A Model of the Macro Economy: Aggregate Demand and Supply

For Online Lecture see:http://www.harpercollege.edu/mhealy/eco212i/lectures/ch12-18.htm

For "yellow page" review exercise answers see: http://www.harper.cc.il.us/mhealy/eco212/lectures/asad/adasansw.htm

For a table of the US Business cycles: http://www.nber.org/cycles.html

Articles used in class:


Here are examples of the types of news articles that you should better understand after completing this chapter: :



12a Introduction to Aggregate Demand and Aggregate Supply

I. Structural Adjustment Policies

1. Privatization
Promotion of Competition
3. Limited and Reoriented Role for Government
4. Price Reform: Removing Controls
Joining the World Economy
6. Macroeconomic Stability

II. Introduction

A. Macroeconomics vs. Microeconomics
1. definition -- economics
2. definition -- macroeconomics
3. definition -- microeconomics

B. Macroeconomics Issues

1. full employment (or UE)
2. price stability (or IN)
3. economic growth (EG)


C. Chapter 6: Macroeconomic Concepts and the role of Price "Stickiness"

1. How well is the economy doing? - Performance and Policy
a. Real GDP (real Gross Domestic Output)
(1) nominal GDP
- total dollar value of all final goods and services produced within the borders of a country using their current prices during the year that they were produced

- PROBLEM: nominal GDP can increase from year to year even if there is no increase in output

(2) real GDP

- measures the total dollar value of a final goods and services produced within the borders of a country in a year

- measures the quantity being produced

- USEFUL to see if a country's output is growing

- real GDP uses THIS YEAR's QUANTITY and BASE YEAR PRICES (prices do not change)

(3) GDP = C + I + G + Xn

b. Unemployment

FULL employment:
- 5 Es Definition: full employment is using all available resources

- Common Definition: all available labor is employed

UNemployment (UE)

- occurs when a person is not working, but looking

- "UE is a waste"

c. Inflation

an increase in the overall level of prices

2. The Miracle of Modern Economic Growth

a. growth before the industrial revolution
(1) output growth increased slowly AND populations increased slowly

(2) output per capita growth stayed about the same = NO GROWTH for hundreds of years or more

(3) result:

(a) no change in living standards in a given place

(b) little difference between living standards between places

b. modern economic growth - "Rapid economic growth is a modern phenomenon")

(1) industrial revolution: output grows faster than population
(a) beginning around 1750 in England

(b) not all countries

(c) even small increases in output result in large increases in living standards over time

  • rule of 70

  • If a $10,000 GDP per capita increases by 2% a year
    • how long will it take to double to $20,000?
    • how long will it take to quadruple to $40,000?
    • how long will it take to reach $80,000?


  • higher living standards in places
  • vast differences in living standards
    • GDP per capita or per person is a measure of the standard of living of a country
    • GDP per capita = GDP / population


3. Savings, Investment, and Choosing between Present and Future Consumption

a. Review: Production Possibilities Model: Present Choices Future Possibilities

b. Saving occurs when current consumption is less than current output

(or when current spending is less than current income)

c. Investment

  • happens when resources are devoted to increasing future output
  • the only way for there to be investment is for there to be saving
  • WARNING: "investment" in economics has a different definition

    (1) financial investment

    • the purchase of financial assets (stocks, bonds, mutual funds) or a real assets (houses, land factories) or the building of such assets in the expectation of financial gain

    (2) economic investment

    • spending for the production and accumulation of capital (capital resources)

d. economic investment is ultimately limited by the amount of savings, and more savings now depends on less consumption now

e. the role of banks

  • households are the principle savers
  • but businesses are the main investors
  • Banks are then the "financial intermediaries"

4. Uncertainty, Expectations, Demand Shocks, and Supply Shocks

a. definitions
  • demand shocks: unexpected changes in the demand for goods and services
  • supply shocks: unexpected changes in the supply of goods and services
  • "shock" means "unexpected"
  • shocks can be positive or negative

b. "Economists believe that most short-run fluctuations in GDP are the result of demand shocks"
[NOTE: there are also supply shocks, but we will concentrate more on demand shocks]

(1) demand shocks and flexible prices: producing the full employment output
For the economy: if the prices of goods and services could always adjust quickly to unexpected changes in demand, then the economy could always produce at its optimal capacity since prices would adjust to ensure that the quantity demanded for each good would always equal the quantity supplied.

