Mankiw PrinciplesOfEconomics 10e PPT CH34

Principles of
Economics, 10e
Chapter 34: Aggregate
Demand and Aggregate
Supply
Mankiw, Principles of Economics, Tenth Edition. © 2024 Cengage. All Rights Reserved. May not be scanned, copied
or duplicated, or posted to a publicly accessible website, in whole or in part. 1
Chapter Objectives (1 of 2)
By the end of this chapter, you should be able to:

• Explain why the aggregate-demand curve is downward sloping.
• Identify factors that cause the aggregate-demand curve to shift.
• Derive the short-run and long-run effects on output and prices
according to the AD-AS model, given a scenario about an economic
shock.
• Determine the effect of an economic event on the position of the long-
run aggregate supply curve.
• Contrast the slope of the long-run aggregate supply curve and the
short-run aggregate supply curve.
Chapter Objectives (2 of 2)
• Determine the effect of a change in one of the determinants of

aggregate supply, given a graph of the short-run aggregate-supply
curve.
• Explain how the sticky-wage theory affects equilibrium.
• Explain how the sticky-price theory affects equilibrium.
• Identify the long-run equilibrium in the AD-AS model.
34-1
Three Key Facts about Economic
Fluctuations
Introduction
• Economic activity
• Fluctuates from year to year
• Recession*
• Period of declining real incomes and rising unemployment
• Depression*
• Severe recession
*Words accompanied by an asterisk are key terms from the chapter.
Figure 1 A Look at Short-Run
Economic Fluctuations Panel (a)
• This figure shows real GDP in panel
(a), investment spending in panel
(b), and unemployment in panel (c)
for the U.S. economy.
• Recessions are shown as the
shaded areas.
• Notice that real GDP and
investment spending decline during
recessions, while unemployment
rises. Source: U.S. Department of Commerce; U.S.
Department of Labor.
Economic Fluctuations Panel (b)
shaded areas.
recessions, while unemployment
rises. Source: U.S. Department of Commerce; U.S.
Department of Labor.
Economic Fluctuations Panel (c)
shaded areas.
recessions, while unemployment Source: U.S. Department of Commerce; U.S.
rises. Department of Labor.
34-2
Explaining Short-Run Economic Fluctuations
The Model of Aggregate Demand and
Aggregate Supply (1 of 2)
• Model of short-run economic fluctuations focuses on behavior of two
variables
1. Real variable: Output of goods and services (real GDP)
2. Nominal variable: Average level of prices (CPI or GDP deflator)
• Model of aggregate demand (AD) and aggregate supply (AS)*
• Model that most economists use to explain short-run fluctuations in
economic activity around its long-run trend
The Model of Aggregate Demand and
Aggregate Supply (2 of 2)
• Aggregate-demand curve*
• Curve that shows the quantity of goods and services that
households, firms, the government, and customers abroad want to
buy at each price level
• Aggregate-supply curve*
• Curve that shows the quantity of goods and services that firms
choose to produce and sell at each price level
Figure 2 Aggregate Demand and
Aggregate Supply
• Economists use the model of
aggregate demand and aggregate
supply to analyze economic
fluctuations.
• On the vertical axis is the overall level

of prices.
• On the horizontal axis is the

economy’s total output of goods and
services.
• Output and the price level adjust to

