1

MacroLecture6
AS-AD and Potential GDP
Lecture Highlights
Output and prices are determined by AS
and AD
In the short run, the AS curve is flat. In the
long run, the AS curve is vertical. It is
upward sloping in the medium run
The AS curve describes the price
adjustment mechanism of the economy
Changes in AD, the result of changes in
fiscal and monetary policy as well as
individual decisions about consumption and
investment
2
AS-AD and Potential GDP
Macroeconomic variables can be divided into
two groups:
Real variables
Nominal variables
Real variables are items such as real GDP, the
real wage rate, the real interest rate, the
levels of employment and unemployment.
Nominal variables are items such as the price
level (CPI or GDP deflator), the inflation
rate, nominal GDP, the nominal wage rate,
the nominal interest rate.
3
Contd.
The AD-AS model provides a framework for thinking
about 3 big macroeconomic issues std. of living,
cost of living, and economic fluctuation.
The AD-AS model is used by economists to analyse the
behavior of the macroeconomy in both the short-run
and in the long-run.
The model outlines the behavior of two macroeconomic
aggregates real output or real GDP/ income and the
price level.
AS shows the relationship between the quantity of real
GDP supplied and the price level when all other
influences on production plans remain the same.
4
Contd.
The fall in price
- Brings layoff
- Decrease in production
- Real GDP
The rise in price
- Firms hire new workers
- Increase production
- Real GDP
5
Contd.
The relationship between real GDP
supplied and the price level can be
described as follows:
Other things remaining the same, the
higher the price level, the greater is
the quantity of real GDP supplied, and
the lower the price level, the smaller
is the quantity of real GDP supplied.
6
Potential GDP
AS
Potential GDP
Yp
Real GDP
Price
level or
GDP
deflator
Potential GDP
the level of real
GDP that the
economy would
produce if it were
at full
employment.
7
Factors determine the qty. of real
GDP supplied
The qty. of real GDP supplied (Y), depends on
The quantity of labour employed
The quantities of capital and human capital
and the technologies they embody
The quantities of land and natural
resources used
The amount of entrepreneurial talent
available
8
Contd.
Along the AS curve, the only factor
which affect the production plans is
changes in the price level. All the
other influences on production plans
remain constant. Among other
influences are
The money wage rate
The money prices of other resources
9
Aggregate Demand (AD)
The relationship between the quantity of
real GDP demanded and the price level
when all other influences on expenditure
plans remain the same.
The relationship between the quantity of real
GDP demanded and the price level can be
described as follows:
Other things remaining the same, the higher
the price level, the smaller the quantity of
real GDP demanded, and the lower the
price level, the greater is the quantity of
real GDP demanded
10
Contd.

AD
Price
level
Real GDP
11
Contd.
The AD curve and equilibrium expenditure are related.
The AE curve is the relationship between agg.planned
expenditure and real GDP when all other influences on
expenditure plans remain the same. A movement
along the AE curve arises from a change in real GDP.
A movement along the AD curve arises from a change
in the price level.
Equilibrium expenditure depends on the price level.
When P, other things remaining the same, AE and
equilibrium expenditure .
When P, other things remaining the same, AE and
equilibrium expenditure
A change in P changes the buying power of money, the real
interest rate, and the real prices of exports and imports.
12
Equilibrium expenditure and AD
AE(Po)
AE(P1)
AE(P2)
AD
P2
Po
P1
13
Contd.
The quantity of real GDP demanded is
the total amount of final goods and
services produced that people,
businesses, governments, and
foreigners plan to buy.
Two factors influence expenditure plans
(i) The price level
(ii) Other factors
14
Contd.
(i) The price level influences the
quantity of real GDP demanded
because a change in the price level
brings changes in
The buying power of money
The real interest rate
The real prices of exports & imports
15
Contd.
The buying power of money a rise in the price level
lowers the buying power of money and decreases the
quantity of real GDP demanded.
The real interest rate when the price level rises, the
real interest rate rises.
the price level the amount of money that people want to
hold ( Md).
When Md nominal interest rate
In the short run, the inflation rate doesnt change
nominal interest rate real interest rate
Businesses and people delay plans to buy new capital and
consumer durable goods
Real GDP demanded
16
Contd.
The real prices of exports & imports.
When domestic price level and other things
remain the same
The prices in other countries do not change
This makes the Malaysian goods & services more
expensive relative to foreign goods & services.
This change in real prices
People to spend less on the Malaysian goods &
services
To spend on foreign made items
17
Changes in AD
The factors that change AD are
Expectations about the future
Fiscal policy and monetary policy
The state of the world economy
18
Macroeconomic Equilibrium
AS & AD determine real GDP and the
price level.

Macroeconomic equilibrium occurs when
the quantity of real GDP demanded
equals the quantity of real GDP
supplied.
19
Contd.

