PRINCIPLES OF

ECONOMICS
ELEVENTH EDITION

CASE FAIR OSTER

PEARSON
Prepared by: Fernando Quijano w/Shelly Tefft

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The Determination of
Aggregate Output,
the Price Level, and
the Interest Rate

27
C H APT E R O U T LI N E

The Aggregate Supply (AS) Curve

Aggregate Supply in the Short Run
Shifts of the Short-Run Aggregate Supply Curve

The Aggregate Demand (AD) Curve

Planned Aggregate Expenditure and the Interest
Rate
The Behavior of the Fed
Deriving the AD Curve

The Final Equilibrium

Other Reasons for a Downward-Sloping
AD Curve
The Long-Run AS Curve
Potential GDP

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The Aggregate Supply (AS) Curve

aggregate supply The total supply of all goods and services in an economy.

aggregate supply (AS) curve A graph that shows the relationship between
the aggregate quantity of output supplied by all firms in an economy and the
overall price level.

Although it is called an aggregate supply curve, it is better thought of as a

price/output response curvea curve that traces out the price decisions and
output decisions of all firms in the economy under different levels of aggregate
demand.

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Aggregate Supply in the Short Run

FIGURE 27.1 The ShortRun Aggregate Supply
Curve

In the short run,

the aggregate supply
curve (the price/output
response curve) has a
positive slope.
At low levels of
aggregate output,
the curve is fairly flat.
As the economy
approaches capacity,
the curve becomes
nearly vertical.
At capacity, ,
the curve is vertical.

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Why an Upward Slope?

Wages are a large fraction of total costs and wage changes lag behind price
changes. This gives us an upward sloping short-run AS curve.

Why the Particular Shape?

Consider the vertical portion of the AS curve. At some level the overall economy
is using all its capital and all the labor that wants to work at the market wage. At
this level (), increased demand for labor and output can be met only by
increased prices. Neither wages nor prices are likely to be sticky.
At low levels of output, the AS curve is flatter. Small price increases may be
associated with relatively large output responses. We may observe relatively
sticky wages upward at this point on the AS curve.

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Shifts of the Short-Run Aggregate Supply Curve

The vertical part of the short-run AS curve represents the economys maximum
(capacity) output, which is determined by the economys existing resources,
like the size of its labor force, capital stock, and the current state of technology.

New discoveries of oil or problems in the production of energy can also shift the
AS curve through effects on the marginal cost of production in many parts of
the economy.

cost shock, or supply shock A change in costs that shifts the short-run
aggregate supply (AS) curve.

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 FIGURE 27.2 Shifts of the Short-Run Aggregate Supply Curve

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The Aggregate Demand (AD) Curve

The aggregate demand (AD) curve is derived from the model of the goods
market in Chapters 23 and 24 and from the behavior of the Fed. We begin with
the goods market.

Planned Aggregate Expenditure and the Interest Rate

We can use the fact that planned investment depends on the interest rate to
consider how planned aggregate expenditure (AE) depends on the interest
rate.
Recall that planned aggregate expenditure is the sum of consumption,
planned investment, and government purchases.
That is,

AE C + I + G
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 FIGURE 27.3 The Effect of an Interest Rate Increase on Planned Aggregate Expenditure and
Equilibrium Output

An increase in the interest rate from 3 percent to 6 percent lowers planned aggregate
expenditure and thus reduces equilibrium output from Y0 to Y1.
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The effects of a change in the interest rate on the equilibrium level of output in
the goods market include:

A high interest rate (r) discourages planned investment (I).

Planned investment is a part of planned aggregate expenditure (AE).
Thus, when the interest rate rises, planned aggregate expenditure (AE) at
every level of income falls.
Finally, a decrease in planned aggregate expenditure lowers equilibrium
output (income) (Y) by a multiple of the initial decrease in planned investment.

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Using a convenient shorthand:

r I AE Y
r I AE Y
IS curve Relationship between aggregate output and the interest rate in the
goods market.

With the interest rate fixed, an increase in government spending (G) increases
AE and thus Y in equilibrium.

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 FIGURE 27.4 The IS Curve

In the goods market,

there is a negative
relationship between
output and the
interest rate because
planned investment
depends negatively
on the interest rate.
Any point on the
IS curve is an
equilibrium in the
goods market for the
given interest rate.

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 FIGURE 27.5 Shift of the IS Curve

An increase in
government
spending (G) with
the interest rate
fixed increases
output (Y),
which is a shift
of the IS curve
to the right.

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The Behavior of the Fed

FIGURE 27.6 Fed Behavior

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As the Fed thinks about its interest rate setting, it considers factors other than
current output and inflation, such as levels of consumer confidence, possible
fragility of the domestic banking sector, and possible financial problems abroad.

