PrinciplesofMacroeconomics-Chapter11Unit4Reading.pdf

269 Chapter 11 | The Aggregate Demand/Aggregate Supply Model

11 | The Aggregate Demand/
Aggregate Supply Model

Figure 11.1 New Home Construction At the peak of the housing bubble, many people across the country were able
to secure the loans necessary to build new houses. (Credit: modification of work by Tim Pierce/Flickr Creative
Commons)

From Housing Bubble to Housing Bust

The United States experienced rising home ownership rates for most of the last two decades. Between 1990
and 2006, the U.S. housing market grew. Homeownership rates grew from 64% to a high of over 69% between
2004 and 2005. For many people, this was a period in which they could either first homes or a larger
and more expensive home. During this time mortgage values tripled. Housing became more accessible to
Americans and was considered to be a safe financial investment. Figure 11.2 shows how new single family
home sales peaked in 2005 at 107,000 units.

270 Chapter 11 | The Aggregate Demand/Aggregate Supply Model

Figure 11.2 New Single Family Houses Sold From the early 1990s up through 2005, the number of new
single family houses sold rose steadily. In 2006, the number dropped dramatically and this dramatic decline
continued through 2011. By 2014, the number of new houses sold had begun to climb back up, but the levels
are still lower than those of 1990. (Source: U.S. Census Bureau)

The housing bubble began to show signs of bursting in 2005, as delinquency and late payments began to
grow and an oversupply of new homes on the market became apparent. Dropping home values contributed to
a decrease in the overall wealth of the household sector and caused homeowners to pull back on spending.
Several mortgage lenders were forced to file for bankruptcy because homeowners were not making their
payments, and by 2008 the problem had spread throughout the financial markets. Lenders clamped down
on credit and the housing bubble burst. Financial markets were now in crisis and unable or unwilling to even
extend credit to credit-worthy customers.

The housing bubble and the crisis in the financial markets were major contributors to the Great Recession
that led to unemployment rates over 10% and falling GDP. While the United States is still recovering from the
impact of the Great Recession, it has made substantial progress in restoring financial market stability through
implementing aggressive fiscal and monetary policy.

The economic history of the United States is cyclical in nature with recessions and expansions. Some of
these fluctuations are severe, such as the economic downturn that occurred during the Great Depression
in the 1930s which lasted several years. Why does the economy grow at different rates in different years?
What are the causes of the cyclical behavior of the economy? This chapter will introduce an important model,
the aggregate demand–aggregate supply model, to begin our understanding of why economies expand and
contract over time.

Introduction to the Aggregate Supply–Aggregate Demand
Model
In this chapter, you will learn about:

• Macroeconomic Perspectives on Demand and Supply

• Building a Model of Aggregate Supply and Aggregate Demand

• Shifts in Aggregate Supply

• Shifts in Aggregate Demand

• How the AS–AD Model Incorporates Growth, Unemployment, and Inflation

• Keynes’ Law and Say’s Law in the AS–AD Model

A key part of macroeconomics is the use of models to analyze macro issues and problems. How is the rate
of economic growth connected to changes in the unemployment rate? Is there a reason why unemployment and
inflation seem to move in opposite directions: lower unemployment and higher inflation from 1997 to 2000, higher
unemployment and lower inflation in the early 2000s, lower unemployment and higher inflation in the mid-2000s,

This OpenStax book is available for free at http://cnx.org/content/col12190/1.4

http://cnx.org/content/col12190/1.4

271 Chapter 11 | The Aggregate Demand/Aggregate Supply Model

and then higher unemployment and lower inflation in 2009? Why did the current account deficit rise so high, but then
decline in 2009?

