Fundamental Questions

1. What factors affect aggregate demand?

2. What causes the aggregate demand curve to shift?

3. What factors affect aggregate supply?

4. Why does the short-run aggregate supply curve become steeper as real GDP increases?

5. Why is the long-run aggregate supply curve vertical?

6. What causes the aggregate supply curve to shift?

7. What determines the equilibrium price level and real GDP?

Teaching Objectives

The primary purpose of this chapter is to introduce the aggregate demand and supply model. This is the second major macroeconomic model developed in the book.

The unique features of the chapter include the development of the aggregate demand curve from its foundation in the aggregate expenditures curve. The chapter also shows the factors that cause the aggregate demand curve to shift. The aggregate supply curve is also developed, and the short-run aggregate supply curve is distinguished from the supply curve that exists in the long run.

All of this material requires special attention as it will be used extensively in discussions of policy and the alternative schools of macroeconomic thought. It will also prove worthwhile to spend some extra time on the relationship between the short-run and long-run aggregate supply curves. The long-run curve is just a series of short-run curves after unexpected price changes have been corrected.

The material in this chapter will be used in Chapters 12 and 14 on monetary and fiscal policy as well as in Chapters 15 and 16, especially in the discussion of the schools of macroeconomic thought.

Key Term Review

demand-pull inflation
cost-push inflation
wealth effect
interest rate effect
international trade effect
aggregate demand curve
aggregate supply curve
long-run aggregate supply curve (LRAS)

Lecture Outline and Teaching Strategies

1. Aggregate Demand, Aggregate Supply, and Business Cycles

Teaching Strategy: Be careful using the supply and demand analogy here. If you don't push it too far, using information that the students already know about market models can help introduce aggregate supply and demand, but they should not get the impression that the macro model is just the sum of individual markets. The underlying arguments in both cases are distinct.

1.a. Aggregate demand and business cycles: Recessions can occur when aggregate demand falls, thereby reducing equilibrium real GDP.

1.b. Aggregate supply and business cycles: A reduction in aggregate supply can cause equilibrium real GDP to fall and the price level to increase.

1.c. A look ahead: The reasons for the shapes and movements of the AD and AS curves are different from those that explain the shapes and movements of the supply and demand curves.

2. Factors That Influence Aggregate Demand

2.a. Consumption: Consumption spending depends on income, wealth, expectations, demographics, and taxes.

2.b. Investment: Investment depends on factors that determine its profitability.

2.c. Government spending: Government spending is a key tool of fiscal policy, because it can be set by government officials independent of the level of income.

Show that government spending includes not only spending at the federal level but also state and local government spending.

2.d. Net exports: Net exports are determined by income, domestic versus foreign prices, exchange rates, and government trade policies.

2.e. Aggregate expenditures: Aggregate expenditures are the sum of all spending on domestic goods and services.

Teaching Strategy: Point out that aggregate expenditures form the foundation for the aggregate demand curve that will be discussed in the forthcoming section. Later you can show how changes in aggregate expenditure components shift the aggregate demand curve.

3. The Aggregate Demand Curve

The aggregate demand curve shows aggregate demand in relation to the price level.

3.a. Changes in aggregate quantity demanded: price-level effects

Teaching Strategy: Note that the arguments that were used to establish a downward-sloping market demand curve do not make sense for an aggregate demand curve because market quantities respond to relative price changes while aggregate quantities respond to general price changes.

3.a.1. The wealth effect: A price change causes the real value of wealth to change, resulting in a change in spending.

3.a.2. The interest rate effect: When prices go up, people need more money to make their purchases. They sell bonds to raise money, the supply of bonds increases, the price of the bonds falls, and the interest rate on the bonds increases. Higher interest rates then lead to lower investment and consumption.

3.a.3. The international trade effect: A change in domestic prices relative to foreign prices can cause net exports to change.

3.a.4. The sum of the price-level effects: A lower (higher) price level leads to higher (lower) consumption, investment, and net exports.

3.b. Changes in aggregate demand: Nonprice determinants

Teaching Strategy: Make certain that your students distinguish between movement along an aggregate demand curve and a shift in the curve.

3.b.1. Expectations

3.b.2. Foreign income and price levels

3.b.3. Government policy

4. Aggregate Supply

The positive relationship between price and national output is due to changes in profits.

4.a. Changes in aggregate quantity supplied: price-level effects-In the short run, resource prices are assumed to be constant, so an increase in product prices leads to an increase in profits and production.

4.b. Short-run versus long-run aggregate supply: In the long run, all costs are variable so there is no variation in the level of real output with the price level.

Point out actual cases where prices will not rise as demand rises (for example, major fast food chains). Provide examples where prices rise concurrently with increases in demand. Ask your students why businesses may not want to change prices when demand changes.

4.b.1. Short-run aggregate supply curve: As the level of real GDP increases, the slope of the aggregate supply curve becomes steeper.

Teaching Strategy: When you are discussing the shape of the aggregate supply curve, note that at any particular time industries across the economy are producing at many different levels relative to their capacity. Hence, when demand increases, some industries will be able to increase production while others will quickly approach full capacity and will increase prices instead of production. As the economy approaches its potential level of output, more industries are at full capacity and raise prices in response to demand increases.

4.b.2. Long-run aggregate supply curve: In the long run, production costs fully adjust to price increases. As a result there is no variation in profits as prices change and thus no variation in real output.

4.c. Changes in aggregate supply: Nonprice determinants

4.c.1. Resource prices

4.c.2. Technology

4.c.3. Expectations: Expectations, especially as they affect wage demands, are critical in determining the position of the aggregate supply curve.

Teaching Strategy: Emphasize the role of expectations in shifting the aggregate supply curve. This will be important when the relationship between the long-run and short-run aggregate supply curve is discussed.

4.c.4. Economic growth: Long-run aggregate supply shifts-The long-run aggregate supply curve shifts rightward over time as the potential output of the economy increases.

5. Aggregate Demand and Supply Equilibrium

5.a. Short-run equilibrium: When the short-run aggregate supply curve intersects the aggregate demand curve, the economy is at a short-run equilibrium price and output level.

5.b. Long-run equilibrium: The long-run level of output is determined by the quantities of capital and labor and the level of technological development in the economy.