ch 26 taylor: principles of economics 3e 1 · as–ad diagram • the as–ad diagram superficially...

CH 26 Taylor: Principles of Economics 3e 1Textbook Media Press

Macroeconomic Perspectives on Demand and Supply

• Neoclassical economists emphasize Say’s Law, which holds that supply creates its own demand.

• Keynesian economists emphasize Keynes’ Law, which holds that demand creates its own supply.

• Many mainstream economists take a Keynesian perspective, emphasizing the importance of aggregate demand, for the short run and a neoclassical perspective, emphasizing the importance of aggregate supply, for the long run.


Aggregate Supply

• The upward-sloping aggregate supply (AS) curve shows the relationship between the price level for outputs and the level of output.

• Aggregate supply slopes up because when the price level for outputs increases, while the price level of inputs remains fixed, then the opportunity for additional profits encourages more production.


The Aggregate Supply Curve

• The aggregate supply curve is near-horizontal on the left and near-vertical on the right.

• This shape occurs because when the level of output is relatively low, there are a large number of available workers, machinery, and factories available, so a relatively small increase in the price level for outputs can easily encourage a large increase in output.

• However, when the level of output is relatively high, and the available workers and facilities are fully employed, then an increase in the price level for outputs cannot encourage much additional output.


Potential GDP

• A vertical line near the right-hand side of the AS curve shows the level of potential GDP…

• Which is the maximum level of output that the economy can produce with its existing levels of workers, physical capital, technology, and economic institutions.


The Aggregate Demand Curve• The downward-sloping aggregate demand (AD) curve shows

the relationship between the price level for outputs and the quantity of aggregate demand in the economy. It slopes down because of:

(a) the wealth effect, which means that a higher price level leads to lower real wealth, which reduces the level of consumption;

(b) the interest rate effect, which holds that a higher price level will mean a greater demand for money, which will tend to drive up interest rates and reduce investment spending;

(c) (c) the foreign price effect, which holds that a rise in the price level will make domestic goods relatively more expensive, discouraging exports and encouraging imports.


Aggregate Supply–Aggregate Demand

• The aggregate supply–aggregate demand (AS–AD) diagram shows how AS and AD interact with each other.

• The intersection of the AD and AS curve shows the equilibrium output and price level in the economy.

• Movements of either AS or AD will result in a different equilibrium output and price level.


Shifts in Aggregate Supply

• The aggregate supply curve will shift out to the right as productivity increases.

• It will shift back to the left as the price of key inputs rises, and will shift out to the right if the price of key inputs falls.


How Productivity Growth Shifts the AS Curve

• If the AS curve shifts back to the left, the combination of lower output, higher unemployment, and higher inflation called stagflation occurs.

• If AS shifts out to the right, a combination of lower inflation, higher output, and lower unemployment is possible.


Shifts in Aggregate Demand

• The AD curve will shift out as the components of aggregate demand—C, I, G, and X – M—rise.

• It will shift back to the left as these components fall.

• These factors can change because of different personal choices, like those resulting from consumer or business confidence, or from policy choices like changes in government spending and taxes.


Shifts in Aggregate Demand

• If the AD curve shifts to the right, then the equilibrium quantity of output and the price level will rise.

• If the AD curve shifts to the left, then the equilibrium quantity of output and the price level will fall.

• Whether equilibrium output changes relatively more than the price level or whether the price level changes relatively more than output is determined by where the AD curve intersects with the AS curve.


AS–AD Diagram

• The AS–AD diagram superficially resembles the microeconomic supply and demand diagram on the surface…

• But in reality, what is on the horizontal and vertical axes and the underlying economic reasons for the shapes of the curves are very different.


Growth and Recession in the AS–AD Diagram

• Long-term economic growth is illustrated in the AS–AD framework by a gradual shift of the aggregate supply curve to the right.

• A recession is illustrated when the intersection of AD and AS is substantially below potential GDP, while an expanding economy is illustrated when the intersection of AS and AD is near potential GDP.


Unemployment in the AS–AD Diagram

• Cyclical unemployment is relatively large in the AS–AD framework when the equilibrium is substantially below potential GDP.

• Cyclical unemployment is small in the AS–AD framework when the equilibrium is near potential GDP.

• The natural rate of unemployment as determined by the labor market institutions of the economy is built into what is meant by potential GDP, but does not otherwise appear in an AS–AD diagram.


Inflationary Pressures in the AS–AD Diagram

• Pressures for inflation to rise or fall are shown in the AS–AD framework when the movement from one equilibrium to another causes the price level to rise or to fall.


The Balance of Trade and the AS–AD Diagram

• The balance of trade does not appear directly in the AS–AD diagram, but it appears indirectly in several ways.

• Increases in exports or declines in imports can cause shifts in AD. Changes in the price of key imported inputs to production, like oil, can cause shifts in AS.


Keynes’ Law and Say’s Law in the AS–AD Model

• The AS curve can be divided into three zones:The Keynesian zone occurs at the left of the AS curve

where it is fairly flat, so movements in AD will affect output, but have little effect on the price level. The neoclassical zone occurs at the right of the AS

curve where it is fairly vertical, and so movements in AD will affect the price level, but have little impact on output. The intermediate zone in the middle of the AS curve is

upward-sloping, so a rise in AD will cause higher output and price level, while a fall in AD will lead to a lower output and price level.


ch 26 taylor: principles of economics 3e 1 · as–ad diagram • the as–ad diagram superficially...

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