Lecture: Aggregate Demand & Aggregate Supply
Lecture script · about 15–20 minutes spoken · Week 5
Opening
Think about a season when gas prices jumped and a delivery driver you know saw hours get cut. Now think about a different season, when stores were packed, help-wanted signs were everywhere, and prices were climbing too. Prices rose both times. But the stories behind them were nothing alike.
You meet these stories wherever you work. A hospital buyer watches supply costs climb. A café owner notices customers spending less. Each of them is living through a change in the whole economy's prices and output, and each of them wants to know which way things go next.
In this course you've already built the tools for that. In Week 2 you split spending into real GDP and a price index, the GDP deflator. In Week 3 you treated the price level as an index. In Week 4 you met potential output, the economy's long-run path. In this lecture I'll put those three ideas into one picture, the AD–AS model. We'll see why its lines slope the way they do and find where they cross. Then we'll practise the habit that matters most: telling a slide along a line from a shift of the whole line. Next, in Week 6, Business Cycles & Short-Run Fluctuations, you'll use this same picture to read recessions and booms.
1. The picture: real output across, the price level up
Here's a puzzle from a coffee shop. Its sales went up from one weekend to the next. Did it sell more lattes, or did it charge more for each one? From the sales total alone, you can't tell. You need the quantity and the price separately.
The whole economy has the same puzzle, and you solved it in Week 2. Real GDP is the quantity part. A price index, like the GDP deflator, is the price part. Our new picture gives each part 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. And the price level is the average level of prices across the whole economy, measured by a price index such as the GDP deflator.
So picture an empty graph. Going across, left to right, is real output, which we call Y, measured in billions of dollars of real GDP. Going up, bottom to top, is the price level, which we call P, measured in index units.
All week we'll follow one illustrative economy, built for this course, not real data. Its real output is 800, counted in billions of dollars, at a price level of 12. That's one point on the picture: 800 across, 12 up.
Pause and try this. If someone labels the up-and-down axis "the price of one product," what have they gotten wrong?
Think about how many prices that axis measures.
Here's the answer. That axis is the price level of everything at once, not the price of one product, because this picture is about the whole economy.
Hold on to that, because it decides how the demand line works.
2. Why aggregate demand slopes down
Picture every buyer in the economy at the same moment. Families buying groceries. A construction firm ordering lumber. A city buying buses. Shoppers in other countries buying goods made here.
Add up everything they want to buy. That's 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. A lower price level goes with more real output demanded.
Now, why? Here's where many people slip. For one product, a lower price pulls you away from some other product. Cereal gets cheaper, you switch brands. But when every price falls at once, there's nothing else to switch away from. So the slope needs three economy-wide reasons instead.
First, savings. 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's savings stretch further, so a trip that was put off gets booked.
Second, borrowing. With the interest-rate effect, a lower price level means people need less money for everyday purchases, so interest rates fall and spending on things bought with loans rises. A small business finds a loan cheaper and orders a second oven.
Third, trade. With the exchange-rate effect, a lower domestic price level makes a country's exports cheaper abroad and imports dearer at home, so net exports rise. Buyers overseas order more of the machine parts made here.
Pause and try this. Prices across the economy fall, and a family's emergency fund now covers more months of groceries, so they eat out more. Which of the three effects is that?
Ask yourself which road the extra spending traveled.
Here's the answer. It's the wealth effect, because the family's savings now buy more, and that's what led them to spend.
3. Two supply lines: sticky now, vertical later
Let me tell you about a café. It prints its menu once a year. It signed a one-year lease. Its cooks agreed to their hourly pay months ago. Now suppose prices across the whole economy rise. The café can charge a bit more at its next menu reprint, but its rent and its wages stay put for a while. For now, each meal earns a little more over its costs, so staying open an extra hour pays.
That lag has a name. 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.
Because of that lag, 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, slopes up. A higher price level, with costs stuck in place, makes more production pay.
Give it enough time, though, and the contracts run out. Workers notice their pay buys less and ask for raises. Landlords reset rents. Once every cost has caught up, a higher price level no longer makes extra output pay. 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, the long-run path you met in Week 4.
Picture it this way. The short-run line rises from lower left to upper right. The long-run line stands straight up and down.
Pause and try this. Why is the long-run line vertical instead of sloping up like the short-run one?
Think about what happens to costs once contracts run out.
Here's the answer. In the long run every price and wage has adjusted, so a higher price level is matched by higher costs and no longer changes how much the economy can make.
4. Where the lines cross
Think of a farmers' market at closing time. Prices settle where what shoppers want matches what the sellers brought. The whole economy settles the same way.
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.
Our illustrative economy has two straight lines. On the demand line, the price level equals 20 minus real output divided by 100. On the short-run supply line, the price level equals 4 plus real output divided by 100. At the crossing, both lines give the same price level, so we set them equal.
