Week 5 · Chapter

Chapter 5 — Aggregate Demand & Aggregate Supply

Principles of Macroeconomics Free sample edition

The module's primary reading · ~35–45 minutes · Objective 5 (use the aggregate-demand and aggregate-supply model to analyze short-run fluctuations and the business cycle — name which curve shifts, in which direction, and what happens to the price level and real output — and measure recessionary and inflationary gaps), with Objective 2 (measure an economy's output with gross domestic product by the expenditure approach (C + I + G + NX), decide what counts and what does not, distinguish real from nominal GDP, and compute and interpret the GDP deflator) · Read it first this week; the lecture, the slides, the tutorial, the quiz, and the Model Workshop all build on it.

In plain language

Prices and output often rise and fall together, and this week you get the picture that explains why. The picture is the AD–AS model (a graph of the whole economy, with total output across the bottom and the overall level of prices up the side). One curve, aggregate demand (how much everyone in the economy wants to buy at each overall price level), slopes down. Another, short-run aggregate supply (how much all firms want to produce at each overall price level for now), slopes up. Where they cross tells you the economy's price level and output, and most of the week builds one habit: name which curve a news event moves and which way, then read where prices and output land.

Why you already care about this

Picture a year, in an illustrative example, when gas jumped 1 dollar a gallon, a grocery bill crept up 10 percent, and a friend's delivery job went from 40 hours a week to 30. Prices were rising, and work was getting scarcer at the same time. Now think about a different kind of year, when stores were busy, help-wanted signs were everywhere, and prices were also climbing. Prices went up in both years. The story behind them was completely different.

You live inside these stories. Whether your hours get cut, whether your rent jumps, and whether the job you want is easy or hard to land all depend on how the whole economy's spending and production are moving. Economists sort these stories with one diagram. It has two lines for buyers and sellers of the economy's entire output, plus a third line for the long run. Once you can read it, a headline about "rising prices" stops being one thing and becomes one of two very different events.

In this chapter you will follow an illustrative economy whose output starts at 800 billion dollars and whose price level starts at 12. You will watch government spending push output to 900 billion dollars and the price level to 13, and you will see why those two numbers had to rise together.

By the end of this chapter you will be able to:

name the two axes of the AD–AS diagram and say why they split spending into a real part and a price part;
explain why aggregate demand slopes down using the wealth, interest-rate, and exchange-rate effects;
explain why short-run aggregate supply slopes up and long-run aggregate supply is vertical;
solve a linear AD–AS pair for the equilibrium price level and real output;
tell a movement along a curve from a shift of the whole curve, and name what shifts each curve;
shift a curve, name its direction, and read the new price level and real output in words.

Carry this line with you: a price-level change slides along; anything else shifts the line.

Where we are

Already covered: Week 1, The Macro Perspective, gave you models and the habit of reading a diagram. Week 2, Measuring Output, taught real GDP and the GDP deflator. Week 3, Measuring Inflation & Unemployment, taught the price level as an index. Week 4, Economic Growth & Productivity, named potential output as the economy's long-run path.
This week: the AD–AS model, why its curves slope the way they do, how to find where they cross, and how to read a shift.
How they connect: the AD–AS diagram puts Week 2's real GDP on one axis and a price index like the deflator on the other, and its long-run line sits at Week 4's potential output.
Where we're going next: Week 6, Business Cycles & Short-Run Fluctuations, uses this same diagram to read recessions and booms as gaps between the crossing and potential output.

Three earlier ideas carry this chapter. From Week 2, real GDP values a year's output at fixed base-year prices, so it measures the amount of stuff made with price changes stripped out. The GDP deflator, nominal GDP divided by real GDP, times 100, measures the price part. From Week 3, a price index such as the CPI or the deflator is 100 in its base year and tracks the overall level of prices. From Week 4, potential output is the real output an economy can produce when its labor, capital, and technology are in normal, full use. This week those three ideas become the three lines of one picture.

