The Aggregate Supply/

Aggregate Demand Model

2012
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia

6-1

Learning Objectives
Introduce the Keynesian Aggregate

Expenditure model and discuss the

importance of the multiplier effect.
Introduce the of aggregate demand

and aggregate supply model.

Copyright 2004 McGraw-Hill Australia Pty Ltd

PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia

8-2

Autonomous Expenditure
Changes
Shifts in the AE curve due to

changes in autonomous
expenditure

result in new equilibrium levels of

output (GDP)

how much output changes by

depends on the size of the
expenditure multiplier
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia

7-3

Expenditure Multiplier
A change in autonomous

expenditure results in a change in

equilibrium income that is a
multiple of the initial change
The multiplier is defined as the ratio

of the change in GDP arising from a

change in autonomous spending
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia

7-4

Changes in Equilibrium GDP and the

(C + I ) 1
Multiplier
(C + I ) 0

Private spending
(billions of dollars)

510
490

Equilibrium GDP
at I1 level of investment

470
450

Saving and investment

(billions of dollars)

430

45

Real GDP
390

450

470

490

510

S
I1
I0

20

390

450

470

490

510

If I
increases...

Real GDP

Copyright 2004 McGraw-Hill Australia Pty Ltd

PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia

7-5

Saving and investment

(billions of dollars)

Private spending
(billions of dollars)

Changes in Equilibrium GDP

510
and the Multiplier(C + I )

(C + I ) 2

490

Equilibrium GDP
at I2 level of investment

470
450
430

45

430

450

470

490

510

Real GDP

S
20

I0
I2
430

450

470

490

510

If I
decreases...
Real GDP

Copyright 2004 McGraw-Hill Australia Pty Ltd

PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia

7-6

The Multiplier Effect

A change in autonomous spending

gives rise to a larger change in GDP

The multiplier effect arises because

initial increase in aggregate

expenditure will induce successive
rounds of increased expenditure

Copyright 2004 McGraw-Hill Australia Pty Ltd

PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia

7-7

Multiplier and Marginal

Propensities
A relationship exists between the

MPS (the amount of leakage) and

the multiplier
Multiplier = 1/MPS = 1/(1 MPC)
The simple multiplier is defined
as 1/MPS, when the leakage in
the economy is only saving
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia

7-8

Recessionary Gap
The amount by which aggregate

expenditures are deficient to that

required to generate the full
employment level of GDP
Produces a concretionary impact

upon the economy

Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia

7-9

Recessionary Gap (cont.)

Private
spending (billions of dollars)

(C + I )0
(C + I )1

Recessionary
Gap
Full Employment

45

470

490

510

Real GDP (billions of dollars)

Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia

7-10

Inflationary Gap
Is the amount by which

aggregate spending exceeds that

required to achieve full
employment
Produces an inflationary effect on

the economy
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia

7-11

Inflationary Gap (cont.)(C + I )

Private
spending (billions of dollars)

Inflationary
Gap

(C + I )0

{
Full Employment
0

45

470

490

510

Real GDP (billions of dollars)

Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia

7-12

Aggregate Demand (AD)

Represents the amount of goods

and services that consumers,

businesses, government and
foreign buyers are willing and
able to buy at various price levels

Copyright 2004 McGraw-Hill Australia Pty Ltd

PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia

8-13

AD Curve
The AD curve is downsloping due to:
Interest-rate effect
Real-balances effect (wealth

effect)
Foreign-purchases effect
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia

8-14

Price level

Aggregate Demand Curve

AD
0

Real gross domestic output

Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia

8-15

Interest-Rate Effect
Rising price level causes higher

nominal interest rates, which

causes reduction in certain kinds
of consumption and investment
spendingmost importantly,
investment spending

Copyright 2004 McGraw-Hill Australia Pty Ltd

PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia

8-16

Real-Balances Effect
Also known as wealth effect
At a higher price level, the real

value or purchasing power of the

accumulated financial assets held
by the public falls (real wealth
falls), leading to a fall in
consumption spending
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia

8-17

Foreign-Purchases Effect
Higher domestic prices cause the

relative price of foreign goods

(local goods) to decrease
(increase)
This causes increased imports

and decreased exports, resulting

in a fall in net exports
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia

8-18

(C + I + G
+ NX) at P
Deriving the AD Curve
(cont.)
Spending
(billions of dollars)

(C + I + G + NX)2 at P 2

(C + I + G + NX)2 at P3

2
3
Real GDP

Price level

P3
P2
P1
0

3
2
1

The Aggregate Demand

can be Constructed
Real GDP

GDP3 GDP2 GDP1

Copyright 2004 McGraw-Hill Australia Pty Ltd

PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia

8-19

Non-Price Determinants
of Aggregate Demand
Results in shift in the AD curve

Household consumption

Investment spending

Government spending and taxes

Exports

Imports

But what changes these?