(2) demand shocks and sticky prices: fluctuations in GDP and employment

For businesses: if prices are inflexible then they respond to demand shocks by adjusting output or maintaining and inventory, but if the shock continues, output, and employment, will have to change

For the economy: if prices are inflexible than the economy adjusts to demand shocks by changing output and hence production and employment

5. How Sticky are Prices?

  • if "sticky prices' explain fluctuations in output and employment in the short run, how sticky are prices?
  • it varies (see table below)
  • WHY?
    • consumers like it
    • businesses fear a price war

6. Macroeconomic models and Price Stickiness

  • price stickiness changes over time
    • "stuck prices" only in the extreme short run
    • "sticky prices" in the short run
    • "flexible prices" in the longer run
  • different macro models for different lengths of time because the economy behaves differently over different lengths of time

D. The Business Cycle

1. phases of the cycle
a. peak
b. recession
c. trough
d. expansion (often called "recovery")


2. the business cycle and the macro economic issues
3. causes of the business cycle: changes in aggregate expenditures (demand shocks)
secular trend

5. For a table of the US Business cycles: http://www.nber.org/cycles.html

E. Chapter 12: A Model of the Macro Economy: AD and AS

1. Chapter 3: D and S
2. Chapter 12: AD and AS

III. Aggregate Demand

A. Definition
B. Real Domestic Output and the Price Level
C. Graphically: downsloping -- why?
1. wealth effect
2. interest-rate effect
3. foreign purchases effect


3. increase and decrease in AD





IV. Aggregate Supply (AS)

A. Definition [lecture]
B. Graphically
1. AS in the Immediate Short Run
a. assumption: both input prices and output prices are fixed
b. can be a few days to a few months depending on the type of firm
c. input prices are often fixed by contract; e.g. wage and salary contracts
d. output prices are often fixed when firms set their "list" price and follow it for awhile, also : catalog prices

e. graph

f. Result: the total output supplied depend on total spending (AD) until the firm is able to change its prices


2. AS in the Short Run

a. input prices are fixed (or highly inflexible), but output prices can vary
b. not really a certain time period, the length of the short run depends on whether input prices (like wage contracts) can change

c. graph

d. shape:

1. initially the price level rises slowly as output increases because since the economy is operating fall below its capacity (Qf) there are large amounts of unused resources available that firms can use without causing its cost per unit to increase

2. as we get near to, or beyond, the full employment level of output the price level rises more quickly because costs per unit rise more quickly

(a) example adding more workers to a fixed size factory (it will get crowded) - result: higher per unit costs

(b) or adding onto the factory, but few additional workers are available to work there - result: higher per unit costs


3. AS in the Long Run

a. both input (including wages) and output prices are fully flexible

b. graph

c. shape:

(1) vertical meaning that in the long run the economy will be producing the full employment level of output no matter what the price level is -- why?

(2) if aggregate spending (demand) is high firms want to produce more than the full employment level because of higher profits, BUT this will cause workers to demand higher wages causing profits to drop and firms will then no longer have the incentive to produce more


C. A Compound AS Graph

1. upsloping
2. shape
a. Keynesian (horizontal) range
b. classical (vertical) range
c. intermediate (upsloping) range

3. aggregate supply and full employment

2. increase and decrease in AS



12b Using Agregate Demand and Aggregate Supply


V. Macroeconomic Equilibrium

A. Equilibrium
1. equilibrium price level
2. equilibrium real domestic output


B. Changes in AD and the Macroeconomic Issues

1. Increase in AD
a. UE decreases

a. IN increases = demand-pull inflation

2. Decrease in AD


a. UE increases

b. inflation decreases

c. ratchet effect: the price-level may not decrease (but IN does decrease)

1) graphically

2) causes of the ratchet effect

a) fear of price wars
b) menu costs
c) wage contracts
e) morale and productivity, training investments
f) minimum wage