1. Read the AD–AS diagram: real output across, the price level up

An illustrative coffee shop sells 200 lattes in one busy day at 5 dollars each, so its sales are 200 × 5 = 1,000 dollars. On the same day a week later, its sales are 1,100 dollars. Did it sell more lattes, or did it charge more for each one? You cannot tell from the 1,100 dollars alone. You need the quantity and the price separately.

The whole economy has the same problem, and you solved it in Week 2. Nominal spending mixes two things: how much was produced and what it cost. Real GDP pulls out the quantity part. A price index such as the GDP deflator pulls out the price part. The AD–AS diagram puts each part on its own axis.

The AD–AS model is a diagram of the whole economy, with real output on the horizontal axis and the price level on the vertical axis, where aggregate demand and aggregate supply cross to set both.
The price level is the average level of prices across the whole economy, measured by a price index such as the GDP deflator; a change in it raises or lowers the prices of goods and services as a group.

In this course, real output is written Y and measured in billions of dollars of real GDP. The price level is written P and measured in index units, like the deflator. A point on the diagram is written (Y, P), output first and price level second.

Worked example — placing one point. The illustrative economy you will follow all week (constructed for this course, not real data) produces 800 billion dollars of real output at a price level of 12.

Find Y. Go 800 along the horizontal axis, real output in billions of dollars.
Find P. Go up to 12 on the vertical axis, the price level in index units.
Mark the point. The point is (800, 12).

In words: this economy makes 800 billion dollars' worth of goods and services, valued at base-year prices, and its overall prices sit at an index level of 12.

Here is the empty diagram in words. The horizontal axis runs left to right and is labeled "real output, Y (billions of dollars)." The vertical axis runs bottom to top and is labeled "price level, P (index)." Every curve this week lives inside that frame.

Misconception check. Students often label the vertical axis "price" and the horizontal axis "quantity," as on a graph of one market. That is tempting, because the picture looks like the supply-and-demand graph you may have seen before. But the vertical axis here is the price level of everything at once, and the horizontal axis is the whole economy's real output. Mixing them up leads straight to the wrong reason for the slope of aggregate demand, which is the next section's subject.

Memory hook: across is how much the economy made; up is how high prices are overall.

2. Explain why aggregate demand slopes down: three economy-wide effects

Picture every buyer in the economy at once: families shopping for groceries, a construction firm ordering lumber, a city buying buses, and shoppers in other countries buying goods made here. Add up everything they want to buy, valued at base-year prices. That total is aggregate demand.

Aggregate demand is the total quantity of real output that households, firms, the government, and foreign buyers want to buy at each price level; its curve slopes down.

Those four groups are the four spending parts you met in Week 2: consumption C, investment I, government purchases G, and net exports NX.

Why does the curve slope down? Why do buyers want more real output when the price level is lower? It is not because a cheaper good pulls buyers away from another good. Three economy-wide reasons do the work.

The wealth effect is the reason aggregate demand slopes down that works through savings: a lower price level raises what people's money holdings can buy, so they spend more. A retiree with savings in the bank feels richer when prices across the economy fall, because each saved dollar now buys more.
The interest-rate effect is the reason aggregate demand slopes down that works through borrowing: a lower price level means people need less money for everyday purchases, so interest rates fall and spending on things bought with loans rises. Cheaper borrowing nudges a family toward a car loan and a firm toward a new delivery van.
The exchange-rate effect is the reason aggregate demand slopes down that works through trade: a lower domestic price level makes a country's exports cheaper abroad and imports dearer at home, so net exports rise. A furniture maker here finds overseas buyers ordering more when its prices fall relative to foreign makers' prices.

Worked example — matching each story to its effect. The price level in the illustrative economy falls. Name the effect behind each buyer's response.

A family's savings account buys more than it did, so the family books a trip it had put off. The price level fell and the savings stretched further. That is the wealth effect.
A small business finds loans a little cheaper and orders a second oven. A lower price level meant less money was needed for transactions, so interest rates fell. That is the interest-rate effect.
Buyers in another country order more of the economy's machine parts. The economy's goods became cheaper next to foreign goods, so exports rose. That is the exchange-rate effect.

