ECONOMICS

Twelfth Edition, Global Edition

Michael Parkin
27 AGGREGATE SUPPLY AND
AGGREGATE DEMAND
After studying this chapter, you will be able to:
 Explain what determines aggregate supply in
the long run and in the short run

 Explain what determines aggregate demand

 Explain how real GDP and the price level are

determined and what causes growth, inflation,
and cycles

 Explain the main schools of thought in

macroeconomics today

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 Aggregate Supply

Quantity Supplied and Supply

The quantity of real GDP supplied is the total quantity that
firms plan to produce during a given period.
Aggregate supply is the relationship between the quantity
of real GDP supplied and the price level.
We distinguish two time frames associated with different
states of the labor market:
▪ Long-run aggregate supply
▪ Short-run aggregate supply

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 Aggregate Supply

Long-Run Aggregate Supply

Long-run aggregate supply is the relationship between
the quantity of real GDP supplied and the price level when
real GDP equals potential GDP.
Potential GDP is independent of the price level.
So the long-run aggregate supply curve (LAS) is vertical at
potential GDP.

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 Aggregate Supply

Short-Run Aggregate Supply

Short-run aggregate supply is the relationship between
the quantity of real GDP supplied and the price level when
the money wage rate, the prices of other resources, and
potential GDP remain constant.
A rise in the price level with no change in the money wage
rate and other factor prices increases the quantity of real
GDP supplied.
The short-run aggregate supply curve (SAS) is upward
sloping.

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 Aggregate Supply

Figure 27.1 shows the

LAS curve.
In the long run, the
quantity of real GDP
supplied is potential GDP.
As the price level rises
and the money wage rate
changes by the same
percentage, the quantity
of real GDP supplied
remains at potential GDP.

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 Aggregate Supply

In the short run, the

quantity of real GDP
supplied increases if the
price level rises.
The SAS curve slopes
upward.
A rise in the price level
with no change in the
money wage rate induces
firms to increase
production.

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 Aggregate Supply

With a given money wage

rate, the SAS curve cuts
the LAS curve at potential
GDP.
The price level is 110.
With the given money
wage rate, as the price
level falls below 110 ...
the quantity of real GDP
supplied decreases along
the SAS curve.

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 Aggregate Supply

With the given money

wage rate, as the price
level rises above 110 …
the quantity of real GDP
supplied increases along
the SAS curve.
Real GDP exceeds
potential GDP.

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 Aggregate Supply

Changes in Aggregate Supply

Aggregate supply changes if an influence on production
plans other than the price level changes.
These influences include
▪ Changes in potential GDP
▪ Changes in money wage rate (and other factor prices)

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 Aggregate Supply

Changes in Potential GDP

When potential GDP increases, both the LAS and SAS
curves shift rightward.
Potential GDP changes for three reasons:
▪ An increase in the full-employment quantity of labor
▪ An increase in the quantity of capital (physical or
human)
▪ An advance in technology

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 Aggregate Supply

Figure 27.2 shows the

effect of an increase in
potential GDP.
The LAS curve shifts
rightward and the SAS
curve shifts along with the
LAS curve.

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 Aggregate Supply

Changes in the Money

Wage Rate
Figure 27.3 shows the
effect of a rise in the
money wage rate.
▪ Short-run aggregate
supply decreases and
the SAS curve shifts
leftward.
▪ Long-run aggregate
supply does not
change.
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 Aggregate Demand

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.
This quantity is the sum of consumption expenditures, C,
investment, I, government expenditure, G, and net
exports, X – M.
That is,
Y = C + I + G + X – M.

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 Aggregate Demand

Buying plans depend on many factors and some of the

main ones are
▪ The price level
▪ Expectations
▪ Fiscal policy and monetary policy
▪ The world economy

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 Aggregate Demand

The Aggregate Demand Curve

Aggregate demand is the relationship between the
quantity of real GDP demanded and the price level.
The aggregate demand curve (AD) plots the quantity of
real GDP demanded against the price level.

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 Aggregate Demand

Figure 27.4 shows an AD

curve.
The AD curve slopes
downward for two
reasons:
▪ Wealth effect
▪ Substitution effects

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 Aggregate Demand

Wealth Effect
A rise in the price level, other things remaining the same,
decreases the quantity of real wealth (money, stocks,
etc.).
To restore their real wealth, people increase saving and
decrease spending.
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, which
increases the quantity of real GDP demanded.

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 Aggregate Demand

Substitution Effects
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.
When the interest rate rises, people borrow 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.
When the interest rate falls, people borrow and spend
more, so the quantity of real GDP demanded increases.
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 Aggregate Demand

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, increases the quantity of real GDP demanded.

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 Aggregate Demand

Changes in Aggregate Demand

A change in any influence on buying plans other than the
price level changes aggregate demand.
The main influences on aggregate demand are
▪ Expectations
▪ Fiscal policy and monetary policy
▪ The world economy

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 Aggregate Demand

Expectations
Expectations about future income, future inflation, and
future profits change aggregate demand.
Increases in expected future income increase people’s
consumption today and increases aggregate demand.
A rise in the expected inflation rate makes buying goods
cheaper today and increases aggregate demand.
An increase in expected future profits boosts firms’
investment, which increases aggregate demand.

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 Aggregate Demand

Fiscal Policy and Monetary Policy

Fiscal policy is the government’s attempt to influence the
economy by setting and changing taxes, making transfer
payments, and purchasing goods and services.
A tax cut or an increase in transfer payments increases
households’ disposable income—aggregate income
minus taxes plus transfer payments.
An increase in disposable income increases consumption
expenditure and increases aggregate demand.

