CHAPTER

8
AGGREGATE
DEMAND
AND
ECONOMICS
Roger A. Arnold • Thirteenth Edition AGGREGATE
SUPPLY
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 8-1 A Way to View the Economy

8-2 Aggregate Demand

8-3 Short-Run Aggregate Supply

8-4 Putting AD and SRAS Together: Short-

Run Equilibrium

8-5 Long-Run Aggregate Supply

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 8-1 A Way to View the Economy (1 of 2)

• This chapter begins our theoretical discussion of an

economy
• We can think of it as consisting of two major
activities: buying and producing (See Exhibit 1)
• When economists speak about aggregate demand
(AD), they are speaking about the buying side
• When they speak about aggregate supply, they are
speaking about the producing side

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 EXHIBIT 1

An Economy

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 8-2 Aggregate Demand (1 of 15)

• Aggregate Demand: The quantity demanded of all goods

and services (Real GDP) at different price levels, ceteris
paribus

• Aggregate Demand Curve: A curve that shows the

quantity demanded of all goods and services (Real GDP) at
different price levels, ceteris paribus

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 EXHIBIT 2

The Aggregate Demand Curve

– The aggregate
demand curve is
downward sloping,
specifying an
inverse
relationship
between the price
level and the
quantity
demanded of Real
GDP.

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 8-2 Aggregate Demand (2 of 15)

• 8-2a Why Does the Aggregate Demand Curve Slope

Downward? (cont)

• Because of three effects:

1- Purchasing Power
2- Interest Rate Effect
3- International Trade Effect

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 8-2 Aggregate Demand (3 of 15)

• Purchasing Power & Real Balance Effect

• Real Balance Effect: The change in the
purchasing power of dollar-denominated assets that
results from a change in the price level
• Monetary Wealth: The value of a person’s
monetary assets.
• Wealth: as distinguished from monetary wealth,
refers to the value of all assets owned, both
monetary and nonmonetary.
– In short, a person’s wealth equals his or her monetary
wealth (e.g., $1,000 cash) plus nonmonetary wealth
(e.g., a car or a house)

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 8-2 Aggregate Demand (4 of 15)

• 1- Purchasing
Power: The
quantity of goods
and services that
can be purchased
with a unit of
money. Purchasing
power and the
price level are
inversely related.
As the price level
goes up (down),
purchasing power
goes down (up)
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 8-2 Aggregate Demand (5 of 15)

• 2- Interest Rate
Effect: The
changes in
household and
business buying as
the interest rate
changes

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 8-2 Aggregate Demand (6 of 15)

• 3- International
Trade Effect:
The change in
foreign sector
spending as the
price level changes

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 8-2 Aggregate Demand (7 of 15)

• 8-2b An Important Word on the Three Effects

• The aggregate demand curve is downward
sloping because of the real balance effect, interest
rate, and international trade effects.
• Keep in mind that what caused these three effects
is a change in the price level
• Why is this point important? The interest rate can
change as a result of things other than the price
level changing, and not everything that changes the
interest rate leads to a movement from one point to
another point on the AD curve
• Other things that change the interest rate can lead
to a shift in the AD curve instead

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 8-2 Aggregate Demand (8 of 15)

• 8-2c A Change in Quantity Demanded of Real GDP

Versus a Change in Aggregate Demand
• As the price level falls, the quantity demanded of
Real GDP rises, ceteris paribus
• In Exhibit 4(a), a change in the quantity
demanded is represented as a movement from one
point (A) on AD1 to point (B) on AD1
• A change in aggregate demand is represented in
Exhibit 4(b) as a shift in the aggregate demand
curve from AD1 to AD2
• When the aggregate demand curve shifts, the
quantity demanded of Real GDP changes even
though the price level remains constant

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 EXHIBIT 4
A Change in the Quantity Demanded of Real GDP
Versus a Change in the Aggregate Demand

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 8-2 Aggregate Demand (9 of 15)

• 8-2d Changes in the Aggregate Demand: Shifts in the AD Curve

• Aggregate demand changes when spending on U.S. goods and
services changes:

• 8-2e How Spending Components Affect Aggregate Demand

• We can relate the components of spending to U.S. aggregate demand:

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 EXHIBIT 5

Changes in Aggregate Demand

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 8-2 Aggregate Demand (10 of 15)

• 8-2f Why Is There More Total Spending?