In words: all three effects say the same thing from different directions. A lower price level raises the total amount of real output buyers want, so aggregate demand slopes down.

Misconception check. Students often say aggregate demand slopes down "because cheaper things get bought instead of something else." That is tempting, because it is the right story for one product: when one brand of cereal gets cheaper, shoppers switch to it. But aggregate demand is about the price level of everything at once. When every price falls together, there is no "something else" left to switch away from. The slope comes from the wealth, interest-rate, and exchange-rate effects, not from substitution.

Memory hook: savings, borrowing, and trade: three roads to a downward slope.

3. Meet the two supply curves: sticky in the short run, vertical in the long run

A café prints its menu once a year and signs a one-year lease. Its cooks agreed to their hourly pay in January. Now suppose prices across the whole economy rise. The café can raise its menu prices at the next reprint, but its rent and its cooks' pay stay where they were for months. For now, each meal it sells earns a bit more over its costs, so staying open an extra hour pays.

That is the idea behind the short-run supply curve. Some prices and wages do not adjust right away.

Sticky prices and wages are prices and wages that are slow to change because of contracts, menus, and agreements already in place, so they lag behind a change in the price level for a while.
Short-run aggregate supply is the total quantity of real output firms supply at each price level while some prices and wages are slow to change; its curve slopes up.

When the price level rises, firms' selling prices rise faster than the wages and input prices they have already agreed to pay. Producing more pays, so firms across the economy produce more. That is why short-run aggregate supply slopes up.

Given enough time, though, the contracts run out. Workers notice that their pay buys less and bargain for raises. Landlords reset rents. Once every price and wage has caught up, a higher price level no longer makes extra production pay, and the economy's output goes back to what its labor, capital, and technology can make in normal, full use. That is Week 4's potential output.

Long-run aggregate supply is the real output an economy produces once every price and wage has fully adjusted; its curve is a vertical line at potential output.

Here is the picture in words. Short-run aggregate supply is a line that rises from lower left to upper right. Long-run aggregate supply is a straight vertical line standing at potential output. Moving up and down that vertical line changes the price level and leaves real output where it is.

Honesty note: this week's linear pair does not place the long-run line on its numbers. Week 6 reads where the crossing sits compared with potential output; for now, you need only the line's shape and its meaning.

Misconception check. Students often think the long-run curve is vertical because firms "stop caring about prices" in the long run. That is tempting, because a vertical line looks like a curve that ignores the price level. The real reason is that in the long run every price and wage has adjusted, including the costs firms pay. A higher price level is matched by higher costs, so it no longer changes how much the economy can make. Output is set by labor, capital, and technology instead.

Memory hook: sticky costs tilt the short run up; fully adjusted costs stand the long run straight.

4. Find the short-run equilibrium: where the curves cross

A farmers' market settles on prices where what shoppers want to buy matches what sellers bring. The whole economy settles the same way. At the crossing of aggregate demand and short-run aggregate supply, the real output buyers want equals the real output firms supply.

Short-run equilibrium is the point where the aggregate demand curve crosses the short-run aggregate supply curve, which sets the economy's price level and real output for now.

The illustrative economy (Dataset C, constructed for this course, not real data) has two straight lines. Y is real output in billions of dollars, and P is the price level in index units.

Aggregate demand: P = 20 − Y⁄100.
Short-run aggregate supply: P = 4 + Y⁄100.

Y⁄100 is real output divided by 100. On the demand line, more output goes with a lower price level. On the supply line, more output goes with a higher price level.

Worked example — solving the linear pair. Find the output and price level where the two lines cross.

Set the two price levels equal. At the crossing, both lines give the same P, so 20 − Y⁄100 = 4 + Y⁄100.
Gather the numbers and the Y terms. Subtract 4 from both sides and add Y⁄100 to both sides: 20 − 4 = 16 = 2Y⁄100.
Solve for Y. Multiply by 100 and divide by 2: Y = 16 × 100 ÷ 2 = 800.
Find P on the demand line. P = 20 − 800⁄100 = 20 − 8 = 12.
Check on the supply line. 4 + 800⁄100 = 4 + 8 = 12. The same price level, so the crossing is (800, 12).