To analyze questions like these, we must move beyond discussing macroeconomic issues one at a time, and begin
building economic models that will capture the relationships and interconnections between them. The next three
chapters take up this task. This chapter introduces the macroeconomic model of aggregate supply and aggregate
demand, how the two interact to reach a macroeconomic equilibrium, and how shifts in aggregate demand or
aggregate supply will affect that equilibrium. This chapter also relates the model of aggregate supply and aggregate
demand to the three goals of economic policy (growth, unemployment, and inflation), and provides a framework
for thinking about many of the connections and tradeoffs between these goals. The chapter on The Keynesian
Perspective focuses on the macroeconomy in the short run, where aggregate demand plays a crucial role. The
chapter on The Neoclassical Perspective explores the macroeconomy in the long run, where aggregate supply
plays a crucial role.

11.1 | Macroeconomic Perspectives on Demand and

Supply

By the end of this section, you will be able to:

• Explain Say’s Law and understand why it primarily applies in the long run

• Explain Keynes’ Law and understand why it primarily applies in the short run

Macroeconomists over the last two centuries have often divided into two groups: those who argue that supply is the
most important determinant of the size of the macroeconomy while demand just tags along, and those who argue that
demand is the most important factor in the size of the macroeconomy while supply just tags along.

Say’s Law and the Macroeconomics of Supply
Those economists who emphasize the role of supply in the macroeconomy often refer to the work of a famous early
nineteenth century French economist named Jean-Baptiste Say (1767–1832). Say’s law is: “Supply creates its own
demand.” As a matter of historical accuracy, it seems clear that Say never actually wrote down this law and that it
oversimplifies his beliefs, but the law lives on as useful shorthand for summarizing a point of view.

The intuition behind Say’s law is that each time a good or service is produced and sold, it generates income that
is earned for someone: a worker, a manager, an owner, or those who are workers, managers, and owners at firms
that supply inputs along the chain of production. We alluded to this earlier in our discussion of the National Income
approach to measuring GDP. The forces of supply and demand in individual markets will cause prices to rise and fall.
The bottom line remains, however, that every sale represents income to someone, and so, Say’s law argues, a given
value of supply must create an equivalent value of demand somewhere else in the economy. Because Jean-Baptiste
Say, Adam Smith, and other economists writing around the turn of the nineteenth century who discussed this view
were known as “classical” economists, modern economists who generally subscribe to the Say’s law view on the
importance of supply for determining the size of the macroeconomy are called neoclassical economists.

If supply always creates exactly enough demand at the macroeconomic level, then (as Say himself recognized) it is
hard to understand why periods of recession and high unemployment should ever occur. To be sure, even if total
supply always creates an equal amount of total demand, the economy could still experience a situation of some firms
earning profits while other firms suffer losses. Nevertheless, a recession is not a situation where all business failures
are exactly counterbalanced by an offsetting number of successes. A recession is a situation in which the economy
as a whole is shrinking in size, business failures outnumber the remaining success stories, and many firms end up
suffering losses and laying off workers.

Say’s law that supply creates its own demand does seem a good approximation for the long run. Over periods of some
years or decades, as the productive power of an economy to supply goods and services increases, total demand in
the economy grows at roughly the same pace. However, over shorter time horizons of a few months or even years,
recessions or even depressions occur in which firms, as a group, seem to face a lack of demand for their products.

Keynes’ Law and the Macroeconomics of Demand
The alternative to Say’s law, with its emphasis on supply, is Keynes’ law: “Demand creates its own supply.” As a

272 Chapter 11 | The Aggregate Demand/Aggregate Supply Model

matter of historical accuracy, just as Jean-Baptiste Say never wrote down anything as simpleminded as Say’s law,
John Maynard Keynes never wrote down Keynes’ law, but the law is a useful simplification that conveys a certain
point of view.

When Keynes wrote his influential work The General Theory of Employment, Interest, and Money during the 1930s
Great Depression, he pointed out that during the Depression, the economy’s capacity to supply goods and services had
not changed much. U.S. unemployment rates soared higher than 20% from 1933 to 1935, but the number of possible
workers had not increased or decreased much. Factories closed, but machinery and equipment had not disappeared.
Technologies that had been invented in the 1920s were not un-invented and forgotten in the 1930s. Thus, Keynes
argued that the Great Depression—and many ordinary recessions as well—were not caused by a drop in the ability
of the economy to supply goods as measured by labor, physical capital, or technology. He argued the economy often
produced less than its full potential, not because it was technically impossible to produce more with the existing
workers and machines, but because a lack of demand in the economy as a whole led to inadequate incentives for firms
to produce. In such cases, he argued, the level of GDP in the economy was not primarily determined by the potential
of what the economy could supply, but rather by the amount of total demand.

