10.1 Graphing Exercise: Aggregate Demand – Aggregate Supply

The aggregate demand – aggregate supply (AD–AS) model is useful for analyzing changes in both real GDP and the price level. Changes in either aggregate demand, aggregate supply, or both can help to explain recession and unemployment, inflation, and economic growth. Our analysis in this exercise will focus on the short run effects of changes in aggregate supply and aggregate demand.

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Exploration: How do changes in aggregate demand and supply affect the equilibrium price level and real GDP?

The graph shows the aggregate demand and aggregate supply curves for a hypothetical economy. The AD curve shows an inverse relationship between the aggregate price level and real GDP. This is because an increase in the price level: 1) reduces the real value of dollar-denominated assets, which reduces consumption expenditures (the real-balances effect); 2) increases the demand for money, which increases interest rates and thereby reduces investment expenditures (the interest-rate effect); and 3) makes domestically produced goods less attractive to foreigners, which reduces net exports (the foreign purchases effect).

The aggregate supply curve, on the other hand, reflects the costs of producing a given level of GDP. At very low levels of GDP, resources are unemployed and output may increase with little upward pressure on the price level. However, as real GDP approaches full employment, bottlenecks for some resources appear and costs begin to rise. The price level must rise sufficiently to cover these higher production costs.

The economy is initially at the full employment level of real GDP, labeled Q₀, and the price level is stable at price level P. To use the graph, click and drag either the AD or AS labels to shift the aggregate demand or aggregate supply curve, respectively, to a new location. Clicking Reset will restore the economy to full employment GDP and a stable price level. Click Update to establish the new equilibrium as a starting point for additional analysis.

1. Starting from full employment, what will be the impact on real GDP and the price level of an increase in desired consumption expenditures?
   See answer here
2. Suppose the economy is operating at full employment and prices are stable. All else equal, will an increase in wages and salaries increase the aggregate price level?
   See answer here
3. Starting from a full-employment, stable price equilibrium, suppose aggregate demand decreases. Which will result in a deeper recession—if the price level falls or if it remains the same?
   See answer here
4. The late 1990s were a period of dramatically rising stock values and rising labor productivity. Real GDP increased, yet prices remained relatively stable. How might this be explained by the AD–AS model?
   See answer here