AD
Price
level
Real GDP
AS
Firms cut
production and
prices
Firms increase
production and prices
20
Three types of macroeconomic
equilibrium

AD2
Price
level
Real GDP
AS
ADo
AD1
Potential GDP
Y
2
Yp Y
1
Yp: full-
employment
equilibrium
Y1: above full-
employment
equilibrium
Y2: below full-
employment
equilibrium
21
The Production Function
- A relationship that shows the maximum qty
of real GDP that can be produced as the qty
of labor employed changes and all other
influences on production remain the same.
The production function displays diminishing
returns each additional hour of labor
employed produces a successively smaller
additional amount of real GDP.
22
Contd.
PF
attainable
unattainable Real
GDP
Labor (billions of hours per year
23
The Labor Market
The qty of labor employed depends on firms
decisions about how much labor to hire
(DL).
It also depends on households decisions
about how to allocate time between
employment and other activities (SL).
It depends on how the labor market
coordinates the decisions of firms and
households (labor market equilibrium).
24
Contd.
Demand for labor (DL) = total labor hours that
all the firms in the economy plan to hire
during a given time period at a given real
wage rate.
The DL is the relationship between the qty of
labor demanded and the real wage rate
when all other influences on firms hiring
plans remain the same.
The real wage rate is the nominal wage rate
divided by the price level i.e. W/P.
25
Contd.
DL
Real
wage
rate
Qty of labor (billions of hours/year
A rise in the real wage rate
decreases the qty of labor
demanded
A fall in the real wage rate
increases the qty of labor
demanded
26
Contd.
The qty of labor supplied (SL) = the
number of labor hours that all the
households in the economy plan to
work during a given time period at a
given wage rate.
The SL is the relationship between the
qty of labor supplied and the real
wage rate when all other influences
on work plans remain the same.
27
Contd.

Real
wage
rate
Labor (billions of hours/year)
A rise in the real wage rate
increases the qty of labor
supplied
SL
A fall in the real wage rate
decreases the qty of labor supplied
28
Labor market equilibrium
SL
DL
200 labor
Real
wage
rate
30
FE
equilibrium
PF
200
Real GDP
10
Potential
GDP
Full
employment
qty of labor
29
Changes in AS
AS changes when any influence on
production plans other than the price
level changes.
AS changes when
Potential GDP changes
The money wage rate changes
The money prices of other resources
change
30
An increase in potential GDP
ASo
AS1
Yp
Yp
Real GDP
Increase in potential GDP
Increase in AS when potential
GDP increases
Price
level
31
Changes in money wage rate and
other resource prices
A change in the money wage rate or
in the money price of another
resources changes AS because it
changes firms costs.
An increase in the money wage rate
or the price of another resources
decreases AS.
32
Contd.
AS1
ASo
Yp
Real GDP
Decrease in AS when money
wage rate rises
Price
level
The AS curve shifts leftward
from ASo to AS1. A rise in
the money wage rate does
not change potential GDP
33
Changes in AD
A change in any factor that influences
expenditure plans other than the price level
brings a change in AD.
When AD increases, the AD curve shifts
rightward.
When AD decreases, the AD curve shifts
leftward.
The factors that change AD are
Expectations about the future
Fiscal policy and monetary policy
The state of the world economy
34
Contd.
AD2
ADo
AD1
Real GDP
Price
level
AD curve shifts to the right
when (i) expected future
income, inflation or profits
increase, (ii) the government
increases planned expenditure,
and (iii) the exchange rate falls
or the global economy
expands.
AD curve shifts to the left when
(i) expected future income,
inflation, or profits decrease,
(ii) the government decreases
planned expenditure, and (iii)
the exchange rate rises/ the
global economy contracts.
35
Factors that shifts AD curve to the
right (summary)
in consumption spending (C)
in investment spending (I)
in government spending (G)
in exports (X)
in imports (M)
in taxes (which C and I)
in household wealth ( C)
in Ms (this i C, I)
36
Factors that shift the AD curve to
the left (summary)
C
I
G
X
M
T
household wealth
Ms
37
AD fluctuations
ADo
AD1
AD2
Real GDP
Price
level
Potential GDP
AS
38
AD fluctuations
AD4
AD3
AD2
Real GDP
Price
level
Potential GDP
AS
39
AS fluctuations
AD
Real GDP
Price
level
Potential GDP
ASo
AS1
A rise in the price of
oil decreases AS. AS
curve shifts
leftward from ASo
to AS1.
Real GDP , and the
price level
40
AS fluctuations (contd.)
AD
Real GDP
Price
level
Potential GDP
ASo
A fall in the price of
oil decreases AS. AS
curve shifts
rightward from ASo
to AS2.
Real GDP , and the
price level
AS2
41
Adjustment toward full employment

When the economy is away from FE, forces begin to
operate that move it back toward FE.

AS is ASo, AD from ADo to AD1
Real GDP above FE
Inflationary gap a gap that exists when real GDP > potential
GDP and that brings a rising price level.
Workers have experienced in the buying power.
Workers DD higher wages.
AS decreases and AS curve shifts leftward from ASo to AS1.
Real GDP is back at potential GDP. (see next slide)
42
Contd.
AD1
Real GDP
Price
level
Potential GDP
AS1
ASo
ADo
Inflationary gap
43
Contd.
As is AS1 and a decrease in AD from AD1 to AD2 real
GDP below FE deflationary gap gap that exists
when potential GDP > real GDP and that brings a
falling price level.
Buying power
Firms profits shrink
With a labor surplus, the money wage rate gradually falls
AS curve shifts rightward from AS1 to AS2
Real GDP is back at potential GDP (see next slide)
44
Contd.
AD1
Real GDP
Price
level
Potential GDP
AS1
AS2
AD2
deflationary gap