For our purposes we will label all these factors (except output and inflation) as
Z factors, which lie outside our model and are likely to vary from period to
period in ways that are hard to predict.

Fed rule Equation that shows how the Feds interest rate decision depends on
the state of the economy.

r Y P Z
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 FIGURE 27.7 Equilibrium Values of the Interest Rate and Output

In the Fed rule,

the Fed raises the
interest rate as
output increases,
other things being
equal.
Along the IS curve,
output falls as the
interest rate
increases because
planned investment
depends negatively
on the interest rate.
The intersection of
the two curves gives
the equilibrium values
of output and the
interest rate for given
values of government
spending (G), the
price level (P), and
the factors in Z.
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E C O N O M I C S I N PR AC T I C E
What Does Ben Bernanke Really Care About?
As the economy sputtered along in late 2012 and early 2013, a number of
newspaper articles began to appear focusing on what Ben Bernanke really
cared about.
One article was titled Does Ben Bernanke Care Too Much About Jobs? while
another journalist opined Ben Bernanke Doesnt Care about the Price of Your
Hamburger.
At this point you should see that these colorful headlines are just asking what
are the variables in the Fed rule!

THINKING PRACTICALLY
THINKING PRACTICALLY
1.In his research work while a professor at Princeton, Bernanke emphasized the dangers
1.In his research work while a professor at Princeton, Bernanke emphasized the dangers
of inflation. As Fed Chair, he has spent more time worrying about output.
of inflation. As Fed Chair, he has spent more time worrying about output.
Why is this? (Hint: go back and look at the data graphs.)
Why is this? (Hint: go back and look at the data graphs.)
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Deriving the AD Curve

Because many prices rise together when the overall price level rises, we cannot
use the ceteris paribus assumption to draw the AD curve.

The logic that explains why a simple demand curve slopes downward fails to
explain why the AD curve also has a negative slope.

Aggregate demand falls when the price level increases because the higher
price level leads the Fed to raise the interest rate, which decreases planned
investment and thus aggregate output.

The higher interest rate causes aggregate output to fall.

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 FIGURE 27.8 The Aggregate Demand (AD) Curve

The AD curve is
derived from
Figure 27.7.
Each point on the
AD curve is an
equilibrium point
in Figure 27.7 for
a given value of P.
When P increases,
the Fed raises the
interest rate (the Fed
rule in Figure 27.7
shifts to the left),
which has a
negative effect on
planned investment
and thus on Y.
The AD curve
reflects this
negative
relationship
between P and Y.
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The Final Equilibrium

FIGURE 27.9 Equilibrium Output and the Price Level

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Other Reasons for a Downward-Sloping AD Curve

The AD curve slopes down in our analysis because the Fed raises the interest
rate when P increases and because planned investment depends negatively on
the interest rate.

There is also a real wealth effect on consumption that contributes to a

downward-sloping AD curve.

real wealth effect The change in consumption brought about by a change in

real wealth that results from a change in the price level.

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The Long-Run AS Curve

FIGURE 27.10 The Long-Run
Aggregate Supply Curve

When the AD curve

shifts from AD0 to AD1,
the equilibrium price
level initially rises from
P0 to P1 and output
rises from Y0 to Y1.
Wages respond in
the longer run,
shifting the AS curve
from AS0 to AS1.
If wages fully adjust,
output will be back
to Y0.
Y0 is sometimes called
potential GDP.

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Potential GDP
Recall that even the short-run AS curve becomes vertical at some particular
level of output.
The vertical portion of the short-run AS curve exists because there are physical
limits to the amount that an economy can produce in any given time period.
potential output, or potential GDP The level of aggregate output that can be
sustained in the long run without inflation.
Short-Run Equilibrium Below Potential Output
Although different economists have different opinions on how to determine
whether an economy is operating at or above potential output, there is general
agreement that there is a maximum level of output (below the vertical portion of
the short-run aggregate supply curve) that can be sustained without inflation.
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E C O N O M I C S I N PR AC T I C E
The Simple Keynesian Aggregate Supply Curve
With planned aggregate expenditure of AE1
and aggregate demand of AD1, equilibrium
output is Y1.
A shift of planned aggregate expenditure to
AE2, corresponding to a shift of the AD
curve to AD2, causes output to rise but the
price level to remain at P1.
If planned aggregate expenditure and
aggregate demand exceed YF, however,
there is an inflationary gap and the price
level rises to P3.
THINKING PRACTICALLY
THINKING PRACTICALLY
1.Why is the distance between AE3 and AE2 called
1.Why is the distance between AE3 and AE2 called
an inflationary gap?
an inflationary gap?
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R E V I E W TE R M S AN D C O N C E PTS
aggregate supply
aggregate supply (AS) curve
cost shock, or supply shock
Fed rule
IS curve
potential output, or potential GDP
real wealth effect

Equations:

AE C + I + G

r Y P Z
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