Dr. Mohammed Alwosabi Econ 141 - Ch.

Notes on Chapter 3
AGGREGATE DEMAND AND AGGREGATE SUPPLY

— The AD-AS model determines RGDP and GDP Deflator and helps us
understand the performance of three macroeconomic fundamentals:
1. Growth of potential GDP
2. Inflation
3. Business cycle fluctuations (expansion and recession)

AGGREGATE DEMAND (AD)

— AD is the total amount of goods and services produced in a country
(i.e., the quantity of RGDP demanded) that people, businesses,
government, and foreigners are willing and able to buy at different
price levels within a given period.
AD = RGDP = Y = C + I + G + NX
P
Aggregate Demand (AD) Curve
P1
— The aggregate demand curve (AD) shows the
inverse relationship between RGDP
P0
demanded and the price level (using either
AD
the GDP Deflator or CPI) when all other
0 RGDP
things remain the same. Y1 Y0
— AD curve has negative slope (slopes downward) because of two
effects:

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Dr. Mohammed Alwosabi Econ 141 - Ch.3

— Wealth Effect:
o Real wealth is measured as the amount of goods and services
wealth will buy.
o When price level increases but other things remain the same,
real wealth decreases. To restore their wealth, people increase
saving and decrease current consumption ⇒ RGDP demanded
decreases
o Conversely, if the price level of goods and services fall but the
value of your assets do not, you feel wealthier and may start
consuming more ⇒ RGDP demanded increases
o Example:
Suppose an individual holds BD50,000 in saving account. If the
price level in Bahrain rises by 6%, then the individual’s real
wealth decreases is worth less in terms of what it can purchase.
As a result, consumption expenditure decreases and saving
increases to restore the original wealth.

— Substitution Effect:
1. Inter-temporal substitution effect (interest rate effect):
o The substitution effect involves substituting goods in the future
for goods in the present or goods in the present for goods in the
future. This is called inter-temporal substitution effect (a
substitution across time).
o This effect is mainly a result of changes in the real interest rate,
which affect the decisions of households and businesses in
terms of their willingness and ability to borrow.

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Dr. Mohammed Alwosabi Econ 141 - Ch.3

o As the price level falls, causing demand for money to decrease

and interest rate to decrease, consumers may decide that it is
not worth it to save since they do not receive as much return.
On the other hand, they may decide that since it is now cheaper
to borrow, they will increase their borrowing to finance their
consumption and investment, which would increase RGDP
demanded. The net effect of the decline of the interest rate is
increasing present consumption and decreasing saving
o Alternatively, when price level increases and other things
remain the same, demand for money increases ⇒ interest rate
increases ⇒ spending on consumption and investment
decreases ⇒ RGDP demanded decreases. Saving increases to
increase future consumption
2. International substitution effect:
o When the domestic price level rises, and other things remain
the same, domestically made goods and services become more
expensive relative to foreign made goods and services. This
change in relative prices encourage people to spend less in the
domestically made goods and more on foreign made products
(export decreases and import increases ⇒net export
decreases)
o Conversely, when the domestic price level falls, and other
things remain the same, domestically made goods and services
become less expensive relative to foreign made goods and
services. This change in relative prices encourage people to
spend more in the domestically made goods and less on foreign
made products (export increases and import decreases)

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Dr. Mohammed Alwosabi Econ 141 - Ch.3

Changes in RGDP demanded (Movement along AD Curve)

— The change in the quantity of RGDP demanded as a result of changes
in price level is represented by movement along AD curve.
— When price level increases, other things remain the same, ⇒ RGDP
demanded decreases ⇒ an upward movement along AD curve
— When price level decreases, other things remain the same, ⇒ RGDP
demanded increases ⇒ a downward movement along AD curve

Changes in AD (Shift of AD Curve)

— AD change if one or more of factors, other than price level, change.
When AD change AD curve shifts rightward or leftward
— The shifts in AD means an increase (or a decrease) in the quantity of
RGDP demanded at every price level P
— The main factors that influence AD
are:
1. Expectations P

2. Fiscal and monetary policies

AD1
3. The world economy
AD0
AD2
0 RGDP
Y2 Y0 Y1
Expectations
— An increase in the expected future income increases the amount of
consumption goods that people plan to buy today ⇒ AD increases ⇒
AD curve shifts rightward
— An increase in the expected future inflation rate in the future
increases the present AD because people have an incentive to buy
more goods and services now, before prices go up ⇒ AD curve shifts