• Aggregate demand rises only if total spending rises
at a given price level
• Total spending can rise for one of two reasons:
– The first deals with a decline in prices and leads to a
movement along a given AD curve
– The second deals with a change in some factor other
than prices and leads to a shift in the AD curve

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 8-2-A Factors Affect Consumption (C)

1- Wealth: The value of all

assets owned, both monetary
and nonmonetary

2- Expectations About
Future Prices and Income

3- Interest Rate

4- Income Taxes

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 8-2-B Factors Affect Investment (I)

1- Interest Rate

2- Expectations
About Future
Sales

3- Business Taxes

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 8-2-C Factors Affect Net Exports (NX)

1- Foreign Real National Income

2- Exchange Rate: The price of one currency in

terms of another currency
• Appreciated: An increase in the value of one currency
relative to other currencies
• Depreciated: A decrease in the value of one currency
relative to other currencies
– Depreciation in a nation’s currency makes foreign goods
more expensive

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 EXHIBIT 6

Factors That Change Aggregate Demand

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 8-2 Aggregate Demand (15 of 15)

• 8-2h Can a Change in the Money Supply Change

Aggregate Demand?
• Most economists would say that it does, but they
differ on how
• One way to explain the effect is this:
1. A change in the money supply affects interest rates
2. A change in interest rates changes consumption and
investment, and
3. A change in consumption and investment affects
aggregate demand
• Therefore, a change in the money supply is a
catalyst in a process that ends with a change in
aggregate demand
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 8-2 Aggregate Demand

• 8-2i If Consumption Rises, Does Some Other Spending

Component Have to Decline?
• Yes, if neither the money supply nor velocity changes - (If
both the money supply and velocity are constant, a rise in one
spending component (such as consumption) necessitates a
decline in one or more other spending components.

• Velocity: The average number of times a dollar is spent to

buy final goods and services in a year

• No, if either the money supply or velocity rises – (If either the
money supply or velocity rises, one spending component can
rise without requiring other spending components to decline.)

• Total spending in the economy can be a greater dollar amount

than the money supply
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 8-2 Self-Test

1- Explain the real balance effect.

• Real balance effect: a rise (fall) in the price level

causes purchasing power to fall (rise), which
decreases (increases) a person’s monetary wealth.
As people become less (more) wealthy, the quantity
demanded of Real GDP falls (rises).

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 8-2 Self-Test

2- Explain what happens to the AD curve if the dollar

appreciates relative to other currencies.

• If the dollar appreciates, it takes more foreign

currency to buy a dollar and fewer dollars to buy
foreign currency. This makes U.S. goods
(denominated in dollars) more expensive for
foreigners and foreign goods cheaper for Americans.
In turn, foreigners buy fewer U.S. exports, and
Americans buy more foreign imports. As exports fall
and imports rise, net exports fall. If net exports fall,
total expenditures fall, ceteris paribus. As total
expenditures fall, the AD curve shifts to the left.
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 8-2 Self-Test

3- The money supply has risen, but total spending has

declined. Is this possible? Explain your answer.

• Total spending is the product of the money supply

and velocity. Let the money supply be $400 and
velocity 3. Then total spending is $1,200. Now,
suppose that the money supply rises to $500 but
velocity declines to 2. Then total spending has fallen
to $1,000, even though the money supply has
increased. So, yes, the money supply can rise while
total spending declines.

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 8-3 Short-Run Aggregate Supply (1 of 2)

• Aggregate Supply: The quantity supplied of all goods

and services (Real GDP) at different price levels, ceteris
paribus
• 8-3a Short-Run Aggregate Supply Curve: What It Is and
Why It Is Upward Sloping?
• Short-Run Aggregate Supply (SRAS) Curve: A curve
that shows the quantity supplied of all goods and
services (Real GDP) at different price levels, ceteris
paribus
• Why is the SRAS curve (Exhibit 7) upward
sloping? Economists have suggested a few
explanations; we discuss two of them:
– Sticky Wages
– Worker Misperceptions
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 EXHIBIT 7

The Short-Run Aggregate Supply Curve

The short-run
aggregate supply
curve (SRAS) is
upward sloping,
specifying a direct
relationship
between the price
level and the
quantity supplied of
Real GDP.

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 8-3 Sticky Wages, the Real Wage Rate, and
SRAS

• Wages are “locked in” for a few years due to labor

contracts or perhaps because of social conventions or
perceived notions of fairness.

• While firms pay nominal wages, they often decide how

many workers to hire based on real wages.