the point at which the aggregate-
supply and aggregate-demand curves
intersect. Mankiw, Principles of Economics, Tenth Edition. © 2024 Cengage. All Rights Reserved. May not be scanned, copied
34-3
The Aggregate-Demand Curve
Why the Aggregate-Demand Curve
Slopes Downward
• Y = C + I + G + NX
• Three effects explain why AD curve slopes downward:
• Wealth effect (C)
• Interest-rate effect (I)
• Exchange-rate effect (NX)
• Assumption: Government spending (G) fixed by policy
Figure 3 The Aggregate-Demand
Curve
• A fall in the price level from P1 to P2
increases the quantity of goods and
services demanded from Y1 to Y2.
• There are three reasons for this negative
relationship.
• As the price level falls, real wealth rises,
interest rates fall, and the exchange rate
depreciates.
• These effects stimulate spending on
consumption, investment, and net
exports.
• Increased spending on any or all of these
components of output means a larger
quantity of Mankiw,
goods and ofservices
Principles demanded.
Economics, Tenth Edition. © 2024 Cengage. All Rights Reserved. May not be scanned, copied
The Price Level and Consumption: The
Wealth Effect
• A lower price level
• Raises the real value of money and makes consumers wealthier,
encouraging them to spend more
• Increases the quantity of goods and services demanded
• A higher price level
• Reduces the real value of money and makes consumers poorer
reducing consumer spending
• Decreases the quantity of goods and services demanded
The Price Level and Investment: The
Interest-Rate Effect
• A lower price level
• Reduces the interest rate
• Encourages spending on investment goods
• A higher price level
• Raises the interest rate
• Discourages investment spending
The Price Level and Net Exports: The
Exchange-Rate Effect
• A lower U.S. price level causes U.S. interest rates to fall
• Real value of the dollar declines in foreign exchange markets
• Depreciation stimulates U.S. net exports
• A higher U.S. price level causes U.S. interest rates to rise
• Real value of the dollar increases
• Appreciation reduces U.S. net exports
Why the Aggregate-Demand Curve
Might Shift
• The AD curve might shift:
• Changes in consumption, C
• Changes in investment, I
• Changes in government purchases, G
• Changes in net exports, NX
Active Learning 1: The Aggregate-
Demand Curve
• What happens to the AD curve in each of the following scenarios?
A. A ten-year-old investment tax credit expires.
B. The U.S. exchange rate falls.
C. A fall in prices increases the real value of consumers’ wealth.
D. State governments replace their sales taxes with new taxes on
interest, dividends, and capital gains.
Active Learning 1: Answers
A. A ten-year-old investment tax credit expires

• I falls, AD curve shifts left
B. The U.S. exchange rate falls
• NX rises, AD curve shifts right
C. A fall in prices increases the real value of consumers’ wealth
• Move down along AD curve (wealth-effect)
D. State governments replace their sales taxes with new taxes on interest,
dividends, and capital gains.
• C rises, AD shifts right
34-4
The Aggregate-Supply Curve
Why the Aggregate-Supply Curve Is
Vertical in the Long Run
• In the long run, an economy’s production of goods and services (its
real GDP) depends on its supplies of labor, capital, and natural
resources and on the available technology used to turn these factors
of production into goods and services
• Because the price level does not affect the long-run determinants of
real GDP, the long-run aggregate-supply curve is vertical
Figure 4 The Long-Run Aggregate-
Supply Curve
• In the long run, the quantity of
output supplied depends on the
economy’s quantities of labor,
capital, and natural resources and
on the technology for turning these
inputs into output.
• Because the quantity supplied does
not depend on the overall price
level, the long-run aggregate-supply
curve is vertical at the natural level
of output.
Why the Long-Run Aggregate-Supply
Curve Might Shift
• Natural level of output*
• Production of goods and services that an economy achieves in the
long run when unemployment is at its normal rate
• Any change in the economy that alters the natural level of output
shifts the long-run aggregate-supply curve
• Output in the classical model depends on labor, capital, natural
resources, and technological knowledge
Using Aggregate Demand and Aggregate
Supply to Depict Long-Run Growth and
Inflation (1 of 2)
• Economy’s long-run trends
• Both AD and LRAS curves shift
• Short-run fluctuations in output and the price level should be viewed
as deviations from long-run trends of output growth and inflation
Using Aggregate Demand and Aggregate
Supply to Depict Long-Run Growth and
Inflation (2 of 2)
• Continual shifts of LRAS curve to right
• Technological progress
• AD curve shifts to right
• Monetary policy
• The Fed increases money supply over time
• Result
• Continuing growth in output
• Continuing inflation
Figure 5 Long-Run Growth and Inflation in
the Model of Aggregate Demand and
Aggregate Supply
• As the economy becomes better able to
produce goods and services, primarily
because of technological progress, the long-
run aggregate-supply curve shifts to the
right. At the same time, as the Fed increases
the money supply, the aggregate-demand
curve also shifts to the right. In this figure,
output grows from Y2000 to Y2010 and then to
Y2020, and the price level rises from P2000 to
P2010 and then to P2020. Thus, the model of
aggregate demand and aggregate supply
offers a new way to describe the classical
analysis of growth and inflation.
Why the Aggregate-Supply Curve
Slopes Upward in the Short Run
• Aggregate supply curve slopes upward in the short-run
• Theories that explain why the AS curve slopes upward in short-run
• Sticky-wage theory
• Sticky-price theory
• Misperceptions theory
The Sticky-Wage Theory
• Nominal wages are slow to adjust to changing economic conditions

