AGGREGATE DEMAND

AND
AGGREGATE SUPPLY 3
TOPIC
A Way to View the Economy

We can think of an economy as consisting of two

major activities: buying and producing.

When economists speak about aggregate

demand, they are speaking about the buying
side of the economy.

When economists speak about aggregate

supply, they are speaking about the producing
side of the economy.
A Way to View the Economy
A Way to View the Economy

The framework of analysis we use is called aggregate

demandaggregate supply (ADAS).

That framework of analysis has three parts:

1. Aggregate demand (AD)

2. Short-run aggregate supply (SRAS)
3. Long-run aggregate supply (LRAS)
Aggregate Demand
Recall from the last chapter that households, firms, governments and
the rest of the world buy domestic goods and services.
Aggregate demand is the quantity demanded of these goods and
services, or the quantity demanded of Real GDP, at various price
levels, ceteris paribus.
For example, the following whole set of data represents aggregate
demand:
Aggregate Demand

An aggregate demand
(AD) curve is the
graphical representation
of aggregate demand.
AD is downward sloping
As the price level falls,
the quantity demanded
of Real GDP rises.
As the price level rises,
the quantity demanded
of Real GDP falls
 Aggregate Demand

Why Does the Aggregate Demand Curve Slope Downward?

This inverse relationship and the resulting downward slope of

the AD curve are explained by:

(1) The real balance effect

(2) The interest rate effect

(3) The international trade effect

Aggregate Demand

Real Balance Effect

When price level goes up, the real value of monetary wealth or
the value of a persons monetary assets goes down.

This means that purchasing power of monetary assets go down,

that is, the quantity of goods and services that can be purchased
with a unit of money decreases.

As a result, ceteris paribus, people demand less.

In summary, a rise in the price level causes purchasing power to

fall, which decreases a persons monetary wealth. As people
become less wealthy, the quantity demanded of Real GDP falls.
Aggregate Demand

Interest Rate Effect

The inverse relationship between the price level and the
quantity demanded of Real GDP is established through changes
in the part of household and business spending that is sensitive
to changes in interest rates.

As the price level rises, the purchasing power of the persons

money decreases.

With less purchasing power (per unit of money), she cannot

purchase her fixed bundle of goods with the same amount of
money.
Aggregate Demand

Interest Rate Effect

If she wants to continue to buy the goods, she needs to
acquire more money.

To do that, she goes to a bank and requests a loan. In terms

of simple supply-and demand analysis, the demand for credit
increases. Consequently, the interest rate rises.

As the interest rate rises, households borrow less to finance,

say, automobile purchases, and firms borrow less to finance
new capital goods spending. Thus, the quantity demanded of
Real GDP falls.
Aggregate Demand

International Trade Effect

The international trade effect takes place through changes in
foreign sector spending due to changes in price level.

As the price level in Bangladesh rises, Bangladeshi goods

become relatively more expensive than foreign goods.

As a result, both Bangladeshis and foreigners buy fewer

Bangladeshi goods and more foreign goods, i.e. exports fall
and imports rise implying a fall in net exports.

The quantity demanded of Real GDP falls.

Aggregate Demand

An Important Word on the Three Effects

Keep in mind that what caused these three effects is a
change in the price level.

When discussing, say, the interest rate effect, we are talking

about the interest rate effect of a change in the price level.

Why is this point important?

The interest rate can change due to things other than the
price level changing. Other things that change the interest
rate lead to a shift in the AD curve instead of a movement
along the AD curve.
 Aggregate Demand
A Change in Quantity Demanded of Real GDP vs. a Change
in Aggregate Demand
A change in the price level brings about a change in the quantity
demanded of Real GDP.

As the price level falls, the quantity demanded of Real GDP

rises, ceteris paribus.

When the aggregate demand curve shifts, the quantity demanded

of Real GDP changes even though the price level remains
constant.
Aggregate Demand
Aggregate Demand

Changes in Aggregate Demand: Shifts in the AD Curve

What can change aggregate demand? What can cause

aggregate demand to rise, and what can cause it to fall?

