BU.220.610 Chap.6 Aggregate Demand, Aggregate Supply and Price Adjustment
Aggregate Demand, Aggregate Supply and Price Adjustment
Module 6 connects the two halves of the course. The long-run model of Modules 2 to 4 has flexible prices and output at potential; the short-run model of Module 5 has fixed prices and output set by spending. The question here is how an economy travels from one to the other, and the answer is the gradual adjustment of prices, studied with the aggregate demand and aggregate supply model.
Aggregate demand is a downward-sloping relation between the price level and output. Chapter 4 obtained it from the quantity equation; this module derives it from IS-LM, which brings in interest rates and investment. A higher price level lowers real money balances, the LM curve shifts left, the interest rate rises, investment falls and output demanded falls.
Everything that shifts IS or LM at a given price level shifts aggregate demand: expansionary monetary policy and expansionary fiscal policy both move it right, contractions move it left, and a change in the price level itself is only a movement along the curve. Aggregate supply depends on the horizon. In the very short run prices are fixed and supply is horizontal, so any change in demand changes output.
In the long run, about ten years in the module's framing, prices are fully flexible and supply is vertical at potential output, so extra demand only raises prices. In between, a simple rule governs the path: prices rise when output is above potential, fall when it is below, and stay put only when output equals potential. Apply the rule to a negative demand shock. Output first falls below potential at the old price level.
Prices then drift down, which raises real balances, lowers the interest rate and moves the economy down along the new aggregate demand curve until output is back at potential with a lower price level. A monetary expansion runs the same path in reverse and, in the long run, leaves only a higher price level, the short-run route to the long-run neutrality of money. Supply shocks behave differently.
A jump in energy or food costs shifts short-run supply up, so prices rise while output falls. Policy then faces a genuine trade-off: accommodating the shock with more demand restores output but keeps the higher prices, while holding demand steady contains prices at the cost of a longer slump.
The module applies these tools to business-cycle events and to the policy responses of the central bank and Congress, both of which shape where aggregate demand sits.
What this chapter covers
- 01
Deriving aggregate demand from IS-LM
- 02
What shifts aggregate demand
- 03
Short-run and long-run aggregate supply
- 04
The price-adjustment rule
- 05
Adjustment after a demand shock
- 06
Supply shocks and stabilization choices
Worked example · free
Follow a confidence boom until prices catch up
- 2Check the start: 500 times 4 divided by 2 = 1,000, so the economy begins at potential.
- 2Short run with the price level stuck at 2: Y = 500 times 4.4 divided by 2 = 1,100, 10% above potential.
- 2Long run with output back at 1,000: P = 500 times 4.4 divided by 1,000 = 2.2.
Key terms
- Aggregate Demand Curve
- A downward-sloping schedule on which each higher price level pairs with less output demanded, derived from IS-LM or from the quantity equation.
- Long-Run Aggregate Supply
- A vertical line at potential output, reflecting that with flexible prices output is fixed by capital, labor and technology.
- Stagflation
- A combination of rising prices and falling output, typically produced by an adverse supply shock that shifts short-run supply upward.
Aggregate Demand, Aggregate Supply and Price Adjustment FAQ
Why does aggregate demand slope downward if firms can raise prices?
The slope comes from the money market, not from individual pricing. A higher price level shrinks real balances, pushes the interest rate up along the IS curve and cuts investment, so the quantity of output demanded falls.
Does the economy return to potential without any policy action?
In this model it does, because prices eventually fall when output is below potential and rise when it is above. The module's point is that the adjustment is gradual, so output and employment can stay away from potential for a long time.
Why is a supply shock harder for policy than a demand shock?
A demand shock moves prices and output in the same direction, so one demand-side action fixes both. A supply shock moves them in opposite directions, so stimulating demand restores output only by adding to the price increase.
Exam move
Sketch AD, SRAS and LRAS on the same axes and practise three experiments until they are automatic: a demand fall with no policy, a monetary expansion from potential, and an adverse supply shock with and without accommodation. For each, label the short-run point and the long-run point and state P and Y at both.
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