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Dr. Mohammed Alwosabi Econ 141 - Ch.3

rightward. Expectation of falling prices (deflation) in the future will

reduce present AD.
— An increase in the expected future profit increases the investment
that firms plan to undertake today and AD increases ⇒ AD curve
shifts rightward

Fiscal and Monetary Policies

— Fiscal Policy:
o Fiscal policy exists when government tries to influence the
economy by changing taxes, making transfer payments and
changing its purchases of goods and services
o If tax decreases ⇒ disposable income increases ⇒ C
increases ⇒ AD increases ⇒ AD curve shifts rightward
o If transfer payments increase ⇒ disposable income increases
⇒ C increases ⇒ AD increases ⇒ AD curve shifts rightward
(Disposable income = Aggregate income – taxes + transfer
payments)
o Government purchase of goods and services is a component of
AD. Thus, if government purchase increases ⇒ AD increases
⇒ AD curve shifts rightward
— Monetary Policy:
o Monetary policy consists of changes in the interest rates and in
the quantity of money in the economy. The monetary policy is
conducted by the Central Bank.
o A lower interest rate ⇒ C and I increases ⇒ AD increases ⇒
AD shifts rightward

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Dr. Mohammed Alwosabi Econ 141 - Ch.3

o An increase in the quantity of money ⇒ C and I increases ⇒

AD increases ⇒ AD shifts rightward

The World Economy:

— The world economy affects AD through foreign exchange rate and
foreign income.
— Foreign exchange rate
o To buy Bahraini products, foreigners first have to buy Bahraini
dinar. To buy foreign products, Bahrainis first have to buy
foreign currency.
o The value of the dinar relative to other currencies will influence
Bahrain's exports (sales) to other countries and Bahrain's
imports (purchases) from other countries.
o Foreign exchange rate is the amount of foreign currency that
you can buy with the domestic currency.
o Foreign exchange rate increases ⇒ domestic goods become
more expensive ⇒ export decreases ⇒ AD decreases ⇒ AD
shifts leftward. How?
If the dinar is very strong, Bahrainis can buy more of foreign
currencies, so, foreign products seem cheap ⇒ Bahrain's
imports go up. At the same time, foreigners find Bahraini goods
seem expensive ⇒ Bahrain exports go down. If Exports go
down and imports go up, net exports go down, and AD
decreases.
o If the dinar depreciates and foreign currencies appreciate,
Bahraini goods are cheap to foreigners and foreign products are

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Dr. Mohammed Alwosabi Econ 141 - Ch.3

expensive to Bahrainis ⇒ Exports go up and imports go down

⇒ net exports go up ⇒ AD increases
o Example:
The current exchange rate between Bahraini Dinar and Saudi
Rial is about BD1 = SR10.
If the exchange rate increases to become BD1 = SR15 we can
see now that Saudis cannot buy the same quantity of the
Bahraini goods and services as before since they cost more. A
one-dinar Bahraini good that used to cost the Saudis YR10 is
costing them now YR15. Bahrainis, on the other hand, would
find Saudi products less expensive than before. A 10-rial Saudi
product used to cost the Bahrainis one dinar but now is costing
them only 750 Fils
The opposite would be true if the exchange rate decreases to
become BD1 = SR5
— Foreign income
o Foreign income increases ⇒ foreigners can buy more of
domestic products ⇒ export increases ⇒ AD increases ⇒ AD
shifts rightward

— In conclusion, in the SR, an increase in AD increases the price level

and increases RGDP; and a decrease in AD decreases the price level
and decreases PGDP.

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Dr. Mohammed Alwosabi Econ 141 - Ch.3

AGGREGATE SUPPLY (AS)

