Chapter 12

The Aggregate
Demand and
Supply Model
 Preview

• To develop the aggregate demand and

aggregate supply model from the previous
three chapters
• To understand developments in the 2007-
2009 period using aggregate demand and
supply analysis

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 Recap of the Aggregate Demand
and Supply Curves

• The Aggregate Demand Curve

– It shows the relationship between the inflation
rate and the level of aggregate output when the
goods market is in equilibrium
– It slopes downward because a rise in inflation
leads the monetary policy authorities to raise real
interest rates to keep inflation from getting out of
control, which lowers aggregate demand and
thus the equilibrium level of aggregate output

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 FIGURE 10.4 Deriving the AD Curve

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 Recap of the Aggregate Demand
and Supply Curves (cont’d)
• Factors that Shift the AD Curve
1. Autonomous monetary policy, r
r   I, C, NX Y (AD curve shifts to the left)
2. Government purchases, G
G  Y  (AD curve shifts to the right)
3. Taxes, T
T   C Y (AD curve shifts to the left)
4. Net exports, NX
NX  Y  (AD curve shifts to the right)
5. Autonomous consumption expenditure, C
C  Y  (AD curve shifts to the right)
6. Autonomous investment, I
I  Y  (AD curve shifts to the right)
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 TABLE 12.1 FACTORS THAT SHIFT
THE AGGREGATE DEMAND CURVE

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 Box: What Does Autonomous
Mean?

• Economists refer the word autonomous to

the component of the variable that is
exogenous.
• E.g. Autonomous monetary policy is the
component of the real interest rate set by
the central bank that is unrelated to any
variable in the model.
• Changes in autonomous variables are not
associated with movements along a curve,
but shifts in the curves.

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 Recap of the Aggregate Demand
and Supply Curves (cont’d)

• Short- and Long-Run Aggregate Supply

Curves
– Wages and prices are sticky in the short run, but
fully flexible in the long run
– The LRAS curve is vertical at the potential output
level, YP, which is determined by available factors
of production (labor and capital) and technology,
as well as the natural rate of unemployment
– The short-run AS curve is upward sloping: As
output rises relative to potential, inflation rises

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 FIGURE 11.3 Long- and Short-Run
Aggregate Supply Curves

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 Recap of the Aggregate Demand
and Supply Curves (cont’d)

• Factors that Shift the Long-Run Aggregate

Supply Curve
– Shocks to the natural rate of unemployment
– Shocks to technology
– Shocks to long-run changes in the amounts of
labor or capital that affect the amount of output
that the economy can produce

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 Recap of the Aggregate Demand
and Supply Curves (cont’d)

• Factors that Shift the Short-Run Aggregate

Supply Curve
1. Expected inflation, π e

– Higher expected inflation leads to an upward and

leftward shift in the short-run AS curve
2. Price shocks, ρ
– Supply restriction or workers pushing for higher wages
leads to an upward and leftward shift in the short-run
AS curve
3. Persistent output gap, (Y>YP)
– A persistently positive output gap (Y>YP) leads to an
upward and leftward shift in the short-run AS curve

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 TABLE 12.2 FACTORS THAT SHIFT THE
SHORT-RUN AGGREGATE SUPPLY CURVE

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 Equilibrium in Aggregate
Demand and Supply Analysis
• General equilibrium in the economy
occurs when all markets are simultaneously
in equilibrium at the point where the
quantity of aggregate output demanded
equals the quantity of aggregate output
supplied
• Graphically, general equilibrium is the point
where the AD curve intersects with the AS
curve
• Short-run and long-run equilibriums exist
because there are two AS curves—one for
the short run and one for the long run.
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 Short-Run Equilibrium

• Graphically, a short-run equilibrium occurs

when the aggregate demand curve AD and
the short-run aggregate supply curve AS
intersect

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 FIGURE 12.1 Short-Run Equilibrium

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 Box: Algebraic Determination of the
Equilibrium Output and Inflation Rate