• Long-term contracts (workers and firms)
• Slowly changing social norms
• Notions of fairness (influence wage setting)
• Nominal wages are based on expected prices
• Don’t respond immediately when actual price level is different from
what was expected
The Sticky-Price Theory
• Price level < Expected

• Firms: Incentive to produce less output
• Price level > Expected
• Firms: Incentive to produce more output
• Prices of some goods and services
• Slow to adjust to changing economic conditions
• Menu costs: Costs to changing prices
The Misperceptions Theory
• Changes in the overall price level

• Can temporarily mislead suppliers
• About changes in individual markets
• Changes in relative prices
• Suppliers respond to changes in level of prices
• Change in quantity supplied of goods and services
Figure 6 The Short-Run Aggregate-
Supply Curve
• In the short run, a fall in the price
level from P1 to P2 reduces the
quantity of output supplied from Y1
to Y2.
• This positive relationship could be

due to sticky wages, sticky prices,
or misperceptions.
• Over time, wages, prices, and
perceptions adjust, so this positive
relationship is only temporary.
Why the Short-Run Aggregate-Supply
Curve Might Shift
• An increase in the expected price level reduces the quantity of goods
and services supplied and shifts the short-run aggregate-supply curve
to the left
• A decrease in the expected price level raises the quantity of goods
and services supplied and shifts the short-run aggregate-supply curve
to the right
34-5
Two Causes of Economic Fluctuations
The Long-Run Equilibrium
• Assumption
• Economy begins in long-run equilibrium
• Long-run equilibrium
• Intersection of AD and LRAS curves
• Natural level of output
• Actual price level
• Intersection of AD and short-run AS curve
• Expected price level = Actual price level
Figure 7 The Long-Run Equilibrium
• The long-run equilibrium of the

economy is found where the
aggregate-demand curve crosses the
long-run aggregate-supply curve (point
A).
• When the economy reaches this long-
run equilibrium, the expected price
level will have adjusted to equal the
actual price level.
• As a result, the short-run aggregate-
supply curve crosses this point as well.
Figure 8 A Contraction in Aggregate
Demand
• A fall in aggregate demand is represented by a
leftward shift in the aggregate-demand curve
from AD1 to AD2.
• In the short run, the economy moves from point
A to point B.
• Output falls from Y1 to Y2, and the price level
falls from P1 to P2.
• But as the expected price level adjusts, the
short-run aggregate-supply curve shifts to the
right from AS1 to AS2, and the economy reaches
point C, where the new aggregate-demand
curve crosses the long-run aggregate-supply
curve.
• In the long run, the price level falls to P3, and
output returns to its
Mankiw, natural
Principles level, Y
of Economics,
1.
Tenth Edition. © 2024 Cengage. All Rights Reserved. May not be scanned, copied
Figure 9 U.S. Real GDP Growth since 1900
Over the course of U.S. economic

history, two fluctuations stand out
as especially large. During the early
1930s, the economy endured the
Great Depression, when the
production of goods and services
plummeted. During the early 1940s,
the United States entered World
War II, and production rose rapidly.
Both events are usually explained
by large shifts in aggregate Source: Louis D. Johnston and Samuel H. Williamson, “What
Was GDP Then?” http://www.measuringworth.com/usgdp/;
demand. Department of Commerce.
The Effects of a Shift in Aggregate
Supply
• When the short-run aggregate-supply curve shifts to the left, the
effect is falling output and rising prices—a combination called
stagflation*
• Over time, as wages, prices, and perceptions adjust, the short-run
aggregate-supply curve shifts back to the right, returning the price
level and output to their original levels