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 8-3 A. Sticky Wages, the Real Wage
Rate, and SRAS
• The Real wage = Nominal wage/Price level.
• Price level ↑ → Real wage ↓, ceteris paribus
• Price level ↓ → Real wage ↑, ceteris paribus

• More individuals are willing to work, and current workers

are willing to work more at higher real wages than at
lower real wages and vice versa.
• Real wage↑ → Quantity of labor supplied ↑
• Real wage↓ → Quantity of labor supplied ↓

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 8-3 A. Sticky Wages and the Real Wage
Rate - Firms
• Firms will employ more workers the cheaper it is to hire
them.
• Real wage ↑ → Quantity of labor demanded ↓
• Real wage ↓ → Quantity of labor demanded ↑

• Thus, if wages are sticky, an increase in the price level

(which pushes real wages down) will result in a increase
in output.
• This is what an upward-sloping SRAS curve represents: As
the price level rises, the quantity supplied of goods and
services rises.
• The opposite occurs if price levels fall.

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 8-3 B. Worker Misconceptions

• If workers misperceive real wage changes, then a fall in

the price level will bring about a decline in output,
ceteris paribus, which is illustrative of an upward-sloping
SRAS curve.

• In response to (the misperceived) falling real wage,

workers may reduce the quantity of labor they are
willing to supply. With fewer workers (resources), firms will
end up producing less.

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 EXHIBIT 8
Wage Rates and a Shift in the Short-Run Aggregate
Supply Curve

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 8-3 Changes in SRAS

• Shifts in the SRAS curve may be caused by changes

in:

A. Wage rates
B. Prices of non-labor inputs
C. Productivity
D. Supply shocks
– Adverse
– Beneficial

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 8-3 A. Changes Wage Rates

• The impact of a rise or fall in equilibrium wage rates can

be understood in terms of the following equation:
• Profit per unit = Price per unit - Cost per unit

• Higher wage rates mean higher costs and, at constant

prices, translate into lower profits and a reduction in the
number of units (of a given good) that firms will want to
produce.

• Lower wage rates mean lower costs and, at constant

prices, translate into higher profits and an increase in the
number of units (of a given good) firms will decide to
produce.
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 8-3 B. Changes in the Price of Non-labor
Inputs

• Changes in the prices of non-labor inputs affect the

SRAS curve in the same way as changes in wage
rates do.

• An increase in the price of a non-labor input (e.g.,

oil) shifts the SRAS curve leftward; a decrease in
their price shifts the SRAS curve rightward.

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 8-3 C. Changes in the Productivity

• Productivity is the output produced per unit of input

employed over some period of time. Although
various inputs can become more productive, let’s
consider the labor input.
• An increase in labor productivity means businesses
will produce more output with the same amount of
labor, causing the SRAS curve to shift rightward.
• A decrease in labor productivity means businesses
will produce less output with the same amount of
labor, causing the SRAS curve to shift leftward.
• A host of factors lead to increased labor
productivity, including a more educated labor
force, a larger stock of capital goods, and
technological advancements.
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 8-3 D. Supply Shocks

• Major natural or institutional changes that affect

aggregate supply are referred to as supply shocks.
Supply shocks are of two varieties.

• Adverse supply shocks shift the SRAS curve

leftward.
• Beneficial supply shocks shift the SRAS curve
rightward

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 EXHIBIT 9

Changes in Short-Run Aggregate Supply

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 8-3 Self-Test

1- If wage rates decline, explain what happens to the

short-run aggregate supply (SRAS) curve.

• As wage rates decline, the cost per unit of

production falls. In the short run (assuming prices
are constant), profit per unit rises. Higher profit
causes producers to produce more units of their
goods and services. In short, the SRAS curve shifts to
the right.

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 8-3 Self-Test

2- Give an example of an increase in labor

productivity.

• Last year, 10 workers produced 100 units of good X

in 1 hour. This year, 10 workers produced 120 units
of good X in 1 hour.

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 8-3 Self-Test

3- Discuss the details of the worker misperceptions

explanation for the upward-sloping SRAS curve.

• Workers initially misperceive the change in their real

wage due to a change in the price level. For example,
suppose the nominal wage is $30 and the price level is
1.50; it follows that the real wage is $20.
• Now suppose the nominal wage falls to $25 and the
price level falls to 1.10. The real wage is now $22.72. But
suppose workers misperceive the decline in the price
level and mistakenly believe it has fallen to 1.40. They will
now perceive their real wage as $17.85 ($25/1.40).