The simple answer is, if:

Spending increases at a given price level AD rises

Spending decreases at a given price level AD falls

Aggregate Demand
How Spending Components Affect Aggregate Demand
At a given price level if:
Aggregate Demand

Why Is There More Total Spending?

True or false?

The price level falls and total spending rises. As a result of

total spending rising, aggregate demand in the economy
rises, and the AD curve shifts rightward.
Aggregate Demand

Why Is There More Total Spending?

The answers is: FALSE

Aggregate demand curve shifts to the right only if total spending

rises at a given price level.

Total spending can rise for one of two reasons.

The first deals with a decline in prices and leads to a movement

along a given AD curve.
The second deals with a change in some factor other than prices
and leads to a shift in the AD curve.
Aggregate Demand

Factors That Can Change C, I, G, and NX and Therefore

Can Shift the AD Curve

Consumption: C
Four factors can affect consumption:

1.Wealth
2.Expectations about future prices and income
3.Interest rate
4.Income taxes
Aggregate Demand

Factors That Can Change C and Therefore Can Shift

the AD Curve

1. Wealth
Individuals consume not only on the basis of their present
income but also on the basis of their wealth.
Greater wealth makes individuals feel financially more secure
and thus more willing to spend.

Wealth C AD
Wealth C AD
Aggregate Demand

Factors That Can Change C and Therefore Can Shift

the AD Curve

2. Expectations About Future Prices and Income

Individuals expectations of future prices can increase or
decrease aggregate demand:
Expect higher future prices C AD
Expect lower future prices C AD

Similarly, expectations regarding income can affect aggregate

demand:
Expect higher future income C AD
Expect lower future income C AD
Aggregate Demand

Factors That Can Change C and Therefore Can Shift the

AD Curve
3. Interest Rate
Current empirical work shows that spending on consumer durables is
sensitive to the interest rate.

Buyers often pay for these items by borrowing; so an increase in the

interest rate increases the monthly payment amounts linked to the
purchase of durables and thereby reduces their consumption.
The reduction in consumption leads to a decline in aggregate demand.

Interest rate C AD
Interest rate C AD
Aggregate Demand

Factors That Can Change C and Therefore Can Shift

the AD Curve

4. Income Taxes
As income taxes rise, disposable income decreases. When people
have less take-home pay to spend, consumption falls.
Consequently, aggregate demand decreases.

A decrease in income taxes has the opposite effect; it raises

disposable income. When people have more take-home pay to
spend, consumption rises and aggregate demand increases.

Income taxes C AD
Income taxes C AD
Aggregate Demand

Factors That Can Change I and Therefore Can Shift the

AD Curve
Investments: I

Three factors can change investment:

1. The interest rate

2. Expectations about future sales
3. Business taxes
Aggregate Demand

Factors That Can Change I and Therefore Can Shift the

AD Curve

1. Interest Rate
As the interest rate rises, the cost of an investment project rises and
businesses invest less. As investment decreases, aggregate demand
decreases.
As the interest rate falls, the cost of an investment project falls and
businesses invest more. Consequently, aggregate demand increases.

Interest rate I AD
Interest rate I AD
Aggregate Demand

Factors That Can Change I and Therefore Can Shift the

AD Curve

2. Expectations About Future Sales

If businesses become optimistic about future sales, investment
spending grows and aggregate demand increases.

If businesses become pessimistic about future sales, investment

spending contracts and aggregate demand decreases.

Businesses become optimistic about future sales I AD

Businesses become pessimistic about future sales I AD
Aggregate Demand

Factors That Can Change I and Therefore Can Shift the

AD Curve
3. Business taxes
An increase in business taxes lowers expected profitability. With less
profit expected, businesses invest less. As investment spending
declines, so does aggregate demand.
A decrease in business taxes, on the other hand, raises expected
profitability and investment spending. This increases aggregate
demand.
Business taxes I AD
Business taxes I AD
Aggregate Demand

Factors That Can Change G and Therefore Can Shift

the AD Curve

Government Expenditure: G
Government expenditure usually rises due to expansionary Fiscal
policy designed to reduce unemployment.