• The AD curve (Ch.10):

Y  11  0.5π

• The short-run AS curve (Ch.11) with π-1  2%

π  2  1.5(Y 10)

• Substituting in for  from the AS curve into the AD curve

so that equilibrium Y is:

Y  11  0.5  [2  1.5(Y 10)]

• Collecting terms in Y so that Y*=10, which is substituted
into the short-run AS curve to yield the equilibrium
inflation rate:
π*  2  1.5(10 10)  2
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 Long-Run Equilibrium

• In aggregate supply and demand analysis,

even when the economy is at the
intersection of the aggregate demand curve
and the short-run aggregate supply curve,
the equilibrium will move over time if output
differs from its potential level (Y*  YP)
• If the current level of inflation changes from
its initial level, the short-run aggregate
supply curve will shift as wages and prices
adjust to a new expected rate of inflation

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 Short-Run Equilibrium over Time

• What happens to the short-run equilibrium

over time if the short-run equilibrium output
is initially above potential output?
– Tightness in labor markets drives up wages,
which result in higher inflation and inflation
expectations, thus the AS curve shifts up and to
the left over time until output returns to its
potential level

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 Short-Run Equilibrium over Time

• What happens to the short-run equilibrium

over time if the short-run equilibrium output
is initially below potential output?
– Excess slack in labor markets drives down
wages, which result in lower inflation and
inflation expectations, thus the AS curve shifts
down and to the right over time returns to its
potential level

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 FIGURE 12.2 Adjustment to Long-Run
Equilibrium in Aggregate Supply and
Demand Analysis (a)

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 FIGURE 12.2 Adjustment to Long-Run
Equilibrium in Aggregate Supply and
Demand Analysis (b)

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 Short-Run Equilibrium over Time
(cont’d)

• According to the aggregate demand and

supply model, regardless of where output is
initially, it eventually returns to potential
output
• This is called the self-correcting
mechanism because the short-run
aggregate supply curve shifts up or down to
restore the economy to full employment
(aggregate output at potential) over time

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 Changes in Equilibrium:
Aggregate Demand Shocks

• Demand shocks are factors that cause the

aggregate demand curve to shift
• Positive demand shocks cause a rightward
shift in the AD curve
• Results: Although the initial short-run effect
of the rightward shift in the aggregate
demand curve is a rise in both inflation and
output, the ultimate long-run effect is only
a rise in inflation because output returns to
its initial level at YP.

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 FIGURE 12.3 Positive Demand Shock

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 Box: Algebraic Determination of the
Response to a Rightward Shift of the
Aggregate Demand Curve
• Suppose the AD curve shifts rightward by $2 trillion, so
that Y in the AD equation is: Y = 12.75 – 0.5
• Substituting in for  = 2+1.5 (Y – 10), from the AS
curve, yields:

Y = 12.75–0.5[2+1.5(Y –10)] = 12.75–0.75–1+7.5 = 19.25–

0.75Y

• Collecting terms in Y, so that the equilibrium output

Y=$11 trillion, which is in turn substituted into the
short-run AS equation,  = 2+1.5(Y – 10), yields  =
2+1.5(11–10)=3.5%
• In the long run, Y=YP=$10 trillion; and substituting this
value of output into the AD equation, Y = 12.75 – 0.5,
so that =5.5%
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 Application: The Volcker Disinflation,
1980-1986

• When Paul Volcker became the Chairman of

the Federal Reserve in 1979, the inflation
rate exceeded 10%. Volcker was
determined to get inflation down by raising
the federal funds rate.
• High real interest rates brought inflation
down from 13.5% in 1980 to 1.9% in 1986,
while the unemployment rate initially
soared
• Our aggregate demand and supply analysis
correctly predicts what happened in this
period
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 FIGURE 12.4 The Volcker Disinflation

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 Application: Negative Demand
Shocks, 2001-2004