— Aggregate Supply (AS) shows the total supply of all goods and
services (RGDP) produced in the economy at a given time.
— AS curve depicts the quantity of RGDP supplied at different price
level.
— The RGDP supplied at full employment (FE) is called the potential
GDP (PGDP).
— The quantity of RGDP produced depends on
1. The quantity of labor (L)
2. The quantity of capital (K)
3. The state of technology (T)
— The aggregate production function is written as the equation:
RGDP = Y = F (L, K, T).
— In words, the RGDP supplied depends on (is a function of) the
quantity of labor employed, the quantity of capital, and the state of
technology.
— The larger is L, K, or T, the greater is Y.
— A country can supply more RGDP if technology improves and/or has
more factors of production.
— At any given time, the quantity of capital and the state of technology
are fixed but the quantity of labor is not fixed (can vary).
— So, over the business cycle, employment fluctuates around FE and
RGDP fluctuates around PGDP.
— Labor market can be: 1) at full employment (FE), 2) above FE, or 3)
below FE.
— To study AS in different states of the labor market we distinguish
between short run aggregate supply (SAS) and long run aggregate
supply (LAS)

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Dr. Mohammed Alwosabi Econ 141 - Ch.3

— The macroeconomic short run is a period during which RGDP has

fallen below or risen above PGDP. Equivalently, the unemployment
rate has fallen below or risen above the natural unemployment rate.
— The macroeconomic long run is a time frame that is sufficiently long
for all adjustments to be made so that RGDP = PGDP and UR = NRU.
That is, when the economy is at full employment.

Short Run Aggregate Supply (SAS) Curve P

— The SAS curve is the relationship between
SAS
the RGDP supplied and the price level (P) in
P1
the SR when the money wage rate, the
Po
prices of other resources, and the PGDP
remain constant.
0 RGDP
— The costs of production will be fixed in the Y0 Y1

short run because the firm previously entered

into long-term contracts. Firm has fixed its interest rates on loans from
banks for the next year, labor costs are pre-determined for years at a
time, lease agreements for real estate and equipment are generally
agreed upon for years, firm has negotiated contracts with its suppliers
for parts, raw materials, etc. Those costs of production were set and
pre-determined for a year or more
— A typical SAS curve is positively sloped (upward sloping) because a
rise in the price level provides profit incentive for the firms. As price
level increases from P0 to P1, revenues increase but costs of
production do not increase as much because money wage rate and
the prices of other resources remain constant. Therefore, profits
increase. The increase in profits encourages the existing firms to

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Dr. Mohammed Alwosabi Econ 141 - Ch.3

produce more and encourages new firms to enter the business. Thus,
the quantity of RGDP supplied increases.
— A fall in the price level with no change in costs induces firms to
decrease production to lower marginal cost.
— Along SAS curve, when P increases real wage rate decreases
— Along the SAS curve, real GDP might be above potential GDP or
below potential GDP.
P
LAS
Long Run Aggregate Supply (LAS) Curve
— LAS curve shows the relationship between
P1
RGDP supplied and the price level (P) in the
LR when RGDP = PGDP and the economy Po

is at full employment. 0 RGDP

Yp
— Potential GDP is independent of the price
level. The country always produces the PGDP in the LR (has FE in the
LR) regardless of the price level.
— Thus, the long-run, AS curve is vertical at the level of PGDP.
— In LR, RGDP is determined by the amount of L, K and T not by price
level.

Combining SAS and LAS

— At P*, RGDP = PGDP, UR= NRU P LAS
SAS
(the economy is at FE)
P1
— If P >P* (at P1) ⇒ RGDP > PGDP,
P*
(At P1 the economy is producing Y1 >Yp) P2
UR < NRU (the economy is above FE)
— If P < P* (at P2) ⇒ RGDP < PGDP, 0 RGDP
Y2 Yp Y1

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Dr. Mohammed Alwosabi Econ 141 - Ch.3

(At P2 the economy is producing Y2 <Yp) AND UR > NRU (the

economy is below FE)
— Thus, RGDP may be more or less than PGDP

Change in RGDP Supplied (Movements along SAS and LAS curves)

— Along SAS, the quantity of RGDP supplied increases as the price level
increases because total revenue increases more than the increase in
the cost of production and as a result profit
increases. And this is a movement along P

SAS.
LAS
— When price level increases, and at the same SAS
time nominal wage rate and other resource
prices increase by the same proportion,
relative prices remain constant and RGDP
remains at PGDP. There is a movement 0 RGDP
Yp
along the LAS curve.
— Conclusion: a change in the price level brings a movement along the
AS curves (both SAS and LAS) but does not change the aggregate
supply (no shift in AS curve).

Changes in AS (Shifts in SAS and LAS)

— What if AD stays the same and there is change in AS? We have to
determine if the change is permanent or temporary. If the change is
permanent, the LAS and the SAS both change. If the change is
temporary, only the SAS shifts.
— LAS does not shift in response to temporary changes in AD.