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 Aggregate Demand

Because government expenditure on goods and services

is one component of aggregate demand, an increase in
government expenditure increases aggregate demand.
The Fed’s attempt to influence the economy by changing
the interest rate and adjusting the quantity of money is
called monetary policy.
An increase in the quantity of money increases buying
power and increases aggregate demand.
A cut in interest rates increases expenditure and increases
aggregate demand.

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 Aggregate Demand

The World Economy

The world economy influences aggregate demand in two
ways:
A fall in the foreign exchange rate lowers the price of
domestic goods and services relative to foreign goods and
services, which increases exports, decreases imports, and
increases aggregate demand.
An increase in foreign income increases the demand for
U.S. exports and increases aggregate demand.

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 Aggregate Demand

Figure 27.5 illustrates

changes in aggregate
demand.
When aggregate demand
increases, the AD curve
shifts rightward…
… and when aggregate
demand decreases, the
AD curve shifts leftward.

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 Explaining Macroeconomic Trends
and Fluctuations
Short-Run Macroeconomic Equilibrium
Short-run 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 SAS curve.

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 Explaining Macroeconomic Trends
and Fluctuations
Figure 27.6 illustrates a
short-run equilibrium.
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.

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 Explaining Macroeconomic Trends
and Fluctuations
These changes bring a
movement along the SAS
curve towards equilibrium.
In short-run equilibrium,
real GDP can be greater
than or less than potential
GDP.

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 Explaining Macroeconomic Trends
and Fluctuations
Long-Run Macroeconomic Equilibrium
Long-run macroeconomic equilibrium occurs when real
GDP equals potential GDP—when the economy is on its
LAS curve.
Long-run equilibrium occurs at the intersection of the AD
and LAS curves.

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 Explaining Macroeconomic Trends
and Fluctuations
Figure 27.7 illustrates the
adjustment to long-run
equilibrium.

Initially, the economy is at

below-full employment
equilibrium.

In the long run, the money

wage falls until the SAS
curve passes through the
long-run equilibrium point.

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 Explaining Macroeconomic Trends
and Fluctuations
Initially, the economy is at
an above-full employment
equilibrium.
In the long run, the money
wage rate rises until the
SAS curve passes
through the long-run
equilibrium point

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 Explaining Macroeconomic Trends
and Fluctuations
Economic Growth and
Inflation in the AS-AD
Model
Figure 27.8 illustrates
economic growth.
Because the quantity of
labor grows, capital is
accumulated, and
technology advances,
potential GDP increases.
The LAS curve shifts
rightward.
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 Explaining Macroeconomic Trends
and Fluctuations
Figure 27.8 also illustrates
inflation.
If the quantity of money
grows faster than potential
GDP, aggregate demand
increases by more than
long-run aggregate
supply.
The AD curve shifts
rightward faster than the
rightward shift of the LAS
curve.
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 Explaining Macroeconomic Trends
and Fluctuations
The Business Cycle in the AS-AD Model
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.
An above full-employment equilibrium is an equilibrium
in which real GDP exceeds potential GDP.
A full-employment equilibrium is an equilibrium in which
real GDP equals potential GDP.
A below full-employment equilibrium is an equilibrium in
which potential GDP exceeds real GDP.
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 Explaining Macroeconomic Trends
and Fluctuations
Figures 27.9(a) and (d)
illustrate above full-
employment equilibrium.
The amount by which real
GDP exceeds potential
GDP is called an
inflationary gap.
Figures 27.9(b) and (d)
illustrate full-employment
equilibrium.

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 Explaining Macroeconomic Trends
and Fluctuations
Figures 27.9(c) and (d)
illustrate below full-
employment equilibrium.
The amount by which real
GDP is less than potential
GDP is called a
recessionary gap.
Figure 27.9(d) 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. © 2016 Pearson Education, Ltd.
 Explaining Macroeconomic Trends
and Fluctuations
Fluctuations in
Aggregate Demand
Figure 27.10 shows the
effects of an increase in
aggregate demand.
An increase in aggregate
demand shifts the AD
curve rightward.
Firms increase production
and the price level rises in
the short run.

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 Explaining Macroeconomic Trends
and Fluctuations
At the short-run
equilibrium, there is an
inflationary gap.
The money wage rate
begins to rise and the
SAS curve starts to shift
leftward.
The price level continues
to rise and real GDP
continues to decrease
until it equals potential
GDP.
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 Explaining Macroeconomic Trends
and Fluctuations
Fluctuations in
Aggregate Supply
Figure 27.11 shows the
effects of a rise in the
price of oil.
The SAS curve shifts
leftward.
Real GDP decreases and
the price level rises.
The economy experiences
stagflation.
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 Macroeconomic Schools of Thought

Macroeconomists can be divided into three broad schools

of thought:
▪ Classical
▪ Keynesian
▪ Monetarist

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 Macroeconomic Schools of Thought

The Classical View

A classical macroeconomist believes that the economy is
self-regulating and always at full employment.
The term “classical” derives from the name of the founding
school of economics that includes Adam Smith, David
Ricardo, and John Stuart Mill.
A new classical view is that business cycle fluctuations
are the efficient responses of a well-functioning market
economy that is bombarded by shocks that arise from the
uneven pace of technological change.

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 Macroeconomic Schools of Thought

The Keynesian View

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.
The term “Keynesian” derives from the name of one of the
twentieth century’s most famous economists, John
Maynard Keynes.
A new Keynesian view holds that not only is the money
wage rate sticky but also are the prices of goods.

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 Macroeconomic Schools of Thought

The Monetarist View

A monetarist is a macroeconomist who 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.
The term “monetarist” was coined by an outstanding
twentieth-century economist, Karl Brunner, to describe his
own views and those of Milton Friedman.

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