Keynes’ law seems to apply fairly well in the short run of a few months to a few years, when many firms experience
either a drop in demand for their output during a recession or so much demand that they have trouble producing
enough during an economic boom. However, demand cannot tell the whole macroeconomic story, either. After all,
if demand was all that mattered at the macroeconomic level, then the government could make the economy as large
as it wanted just by pumping up total demand through a large increase in the government spending component or by
legislating large tax cuts to push up the consumption component. Economies do, however, face genuine limits to how
much they can produce, limits determined by the quantity of labor, physical capital, technology, and the institutional
and market structures that bring these factors of production together. These constraints on what an economy can
supply at the macroeconomic level do not disappear just because of an increase in demand.

Combining Supply and Demand in Macroeconomics
Two insights emerge from this overview of Say’s law with its emphasis on macroeconomic supply and Keynes’ law
with its emphasis on macroeconomic demand. The first conclusion, which is not exactly a hot news flash, is that
an economic approach focused only on the supply side or only on the demand side can be only a partial success.
We need to take into account both supply and demand. The second conclusion is that since Keynes’ law applies
more accurately in the short run and Say’s law applies more accurately in the long run, the tradeoffs and connections
between the three goals of macroeconomics may be different in the short run and the long run.

11.2 | Building a Model of Aggregate Demand and

Aggregate Supply

By the end of this section, you will be able to:

• Explain the aggregate supply curve and how it relates to real GDP and potential GDP

• Explain the aggregate demand curve and how it is influenced by price levels

• Interpret the aggregate demand/aggregate supply model

• Identify the point of equilibrium in the aggregate demand/aggregate supply model

• Define short run aggregate supply and long run aggregate supply

To build a useful macroeconomic model, we need a model that shows what determines total supply or total demand
for the economy, and how total demand and total supply interact at the macroeconomic level. We call this the
aggregate demand/aggregate supply model. This module will explain aggregate supply, aggregate demand, and the
equilibrium between them. The following modules will discuss the causes of shifts in aggregate supply and aggregate
demand.

The Aggregate Supply Curve and Potential GDP
Firms make decisions about what quantity to supply based on the profits they expect to earn. They determine profits,
in turn, by the price of the outputs they sell and by the prices of the inputs, like labor or raw materials, that they need
to . Aggregate supply (AS) refers to the total quantity of output (i.e. real GDP) firms will produce and sell. The

This OpenStax book is available for free at http://cnx.org/content/col12190/1.4

http://cnx.org/content/col12190/1.4

273 Chapter 11 | The Aggregate Demand/Aggregate Supply Model

aggregate supply (AS) curve shows the total quantity of output (i.e. real GDP) that firms will produce and sell at
each price level.

Figure 11.3 shows an aggregate supply curve. In the following paragraphs, we will walk through the elements of
the diagram one at a time: the horizontal and vertical axes, the aggregate supply curve itself, and the meaning of the
potential GDP vertical line.

Figure 11.3 The Aggregate Supply Curve Aggregate supply (AS) slopes up, because as the price level for outputs
rises, with the price of inputs remaining fixed, firms have an incentive to produce more to earn higher profits. The
potential GDP line shows the maximum that the economy can produce with full employment of workers and physical
capital.

The diagram’s horizontal axis shows real GDP—that is, the level of GDP adjusted for inflation. The vertical axis
shows the price level, which measures the average price of all goods and services produced in the economy. In
other words, the price level in the AD-AS model is what we called the GDP Deflator in The Macroeconomic
Perspective. Remember that the price level is different from the inflation rate. Visualize the price level as an index
number, like the Consumer Price Index, while the inflation rate is the percentage change in the price level over time.