4. Changes in AS and the Macroeconomic Issues
a. Increase in AS

1) UE decreases

2) IN decreases

b. decrease in AS

1) IN increases -- called cost-push inflation

2) UE increases

3) "stagflation" = increase in UE and increase in IN


3. So what causes changes in AD?
a. determinants of AD: FROM CLASS
  1. change in consumer spending (C)
  2. change in Investment spending (I)
  3. change in Government spending (G)
  4. change in Net Exports (Xn)
  5. change in Money Supply (S)
  6. change in Taxes (T)
  7. change in Saving (S)

b. determinants of AD: FROM TEXT

1) C = consumer spending (and saving)
1) consumer wealth
2) consumer expectations
3) taxes
4) consumer indebtedness
I like the determinant "consumer debt" better than the "household borrowing" determinant mentioned in the textbook. The authors of our textbook say:
Household borrowing C AD
Household borrowing

I think what they are really saying is:

Interest rates Household borrowing C AD
Interest rates
Household borrowing C AD

But they also say, "The aggregate demand curve will also shift to the left ( AD) if consumers increase their savings rates in order to pay off their debts".

So why then do I prefer "consumer debt" as a determinant of AD? Because newspapers discuss it.

If consumers are greatly in debt they may be expected to begin to pay off those debts which will: S C AD

If consumer debt is going down, as it was during 2009, we might expect that in the near future: S C AD


2) I = investment spending

1) interest rates (money supply)
I know the textbook does not mention "money supply", but it will in unit 3. So, we might as well learn it now.

2) profit expectations on investment projects
3) business taxes
4) technology
5) degree of excess capacity

3) G = government spending
4) Xn = net export spending

1) net income abroad
2) exchange rates


5. So what causes changes in AS?

a. determinants of AS
1) change in input prices
a) labor
b) land (OPEC)
c) capital
d) entrepreneurial ability

2) changes in the productivity of resource

a) productivity
b) production
c) productive efficiency

3) legal-institutional environment

a) business taxes and subsidies
b) government regulation (red-tape)


C. What about economic growth (EG) ?

1. Review: What do we already know about Economic Growth?
a. Definition from chapter 1:
  • 5Es Definition
    • Increasing our ABILITY to Produce or Increasing POTENTIAL output
    • one of the 5Es of economics to maximize satisfaction or reducing SCARCITY
    • causes
      • more resources
      • better resources
      • better technology
  • Production Possibilities Graph

2. Two (or Three) Definitions

  1. Increasing the ABILITY to produce = increasing our potential
  2. Increasing Real GDP = producing more = achieving our potential
  3. Increasing GDP per capita = increasing output PER PERSON

a. Increasing our ABILITY to Produce

  • Ch. 1 Definition
  • "economic growth" on the 5Es chart
  • shifts production possibilities curve outward


  • AD and AS model increases AS

  • Causes of this type of EG (increase Potential):
    • change in input prices (more resources)
    • changes in the productivity of resource (better resources, better technology)
    • legal-institutional environment

b. Increasing Real GDP

  • increasing output = definition often used in the news = producing more
  • "Ch. 8 definition"
  • achieving "full employment" and "productive efficiency"
  • production possibilities curve:

  • AD and AS model: ­AD


c. A third definition of EG: increasing GDP per capita; we will discuss in ch. 9



A. Yellow Pages

b. Articles used in class:


VII. Long Run Aggregate Supply

A. Define LRAS
  • Assumption: both input and output prices are flexible.


  • AS graph is vertical meaning that in the long run the economy will produce the full employment level of output no matter what the price level is. Why?


  • If people are willing to buy more by paying more you would think that firms will want to produce more. But if in order to produce more they must also pay more for resources (since all are already being used and they will have to pay more to draw them away from other firms) then input prices will rise and there is no increase in profits to encourage firms to produce more.

B. Graph

C. Why?

1. Short Run AS and AD achieving full employment:


2. The LRAS curve will occur at the full employment (potential) level of output


 3. WHY?

a. If AD increases:
  • price level increases (equilibrium moves from a to b on the graph below)
  • price of resources will increase
  • short run AS will decrease(equilibrium moves from b to c on the graph below)


  • RESULT: higher price level but THE SAME LEVEL OF RDO


  • See graph:

B. If AD decreases:
  • price level decreases (equilibrium moves from a to b on the graph below)
  • price of resources will decrease
  • short run AS will increase (equilibrium moves from b to c on the graph below)


  • RESULT: lower price level but THE SAME LEVEL OF RDO


  • See graph:

VII. Macroeconomic Policies

A. Stabilization Policies ("Promoting Stability" )
1. definition:
  • a structural adjustment policy
  • Def. - a gov't policy designed to lower unemployment and/or inflation. to "stabilize the business cycle

2. Stabilization is one of the roles of government in market economy

B. Demand-Management

1. definition: policies where the government changes AD in order to reduce UE or IN

2. tools: AD curve shifters controlled by the government

  • change government purchases (G)
  • change taxes (T)
  • change interest rates by changing the money supply (MS)

3. two types of demand management policies: fiscal policy (FP) and monetary policy (MP)

a. fiscal policy (FP)
  • where the gov't use changes in G and/or T
  • conducted by the congress and the president
  • there are 2 types of FP

    1) expansionary FP

    • FP that fights UE
    • tools: increase G or decrease T
    • result: increase AD and thereby decrease UE
    • but: may result in some IN


    • graph:



    2) contractionary FP

    • FP that fights IN
    • tools: increase T or decrease G
    • result: decrease AD and thereby decrease IN
    • but: may result in some UE


    • graph:


b. monetary policy (MP) (Ch. 16)

1) easy money policy
  • occurs when the Fed tries to increase money supply in order to stimulate the economy.
  • also called expansionary MP
  • goal is to reduce UE
  • may cause some IN
  • HOW:
    • increase money supply causes
    • lower interest rates which causes
    • more investment which causes
    • increase in AD


  • Graph:

2) tight money policy

  • occurs when the Fed tries to decrease money supply in order to slow down the economy.
  • also called contractionary MP
  • goal is to reduce IN
  • may cause some UE
  • HOW:
    • decrease money supply causes
    • higher interest rates which causes
    • less investment which causes
    • decrease in AD


  • Graph:


3. AD policies and the AS curve

the effectiveness of demand management policy depends on where the economy is on the AS curve

C. "Supply-Side Economics" ( "Taxation and Aggregate Supply" )

1. Increase AS to decrease UE AND to decrease IN

2. Graph

2. AS curve shifters (review):

a. change in input prices
b. changes in the productivity of resource
c. legal-institutional environment
: business taxes and government regulation (red-tape)

Problem: the government has little control over AS

3. Four Supply Side Government Policies

a. lower marginal INCOME tax rates increase the incentives to work
  • Lower marginal tax rates may encourage more people to enter the labor force.
  • Lower marginal tax rates may encourage more people to to work longer.
  • Lower marginal tax rates may encourage more people to postpone retirement.
  • Lower marginal tax rates may encourage more people to work harder.
  • This would increase AS
  • NOTE: this also increases AD.
  • Many economists would argue that the effect on AD is quicker and more direct and that the effect on AS is slower and more uncertain

b. lower marginal tax rates on income earned from savings

  • The rewards for saving are increased by lower marginal tax rates, and more saving means more investment in new technology and higher productivity
  • This would increase AS

c. lower tax rates on income earned from capital (capital gains)

  • The rewards investing in new technologies are increased and productivity increases
  • This would increase AS

d. government deregulation

4. Supply-side Economics and the Budget Deficit

a. Question: Does a decrease in tax rates increase or decrease the government budget deficit?

b. Supply-Side supporters argue that it could decrease the deficit by increasing government revenue

c. Supply Side Policies and the Laffer Curve

d. Criticisms of the Laffer Curve
1) the impact of tax cuts on incentives to work may be small
  • some people work more
  • some people work less = buy more leisure

2) most economists think that the demand side effects of tax cuts are more immediate and certain

  • can cause inflation

3) it depends where you are on the laffer curve

e. Consensus:

  • there seems to be a general, but not universal, agreement among economicts theat the US tax rates are below "m" on the laffer curve above so continued tax cuts probably will not increase revenues
  • there are some supply-side effects of changes in tax rates that must be considered.


VIII. Historical Review of the U.S. Economy

A. Depression
B. W.W.II Boom
D. Vietnam War Inflation
E. Monetary Restraint: 1979-1982
F. Aggregate Supply Shocks in the 1970s & Early 1980s:
1. OPEC and energy prices
2. agricultural shortfalls
3. depreciated dollar
4. demise of wage-price controls
5. productivity decline
6. inflationary expectations and wages

G. Financial Crises 2007