In words: this economy settles at 800 billion dollars of real output and a price level of 12, the one combination where buyers want exactly what firms supply.

Why does the economy end up there and not somewhere else? Read a few points off each line.

Price level on each line at three levels of real output, Dataset C (illustrative, constructed for this course, not real data)
Real output Y (billions of dollars)	Aggregate demand P	Short-run aggregate supply P
700	20 − 7 = 13	4 + 7 = 11
800	20 − 8 = 12	4 + 8 = 12
900	20 − 9 = 11	4 + 9 = 13

At 700, buyers would accept a price level of 13 while firms need only 11, so firms find it pays to produce more. At 900, firms need 13 but buyers accept only 11, so output gets cut back. Only at 800 do the two lines agree.

In practice (your tools). Open the free Desmos graphing calculator. Desmos calls the horizontal axis x and the vertical axis y, so x stands for Y and y stands for P. Type y=20-x/100 on the first line and y=4+x/100 on the second. Zoom out until both lines show, then click where they cross. Desmos labels the crossing (800, 12).

Misconception check. Students often stop after finding Y = 800 and forget the price level, or they find P on one line and never check it on the other. That is tempting, because the hard algebra is done. But an equilibrium is a point with two numbers, and the check on the second line catches an arithmetic slip before it spreads. Always report both, (800, 12), and say them in words.

Memory hook: set them equal, solve for Y, then find P twice.

5. Tell a movement along from a shift: the term's most important habit

A bus route is a fixed line on a map. When the bus moves from one stop to the next, it travels along the same route. When the city redraws the route to serve a new neighborhood, the whole line moves. A curve on the AD–AS diagram works the same way.

A movement along a curve is a slide from one point to another on the same curve, caused by a change in the price level, with the curve itself staying put.
A shift of a curve is a move of the whole curve to the left or right, caused by a change in something other than the price level, such as spending or input costs.

The price level is on the diagram's own axis. So a change in P, by itself, can only slide the economy along a curve that is already drawn. Everything else that matters to buyers or sellers is not on an axis, so a change in it redraws the line.

Worked example — a movement along the starting demand line. Suppose the price level were 13 instead of 12, with nothing else about buyers changed. How much real output would they want?

Use the same demand line. P = 20 − Y⁄100, so at P = 13, 13 = 20 − Y⁄100.
Solve. Y⁄100 = 20 − 13 = 7, so Y = 7 × 100 = 700.
Read it. At P = 13 buyers want 700 billion dollars of real output, down from 800 at P = 12.

In words: a higher price level by itself means buyers want less real output, and the economy slides up and to the left along the same aggregate demand line. No new line is drawn.

What does redraw a line? Each curve has its own list of shifters, and none of them is the price level.

What shifts each curve in the AD–AS model, with an example of a rightward or leftward shift
Curve	Shifter	Example
Aggregate demand	Consumption C	Households grow more confident about their jobs and spend more (right)
Aggregate demand	Investment I	Firms expect weaker sales next year and delay new equipment (left)
Aggregate demand	Government purchases G	A government orders more road repairs (right)
Aggregate demand	Net exports NX	Buyers abroad grow richer and order more of the economy's goods (right)
Short-run aggregate supply	Input costs	Oil, a key input for shipping and factories, gets more expensive (left)
Short-run aggregate supply	Productivity	A better scheduling technology lets each worker produce more (right)
Short-run aggregate supply	Expected inflation	Workers expect prices to rise and bargain for higher pay now (left)

In practice (your tools). In Desmos, under your two lines, type (800,12) and (700,13) on two new lines. Both points sit on the same demand line, y=20-x/100. Sliding from one to the other is a movement along the curve; the line itself never moved.

Misconception check. Students often draw a rise in the price level as a leftward shift of aggregate demand. That is tempting, because buyers do want less output at the higher price level. But that drop in quantity is already built into the downward slope of the line you drew. A change in P is a movement along the curve. Only a change in C, I, G, or NX, or in input costs, productivity, or expected inflation for the supply line, shifts a curve.

