ECON102 Study Guide

Unit 3: Aggregate Demand, Supply, and Equilibrium

3a. Graphically represent and interpret the aggregate demand curve and explain why it slopes downward

  • Why does the product demand curve slope downward?
  • Why does a change in the price level lead to a change in demand in terms of real GDP?

The aggregate demand curve resembles the product demand curve we reviewed in Unit 1. The aggregate demand curve slopes downward to reflect the negative relationship between price level (on the vertical axis) and real GDP (on the horizontal axis). Three important effects lead to the negative slope of the aggregate demand curve, which are all caused by a change in the price level, including the wealth effect, the interest rate effect, and the foreign price effect.

The wealth effect, the interest rate effect, and the foreign price effect influence the downward slope of the aggregate demand curve. Although "a higher price level for final outputs reduces the aggregate demand level for all three reasons", this does not result in a large change in price level.

The wealth effect argues that the buying power of the savings people have saved in bank accounts and other assets diminishes as the price level increases. Consumption spending falls as the price level rises due to a rise in the price level. The people's wealth falls, and it is eaten away by inflation to some extent.

The interest rate effect argues that the buying power of savings people have saved in bank accounts and other assets diminishes when the price of outputs increases. In effect, purchases require more money or credit. In addition, the increased demand for money and credit pushes interest rates even higher. In turn, higher interest rates cause businesses to limit borrowing for investment, and households borrow less to purchase homes and cars – reducing consumption and investment spending.

The foreign price effect argues that U.S. goods are relatively more expensive than goods in the rest of the world when U.S. prices rise (but remain fixed in other countries). Since U.S. exports become relatively more expensive, the quantity of U.S. exports sold will fall. The quantity of U.S. imports rises because importing goods from abroad is relatively cheaper. Consequently, higher domestic price levels, relative to price levels in other countries, reduce net export expenditures.

Review this graph, which illustrates factors that 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. As price levels rise, total spending on domestic goods and services declines.

– From OpenStax, https://openstax.org/books/principles-macroeconomics-3e/pages/11-4-shifts-in-aggregate-demand


Aggregate demand (AD) slopes down, showing the amount of total spending on domestic goods and services decreases as the price level rises.

The demand curve for goods and services slopes down due to the availability of substitute goods, not the wealth effect, interest rate, or foreign price effects associated with aggregate demand curves.

To review, see:


3b. Analyze factors leading to shifts in the aggregate demand curve

  • What factors lead to shifts in the aggregate demand curve?

Factors that shift the short-run aggregate supply curve include:

  • Aggregate stock, or amount, of available capital;
  • Aggregate stock, or amount, of available natural resources;
  • Aggregate level of technology and innovation; and,

Aggregate cost, or prices of the factors of production.

Short-run aggregate supply is upward-sloping and represents the total production of goods and services available in an economy at different price levels while some resources are fixed. The long-run aggregate supply is an economy's production level when all available resources are used efficiently. It equals the highest level of production an economy can sustain. Changes in prices of factors of production shift the short-run aggregate supply curve. Changes in capital stock, the stock of natural resources, and technology levels can also cause the short-run aggregate supply curve to shift. The long-run aggregate supply curve is perfectly inelastic and vertical because firms can adapt to price-level changes better in the long run than in the short run.

We can look at all of the factors above and think of them as necessary for the production of other goods and services. When these "inputs'' become less or more available, productivity is impacted. In the long run, the most important factor that shifts the aggregate supply curve is due to growth in productivity. For example, the same quantity of labor can produce more output. This moves the AS curve rightward since better productivity lets firms make more output at each price.

The AS curve shifts out from short-run aggregate supply SRAS0 to SRAS1, to SRAS2, etc. The equilibrium shifts from E0 to E1 to E2, etc. Because of increased productivity, workers produce more GDP. At full employment, this leads to a higher potential GDP and a rightward shift of the long-run supply curve from LRAS0 to LRAS1 to LRAS2.