Government expenditure usually falls due to contractionary Fiscal

policy designed to reduce inflation.

Expansionary Fiscal Policy G AD

Contractionary Fiscal Policy G AD
Aggregate Demand

Factors That Can Change NX and Therefore Can Shift

the AD Curve
Net Exports: NX

Two factors can change net exports:

1. Foreign real national income

2. The exchange rate
Aggregate Demand

Factors That Can Change NX and Therefore Can Shift the

AD Curve
1. Foreign real national income
As foreign real national income rises, foreigners buy more Bangladeshi
goods and services. Thus, exports rise. As exports rise, net exports rise,
ceteris paribus. As net exports rise, aggregate demand increases.

This process works in reverse. As foreign real national income falls,

foreigners buy fewer Bangladeshi goods and exports fall. This lowers
net exports, reducing aggregate demand.

Foreign real national income BD exports BD net exports AD

Foreign real national income BD exports BD net exports AD
 Aggregate Demand
Factors That Can Change NX and Therefore Can Shift the AD
Curve
2. Exchange Rate
As the Taka depreciates, Bangladeshi goods become cheaper and foreign goods
become more expensive. Bangladeshis cut back on imported goods, and foreigners
increase their purchases of Bangladeshi exported goods. If exports rise and imports
fall, net exports increase and aggregate demand increases.

As Taka appreciates, Bangladeshi goods become more expensive and foreign goods
become cheaper, Bangladeshis increase their purchases of imported goods, and
foreigners cut back on their purchases of Bangladeshi exported goods. If exports fall
and imports rise, net exports decrease, thus lowering aggregate demand.

Taka depreciates BD exports and BD imports BD net exports AD

Taka appreciates BD exports and BD imports BD net exports AD
Aggregate Demand

Can a Change in the Money Supply Change Aggregate

Demand?
Most economists would say that it does, but they differ on
how.

One way to explain the effect is as follows:

1. A change in the money supply affects interest rates.

2. A change in interest rates changes consumption and
investment.
3. A change in consumption and investment affects
aggregate demand.
Aggregate Demand

If One Component of Aggregate Spending Rises, Does Some

Other Spending Component Have to Decline?
Lets say that the money supply in the economy is Tk. 1 and that Tk. 1 is
currently in the hands of Shakib. Shakib takes the Tk. 1 and buys good
X from Tamim. Later, Tamim takes the Tk. 1 and buys good Y from
Mushfique. Still later, Mushfique takes the Tk.1 and buys good Z from
Mashrafe.

We started with a money supply of just Tk. 1, and that 1 Taka changed
hands three times. The average number of times a Taka changes hands
(or is spent) to buy final goods and services is what economists call
velocity. In our simple example, velocity is 3.

The product of our money supply (Tk. 1) and velocity (3) is Tk. 3, which
represents the total amount of spending in the economy.
Aggregate Demand

From our example, two things are obvious: First, total spending in the
economy can be a greater dollar amount than the money supply.
Proof: In our example, the money supply was Tk. 1, but total spending
equaled Tk. 3.

Second, total spending depends on the money supply and velocity.

Proof: Total spending in our example was the product of the money
supply times velocity.

Now, say out of this Tk. 3, Tk. 1 is spent on C, Tk. 1 is spent on I and
Tk. 1 is spent on G. If, say, government expenditure rises to Tk. 2,
must some other spending component decline?

The answer is yes if neither the money supply nor velocity changes.

But the answer is no if either the money supply or velocity rises.

Aggregate Demand

So, to summarize:
If both the money supply and velocity are constant, a rise in
one spending component (such as government expenditure)
necessitates a decline in one or more other spending
components.

If either the money supply or velocity rises, one spending

component can rise without requiring other spending
components to decline.
Short-Run Aggregate Supply

Aggregate demand is one side of the economy;

aggregate supply is the other.

