Key Concepts and Summary
Key Terms
aggregate (AD) the amount of total spending on domestic goods and services in an economy the total spending on domestic goods and services at each level a that shows what determines total supply or total for the economy, and how total and total supply interact at the macroeconomic level aggregate supply (AS) the total quantity of output (i.e. ) firms will produce and sell the total quantity of output (i.e. ) that firms will produce and sell at each level another name for potential GDP, when the economy is producing at its potential and unemployment is at the natural rate of unemployment intermediate zone portion of the SRAS curve where GDP is below potential but not so far below as in the Keynesian zone; the SRAS curve is upward-sloping, but not vertical in the intermediate zone Keynes’ law “demand creates its own supply” Keynesian zone portion of the SRAS curve where GDP is far below potential and the SRAS curve is flat long run aggregate supply (LRAS) curve vertical line at potential GDP showing no relationship between the price level for output and real GDP in the long run neoclassical economists economists who generally emphasize the importance of aggregate supply in determining the size of the macroeconomy over the long run neoclassical zone portion of the SRAS curve where GDP is at or near potential output where the SRAS curve is steep potential GDP the maximum quantity that an economy can produce given full employment of its existing levels of labor, physical capital, technology, and institutions Say’s law “supply creates its own demand” short run aggregate supply (SRAS) curve positive short run relationship between the price level for output and real GDP, holding the prices of inputs fixed stagflation an economy experiences stagnant growth and high inflation at the same time
Key Concepts and Summary
11.1 Macroeconomic Perspectives on Demand and Supply
emphasize , which holds that supply creates its own . Keynesian economists emphasize , which holds that creates its own supply. Many mainstream economists take a Keynesian perspective, emphasizing the importance of aggregate , for the , and a , emphasizing the importance of aggregate supply, for the .
11.2 Building a Model of Aggregate Demand and Aggregate Supply
The upward-sloping shows the positive relationship between the level and the level of in the . Aggregate supply slopes up because when the level for outputs increases, while the level of remains fixed, the opportunity for additional profits encourages more . The aggregate supply curve is near-horizontal on the left and near-vertical on the right. In the , we show the aggregate supply by a vertical line at the level of potential output, which is the maximum level of output the economy can produce with its existing levels of workers, , , and economic institutions. The downward-sloping shows the relationship between the price level for outputs and the quantity of total spending 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; and (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.
11.3 Shifts in Aggregate Supply
The aggregate /aggregate supply (AD/AS) diagram shows how AD and AS interact. The intersection of the AD and AS curves shows the output and level in the economy. Movements of either AS or AD will result in a different output and level. The aggregate supply curve will shift out to the right as productivity increases. It will shift back to the left as the of key rises, and will shift out to the right if the of key falls. If the AS curve shifts back to the left, the combination of lower output, higher unemployment, and higher , called , occurs. If AS shifts out to the right, a combination of lower , higher output, and lower unemployment is possible.
11.4 Shifts in Aggregate Demand
The AD curve will shift out as the components of aggregate —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. If the AD curve shifts to the right, then the of output and the level will rise. If the AD curve shifts to the left, then the of output and the level will fall. Whether output changes relatively more than the level or whether the level changes relatively more than output is determined by where the AD curve intersects with the AS curve. The AD/AS diagram superficially resembles the microeconomic supply and 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. We can illustrate long-term economic growth in the AD/AS framework by a gradual shift of the aggregate supply curve to the right. We illustrate a when the intersection of AD and AS is substantially below , while we illustrate an expanding economy when the intersection of AS and AD is near .
11.5 How the AD/AS Model Incorporates Growth, Unemployment, and Inflation
is relatively large in the AD/AS framework when the is substantially below . is small in the AD/AS framework when the is near . The , as determined by the institutions of the economy, is built into what economists mean by , but does not otherwise appear in an AD/AS diagram. The AD/AS framework shows pressures for to rise or fall when the movement from one to another causes the level to rise or to fall. The balance of trade does not appear directly in the AD/AS 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. The AD/AS model is the key model we use in this book to understand macroeconomic issues.
11.6 Keynes’ Law and Say’s Law in the AD/AS Model
We can divide the SRAS curve into three zones. says creates its own supply, so that changes in aggregate cause changes in and employment. We can show on the horizontal of the aggregate supply curve. The occurs at the left of the SRAS curve where it is fairly flat, so movements in AD will affect output, but have little effect on the level. says supply creates its own . Changes in aggregate have no effect on and employment, only on the price level. We can show Say’s law on the vertical neoclassical zone of the aggregate supply curve. The neoclassical zone occurs at the right of the SRAS 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 SRAS 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.
Self-Check Questions
1 . Describe the mechanism by which supply creates its own . 2 . Describe the mechanism by which creates its own supply. 3 . The aggregate supply curve was constructed assuming that as the of outputs increases, the of stays the same. How would an increase in the prices of important , like energy, affect aggregate supply? 4 . In the AD/AS , what prevents the economy from achieving at potential output? 5 . Suppose the U.S. Congress passes significant immigration reform that makes it more difficult for foreigners to come to the United States to work. Use the AD/AS to explain how this would affect the level of GDP and the level. 6 . Suppose concerns about the size of the federal budget deficit lead the U.S. Congress to cut all funding for research and development for ten years. Assuming this has an impact on technology growth, what does the AD/AS model predict would be the likely effect on equilibrium GDP and the price level? 7 . How would a dramatic increase in the value of the stock market shift the AD curve? What effect would the shift have on the equilibrium level of GDP and the price level? 8 . Suppose Mexico, one of our largest trading partners and purchaser of a large quantity of our exports, goes into a recession. Use the AD/AS model to determine the likely impact on our equilibrium GDP and price level. 9 . A policymaker claims that tax cuts led the economy out of a recession. Can we use the AD/AS diagram to show this? 10 . Many financial analysts and economists eagerly await the press releases for the reports on the home price index and consumer confidence index. What would be the effects of a negative report on both of these? What about a positive report? 11 . What impact would a decrease in the size of the labor force have on GDP and the price level according to the AD/AS model? 12 . Suppose, after five years of sluggish growth, the European Union's economy picks up speed. What would be the likely impact on the U.S. trade balance, GDP, and employment? 13 . Suppose the Federal Reserve begins to increase the supply of money at an increasing rate. What impact would that have on GDP, unemployment, and inflation? 14 . If the economy is operating in the neoclassical zone of the SRAS curve and aggregate demand falls, what is likely to happen to real GDP? 15 . If the economy is operating in the Keynesian zone of the SRAS curve and aggregate demand falls, what is likely to happen to real GDP?
Review Questions
16 . What is ? 17 . What is ? 18 . Do believe in or ? 19 . Does apply more accurately in the or the ? What about ? 20 . What is on the horizontal axis of the AD/AS diagram? What is on the vertical axis?
Text from Principles of Macroeconomics 3e, OpenStax, licensed CC BY-NC-SA 4.0. Access for free at openstax.org.
My notes
No notes yet on this page.