Let's walk it. Take 4 away from 20 and you get 16. The two copies of "output divided by 100" add up to twice that amount. So 16 equals two times output divided by 100. Multiply 16 by 100 and divide by 2, and output comes out to 800, in billions of dollars.
Now find the price level. Output of 800 divided by 100 is 8. On the demand line, 20 minus 8 is 12. Check it on the supply line: 4 plus 8 is also 12. Both lines agree, so the crossing is real output of 800 at a price level of 12.
Why there? At output of 700, buyers would accept a price level of 13, but firms need only 11, so producing more pays. At 900, firms need 13 and buyers accept only 11, so output gets cut back. Only at 800 do they agree.
Pause and try this. You found output of 800. Why check the price level on both lines instead of stopping at one?
Think about what an equilibrium point has to satisfy.
Here's the answer. An equilibrium sits on both lines at once, so the second check catches any arithmetic slip before it spreads.
5. Sliding along versus shifting
Here's the most important habit in this course, so let's take it slowly. Picture a bus route drawn on a city map. When the bus goes from one stop to the next, it's traveling along the same route. When the city redraws the route, the whole line moves. Those are two very different events.
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 picture's own axis. So when only P changes, the economy can only slide along a line that's already drawn.
Let's see it with our numbers. Suppose the price level were 13 instead of 12, with nothing else about buyers changed. Use the same demand line: 20 minus 13 is 7, and 7 times 100 is 700. Buyers want real output of 700, down from 800. That's a slide up and to the left along the same line. No new line.
So what does redraw a line? For demand: consumption, investment, government purchases, and net exports. For short-run supply: input costs, productivity, and expected inflation.
Pause and try this. Firms across the economy grow gloomy about next year's sales and cancel orders for new equipment. Is that a slide along a line or a shift, and of which line?
Check whether the price level is what changed.
Here's the answer. It's a shift of aggregate demand to the left, because investment fell, and investment is one of demand's shifters, not the price level.
6. Shifting demand and reading the new crossing
Now let's use the habit. Comparative statics sounds fancy, but it's three steps you can say out loud. 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.
Suppose the government starts a big road-repair program. Step one: government purchases are part of demand, so the demand line moves. Step two: more spending at every price level shifts demand to the right. The new demand line starts at 22 instead of 20, a rise of 2.
Step three: find the new crossing. Take 4 from 22 and you get 18. So 18 equals two times output divided by 100. Multiply 18 by 100 and divide by 2, and output is 900. On the new demand line, 22 minus 9 is 13. On the supply line, 4 plus 9 is 13. The new crossing is real output of 900 at a price level of 13.
Say what changed in words. Output rose by 100, in billions of dollars, from 800 to 900. The price level rose from 12 to 13. Both went up, together. The supply line never moved; the economy walked up it.
The mirror case runs the other way. If spending fell, demand would shift left, and output and the price level would both fall together.
Pause and try this. After demand shifts right, someone predicts output will rise but the price level will fall. What's the flaw?
Think about which line the economy travels along after the shift.
Here's the answer. After a demand shift the economy moves along the upward-sloping supply line, so output and the price level rise together, not in opposite directions.
7. Supply shocks: when prices and output split
Now picture oil prices jumping. A trucking company pays more for diesel. A bakery pays more to heat its ovens and get flour delivered. Nothing about buyers has changed yet, but producing the same output now costs firms more.
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.
Run the three steps. The curve: oil is an input cost, so short-run supply moves. The direction: higher costs mean less supplied at every price level, so it shifts left. The new crossing: the economy slides up the unchanged demand line, so the price level rises while real output falls.
That combination has a name. 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. It's a hard season to live through: your paycheck buys less while hours get harder to find.
Here's the rule that lets you work backward from the news. A demand shift moves prices and output together. A short-run supply shift moves them apart.
Pause and try this. A headline says prices rose and output fell in the same season. Is a demand shift or a supply shift the likelier story?
Use the together-or-apart rule.
Here's the answer. A supply shift is likelier, because prices and output moved apart, and only a short-run supply shift moves them in opposite directions.
Closing
Let's pull it together. The AD–AS picture puts real output across and the price level up. Demand slopes down because of savings, borrowing, and trade, not because buyers switch goods. Short-run supply slopes up because some costs are sticky, and long-run supply stands vertical at potential output. The crossing sets the price level and real output; in our example, output of 800 at a price level of 12. A price-level change slides along a line; anything else shifts it. A demand shift to the right took us to 900 and 13, both up together. And a supply shock pulls prices and output apart.
Next in this module come the Readings & Resources page, the lecture tutorial, the practice set, and the quiz. Then in Week 6, Business Cycles & Short-Run Fluctuations, you'll compare the crossing with potential output and read recessions and booms on this same picture.
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