Aggregate supply is the quantity supplied of all goods

and services (Real GDP) at various price levels, ceteris
paribus. Aggregate supply includes both short-run
aggregate supply (SRAS) and long-run aggregate supply
(LRAS).
 Short-Run Aggregate Supply

Short-Run Aggregate Supply

Curve: What It Is
A short-run aggregate supply
(SRAS) curve shows the quantity
supplied of all goods and services
(Real GDP or output) at different
price levels, ceteris paribus.
the SRAS curve is upward sloping:
As the price level rises, firms
increase the quantity supplied of
goods and services; as the price
level drops, firms decrease the
quantity supplied of goods and
services.
Short-Run Aggregate Supply

Short-Run Aggregate Supply Curve: Why It Is Upward

Sloping

Why is the SRAS curve upward sloping?

Two Explanations:

1. Sticky wages
2. Worker misperceptions
Short-Run Aggregate Supply

Short-Run Aggregate Supply Curve: Why It Is Upward

Sloping

1. Sticky wages
Some economists believe that wages are sticky, or inflexible.

This may be because wages are locked in for a few years due to
labor contracts that workers and management enter into.

Both labor and management may see this as in their best interest.

Management has some idea of what its labor costs will be during
the time of the contract.

Workers may have a sense of security knowing that their wages

cant be lowered.
Short-Run Aggregate Supply
Short-Run Aggregate Supply Curve: Why It Is Upward
Sloping

Firms pay nominal wages but they decide how many workers to hire
based on real wages.

=

The quantity supplied of labor is directly related to the real wage:

As the real wage rises, the quantity supplied of labor rises.

As the real wage falls, the quantity supplied of labor falls.

In short, more individuals are willing to work, and current workers are
willing to work more at higher real wages than at lower real wages.
Short-Run Aggregate Supply

Short-Run Aggregate Supply Curve: Why It Is Upward

Sloping
The quantity demanded of labor is inversely related to the real wage:

As the real wage rises, the quantity demanded of labor falls

As the real wage falls, the quantity demanded of labor rises.

Firms will employ more workers because it is cheaper to hire them.

Now, suppose that the price index falls. As a result, real wage rises.
What will firms do?
At higher real wages, firms will cut back on its labor. With fewer
workers working, less output is produced.
Short-Run Aggregate Supply

Short-Run Aggregate Supply Curve: Why It Is Upward

Sloping

So, if nominal wages are sticky, a decrease in the price

level (which pushes real wages up) will result in a
decrease in output.

This is what an upward-sloping SRAS curve represents:

As the price level falls, the quantity supplied of goods
and services declines.
Short-Run Aggregate Supply
Short-Run Aggregate Supply Curve: Why It Is Upward
Sloping

2. Worker misperceptions
Another explanation for the upward-sloping SRAS curve holds that
workers may misperceive real wage changes.
Suppose that the nominal wage is $30 an hour and price level is
$1.50. So, real wage = $30 / $1.50 = $20
Now suppose the nominal wage falls to $25 and the price level falls
to $1.25. The real wage is still $20 ($25 / $1.25 = $20) but workers
may not know this.
They know their nominal wage has fallen (i.e., they are earning $25
an hour instead of $30).They also may know that the price level is
lower, but they may not know initially how much lower the price level
is.
 Short-Run Aggregate Supply
Short-Run Aggregate Supply Curve: Why It Is Upward
Sloping
For example, suppose they mistakenly believe the price level has
fallen from 1.50 to 1.39.

They will then think that their real wage has actually fallen from $20
($30 / $1.50) to $17.98 ($25 / $1.39).

In response to the misperceived falling real wage, workers reduce

the quantity of labor they are willing to supply.

With fewer workers (resources), firms produce less.

So, if workers misperceive real wage changes, then a fall in the

price level will bring about a decline in output, which is illustrative of
an upward-sloping SRAS curve.
Short-Run Aggregate Supply

Issues with these two labor market based explanations

Take the first explanation. We have discussed the upward sloping

SRAS curve when price falls. What about when price rises? Then,
given sticky wages, real wage falls. So, the argument would be that
because real wage falls, employers will hire more workers which will in
turn lead to more production.