• In the early 2000s, a series of negative shocks

to aggregate demand occurred in the U.S.
economy (sharp falls stock prices, weakening
consumer and business confidence, and rises in
interest rates on corporate bonds)
• As a result of the leftward shift of the AD curve,
unemployment rose and inflation fell.
• But by 2004, the self-correcting mechanism
began to come into play: The short-run AS
curve shifted downward so that output returned
to its potential level and unemployment
dropped back to its natural rate level.
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 FIGURE 12.5 Negative Demand
Shocks, 2001-2004

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 Changes In Equilibrium:
Aggregate Supply (Price) Shocks

• The AS curve can shift from two types of

supply shocks:
1. Temporary supply (price) shocks that do not
shift the LRAS curve
2. Permanent supply shocks that cause the LRAS
curve to shift

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 Temporary Supply Shocks

• Negative (unfavorable) supply shock

– Shifts the short-run AS curve up and to the left,
initially causing a situation of rising inflation and
falling output—stagflation (stagnation and
inflation)
– Results: Although a temporary negative supply
shock leads to an upward and leftward shift in
the short-run aggregate supply curve, which
raises inflation and lowers output initially, the
ultimate long-run effect is that output and
inflation are unchanged.

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 FIGURE 12.6 Temporary Negative
Supply Shock

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 Temporary Supply Shocks (cont’d)

• Positive (favorable) supply shock

– Shifts the short-run AS curve down and to the
right, initially causing a situation of falling
inflation and rising output
– A temporary positive supply shock shifts the
short-run aggregate supply curve downward and
to the right, leading initially to a fall in inflation
and a rise in output
– In the long run, however, output and inflation
will be unchanged (holding the aggregate
demand curve constant)

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 Application: Negative Supply Shocks,
1973-1975 and 1978-1980

• In 1973, the U.S. was hit by negative supply

shocks that shifted the short-run AS curve
up and to the left:
1. OPEC oil embargo
2. Increases in food prices due to crop failures
around the world
3. Wage hikes immediately after the termination of
U.S. wage and price controls
• In 1979 the short-run AS curve shifted up
and to the left again due to poor harvests
and a doubling of oil prices (as a result of
the Iranian revolution)
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 FIGURE 12.7 Negative Supply Shocks,
1973-1975 and 1978-1980

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 Permanent Supply Shocks

• Permanent negative supply shocks

– Decrease potential output and shift the long-run
AS curve to the left
– A permanent negative supply shock leads
initially to both a decline in output and a rise in
inflation
– However, in contrast to a temporary supply
shock, in the long run the negative supply
shock, which results in a fall in potential output,
leads to a permanent decline in output and a
permanent rise in inflation

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 Permanent Supply Shocks (cont’d)

• Permanent positive supply shocks

– Increase potential output and shift the long-run
AS curve to the right
– A permanent positive supply shock lowers
inflation and raises output both in the short run
and the long run

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 FIGURE 12.8 Permanent Negative
Supply Shock

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 Application: Positive Supply Shocks,
1995-1999

• In the late 1990s, two permanent positive

supply shocks hit the U.S. economy:
1. Changes in the health care industry substantially
reduced medical care costs relative to other
goods and services
2. The computer revolution raised productivity and
the potential growth rate of the economy
• These shocks led to a rightward shift in the
LRAS curve, resulting in rising aggregate
output, lowering unemployment along with
falling inflation

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 FIGURE 12.9 Positive Supply Shocks,
1995-1999

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 Conclusions (Aggregate Demand and
Supply Analysis)

1. A shift in the AD curve affects output only in the

short run and has no effect in the long run
Furthermore, the initial change in inflation is lower
than the long- run change in inflation when the
short-run AS curve has fully adjusted
2. A temporary supply shock affects output and
inflation only in the short run and has no effect in
the long run
3. A permanent supply shock affects output and
inflation both in the short and the long run
4. The economy has a self-correcting mechanism that
returns it to potential output and the natural rate
of unemployment over time
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