The AS curve shifts out from short-run aggregate supply SRAS0 to SRAS1, to SRAS2, etc. The equilibrium shifts from E0 to E1 t


Increased costs for inputs like labor and energy push the SRAS curve left. At every output price, higher input costs lower production due to decreased profit potential. A shift occurs to the left for a new equilibrium. This new relationship between price levels for inputs and decreased GDP can bring recession, higher unemployment, and inflation (stagflation).

A decline in the price of inputs will have the reverse effect. A decline in the price of a key input will shift the SAS to the right, thereby providing an incentive for firms to produce more at every given price level of output. This can result in economic expansion, lower unemployment, and a decline in inflation. Other key inputs that may shift the SRAS curve include the cost of labor (wages) and the cost of imported goods used as inputs for other products. (The long-run aggregate supply curve usually does not shift with a change in input prices, only the short-run aggregate supply curve).

To review, see:

 

3c. Graphically represent and interpret a short-run aggregate supply curve and explain why it slopes upward

  • Why does the product supply curve slope upward?

The short-run aggregate supply curve resembles the product supply curve we reviewed in Unit 1. The short-run aggregate supply curve slopes upward to reflect the positive relationship between price level (on the vertical axis) and real GDP (on the horizontal axis).

Just as when we studied the supply and demand curves for a limited customer base or business, remember that the short-run aggregate supply curve is a ratio plotted on a graph that depicts the relationship between price (the y-axis) and Real GDP (the x-axis). So, a price fluctuation will cause a movement along the short-run aggregate supply curve (you can see the points on the supply curve refer to Real GDP based on a given price). Price fluctuations do not shift the short-run aggregate supply curve.

See the diagrams below to see examples of movement along the SRAS curve. Changes in price levels may cause movements along the SRAS curve. When prices increase, businesses record profits and increase their production levels. Conversely, when price levels fall, they reduce production levels. This change in price levels and quantity supplied (output) causes movement along the aggregate supply curve. The aggregate supply curve will shift when costs such as labor or other inputs rise or fall. Shocks to input goods, such as labor markets, imported goods used as inputs for other products, etc., may also shift the aggregate supply curve.

Image credit: http://www.economicshelp.org

To review, see:


3d. Analyze the factors leading to shifts in the short-run aggregate supply curve

  • What factors lead to wage and price stickiness?
  • What role do employment contracts play in maintaining a fixed wage?
  • How do efficiency wage theory, implicit contracts theory, the adverse selection of wage cuts argument, the insider-outsider model of the labor force, and the relative wage coordination argument help explain wage stickiness?

Prices and wages often fail to adjust quickly to changes in the economic environment. As Keynes argued, sticky wages and sticky prices can contribute to sustained periods of economic divergence from long-run equilibrium.

To review these theories, see:


3e. Graphically represent and interpret a long-run aggregate supply curve and short-run and long-run equilibrium

  • What types of employment does the natural level of employment represent and exclude?
  • What is the shape of the long-run aggregate supply (LRAS) curve?
  • What factors shift the aggregate supply curve over time?

The long-run aggregate supply curve compares the price level to the level of real GDP in the long-run. Note that we draw the long-run aggregate supply curve vertically at a fixed level of real GDP (the level of real GDP associated with the natural level of employment). An economy that experiences employment levels lower than the natural level of employment indicates the presence of cyclical unemployment.

The image below depicts the long-run aggregate supply curve at full employment. You will notice it is vertical!

The image depicts the long-run aggregate supply curve at full employment. You'll notice it is vertical!


To review, see Aggregate Demand and Aggregate Supply and Short- and Long-Run AD and AS.


3f. Examine how aggregate demand and aggregate supply determine the equilibrium price level and level of real GDP

  • How do aggregate demand and aggregate supply determine the equilibrium price level and level of real GDP?

The diagrams below help us to understand how new equilibriums are established with changes in price levels and real GDP.

– From OpenStax, https://openstax.org/books/principles-macroeconomics-3e/pages/11-5-how-the-ad-as-model-incorporates-growth-u


"A shift in aggregate demand from AD0 to AD1, when it occurs in the area of the SRAS curve that is near potential GDP, leads to a higher price level and pressure for a higher price level and inflation. The new equilibrium (E1) is at a higher price level (P1) than the original equilibrium. A shift in aggregate supply from SRAS0 to SRAS1 will lead to a lower real GDP and pressure for a higher price level and inflation. The new equilibrium (E1) is at a higher price level (P1), while the original equilibrium (E0) is at a lower price level (P0)."