However, what about the workers? Will they be willing to supply more
labor at lower real wages? When real wage rises, its reasonable to
argue that employers will hire less workers. Because even if the
workers want to supply more, its really the employers prerogative to
decide how many workers they are willing to hire. But when real wage
falls, and workers do not want to supply more labor, its hard to justify
a scenario whereby employers are forcing workers to work.
Short-Run Aggregate Supply
Issues with these two labor market based explanations
Take the second explanation. We have discussed the upward
sloping SRAS curve when workers underestimate the decline in
price. But what if they overestimate the price decline? Then, they will
think that real wage has actually gone up. Then they will be willing to
supply more labor. More labor implies more production. In that case
a fall in price would actually result in higher supply! Of course,
assuming that employers agree to hire more workers. If they dont,
then there will be no change in production. Either way, the
direct/positive relationship between price and quantity supplied
breaks down.

Also, why only assume that the workers misperceive real wage
changes? What happens if employers also have misperceptions?
Short-Run Aggregate Supply

To avoid these problems, we can think about the upward sloping

SRAS curve in the following way.

Think about an individual firm: firm A. Its fair to assume that in the
short run the money wage rate and the prices of nonlabor inputs
remain unchanged. Now, if price of the good that firm A produces rises
with no change in these costs, then firm A can increase profit by
increasing production. Since any firm usually is in business to
maximize its profit, firm A will increase production.

Similarly, if price of the good produced by firm A falls while the money
wage rate and the prices of nonlabor inputs remain unchanged, then
firm A can reduce its losses (or profit reductions) by decreasing
production.
Short-Run Aggregate Supply

Whats true for firm A is true for the producers of all

goods and services. When all prices rise, the price level
rises. If the price level rises and the money wage rate
and other factor prices remain constant, all firms
increase production and the quantity of real GDP
supplied increases.

A fall in the price level has the opposite effect and

decreases the quantity of real GDP supplied.
Short-Run Aggregate Supply
What Puts the Short Run in the SRAS Curve?
According to most macroeconomists, the SRAS curve slopes
upward because of the reasons explained in the previous
slides (including sticky wages and worker misperceptions).

No matter what the explanation, things are likely to change

over time.

Wages will not be sticky forever (labor contracts will expire),

and workers will figure out that they misperceived real wage
changes. Factor costs will also not remain constant.

Only for a period of timeidentified as the short runare

these issues likely to be relevant.
Short-Run Aggregate Supply

Changes in Short-Run Aggregate Supply: Shifts in the

SRAS Curve

The factors that can shift the SRAS curve are:

1. Wage rates
2. Prices of nonlabor inputs
3. Productivity
4. Supply shocks
5. Expected price level
Short-Run Aggregate Supply

Changes in Short-Run Aggregate Supply: Shifts in the

SRAS Curve

1. Wage rates
Changes in wage rates have a major impact on the position of
the SRAS curve because wage costs are usually a firms major
cost item.

The impact of a rise or fall in equilibrium wage rates can be

understood in terms of the following equation:

Profit per unit = Price per unit - Cost per unit

Short-Run Aggregate Supply

Changes in Short-Run
Aggregate Supply: Shifts in
the SRAS Curve
Higher wage rates mean higher
costs and, at constant prices,
translate into lower profits and a
reduction in the number of units
(of a given good) that firms will
want to produce.
Lower wage rates mean lower
costs and, at constant prices,
translate into higher profits and
an increase in the number of
units (of a given good) firms will
decide to produce.
Short-Run Aggregate Supply

Changes in Short-Run Aggregate Supply: Shifts in the

SRAS Curve

2. Prices of nonlabor inputs

There are other inputs to the production process besides
labor.

Changes in the prices of nonlabor inputs affect the SRAS

curve in the same way as changes in wage rates do.