As the price level rises, real GDP rises as well. Why? The price level on the vertical axis represents prices for final
goods or outputs bought in the economy—i.e. the GDP deflator—not the price level for intermediate goods and
services that are inputs to production. Thus, the AS curve describes how suppliers will react to a higher price level for
final outputs of goods and services, while holding the prices of inputs like labor and energy constant. If firms across
the economy face a situation where the price level of what they produce and sell is rising, but their costs of production
are not rising, then the lure of higher profits will induce them to expand production. In other words, an aggregate
supply curve shows how producers as a group will respond to an increase in aggregate demand.

An AS curve’s slope changes from nearly flat at its far left to nearly vertical at its far right. At the far left of
the aggregate supply curve, the level of output in the economy is far below potential GDP, which we define as
the amount of real GDP an economy can produce by fully employing its existing levels of labor, physical capital,
and technology, in the context of its existing market and legal institutions. At these relatively low levels of output,
levels of unemployment are high, and many factories are running only part-time, or have closed their doors. In this
situation, a relatively small increase in the prices of the outputs that businesses sell—while assuming no rise in
input prices—can encourage a considerable surge in the quantity of aggregate supply because so many workers and
factories are ready to swing into production.

As the GDP increases, however, some firms and industries will start running into limits: perhaps nearly all of the
expert workers in a certain industry will have jobs or factories in certain geographic areas or industries will be running
at full speed. In the AS curve’s intermediate area, a higher price level for outputs continues to encourage a greater
quantity of output—but as the increasingly steep upward slope of the aggregate supply curve shows, the increase in
real GDP in response to a given rise in the price level will not be as large. (Read the following Clear It Up feature to
learn why the AS curve crosses potential GDP.)

274 Chapter 11 | The Aggregate Demand/Aggregate Supply Model

Why does AS cross potential GDP?

Economists typically draw the aggregate supply curve to cross the potential GDP line. This shape may
seem puzzling: How can an economy produce at an output level which is higher than its “potential” or “full
employment” GDP? The economic intuition here is that if prices for outputs were high enough, producers
would make fanatical efforts to produce: all workers would be on double-overtime, all machines would run
24 hours a day, seven days a week. Such hyper-intense production would go beyond using potential labor
and physical capital resources fully, to using them in a way that is not sustainable in the long term. Thus, it is
possible for production to sprint above potential GDP, but only in the short run.

At the far right, the aggregate supply curve becomes nearly vertical. At this quantity, higher prices for outputs cannot
encourage additional output, because even if firms want to expand output, the inputs of labor and machinery in the
economy are fully employed. In this example, the vertical line in the exhibit shows that potential GDP occurs at a total
output of 9,500. When an economy is operating at its potential GDP, machines and factories are running at capacity,
and the unemployment rate is relatively low—at the natural rate of unemployment. For this reason, potential GDP is
sometimes also called full-employment GDP.

The Aggregate Demand Curve
Aggregate demand (AD) refers to the amount of total spending on domestic goods and services in an economy.
(Strictly speaking, AD is what economists call total planned expenditure. We will further explain this distinction in
the appendix The Expenditure-Output Model . For now, just think of aggregate demand as total spending.) It
includes all four components of demand: consumption, investment, government spending, and net exports (exports
minus imports). This demand is determined by a number of factors, but one of them is the price level—recall though,
that the price level is an index number such as the GDP deflator that measures the average price of the things we .
The aggregate demand (AD) curve shows the total spending on domestic goods and services at each price level.

Figure 11.4 presents an aggregate demand (AD) curve. Just like the aggregate supply curve, the horizontal axis
shows real GDP and the vertical axis shows the price level. The AD curve slopes down, which means that increases in
the price level of outputs lead to a lower quantity of total spending. The reasons behind this shape are related to how
changes in the price level affect the different components of aggregate demand. The following components comprise
aggregate demand: consumption spending (C), investment spending (I), government spending (G), and spending on
exports (X) minus imports (M): C + I + G + X – M.

