand increases if (1) expected future incomes, inflation, or profits increase; (2) the
government increases its purchases or reduces taxes; (3) the Fed increases the quantity of money
and decreases interest rates; or (4) the exchange rate decreases or foreign income increases.
d. Short-run aggregate supply decreases if resource prices increase.
10. a. Point B. The short-run aggregate supply curve is SAS1. The aggregate demand curve has not
changed. These curves intersect at point B.
b. There are three possible events that could have changed the long-run aggregate supply curve
from LAS0 to LAS1: an increase in the full-employment quantity of labor; an increase in the
quantity of capital; and/or an advance in technology.
c. The same events that changed the LAS curve also will shift the SAS curve. The SAS curve will
shift by the same amount as the LAS curve.
d. After the increase in aggregate supply, there is a new short-run equilibrium at point B. Real
GDP is less than potential GDP, which is now along the LAS1 curve. There is a recessionary gap
at point B.
e. Aggregate demand would need to increase. Full-employment equilibrium would be achieved at
point C with an increase in AD.