An increase in the price of a nonlabor input (e.g., oil)

shifts the SRAS curve leftward; a decrease in their price
shifts the SRAS curve rightward.
 Short-Run Aggregate Supply
Changes in Short-Run Aggregate Supply: Shifts in the
SRAS Curve

3. Productivity
Productivity is the output produced per unit of input employed
over some period of time.

Lets consider the labor input. An increase in labor productivity

means businesses will produce more output with the same
amount of labor, causing the SRAS curve to shift rightward.

A decrease in labor productivity means businesses will produce

less output with the same amount of labor, causing the SRAS
curve to shift leftward.
Short-Run Aggregate Supply

Changes in Short-Run Aggregate Supply: Shifts in the

SRAS Curve

Many factors lead to increased labor productivity. Some

examples:

A more educated labor force

A larger stock of capital goods

Technological advancements
Short-Run Aggregate Supply

Changes in Short-Run Aggregate Supply: Shifts in the

SRAS Curve

4. Supply shocks
Major natural or institutional changes that affect aggregate supply
are referred to as supply shocks.

Supply shocks are of two varieties. Adverse supply shocks shift the
SRAS curve leftward.

A long drought can have severe impact on the production of

paddy in Bangladesh.
A major cutback in the supply of oil coming to the United
States from the Middle East.
Short-Run Aggregate Supply

Changes in Short-Run Aggregate Supply: Shifts in the

SRAS Curve

Beneficial supply shocks shift the SRAS curve rightward.

A major oil discovery or unusually good weather

leading to increased production of a food staple

These supply shocks can be reflected in resource or

input prices.
Short-Run Aggregate Supply

Changes in Short-Run Aggregate Supply: Shifts in the

SRAS Curve

5. Expected price level

A change in expected price level can lead to a shift in the SRAS
curve.

Suppose individuals expect the price level to decline. Thus they

expect their real wages to rise and will work more. Working more
produces more output; so the SRAS curve shifts rightward.

Suppose individuals expect the price level to rise. Thus they expect
their real wage to decline and will work less. Working less produces
less output; so the SRAS curve shifts leftward.
Short-Run Aggregate Supply

Changes in Short-Run Aggregate Supply: Shifts in the

SRAS Curve
 Putting AD and SRAS Together: Short-
Run Equilibrium
How Short-Run
Equilibrium in the
Economy is Achieved
At 1 , the quantity supplied of Real
GDP is greater than the quantity
demanded. As a result, the price level
falls and firms decrease output.
At 2 , the quantity demanded of Real
GDP is greater than the quantity
supplied. As a result, the price level
rises and firms increase output.
Short-run equilibrium occurs at point E,
where the quantity demanded of Real
GDP equals the (short-run) quantity
supplied. This is at the intersection of
the AD curve and the SRAS curve.
Putting AD and SRAS Together: Short-
Run Equilibrium
Changes in Short-Run Equilibrium in the Economy
Putting AD and SRAS Together: Short-
Run Equilibrium
In Dollars and in Oil
In November 2007 the barrel price of oil was rising. On
November 1, 2007, it had risen to $96 a barrel.

In the same month the value of the dollar was falling in foreign
exchange markets. In fact, the value of the dollar had been
falling for some time. Although the value of $1 was 0.83 in
January 2006, it had fallen to 0.69 by November 1, 2007.

How would Real GDP and Price change?

Putting AD and SRAS Together: Short-
Run Equilibrium
In Dollars and in Oil

We know that the falling value of the dollar would lead to

greater U.S. exports, and this is exactly what was
happening at the time. As a result, U.S. net exports were
rising, pushing the AD curve in the economy to the right.

But because oil prices were rising, the SRAS curve in

the economy was shifting to the left.

How would these two changes affect Real GDP?

Putting AD and SRAS Together: Short-
Run Equilibrium
In Dollars and in Oil
The answer depends on the relative shifts of the AD and SRAS curves.
There are the three possibilities:

1. If the AD curve shifted rightward more than the SRAS curve shifted
leftward, then Real GDP will rise.
2. If the AD curve shifted rightward by less than the SRAS curve shifted
leftward, then Real GDP would fall.
3. If the AD curve shifted rightward by the same amount as the SRAS
curve shifted leftward, then Real GDP would remain unchanged.

