Principles of Macroeconomics

Thirteenth Edition

Chapter 11
The Determination of
Aggregate Output, the Price
Level, and the Interest Rate

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Chapter 11 The Determination of
Aggregate Output, the Price Level,
and the Interest Rate
We are now ready to bring together the three pieces of the
economy—output, the price level, and the interest rate.
This chapter and the next one will give you the ability to think
about the key issues policy makers face in trying to manage
the economy.

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The Aggregate Supply (AS) Curve
(1 of 3)

• aggregate supply The total supply of all goods and

services in an economy.
• aggregate supply (AS) curve A graph that shows the
relationship between the aggregate quantity of output
supplied by all firms in an economy and the overall price
level.
• It is better thought of as a “price/output response” curve: a
curve that traces out the price decisions and output
decisions of all firms in the economy under different levels
of aggregate demand.

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Aggregate Supply in the Short Run
Figure 11.1 The Short-Run Aggregate Supply Curve
• In the short run, the aggregate
supply curve (the price/output
response curve) has a positive
slope.
• At low levels of aggregate
output, the curve is fairly flat.
• As the economy approaches
capacity, the curve becomes
nearly vertical.
• At capacity Y , the curve is vertical.

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The Aggregate Supply (AS) Curve
(2 of 3)

Why an Upward Slope?

• Wages are a large fraction of total costs, and wage
changes lag behind price changes. This gives us an
upward-sloping short-run AS curve.

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The Aggregate Supply (AS) Curve
(3 of 3)

Why the Particular Shape?

• As the overall economy is using all its capital and all the
labor that wants to work at the market wage at Y ,
increased demand for labor and output can be met only by
increased prices.
• At low levels of output, the AS curve is flatter. Small price
increases may be associated with relatively large output
responses.

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Shifts of the Short-Run Aggregate
Supply Curve
• The vertical part of the short-run AS curve represents the
economy’s maximum (capacity) output, as determined by
existing resources.
• New discoveries of oil or problems in the production of
energy can shift the AS curve through effects on the
marginal cost of production.
• cost shock, or supply shock A change in costs that
shifts the short-run aggregate supply (AS) curve.

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Figure 11.2 Shifts of the Short-Run
Aggregate Supply Curve

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Figure 11.3 The Effect of an Interest
Rate Increase on Planned Aggregate
Expenditure and Equilibrium Output

• An increase in the interest rate from 3% to 6% lowers planned

aggregate expenditure and thus reduces equilibrium output from Y0 to
Y1.
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Planned Aggregate Expenditure and
the Interest Rate (1 of 2)
Recall: AE C  I  G
• The effects of a change in the interest rate:
– A high interest rate (r) discourages planned investment
(I).
– Planned aggregate expenditure (AE) at every level of
income falls.
– A decrease in AE lowers equilibrium output (income)
(Y) by a multiple of the initial decrease in I.

r   I   AE   Y 
r   I   AE   Y 
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Planned Aggregate Expenditure and
the Interest Rate (2 of 2)
• IS curve Relationship between aggregate output and the
interest rate in the goods market.
• With the interest rate fixed, an increase in government
spending (G) increases AE and thus Y in equilibrium.

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Figure 11.4 The IS Curve
• In the goods market, there
is a negative relationship
between output and the
interest rate because
planned investment
depends negatively on the
interest rate.
• Any point on the IS curve is
an equilibrium in the goods
market for the given interest
rate.

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Figure 11.5 Shift of the IS Curve
• An increase in government
spending (G) with the
interest rate fixed increases
output (Y), which is a shift of
the IS curve to the right.

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The Behavior of the Fed
• Output (Y) and inflation (P) are two main inputs into the
Fed’s interest rate decision.

• Fed rule Equation that shows how the Fed’s interest rate
decision depends on the state of the economy.
r  Y   P   Z

where Z includes economic factors (other than Y and P) that

lie outside our model and are likely to vary from period to
period in ways that are hard to predict.

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Economics In Practice (1 of 3)
The Fed Gets a New Chair, Jerome Powell
In February 2018 President Trump
appointed Jerome Powell the
sixteenth chair of the Federal
Reserve Bank, replacing Janet
Yellen.
In his first testimony to Congress,
Powell reiterated the goals of
monetary policy: “The Congress has
assigned us the goals of promoting
maximum employment and stable
prices.”

CRITICAL THINKING
1. The Fed Chair is sometimes said to be the second most powerful person in
the United States after the president. Why might this be so?

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Figure 11.6 Equilibrium Values of the
Interest Rate and Output
• In the Fed rule, the Fed raises the
interest rate as output increases,
other things being equal.
• Along the IS curve, output falls as
the interest rate increases
because planned investment
depends negatively on the
interest rate.
• The intersection of the two curves
gives the equilibrium values of
output and the interest rate for
given values of government
spending (G), the price level (P),
and the factors in Z.
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Deriving the AD Curve
• The AD curve is not a market demand curve, and it is not
the sum of all market demand curves in the economy.
• Because many prices rise together when the overall price
level rises, we cannot use the ceteris paribus assumption
to draw the AD curve.
• AD falls when P increases because the higher P leads the
Fed to raise r, which decreases I and thus Y.
• The higher interest rate causes aggregate output to fall.

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Figure 11.7 The Aggregate Demand
(AD) Curve

• The AD curve reflects this negative

relationship between P and Y.

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The Final Equilibrium
Figure 11.8 Equilibrium Output and the Price Level
• Aggregate output and the
aggregate price level are
determined by the
intersection of the AS and
AD curves.
• These two curves embed
within them decisions of
households, firms, and the
government.

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Other Reasons for a Downward-
Sloping AD Curve
• The AD curve slopes down because the Fed raises the
interest rate (r) when P increases and because I depends
negatively on r.
• A real wealth effect on consumption also contributes to a
downward-sloping AD curve.
• real wealth effect The change in consumption brought
about by a change in real wealth that results from a
change in the price level.

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The Long-Run AS Curve
Figure 11.9 The Long-Run Aggregate Supply Curve
• When the AD curve shifts from
AD0 to AD1, the equilibrium price
level initially rises from P0 to P1
and output rises from Y0 to Y1.

• Wages respond in the longer run,

shifting the AS curve from AS0 to
AS1.

• If wages fully adjust, output will

be back to Y0.

• Y0 is sometimes called potential

GDP.
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Potential GDP (1 of 2)
• The vertical portion of the short-run AS curve exists
because there are physical limits to the amount that an
economy can produce in any given time period.
• potential output, or potential GDP The level of
aggregate output that can be sustained in the long run
without inflation.

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Potential GDP (2 of 2)
Short-Run Equilibrium below Potential Output
• Economists have different opinions on how to determine
whether an economy is operating at or above potential
output.
• Those who believe the AS curve is vertical in the long run
believe that output will tend to rise when wages fall with
high unemployment.

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Review Terms and Concepts
• aggregate supply
• aggregate supply (AS) curve
• cost shock, or supply shock
• Fed rule
• IS curve
• potential output, or potential GDP
• real wealth effect
Equations:
AE C  I  G
r  Y   P  Z

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