Pause and reflect — choose one. Pick either prompt; they count the same.

(a) Think of a news story you have seen about prices or jobs. Was it describing a change in the price level itself, or a change in something that would shift a curve? Which shifter fits best?
(b) Think of a business you know, such as a restaurant, a shop, or a clinic. Which input cost, if it rose sharply, would most change how much that business could afford to produce?

Memory hook: a price-level change slides along; anything else shifts the line.

6. Shift aggregate demand: name it, move it, read the new P and Y

When a government starts a large road-repair program, it orders asphalt, hires crews, and rents equipment. At every price level, total spending is now higher than before. That is a shift of aggregate demand to the right.

Comparative statics is the habit of comparing two equilibriums before and after one change: name the curve that moves, name the direction, then read the new price level and real output.

Use the habit in three steps every time: which curve, which direction, and where the new crossing lands.

Worked example — government spending rises. In the illustrative economy, government purchases rise.

Name the curve. Government purchases G are part of aggregate demand, so aggregate demand moves. Short-run aggregate supply does not.
Name the direction. More spending at every price level shifts aggregate demand to the right. The new line is P = 22 − Y⁄100, its intercept up 22 − 20 = 2.
Set the new pair equal. 22 − Y⁄100 = 4 + Y⁄100, so 22 − 4 = 18 = 2Y⁄100.
Solve for Y. Y = 18 × 100 ÷ 2 = 900.
Find P and check it. P = 22 − 900⁄100 = 22 − 9 = 13, and on short-run aggregate supply 4 + 9 = 13. The new crossing is (900, 13).
Measure the change. Output rose 900 − 800 = 100 billion dollars, and the price level rose 13 − 12 = 1 index point.

In words: aggregate demand shifted right, and the economy walked up the unchanged short-run aggregate supply line from (800, 12) to (900, 13). Real output rose by 100 billion dollars and the price level rose from 12 to 13, both up, together.

Notice what stayed put. The short-run aggregate supply line never moved. The economy traveled along it, from one point on it to another. One curve shifted; the economy moved along the other.

In practice (your tools). In Desmos, replace the demand line with y=a-x/100. Desmos offers to add a slider for a; accept it and set a to 20. The crossing with y=4+x/100 sits at (800, 12). Now drag the slider from 20 to 22. Watch the crossing walk up the supply line until it reaches (900, 13).

The mirror case runs the other way. If spending fell instead, say because households grew worried about their jobs and cut back, aggregate demand would shift left. The crossing would walk down the same supply line, and both the price level and real output would fall together.

Misconception check. Students often say that after aggregate demand shifts right, output rises but the price level falls, as if the two must move in opposite directions. That is tempting, because on a demand curve a higher price level goes with less output. But after a shift of aggregate demand, the economy travels along the supply line, which slopes up. So P and Y move the same way: both up for a rightward shift, both down for a leftward one.

Memory hook: an aggregate demand shift moves price level and output together.

7. Read a supply shock: when P and Y move apart

Suppose oil prices jump. A trucking company pays more for diesel. A bakery pays more to heat its ovens and to have flour delivered. An airline adds a fuel charge. Nothing about how much buyers want to spend has changed yet, but it now costs firms more to produce the same output.

A supply shock is a sudden change in input costs or productivity, such as a jump in oil prices, that shifts the short-run aggregate supply curve.

Worked example — an oil-price shock, read in words. Use the comparative-statics habit. This case is described in words, with no new numbers.

Name the curve. Oil is an input cost, so short-run aggregate supply moves. Aggregate demand does not.
Name the direction. Higher costs mean firms supply less at every price level, so short-run aggregate supply shifts left.
Read the new crossing. The economy slides up and to the left along the unchanged aggregate demand line. The price level rises, and real output falls.

In words: an oil-price shock raises the price level and lowers real output at the same time.

Stagflation is a rise in the price level together with a fall in real output, the result of a short-run aggregate supply curve shifting to the left.