In all three cases, though, the price level would increase. Rising
aggregate demand, combined with falling short-run aggregate supply,
always results in a rising price level.
An Important Exhibit

Expected Price Level

1. Expansionary Fiscal Policy

2. Contractionary Fiscal Policy
Long-Run Aggregate Supply
Going from the Short Run to the Long Run
Remember that an upward-sloping SRAS curve is explained by sticky
wages, worker misperceptions and constant factor costs. When these
conditions hold, short-run equilibrium identifies the Real GDP that the
economy produces.
In time, though, wages become unstuck, misperceptions turn into
accurate perceptions, and costs of other factors change in the direction
of the price change. In that event, the economy is said to be in the long
run. In other words, these conditions do not hold in the long run.

Most economists argue that, in the long run, the economy produces the
full-employment Real GDP, Potential Real GDP or the Natural Real
GDP ( ). The aggregate supply curve that identifies the output the
economy produces in the long run is the long-run aggregate supply
(LRAS) curve.
Long-Run Aggregate Supply

Going from the Short Run

to the Long Run
Long-run equilibrium identifies the
level of Real GDP the economy
produces when wages, other factor
costs and prices have adjusted to
their final equilibrium levels and
when workers have no relevant
misperceptions.
Graphically, this occurs at the
intersection of the AD and LRAS
curves. Further, the level of Real
GDP that the economy produces in
long-run equilibrium is the Natural
Real GDP ( ).
 Long-Run Aggregate Supply
Short-Run Equilibrium, Long-
Run Equilibrium, and
Disequilibrium
In this Exhibit, the economy is at
point 1, producing 1 amount of
Real GDP. At point 1, the quantity
supplied of Real GDP (in the short
run) is equal to the quantity
demanded of Real GDP, and both
are 1 . The economy is in short-
run equilibrium.
Long-Run Aggregate Supply

Short-Run Equilibrium,
Long-Run Equilibrium, and In both short-run and long-
Disequilibrium run equilibrium, the quantity
In this Exhibit, the economy is supplied of Real GDP
at point 1, producing .In equals
other words, it is producing the quantity demanded.
Natural Real GDP. The So what is the difference
economy is in long-run between short-run
equilibrium when it produces equilibrium and
.
Long-Run Aggregate Supply

Short-Run Equilibrium, Long-Run Equilibrium, and

Disequilibrium
In both short-run and long-run equilibrium, the quantity supplied of
Real GDP equals the quantity demanded.

So what is the difference between short-run equilibrium and long-run

equilibrium?

In long-run equilibrium, the quantities supplied and demanded of Real

GDP equal Natural Real GDP. But in short-run equilibrium, the
quantities supplied and demanded of Real GDP are either more or
less than Natural Real GDP.
Long-Run Aggregate Supply

Short-Run Equilibrium, Long-Run Equilibrium, and

Disequilibrium

Lets illustrate that difference with numbers. Suppose

= $9.0 trillion. In long-run equilibrium, the quantity
supplied of Real GDP equals the quantity demanded:
$9.0 trillion.

In short-run equilibrium, the quantity supplied of Real

GDP equals the quantity demanded, but neither
equals $9.0 trillion. For example, the quantity supplied
of Real GDP could equal the quantity demanded of
Real GDP at $8.5 trillion.
Long-Run Aggregate Supply

Short-Run Equilibrium, Long-Run Equilibrium, and

Disequilibrium

When the economy is in neither short-run nor long-run

equilibrium, it is said to be in disequilibrium.

Essentially, disequilibrium is the state of the economy as

it moves from one short-run equilibrium to another or
from short-run equilibrium to long-run equilibrium.

In disequilibrium, the quantity supplied and the quantity

demanded of Real GDP are not equal.
Practice Question

Do in Class:

Question:
Suppose wealth rises and at the same time, the price of
nonlabor inputs rises. What is the effect of these changes
on the price level and Real GDP?

Answer:
See page 219 of the textbook under the title Reality Can
Be Messy, and Correct Predictions Can Be Difficult to
Make