Figure 11.4 The Aggregate Demand Curve Aggregate demand (AD) slopes down, showing that, as the price level
rises, the amount of total spending on domestic goods and services declines.

This OpenStax book is available for free at http://cnx.org/content/col12190/1.4

http://cnx.org/content/col12190/1.4

275 Chapter 11 | The Aggregate Demand/Aggregate Supply Model

The wealth effect holds that as the price level increases, the ing power of savings that people have stored up in
bank accounts and other assets will diminish, eaten away to some extent by inflation. Because a rise in the price level
reduces people’s wealth, consumption spending will fall as the price level rises.

The interest rate effect is that as prices for outputs rise, the same purchases will take more money or credit to
accomplish. This additional demand for money and credit will push interest rates higher. In turn, higher interest rates
will reduce borrowing by businesses for investment purposes and reduce borrowing by households for homes and
cars—thus reducing consumption and investment spending.

The foreign price effect points out that if prices rise in the United States while remaining fixed in other countries,
then goods in the United States will be relatively more expensive compared to goods in the rest of the world. U.S.
exports will be relatively more expensive, and the quantity of exports sold will fall. U.S. imports from abroad will be
relatively cheaper, so the quantity of imports will rise. Thus, a higher domestic price level, relative to price levels in
other countries, will reduce net export expenditures.

Among economists all three of these effects are controversial, in part because they do not seem to be very large. For
this reason, the aggregate demand curve in Figure 11.4 slopes downward fairly steeply. The steep slope indicates
that a higher price level for final outputs reduces aggregate demand for all three of these reasons, but that the change
in the quantity of aggregate demand as a result of changes in price level is not very large.

Read the following Work It Out feature to learn how to interpret the AD/AS model. In this example, aggregate supply,
aggregate demand, and the price level are given for the imaginary country of Xurbia.

Interpreting the AD/AS Model

Table 11.1 shows information on aggregate supply, aggregate demand, and the price level for the imaginary
country of Xurbia. What information does Table 11.1 tell you about the state of the Xurbia’s economy? Where
is the equilibrium price level and output level (this is the SR macroequilibrium)? Is Xurbia risking inflationary
pressures or facing high unemployment? How can you tell?

110 $700 $600

120 $690 $640

130 $680 $680

140 $670 $720

150 $660 $740

160 $650 $760

170 $640 $770

Price Level Aggregate Demand Aggregate Supply

Table 11.1 Price Level: Aggregate Demand/Aggregate Supply

To begin to use the AD/AS model, it is important to plot the AS and AD curves from the data provided. What
is the equilibrium?

Step 1. Draw your x- and y-axis. Label the x-axis Real GDP and the y-axis Price Level.

Step 2. Plot AD on your graph.

Step 3. Plot AS on your graph.

Step 4. Look at Figure 11.5 which provides a visual to aid in your analysis.

276 Chapter 11 | The Aggregate Demand/Aggregate Supply Model

Figure 11.5 The AD/AS Curves AD and AS curves created from the data in Table 11.1.

Step 5. Determine where AD and AS intersect. This is the equilibrium with price level at 130 and real GDP at
$680.

Step 6. Look at the graph to determine where equilibrium is located. We can see that this equilibrium is fairly
far from where the AS curve becomes near-vertical (or at least quite steep) which seems to start at about
$750 of real output. This implies that the economy is not close to potential GDP. Thus, unemployment will be
high. In the relatively flat part of the AS curve, where the equilibrium occurs, changes in the price level will not
be a major concern, since such changes are likely to be small.

Step 7. Determine what the steep portion of the AS curve indicates. Where the AS curve is steep, the economy
is at or close to potential GDP.

Step 8. Draw conclusions from the given information:

• If equilibrium occurs in the flat range of AS, then economy is not close to potential GDP and will be
experiencing unemployment, but stable price level.

• If equilibrium occurs in the steep range of AS, then the economy is close or at potential GDP and will
be experiencing rising price levels or inflationary pressures, but will have a low unemployment rate.