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Dr. Mohammed Alwosabi Econ 141 - Ch.3

— AS changes when factors other than price level change. This includes
(1) changes in potential GDP and (2) changes in money wage rate
and other resource prices.

(1) Change in potential GDP:

— The factors that change LAS are the same factors that shift the PPF
— When potential GDP changes, both LAS and SAS change and both
LAS and SAS curves shift. Why? Since RGDP fluctuates around
PGDP, SAS fluctuates around LAS
— Potential GDP changes as a result of three reasons
1. Change in full employment (FE) level of labor
2. Change in capital
3. Change in technology
When one or some of these factors change, potential GDP changes
when potential GDP change, both LAS and SAS change.
— Change in full employment level of labor
PGDP increases because of the increase in labor. But (with fixed
K&T) PGDP increases only if FE quantity of labor increases.
Fluctuations in employment over the business cycle bring fluctuations
in RGDP around PGDP. They are
P LAS0 LAS1 SAS0
not change in PGDP or LAS.
SAS1
— Change in capital:
The larger the capital, the more P0
productive is the labor force and the
greater is the PGDP. Capital includes
human capital - skills, knowledge,
RGDP
and experience. The larger is the 0 Y0 Y1

human capital the larger is the PGDP

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Dr. Mohammed Alwosabi Econ 141 - Ch.3

— Change in technology:
Even with fixed quantities of labor and capital, if the country
experiences technological progress or improvement, the country’s
PGDP increases and the both LAS and SAS shift to the right.
— The increase in PGDP is called economic growth. Economic growth is
represented by the increase in the PGDP and the shift of LAS and AS
curve rightward.

Change in money (nominal) wage rate and/or other resource prices:

— When money wage rate or the money prices of other resources
change,
SAS2
SAS changes but LAS does not change. LAS
P SAS0
o A decrease in money wage rate
C SAS1
increases SAS from SAS0 to SAS1. P2
The money wage rate (and other A
P0
resource prices) affect SAS
because they influence firms' costs.
P1
B
But they do not change LAS curve.
o The higher the money wage rate 0 RGDP
YP
(or money prices of other resources),
the higher are the firms’ costs and the smaller is the quantity
that firms are willing to supply at each price level. So an
increase in the money wage rate decreases aggregate supply
and shifts the AS curve leftward (from SAS0 to SAS2)
— In LR, The change in money wage rate (and other resource prices) is
accompanied by an equal percentage change in the price level. With
no change in relative prices, firms have no incentive to change
production and GDP remains constant at PGDP.

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Dr. Mohammed Alwosabi Econ 141 - Ch.3

MACROECONOMIC EQUILIBRIUM
— The equilibrium level of P and RGDP in the economy will be where the
desired total level of expenditures in the goods markets exactly
matches the desired total level of output to be sold.
— The equilibrium price level and equilibrium RGDP in the economy
exists where the quantity of RGDP demanded = the quantity of RGDP
supplied (when AD curve intersects AS curve). However, there is
macroeconomic equilibrium for each time frame (SR and LR).
— SR equilibrium is the normal state of the economy as it fluctuates
around PGDP; and the UR fluctuates around the NRU
— LR equilibrium is the state forward, which the economy is heading.
— AD-AS model studies the relationship between the price level and
unemployment.
P
SAS

SR Macroeconomic Equilibrium
— SR equilibrium occurs when the quantity of
P*
RGDP demanded equal the quantity of
RGDP supplied at the intersection of AD
AD
curve and SAS curve RGDP
Y0
— In SR, we assume that money wage and
price of other factors are fixed.
— If P >P*, RGDP supplied > RGDP demanded
Ö surplus ÖFirms will not be able to sell all their output Öfirms
decrease production and lower prices
— If P < P*, RGDP demanded > RGDP supplied Ö shortage Ö
Inventories are unexpectedly less than the quantity of RGDP
Demanded Ö firms increase production and raise prices.