(continued)

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 8-3 Self-Test

3- Discuss the details of the worker misperceptions

explanation for the upward-sloping SRAS curve.
(continued)

• In other words, they will misperceive their real wage

as falling when it has actually increased.
• How will workers react if they believe their real
wage has fallen? They will cut back on the quantity
supplied of labor, which will end up reducing
output (or Real GDP). This process is consistent with
an upward-sloping SRAS curve: A decline in the
price level leads to a reduction in output.
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 8-4 Putting AD and SRAS Together: Short-
Run Equilibrium
• Short-Run Equilibrium: The condition in the economy
when the quantity demanded of Real GDP equals the
(short-run) quantity supplied of Real GDP. This condition
is met where the aggregate demand curve interacts the
short-run aggregate supply curve
• 8-4a How Short-Run Equilibrium in the Economy is
Achieved
• Exhibit 10 shows an aggregate demand (AD) curve
and a short-run aggregate supply (SRAS) curve
• The quantity demanded of Real GDP and the quantity
supplied of Real GDP are illustrated at 3 different price
levels, P1, P2, and P3
• A change in aggregate demand in short-run
aggregate supply or both, will affect the price level
and/or Real GDP (Exhibit 11)
44
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 EXHIBIT 10

Short-Run Equilibrium

• At P1, the quantity supplied of

Real GDP is greater than the
quantity demanded. As a result,
the price level falls and firms
decrease output.

• At P2, the quantity demanded of

Real GDP is greater than the
quantity supplied. As a result, the
price level rises and firms
increase output.

• Short-run equilibrium occurs at

point E, where the quantity
demanded of Real GDP equals
the (short-run) quantity supplied.
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 EXHIBIT 11

Changes in Short-Run Equilibrium in the Economy

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 EXHIBIT 12

How a
Factor
Affects the
Price Level
and Real
GDP in the
Short Run

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 EXHIBIT 14

A Summary Exhibit of AD and SRAS

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 8-5 Long-Run Aggregate Supply

• Natural Real GDP: The Real GDP that is produced at

the natural unemployment rate. Also, the Real GDP that
is produced when the economy is in long-run equilibrium
• Long-Run Aggregate Supply (LRAS) Curve: A curve
that represents the output the economy produces when
wages and prices have adjusted to their final equilibrium
levels and when workers do not have any relevant
misperceptions. The LRAS curve is a vertical line at the
level of Natural Real GDP
• Long-Run Equilibrium: The condition that exists in the
economy when wages and prices have adjusted to their
(final) equilibrium levels and when workers do not have
any relevant misperceptions. Graphically, long-run
equilibrium occurs at the intersection of the AD and LRAS
curves
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 EXHIBIT 15

Long-Run Aggregate Supply (LRAS) Curve

• The LRAS curve is a vertical

line at the level of Natural
Real GDP.

• It represents the output the

economy produces when
all economy wide
adjustments have taken
place and workers do not
have any relevant
misperceptions.

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 EXHIBIT

Short-Run Equilibrium

• The condition that

exists in the economy
when the quantity
demanded of Real
GDP equals the (short-
run) quantity supplied
of Real GDP.

• This condition is met

where the aggregate
demand curve
intersects the short-run
aggregate supply
curve.
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 EXHIBIT

Long-Run Equilibrium

• The condition that

exists in the economy
when wages and
prices have adjusted
to their (final)
equilibrium levels and
workers do not have
any relevant
misperceptions.

• Graphically, long-run
equilibrium occurs at
the intersection of the
AD and LRAS curves.
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 EXHIBIT 16

Equilibrium States of the Economy

During the time an economy moves from one

equilibrium to another, it is said to be in
disequilibrium.
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 8-5 Three States of an Economy

• An economy can be in short-run equilibrium, long-run

equilibrium, or disequilibrium.
• When the economy is in neither short-run nor long-run
equilibrium, it is said to be in disequilibrium.
• Essentially, disequilibrium is the state of the economy
as it moves from one short-run equilibrium to another
or from short-run equilibrium to long-run equilibrium.

• In disequilibrium, the quantity supplied and the quantity

demanded of Real GDP are not equal.

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 Self-Test

1- What is the difference between short-run

equilibrium and long-run equilibrium?

• In long-run equilibrium, the economy is producing

Natural Real GDP. In short-run equilibrium, the
economy is not producing Natural Real GDP,
although the quantity demanded of Real GDP
equals the quantity supplied of Real GDP.

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 Self-Test

2- Diagrammatically represent an economy that is in

neither short-run equilibrium nor long-run equilibrium.

• The diagram should show the price level in the

economy at P1 and Real GDP at Q1 but the
intersection of the AD curve and the SRAS curve at
some point other than (P1, Q1). In addition, the
LRAS curve should not be at Q1 or at the
intersection of the AD and SRAS curves.

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