The word joins "stagnation," output standing still or shrinking, with "inflation," rising prices. It is a hard combination to live through: your paycheck buys less and your hours may be cut in the same season.

Compare the two shocks side by side. An aggregate demand shift moves P and Y together. A short-run aggregate supply shift moves them apart. That one fact lets you work backward from the news. If prices rose and output rose, look for a demand story. If prices rose and output fell, look for a supply story.

Caveat: real economies are often hit by more than one change at once, so the news rarely shows a single clean shift. The model's job is to separate the forces so you can reason about each one.

Misconception check. Students often read an oil-price shock as a shift of aggregate demand, because higher gas prices feel like something that changes how much people buy. That is tempting, because drivers do grumble at the pump. But the first thing an oil shock changes is what it costs firms to produce. That is an input cost, so short-run aggregate supply shifts left. If you shift aggregate demand instead, you will predict that output and prices move together, and you will get the direction of output wrong.

Pause and reflect — choose one. Pick either prompt; they count the same.

(a) Describe a time when prices you pay rose while work or hours near you seemed harder to find. Does a supply shock fit that story? What evidence would you look for?
(b) Describe a time when prices rose while stores and employers near you were busy. Which aggregate demand shifter might explain it?

Memory hook: together means demand; apart means supply.

Key terms

AD–AS model — A diagram of the whole economy, with real output on the horizontal axis and the price level on the vertical axis, where aggregate demand and aggregate supply cross to set both. (first used: 1. Read the AD–AS diagram: real output across, the price level up)
price level — The average level of prices across the whole economy, measured by a price index such as the GDP deflator; a change in it raises or lowers the prices of goods and services as a group. (first used: 1. Read the AD–AS diagram: real output across, the price level up)
aggregate demand — The total quantity of real output that households, firms, the government, and foreign buyers want to buy at each price level; its curve slopes down. (first used: 2. Explain why aggregate demand slopes down: three economy-wide effects)
wealth effect — The reason aggregate demand slopes down that works through savings: a lower price level raises what people's money holdings can buy, so they spend more. (first used: 2. Explain why aggregate demand slopes down: three economy-wide effects)
interest-rate effect — The reason aggregate demand slopes down that works through borrowing: a lower price level means people need less money for everyday purchases, so interest rates fall and spending on things bought with loans rises. (first used: 2. Explain why aggregate demand slopes down: three economy-wide effects)
exchange-rate effect — The reason aggregate demand slopes down that works through trade: a lower domestic price level makes a country's exports cheaper abroad and imports dearer at home, so net exports rise. (first used: 2. Explain why aggregate demand slopes down: three economy-wide effects)
sticky prices and wages — Prices and wages that are slow to change because of contracts, menus, and agreements already in place, so they lag behind a change in the price level for a while. (first used: 3. Meet the two supply curves: sticky in the short run, vertical in the long run)
short-run aggregate supply — The total quantity of real output firms supply at each price level while some prices and wages are slow to change; its curve slopes up. (first used: 3. Meet the two supply curves: sticky in the short run, vertical in the long run)
long-run aggregate supply — The real output an economy produces once every price and wage has fully adjusted; its curve is a vertical line at potential output. (first used: 3. Meet the two supply curves: sticky in the short run, vertical in the long run)
short-run equilibrium — The point where the aggregate demand curve crosses the short-run aggregate supply curve, which sets the economy's price level and real output for now. (first used: 4. Find the short-run equilibrium: where the curves cross)
movement along a curve — A slide from one point to another on the same curve, caused by a change in the price level, with the curve itself staying put. (first used: 5. Tell a movement along from a shift: the term's most important habit)
shift of a curve — A move of the whole curve to the left or right, caused by a change in something other than the price level, such as spending or input costs. (first used: 5. Tell a movement along from a shift: the term's most important habit)
comparative statics — The habit of comparing two equilibriums before and after one change: name the curve that moves, name the direction, then read the new price level and real output. (first used: 6. Shift aggregate demand: name it, move it, read the new P and Y)
supply shock — A sudden change in input costs or productivity, such as a jump in oil prices, that shifts the short-run aggregate supply curve. (first used: 7. Read a supply shock: when P and Y move apart)
stagflation — A rise in the price level together with a fall in real output, the result of a short-run aggregate supply curve shifting to the left. (first used: 7. Read a supply shock: when P and Y move apart)