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Dr. Mohammed Alwosabi Econ 141 - Ch.3

— These changes bring a movement along the SAS curve toward

equilibrium.
— In short-run equilibrium, real GDP can be greater than or less than
potential GDP because in the SR money wage is fixed.
— In macroeconomic SR equilibrium, there exists frictional and structural
unemployment and the economy might not be at the natural rate of
unemployment

LR Macroeconomic Equilibrium
— LR equilibrium occurs when RGDP = PGDP P
at the intersection of AD curve and LAS curve LAS
SAS
(when the economy is at full employment).
— In the LR, AD determines price level and has P*
no impact on RGDP.
— The money wage rate adjusts in the LR
Ö SAS curve intersects the LAS curve at the AD

equilibrium price level and LR equilibrium point.

Yp RGDP

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Dr. Mohammed Alwosabi Econ 141 - Ch.3

Economic Growth and Inflation

P
— Economic growth is the persistent increase in LAS0 LAS
1
PGDP.
P1
— It occurs because the quantity of labor
at FE grows, capital accumulated P0
and/or technology advances Ö PGDP AD1

increases ÖLAS curve shifts rightward. AD0

— The growth rate of PGDP is determined by the Yp0 Yp1 RGDP

pace at which labor, capital, and technology change. (Economic

Growth = Yp1 – Yp0)
— Inflation is the persistent rise in the price level. Inflation occurs
because the quantity of money grows faster than potential GDP, which
increases AD by more than LAS. Ö AD curve shifts rightward by
more than the rightward shift in the LAS curve. (Inflation = P1 – P0)
— Deflation occurs if AD curve shifts is less than the shift in the LAS
curve
— If the increase in AD is the same as the increase of LAS, PGDP will
grow with no inflation (price level is constant).
— In LR, the main influence on AD is the growth rate of the quantity of
money (Qm). Quantity of money increases Ö AD increases Ö inflation
rate increases. When the growth rate of quantity of money slows, the
inflation rate decreases.

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Dr. Mohammed Alwosabi Econ 141 - Ch.3

The Equilibrium and Business Cycle

— The business cycle occurs because AD and SAS fluctuate but the
money wage rate does not adjust quickly enough to keep RGDP at
PGDP.
— To simplify our analysis of the business cycle, we ignore economic
growth

SAS
(a) Recessionary gap recessionary
gap LAS
o Below FE equilibrium is a macroeconomic
SR equilibrium where AD curve intersects
SAS curve at RGDP of Y1 (less than Yp) P1

and price level P1.

o The amount by which RGDP < PGDP AD
is called a recessionary gap. Y1 Yp

o In the LR, money wage rate decreases ⇒ SAS shifts rightward

⇒ unemployment decreases and price level decreases.

(b) Inflationary gap Inflationary

gap
o An above FE equilibrium is a macroeconomic
LAS
equilibrium in which RGDP > PGDP. SAS

o It occurs when AD intersects SAS at

P2
RGDP = Y2 (more than Yp) and P = P2.
o The amount by which real GDP exceeds AD

potential GDP is called an inflationary gap,

o In the LR money wage rate increases ⇒ SAS Yp Y2

shift leftward ⇒price level increases and above full employment

goes back to full employment.

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Dr. Mohammed Alwosabi Econ 141 - Ch.3

(c) Full Employment Equilibrium SAS

LAS
o A long-run equilibrium is
an equilibrium in which PGDP = RGDP,
P*
where AD curve intersects SAS curve on
a point at LAS. The economy is at FE.
AD
o RGDP=PGDP
Yp

Business Cycle
o The economy moves from one type of SR
equilibrium to another as a result of RGDP=PGDP
Inflationary gap
fluctuations in AD and SAS.
o These fluctuations produce fluctuations of
RGDP around PGDP and unemployment
rate around the natural rate of unemployment.
o So, business cycle occurs because AD and recessionary gap

SAS change at different rates.

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Dr. Mohammed Alwosabi Econ 141 - Ch.3

FLUCTUATIONS IN AD P
(AD shifts rightward) LAS SAS1
— One reason that RGDP fluctuates around
P2 SAS0
C
PGDP is the fluctuations in AD.
B
— AD fluctuate for any changes in P1
A
consumption, investment, government P0
purchase, exports and imports, and AD1
AD0
quantity of money. Yp Y1 RGDP
— Initially, the economy is at LR equilibrium (FE equilibrium at point A),
where the intersection of LAS, AD0 and SAS0. At this point, RGDP =
PGDP and P = P0.
— Suppose some of C, I, NX increases or government may increase G
or Qm ⇒ AD increases ⇒ AD curve shifts rightward to AD1 (firms
expect higher future profits)
Short- run effect:
— Faced with the increase in AD, firms increase production and raise
the price. RGDP increases from Yp to Y1 and price increases from P0
to P1 (at B)
— The economy is now in an above-employment equilibrium
(negative cyclical unemployment) where RGDP > PGDP and P1 > P0
⇒ inflationary gap.
— At this stage, price level increases but wage rates have not change
(as we move along SAS, money wage rate is constant)
Long-run effect:
— The economy cannot produce in excess of PGDP forever. At point
B, firms have higher profits but workers now have lower real wage
because price level increased from P0 to P1 but money wage

