Chapter 23

Aggregate
Supply and
Aggregate
Demand in the
Short Run

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 In this chapter you will learn to

1. Explain why an exogenous change in the price level shifts

the AE curve and changes the equilibrium level of real
GDP.
2. Derive the aggregate demand (AD) curve and what causes
it to shift.
3. Explain the meaning of the aggregate supply (AS) curve
and why it shifts when technology or factor prices change.
4. Describe and define macroeconomic equilibrium.
5. Analyze the impacts of aggregate demand and aggregate
supply shocks on real GDP and the price level.
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 The Demand Side of the Economy

Exogenous Changes in the Price Level

An increase in P reduces the real value of money holdings.

A fall in P raises the real value of money holdings.

Changes in P also affect the wealth of bondholders and bond

issuers
- but there is no change in aggregate wealth

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 The Demand Side of the Economy

Changes in Consumption
An increase in P thus reduces private-sector wealth:
- reduction in desired consumption
- downward shift in AE curve

Changes in Net Exports

There is also an effect on net exports:
- the NX function shifts downward
- further downward shift in AE curve
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Figure 23.1 Desired Aggregate
Expenditure and the Price Level

An increase in P reduces
desired aggregate
expenditure:
- AE shifts down
- equilibrium Y falls

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 The Aggregate Demand Curve

The aggregate demand (AD) curve relates equilibrium real

GDP to the price level.

For any given P, the AD curve shows the level of real GDP for
which desired aggregate expenditure equals actual GDP.

Changes in the price level cause movements along the AD

curve.

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Figure 23.2 Derivation of the
AD Curve

Consider a rise in the price

level, from P0 to P2:

The AE curve shifts

down, but we move along
the AD curve.

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Figure 23.3 The Simple Multiplier
and Shifts in the AD Curve

Any shock that increases

equilibrium GDP at a given
price level shifts the AD curve
to the right.

The horizontal shift of the AD

curve is the simple multiplier
times the change in
autonomous spending.

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 The Simple Multiplier and the
AD Curve

The simple multiplier measures the horizontal shift in the

AD curve in response to a change in autonomous desired
expenditure.

If the price level is constant and producers are willing to

supply everything that is demanded at that price level,
then the simple multiplier will also show the change in
equilibrium income that will occur in response to a change
in the autonomous expenditure.

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 The Supply Side of the Economy

The Aggregate Supply Curve

The AS curve relates the price level to the quantity of output
that firms would like to produce and sell.

The AS curve is drawn for a given

- level of technology
- set of factor prices.

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 The Slope of the AS Curve

As unit costs rise with output, firms will produce more output
only if prices increase.
 AS curve is upward sloping

The slope of the AS Curve has an increasing slope:

– Low output: firms have excess capacity
– High output (above normal capacity): unit costs rise
more rapidly.

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Figure 23.4 The Aggregate
Supply Curve

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Figure 23.5 Shifts in the AS
Curve

Anything that
increases firms’ costs
causes the AS curve to
shift up:
- factor prices
- technology

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The Slope of the AS Curve

The slope of the AS curve is increasing as output rises:

- when output is low, firms have excess capacity
 costs do not rise quickly

- when output is nearer Y*, costs rise as output rises

 firms need higher prices

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Figure 23.6 Macroeconomic
Equilibrium

Demand behavior is
consistent with
supply behaviour
only at the
intersection of the
two curves.

E0 is the
macroeconomic
equilibrium.

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Changes in the Macroeconomic
Equilibrium

Demand shocks can either be expansionary or contractionary

- direction of AD shift

Supply shocks can either be expansionary or contractionary

- direction of the AS shift

In both cases, “expansionary” or “contractionary” refers to the

effect on equilibrium output.

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Figure 23.7 Aggregate
Demand Shocks

Demand shocks cause P

and Y to change in the
same direction.

Possible causes:
1. ΔG > 0
2. ΔI > 0
3. ΔX > 0
4. ΔC > 0

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Figure 23.8 The Multiplier When
the Price Level Varies

The shock causes the AE curve

to shift upward, but the rise in
the price level causes it to shift
down.

With an upward sloping AS

curve, the multiplier is smaller
than the simple multiplier.

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Figure 23.9 The Effects of
Increases in Aggregate Demand

The effect of any given shift

of the AD curve will depend
on the slope of the AS curve.

The steeper the AS curve, the

greater the price effect and
the smaller the output effect.

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The Importance of the Shape of the
AS Curve

We have now seen that the shape of the AS curve has

important implications for how the effects of an AD shock are
divided between changes in real GDP and changes in the
price level. For any change in AD:

• Flat range of AS: no change in prices but a change in

output

• Positively sloped AS : changes in both the price level and

output
• Steep range of AS : little change in output but more
change in the price level
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The Keynesian AS Curve

EXTENSIONS IN THEORY 23.1

The Keynesian AS Curve

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Figure 23.10 A Negative
Aggregate Supply Shock

Aggregate supply shocks cause P

and Y to change in opposite
directions.

Possible causes:
- Δ price of inputs
- Δ wages
- Δ technology

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 A Word of Warning

Many economic events (especially changes in the world prices

of raw materials) cause both aggregate demand and
aggregate supply shocks.

The overall effect on the economy depends on the relative

importance of the two separate effects.

APPLYING ECONOMIC CONCEPTS 23.1

Hurricane Katrina and the U.S.
Economy

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