Copyright 2004 McGraw-Hill Australia Pty Ltd

PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia

8-20

Changes in Aggregate Demand

Price level

Increase in AD

AD2

Decrease in AD
0

AD3

AD1

Real gross domestic output

Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia

8-21

Aggregate Supply (AS)

Indicates the level of real GDP

that will be produced at each

possible price level

Copyright 2004 McGraw-Hill Australia Pty Ltd

PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia

8-22

Short-Run Aggregate
Supply Curve
Upward sloping and is

constructed on the basis of two

assumptions:

a given price level

nominal wages have been

established on the expectations that
the given price level will persist
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia

8-23

Price level

Short-Run AS
A2

P2
A1

P1
P3

AS1

A3

Q3
QP
Q2
Real gross domestic output

Copyright 2004 McGraw-Hill Australia Pty Ltd

PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia

8-24

Long-Run AS

AS2 AS1 AS3

Price level

ASLS

P2
P1
P3

A2

B1
A1
A3
C1

QP
Real gross domestic output, GDP

Copyright 2004 McGraw-Hill Australia Pty Ltd

PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia

8-25

Production Possibilities
Frontier and the LRAS
Consumer goods

15

10

4
5
Capital goods)

Non-Price Determinants of AS
Shift the AS curve
Changes in input prices
Changes in productivity
Changes in the legal and

institutional environment

Copyright 2004 McGraw-Hill Australia Pty Ltd

PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia

8-27

Changes in Short-Run AS
AS2

AS1

Price level

Decrease in
Short-run AS

Real gross domestic output

Copyright 2004 McGraw-Hill Australia Pty Ltd

PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia

8-28

Changes in Short-Run AS
AS1

Price level

AS3

Increase in
Short-run AS
0

Real gross domestic output

Copyright 2004 McGraw-Hill Australia Pty Ltd

PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia

8-29

Changes inASLong-Run
AS
AS
Price level

LS1

LS3

Increase in
Long-run AS
0

QP
QP
Real gross domestic output, GDP

Copyright 2004 McGraw-Hill Australia Pty Ltd

PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia

8-30

Changes in Long-Run AS
Price level

ASLS2

ASLS1

Decrease in
Long-run AS
0

QP
QP
Real gross domestic output

Copyright 2004 McGraw-Hill Australia Pty Ltd

PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia

8-31

Equilibrium
Intersection of AS and AD

determines equilibrium real GDP

and the price level
At all other points there will be

pressure on real GDP and/or

prices to change
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia

8-32

Equilibrium Real GDP and

AS
Equilibrium Price
Level
AS
Price level

LS

P2
Pe
P3
AD
Q1

Qe Q2

Qp

Real domestic output

Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia

8-33

Shift in Aggregate Demand

and the Price Level
The effects of an increase in

aggregate demand on the price

level depend upon the position of
the short-run aggregate supply in
which it occurs
Demand-pull inflation is a situation

of rising prices due to shift in AD

Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia

8-34

Effects of an Increase in AD
Low Employment and the Price Level
AS
ASLS
AD3

Price level

AD1 AD2

P3
P2
P1

Q1

Q2

Q2 Qp

Real gross domestic output

Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia

8-35

Effects of an Increase in AD
High Employment and the Price Level
AS
ASLS

Price level

AD3
P5
P4
P3
AD3
Q3 Qp Q4

Real gross domestic output

Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia

8-36

Shift in Aggregate Supply

and the Price Level
Causes
Higher production costs shift the AS
leftwards, resulting in higher prices and
lower real GDP
Leads to cost-push inflation
Adverse shifts in the aggregate supply
result in stagflation, a situation of
higher prices and higher unemployment
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia

8-37

Effects of a Decrease in AS

Price level

AD

ASLS
AS2
AS1

P2
P1

Q2 Q1

Qp

Real domestic product

Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia

8-38

Effects of an Increase in AS

Price level

AD

ASLS

AS1
AS3
P1
P3

QeQ3Qp

Real domestic output, GDP

Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia

8-39

Price level

The AS curve

P2

Classical range;
No multiplier
effect
price response
only
Intermediate range;
Multiplier reduces as
economy approaches full
employment

P1

Keynesian range;
full multiplier effect

Real domestic product

Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia

6-40
8-40

Demand-Pull Inflation
Occurs when an increase in AD

pulls up the price level

Graphically: AD shifts rightward

along a stable AS curve

Short-run: increased prices and

real output
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia

1441

Price Level

Demand pull inflation

AD0

ASLR

AD1

AS

P2
AD3

P1
P0

Q0

Q1

Q2

Real GDP
1442

Cost-Push Inflation
Occurs when an increase in the

cost of production at each price

level shifts the AS curve leftward,
resulting in increased prices
Short run: increased prices and

decreased real output (and more

unemployment)
1443

Price Level

Cost push inflation

AS
ASLR

AS2
AS1

P3
P2

P1

AD1

Q3 Q2 Q1 QF

Real GDP
1444

Demand-Pull Inflation
In the short run demand-pull

inflation will drive up the price level

and increase output
In the long run, the increase in

aggregate demand has only moved

the economy along the vertical
aggregate supply curve ASLR
1445

Demand-Pull Cost-Push AS
Inflation
ASLR

Price Level

AS1
P3

e3
e2

P2
P1

e1

AD1
0

Q1 Q2
Copyright 2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia

AD2

Real GDP
1446