To review, see:

 

3g. Apply the AD-AS model to explain demand-pull and cost-push inflation and recession

  • What are demand-pull inflation and cost-push inflation?

To identify sources of inflation, consider the demand and supply framework where companies determine equilibrium price and quantity. A shift in demand to the right or a shift in supply to the left will increase prices. See the illustration below for a graphic description of what occurs relative to the factors listed on the left in cost-push inflation and demand-pull inflation.

Image credit: https://slidesharenow.blogspot.com/2019/10/cost-push-vs-demand-pull.html


To review, see:


3h. Explain recessionary and inflationary gaps, the natural unemployment rate, and potential income

  • What can we say about the level of real GDP during a recessionary gap?
  • What is the level of employment during a recessionary gap?
  • Do sticky wages cause a recessionary gap to persist?
  • What can we say about the level of real GDP during an inflationary gap?
  • What is the level of employment during an inflationary gap?
  • Do sticky wages cause an inflationary gap to persist?
  • What actions can help reestablish the long-run equilibrium to eliminate an inflationary gap?

A recessionary gap is not the same as a recession. A recessionary gap describes an economic situation where unemployment exceeds the natural levels. A recession, on the other hand, indicates a falling real GDP. A recession can, and often does, lead to a recessionary gap.

A Recessionary Gap -– From https://saylordotorg.github.io/text_principles-of-macroeconomics-v2.0/s10-03-recessionary-and-infl

A Recessionary Gap


"When employment is below the natural level, as shown in Panel (a), then output must be below potential. Panel (b) shows the recessionary gap YP − Y1, which occurs when the aggregate demand curve (AD) and the short-run aggregate supply curve (SRAS) intersect to the left of the long-run aggregate supply curve (LRAS)."

An inflationary gap is a long-run disequilibrium situation. An inflationary gap describes the opposite situation to a recessionary graph, as illustrated in the graphs.

– From https://saylordotorg.github.io/text_principles-of-macroeconomics-v2.0/s10-03-recessionary-and-inflationary-.html

An Inflationary Gap


"When employment is above the natural level, the output must be above the potential. The inflationary gap equals Y1 − YP. The aggregate demand curve (AD) and the short-run aggregate supply curve (SRAS) intersect to the right of the long-run aggregate supply curve (LRAS)."

To review, see How the AD/AS Model Incorporates Growth, Unemployment, and Inflation and Recessionary and Inflationary Gaps and Long-Run Macroeconomic Equilibrium.


3i. Explain different schools of thought about the shape of the aggregate supply curve

  • What actions can governments take to help re-establish the long-run equilibrium to eliminate a recessionary gap?
  • Without active government policy, how will adjustments among wages and prices (unsticking) eventually lead to a shift of the short-run aggregate supply curve toward the long-run equilibrium real GDP?
  • What did classical economic theorists and Keynesians recommend policymakers do when a long-run disequilibrium occurs to help the economy move toward equilibrium?

The intersection of the short-run aggregate demand and supply curves describes a short-run equilibrium of the price level and real GDP. We describe this equilibrium as a long-run equilibrium when the level of real GDP equals the level associated with the "natural level of employment" or equals the real GDP for the long-run aggregate supply (LRAS) curve.

A common policy disagreement exists about the options a country has to address long-run disequilibrium. According to the classical view, an economy can recover from a downturn through adjustments in the labor market. This requires flexible wages and prices.

We know wages and prices are sticky. A long-run disequilibrium can persist until the wages and prices are able to adjust to changes in the economy. Wages and prices need to unstick.

To review, see Keynes' Law and Say's Law in the AD/AS Model and Macroeconomic Viewpoints.


Unit 3 Vocabulary

  • aggregate demand curve
  • cost-push inflation
  • demand-pull inflation
  • foreign price effect
  • inflationary gap
  • interest rate effect
  • long-run equilibrium
  • recessionary gap
  • wealth effect