Summary

The AD–AS diagram puts real output on the horizontal axis and the price level on the vertical axis.
Aggregate demand slopes down because of the wealth, interest-rate, and exchange-rate effects, not substitution.
Short-run aggregate supply slopes up because some prices and wages are sticky.
Long-run aggregate supply is vertical at potential output.
The short-run equilibrium is where aggregate demand crosses short-run aggregate supply; report both P and Y.
A change in the price level is a movement along a curve; anything else shifts the whole curve.
C, I, G, and NX shift aggregate demand; input costs, productivity, and expected inflation shift short-run aggregate supply.
An aggregate demand shift moves P and Y together; a short-run aggregate supply shift moves them apart.

Check your understanding

Work these before looking at the answers — they are ungraded, and the answers (with reasoning) are at the bottom of the page.

Name the effect behind each response to a lower price level: (a) a household's emergency fund now covers more months of groceries, so it eats out more often; (b) a ski resort in a mountain country sees more foreign visitors once its prices fall relative to resorts abroad; (c) a family finds a home-improvement loan cheaper and redoes its kitchen.
An illustrative mountain economy (not real data) has aggregate demand P = 30 − Y⁄50 and short-run aggregate supply P = 6 + Y⁄50, with Y in billions of dollars. Find its short-run equilibrium and check it on both lines.
In the mountain economy from item 2, foreign tourists start spending more, and aggregate demand becomes P = 34 − Y⁄50. Name the curve, the direction, and the new price level and real output, and say what happened to each.
For each event in the mountain economy, say whether it is a movement along a curve or a shift, and if it is a shift, name the curve, the direction, and what happens to P and Y: (a) the price level rises with nothing else changed; (b) a drought raises the cost of feed and fertilizer for every farm; (c) firms grow gloomy about next year's sales and cancel orders for new equipment.

Answers (worked reasoning — read after attempting)

(a) The wealth effect: a lower price level raises what the household's savings can buy, so it spends more. (b) The exchange-rate effect: the country's goods and services became cheaper next to foreign ones, so foreign buyers purchase more and net exports rise. (c) The interest-rate effect: a lower price level means less money is needed for transactions, interest rates fall, and loan-financed spending rises.
Set the lines equal: 30 − Y⁄50 = 6 + Y⁄50, so 30 − 6 = 24 = 2Y⁄50. Solve: Y = 24 × 50 ÷ 2 = 600. Find P on the demand line: 30 − 600⁄50 = 30 − 12 = 18. Check on the supply line: 6 + 12 = 18. The short-run equilibrium is (600, 18): 600 billion dollars of real output at a price level of 18.
Tourist spending is spending by foreign buyers, which raises net exports, so aggregate demand shifts right. Set the new pair equal: 34 − Y⁄50 = 6 + Y⁄50, so 34 − 6 = 28 = 2Y⁄50, and Y = 28 × 50 ÷ 2 = 700. Then P = 34 − 700⁄50 = 34 − 14 = 20, checked as 6 + 14 = 20. Real output rose from 600 to 700 billion dollars and the price level rose from 18 to 20, both up together, because a demand shift moves the economy along the upward-sloping supply line.
(a) A movement along a curve: the price level is on the diagram's axis, so a change in it slides the economy along the curves already drawn. (b) A shift: the drought raises input costs, so short-run aggregate supply shifts left; the price level rises and real output falls, a stagflation pattern. (c) A shift: lower investment I means aggregate demand shifts left; the price level and real output both fall.

Next up in this module: the Readings & Resources page, the lecture tutorial, the practice set, and the quiz — and next week the AD–AS model reads recessions and booms as gaps between the crossing and potential output.

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