Equilibrium in the Aggregate Demand/Aggregate Supply Model
The intersection of the aggregate supply and aggregate demand curves shows the equilibrium level of real GDP
and the equilibrium price level in the economy. At a relatively low price level for output, firms have little incentive
to produce, although consumers would be willing to purchase a large quantity of output. As the price level rises,
aggregate supply rises and aggregate demand falls until the equilibrium point is reached.

Figure 11.6 combines the AS curve from Figure 11.3 and the AD curve from Figure 11.4 and places them both
on a single diagram. In this example, the equilibrium point occurs at point E, at a price level of 90 and an output level
of 8,800.

This OpenStax book is available for free at http://cnx.org/content/col12190/1.4

http://cnx.org/content/col12190/1.4

277 Chapter 11 | The Aggregate Demand/Aggregate Supply Model

Figure 11.6 Aggregate Supply and Aggregate Demand The equilibrium, where aggregate supply (AS) equals
aggregate demand (AD), occurs at a price level of 90 and an output level of 8,800.

Confusion sometimes arises between the aggregate supply and aggregate demand model and the microeconomic
analysis of demand and supply in particular markets for goods, services, labor, and capital. Read the following Clear
It Up feature to gain an understanding of whether AS and AD are macro or micro.

Are AS and AD macro or micro?

These aggregate supply and demand models and the microeconomic analysis of demand and supply in
particular markets for goods, services, labor, and capital have a superficial resemblance, but they also have
many underlying differences.

For example, the vertical and horizontal axes have distinctly different meanings in macroeconomic and
microeconomic diagrams. The vertical axis of a microeconomic demand and supply diagram expresses a
price (or wage or rate of return) for an individual good or service. This price is implicitly relative: it is intended
to be compared with the prices of other products (for example, the price of pizza relative to the price of fried
chicken). In contrast, the vertical axis of an aggregate supply and aggregate demand diagram expresses the
level of a price index like the Consumer Price Index or the GDP deflator—combining a wide array of prices
from across the economy. The price level is absolute: it is not intended to be compared to any other prices
since it is essentially the average price of all products in an economy. The horizontal axis of a microeconomic
supply and demand curve measures the quantity of a particular good or service. In contrast, the horizontal
axis of the aggregate demand and aggregate supply diagram measures GDP, which is the sum of all the final
goods and services produced in the economy, not the quantity in a specific market.

In addition, the economic reasons for the shapes of the curves in the macroeconomic model are different from
the reasons behind the shapes of the curves in microeconomic models. Demand curves for individual goods
or services slope down primarily because of the existence of substitute goods, not the wealth effects, interest
rate, and foreign price effects associated with aggregate demand curves. The slopes of individual supply and
demand curves can have a variety of different slopes, depending on the extent to which quantity demanded
and quantity supplied react to price in that specific market, but the slopes of the AS and AD curves are much
the same in every diagram (although as we shall see in later chapters, short-run and long-run perspectives
will emphasize different parts of the AS curve).

In short, just because the AD/AS diagram has two lines that cross, do not assume that it is the same as every
other diagram where two lines cross. The intuitions and meanings of the macro and micro diagrams are only

278 Chapter 11 | The Aggregate Demand/Aggregate Supply Model

distant cousins from different branches of the economics family tree.

Defining SRAS and LRAS
In the Clear It Up feature titled “Why does AS cross potential GDP?” we differentiated between short run changes
in aggregate supply which the AS curve shows and long run changes in aggregate supply which the vertical line at
potential GDP defines. In the short run, if demand is too low (or too high), it is possible for producers to supply less
GDP (or more GDP) than potential. In the long run, however, producers are limited to producing at potential GDP.
For this reason, we may also refer to what we have been calling the AS curve as the short run aggregate supply
(SRAS) curve. We may also refer to the vertical line at potential GDP as the long run aggregate supply (LRAS)
curve.

11.3 | Shifts in Aggregate Supply

By the end of this section, you will be able to:

• …