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Dr. Mohammed Alwosabi Econ 141 - Ch.3

remains the same as in point A. Thus, inflationary gap exists and the
purchasing power of workers wages falls.
— Workers (and owners of other factors of production) demand higher
wages and prices for their services and firms meet their demand in
order to keep the higher level of production and profits (if firms do
not raise the money wage rate they will either lose workers or have
to hire less productive ones).
— As money wage and other resource prices increase (higher cost of
production) SAS begins to shift leftward until it reaches SAS1 where
it intersects with AD1 and LAS at point C. RGDP comes back to FE
equilibrium (PGDP =Yp) and price level increases to P2 causing
higher inflation
— In the LR, the increase in nominal (money) wage rate will decrease
inflationary gap and reach FE with higher price level
— In LR, money wage rate increases by the same percentage as the
increase in price level
— Firms' owners use this illustration to argue with labor unions that any
increase in wages would result in higher price level, which, at the
end, increases the cost of living for workers and for the entire
population.

Firms expect a loss in the future (AD shifts leftward)

— A decrease in AD has similar but opposite effects to those of an
increase in AD
— Initially, the economy is at LR equilibrium where the intersection of
LAS, AD and SAS. At this point, RGDP = PGDP.
— Suppose some of AD components such as C, I, NX decreases or
government may decreases G or Qm ⇒ AD decreases ⇒ AD curve

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Dr. Mohammed Alwosabi Econ 141 - Ch.3

shifts leftward ⇒ RGDP  ⇒ recessionary gap ⇒ P  but money

wage remains constant along the same SAS ⇒ purchasing power of
real wages increase and firms cost increased (relative to the output
prices) ⇒ firms start decreasing wages and the prices of other
factors of production ⇒ SAS start to shift rightward until RGDP =
PGDP at lower price level

FLUCTUATIONS IN SAS
When nominal wage and prices of other factors of production increase (cost
of production increases)
P
— Initially at point A, LR FE equilibrium, LAS
SAS1
where RGDP = PGDP SAS0

— If nominal wages or prices of other P1

B

factors of production increase ⇒

P0 A
production cost increases ⇒ firms
reduce production ⇒ SAS  ⇒ AD

RGDP
SAS curve shifts leftward to SAS1⇒ Y1 Yp

(1) price level increases to P1 ⇒ the economy experiences inflation

(2) RGDP decreases to Y1 (RGDP < PGDP) ⇒ the economy
experiences recession
— A combination of recession (stagnation) and inflation is called
stagflation
— Government should intervene to correct the situation
— In the LR, money wage decreases ⇒ SAS shifts rightward until FE
equilibrium where RGDP = PGDP at lower price level.

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Dr. Mohammed Alwosabi Econ 141 - Ch.3

When nominal wage and prices of other factors of production decrease (cost
of production decreases)
P
— The economy was initially at point A
LAS SAS0
where RGDP = PGDP
SAS2
— When prices of factors of production
P0 A
fall, cost of production falls ⇒ SAS C
P2
increases ⇒ SAS curve shifts
rightward to SAS2 AD

Yp Y2 RGDP

— New short run equilibrium is at point C. RGDP increases to Y2

(employment increases to more than FE equilibrium) and price level 
toP2 ⇒ deflation
— Low prices discourage firms from increasing their production ⇒ RGDP
 ⇒ SAS  until it goes back to LR equilibrium at some higher price.