Figure 10 An Adverse Shift in
Aggregate Supply
• When some event increases
firms’ costs, the short-run
aggregate-supply curve shifts to
the left from AS1 to AS2.
• The economy moves from point

A to point B.
• The result is stagflation: Output

falls from Y1 to Y2, and the price
level rises from P1 to P2.
Accommodating an Adverse Shift in
Aggregate Supply
• Monetary and fiscal policymakers might attempt to offset some of the
effects of the shift in the short-run aggregate-supply curve by shifting
the aggregate-demand curve
• Policymakers are said to accommodate the shift in aggregate supply
• An accommodative policy accepts a permanently higher level of
prices to maintain a higher level of output and employment
Figure 11 Accommodating an Adverse
Shift in Aggregate Supply
• Faced with an adverse shift in
aggregate supply from AS1 to AS2,
policymakers who can influence
aggregate demand might try to shift
the aggregate-demand curve to the
right from AD1 to AD2.
• The economy would move from point A

to point C.
• This policy would prevent the supply
shift from reducing output in the short
run, but the price level would
permanently rise from P1 to P3.
Active Learning 2: Working with the
Model
• Draw the AD–AS diagram for the U.S. economy starting in a long-run
equilibrium (point A)
• A boom occurs in Canada. Use your diagram to determine the SR
and LR effects on U.S. GDP, the price level, and unemployment
Active Learning 2: Answers
• Event: Boom in Canada

1. Affects NX, AD curve
2. Shifts AD right
3. SR equilibrium at point B
• P and Y higher, unemployment lower
4. Over time, PE rises, SRAS shifts left,
until LR equilibrium at C
• Y and unemployment back at initial
levels
34-6
Conclusion
Conclusion
• This chapter had two goals

• First, it discussed some of the important facts about short-run
fluctuations in economic activity
• Second, it introduced a basic model to explain those fluctuations,
called the model of aggregate demand and aggregate supply
• We continue our study of this model in the next chapter to understand
more fully what causes economic fluctuations and how policymakers
might respond to them
Think-Pair-Share Activity
You are watching the evening news on television. The news anchor reports that union
wage demands are much higher this year because the workers anticipate an increase
in the rate of inflation. Your roommate says, “Inflation is a self-fulfilling prophecy. If
workers think there are going to be higher prices, they demand higher wages. This
increases the cost of production and firms raise their prices. Expecting higher prices
simply causes higher prices.”
A. Is this true in the short run? Explain.
B. If policymakers do nothing and allow the economy to adjust to the natural level of
output on its own, does expecting higher prices cause higher prices in the long
run? Explain.
C. If policymakers accommodate the adverse supply shock, does the expectation of
higher prices cause higher prices in the long run? Explain.
Self-Assessment
• What are two macroeconomic variables that decline when the

economy goes into a recession? Which macroeconomic variable rises
during a recession?
Summary
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Principles of

By the end of this chapter, you should be able to:

• Determine the effect of a change in one of the determinants of

*Words accompanied by an asterisk are key terms from the chapter.

*Words accompanied by an asterisk are key terms from the chapter.

*Words accompanied by an asterisk are key terms from the chapter.

• On the vertical axis is the overall level

• On the horizontal axis is the

• Output and the price level adjust to

A. A ten-year-old investment tax credit expires

*Words accompanied by an asterisk are key terms from the chapter.

• Nominal wages are slow to adjust to changing economic conditions

• Price level < Expected

• Changes in the overall price level

• This positive relationship could be

• The long-run equilibrium of the

Over the course of U.S. economic

*Words accompanied by an asterisk are key terms from the chapter.

• The economy moves from point

• The result is stagflation: Output

• The economy would move from point A

• Event: Boom in Canada

• This chapter had two goals

• What are two macroeconomic variables that decline when the

Click the link to review the objectives for this presentation.

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