Aggregate Demand and Aggregate Supply

This chapter introduces the Aggregate Demand/Aggregate Supply model of macroeconomics. Read the introduction and Section 1 to learn about Aggregate Demand and the three effects (weath, interest rate, and international trade) that cause the downward slope. Recall the difference between quantity demanded and demand - the same logic applies to Aggregate Demand. Identify the variables that change (shift) the Aggregate Demand curve. Read this chapter and attempt the "Try It" exercises. You will revisit certain sections of the chapter later in this unit.

Recessionary and Inflationary Gaps and Long-Run Macroeconomic Equilibrium

Restoring Long-Run Macroeconomic Equilibrium

We have already seen that the aggregate demand curve shifts in response to a change in consumption, investment, government purchases, or net exports. The short-run aggregate supply curve shifts in response to changes in the prices of factors of production, the quantities of factors of production available, or technology. Now we will see how the economy responds to a shift in aggregate demand or short-run aggregate supply using two examples presented earlier: a change in government purchases and a change in health-care costs. By returning to these examples, we will be able to distinguish the long-run response from the short-run response.

A Shift in Aggregate Demand: An Increase in Government Purchases

Suppose an economy is initially in equilibrium at potential output YP as in Figure 7.12 "Long-Run Adjustment to an Inflationary Gap". Because the economy is operating at its potential, the labor market must be in equilibrium; the quantities of labor demanded and supplied are equal.

Figure 7.12 Long-Run Adjustment to an Inflationary Gap

An increase in aggregate demand to AD₂ boosts real GDP to Y₂ and the price level to P₂, creating an inflationary gap of Y₂−Y_P. In the long run, as price and nominal wages increase, the short-run aggregate supply curve moves to SRAS₂. Real GDP returns to potential.

Now suppose aggregate demand increases because one or more of its components (consumption, investment, government purchases, and net exports) has increased at each price level. For example, suppose government purchases increase. The aggregate demand curve shifts from AD₁ to AD₂ in Figure 7.12 "Long-Run Adjustment to an Inflationary Gap". That will increase real GDP to Y₂ and force the price level up to P₂ in the short run. The higher price level, combined with a fixed nominal wage, results in a lower real wage. Firms employ more workers to supply the increased output.

The economy's new production level Y₂ exceeds potential output. Employment exceeds its natural level. The economy with output of Y₂ and price level of P₂ is only in short-run equilibrium; there is an inflationary gap equal to the difference between Y₂ and Y_P. Because real GDP is above potential, there will be pressure on prices to rise further.

Ultimately, the nominal wage will rise as workers seek to restore their lost purchasing power. As the nominal wage rises, the short-run aggregate supply curve will begin shifting to the left. It will continue to shift as long as the nominal wage rises, and the nominal wage will rise as long as there is an inflationary gap. These shifts in short-run aggregate supply, however, will reduce real GDP and thus begin to close this gap. When the short-run aggregate supply curve reaches SRAS₂, the economy will have returned to its potential output, and employment will have returned to its natural level. These adjustments will close the inflationary gap.

A Shift in Short-Run Aggregate Supply: An Increase in the Cost of Health Care

Again suppose, with an aggregate demand curve at AD₁ and a short-run aggregate supply at SRAS₁, an economy is initially in equilibrium at its potential output Y_P, at a price level of P₁, as shown in Figure 7.13 "Long-Run Adjustment to a Recessionary Gap". Now suppose that the short-run aggregate supply curve shifts owing to a rise in the cost of health care. As we explained earlier, because health insurance premiums are paid primarily by firms for their workers, an increase in premiums raises the cost of production and causes a reduction in the short-run aggregate supply curve from SRAS₁ to SRAS₂.

Figure 7.13 Long-Run Adjustment to a Recessionary Gap

A decrease in aggregate supply from SRAS₁ to SRAS₂ reduces real GDP to Y₂ and raises the price level to P₂, creating a recessionary gap of Y_P−Y₂. In the long run, as prices and nominal wages decrease, the short-run aggregate supply curve moves back to SRAS₁ and real GDP returns to potential.

As a result, the price level rises to P₂ and real GDP falls to Y₂. The economy now has a recessionary gap equal to the difference between Y_P and Y₂. Notice that this situation is particularly disagreeable, because both unemployment and the price level rose.

With real GDP below potential, though, there will eventually be pressure on the price level to fall. Increased unemployment also puts pressure on nominal wages to fall. In the long run, the short-run aggregate supply curve shifts back to SRAS₁. In this case, real GDP returns to potential at Y_P, the price level falls back to P₁, and employment returns to its natural level. These adjustments will close the recessionary gap.

How sticky prices and nominal wages are will determine the time it takes for the economy to return to potential. People often expect the government or the central bank to respond in some way to try to close gaps. This issue is addressed next.