FLUCTUATIONS IN BOTH AD AND AS

Profit is expected to increase and cost of production is expected to decrease
— Initially the economy was at point A. P
LAS SAS0
— If resource cost expected to decrease,
SAS1
AS curve shifts rightward and firms profit
expected to increase AD curve shifts
P1 E
rightward
P0 A
1. If the shift in ADC > the shift in SASC AD1

⇒ RGDP  and P
AD0
2. If the shift in ADC < the shift in SASC
⇒ RGDP  but P
Yp Y1 RGDP

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Dr. Mohammed Alwosabi Econ 141 - Ch.3

3. If the shift in both curves is with the same pace, RGDP  but P
remains the same.
— Conclusion: When both curves shift rightward, RGDP  but P ,, or
remains the same (P is undetermined).
— Exercise:
Starting from LR equilibrium, show graphically that
a. When businesses expect loss in the future (C, I, G, NX, or Qm
decreases) and at the same time nominal wage increases,
RGDP definitely decreases but P may increase, decrease or
stay the same
b. When businesses expect higher profit in the future (C, I, G, NX,
or Qm increases) and at the same time nominal wage
increases, P definitely increases but RGDP may increase,
decrease or stay the same
c. When businesses expect loss in the future (C, I, G, NX, or Qm
decreases) and at the same time nominal wage decreases, P
definitely decreases but RGDP may increase, decrease or stay
the same
— Exercise:
Use graphical illustration to show that P increases if (a) ADC shifts
right, (b) SASC shifts left, or (c) ADC shifts right and SASC shifts left

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Dr. Mohammed Alwosabi Econ 141 - Ch.3

EFFECTS OF GOVERNMENT'S ECONOMIC POLICIES

— Government uses the tools of fiscal and monetary policies to achieve
three main objectives:
1. Economic Growth (higher growth of the economy)
2. Price stability (low inflation)
3. Full employment (high employment)

Fiscal Policy Monetary Policy AD Shift

Expansionary G, T, or both  Qm, i, or both rightward

Contractionary G, T, or both Qm, i, or both leftward

Eliminating (Cyclical) Unemployment P

— Suppose the country experiences less than LAS SAS

FE equilibrium (recessionary gap or

positive cyclical unemployment) P1 A
at the initial equilibrium at point B B
P0
— Government can eliminate this cyclical
AD1
unemployment or recessionary gap
AD0
(which is equal to Y0 – Yp) by using Y0 Yp
RGDP

expansionary fiscal policy, expansionary

monetary policy or both ⇒ AD increases ⇒ AD curve begins to shift
rightward all the way to AD1 ⇒ the new equilibrium is at point A where
the economy is back at FE equilibrium and cyclical unemployment is
eliminated.

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Dr. Mohammed Alwosabi Econ 141 - Ch.3

P
Eliminating Inflation
LAS
— The economy has more than FE equilibrium
SAS
(inflationary gap or negative cyclical
P1 C
unemployment) equal to (Y1 – Yp)
at the initial equilibrium at point C P2 A

— Government main concern here is to AD0

AD2
eliminate the inflation
RGDP
— Government can eliminate the inflationary Yp Y1

gap by using contractionary fiscal policy, contractionary monetary

policy, or both ⇒ AD decreases ⇒ AD curve starts to shift leftward all the
way to AD2 ⇒ the new equilibrium at point A where the economy has FE
and the inflationary gap has been eliminated (price level decreased from
P1 to P2)
— In the long run, when AS is vertical, fiscal and monetary policy efforts
to increase output will be ineffective.

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Dr. Mohammed Alwosabi Econ 141 - Ch.3

Exercise:
The following table shows AD, SAS, and LAS for a country (in billions
of dollars)
P AD SAS LAS
110 10 5 8.5
120 9 6 8.5
130 8 7 8.5
140 7 8 8.5
150 6 9 8.5

a. Find SR- equilibrium RGDP and price level

b. What is the economic situation of the country when the economy at
the SR- equilibrium (RGDP and unemployment rate)?
c. When the economy is at its SR equilibrium, what will happen to SAS in
the LR?
d. How government should use its economic policies to achieve LR
equilibrium? Show graphically
e. What would be the full employment RGDP and P?
f. Suppose the RGDP at full employment is $5 billions, now what is the
economic situation of the country when the economy at the SR-
equilibrium (RGDP and unemployment rate)
g. How government should use its economic policies to reach at LR
equilibrium?
h. What is the situation when the price is 120? (surplus - inventories rise
(firms have unexpectedly low inventories) so the price level falls)
i. What is the situation when the price is 150? (shortage - inventories
falls (firms have unexpectedly low inventories) so the price level rise)

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