Dynamic Change,

Economic Fluctuations, and

the AD-AS Model
Full Length Text — Part: 3 Chapter: 10
Macro Only Text — Part: 3 Chapter: 10

To Accompany “Economics: Private and Public Choice 13th ed.”

James Gwartney, Richard Stroup, Russell Sobel, & David Macpherson
Slides authored and animated by:
Joseph Connors, James Gwartney, & Charles Skipton

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Anticipated and
Unanticipated Changes

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Anticipated & Unanticipated Changes
• Anticipated changes are fully expected
by economic participants.
• Decision makers have time to adjust to
them before they occur.
• Unanticipated changes catch people by
surprise.

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Factors That Shift
Aggregate Demand

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Shifts in Aggregate Demand
• The aggregate demand (AD) curve indicates
the quantity of goods and services that will
be demanded at alternative price levels.
• An increase in aggregate demand (a shift
of the AD curve to the right) indicates that
decision makers will purchase a larger
quantity of goods and services at each
different price level.
• A decrease in aggregate demand (a shift
of the AD curve to the left) indicates that
decision makers will purchase a smaller
quantity of goods and services at each
different price level.

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Factors that Shift Aggregate Demand
• The following factors will cause a shift in
aggregate demand outward (inward):
• an increase (decrease) in real wealth
• a decrease (increase) in the real interest rate
• an increase in the optimism (pessimism)
of businesses and consumers about future
economic conditions
• an increase (decline) in the expected rate
of inflation
• higher (lower) real incomes abroad
• a reduction (increase) in the exchange rate
value of the nation’s currency

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Shifts in Aggregate Demand
Price
Level

AD1
AD0
AD2
Goods & Services
(real GDP)

• An increase in real wealth, such as would result from a

stock market boom, would increase aggregate
demand, shifting the entire curve to the right (from
ADcontrast,
• In 0 to AD1).
a reduction in real wealth decreases
aggregate demand, shifting AD left (from AD0 to AD2).
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 Consumer Sentiment Index:
A Measure of Optimism
• Below is the consumer sentiment index for 1978-2009.
• This measure attempts to capture consumers’ optimism
and pessimism regarding the future of the economy.
• Moves toward optimism tend to increase AD, while
moves toward pessimism tend to decrease AD.
• Note how the index turns down prior to or during
recessions (shaded time periods).

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Questions for Thought:
1. Explain how and why each of the following
factors would influence current aggregate
demand in the United States:
(a) an increased fear of recession
(b) an increased fear of inflation
(c) the rapid growth of real income in Canada
and Western Europe
(d) a reduction in the real interest rate
(e) a decline in housing prices
(f) a higher price level (be careful)

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Shifts in Aggregate Supply

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Long and Short-Run Aggregate Supply
• When considering shifts in aggregate supply,
it is important to distinguish
between the long run and short run.
• Shifts in LRAS:
A long run change in aggregate supply
indicates that it will be possible to achieve
and sustain a larger rate of output.
• A shift in the long run aggregate supply
curve (LRAS) will cause the short run
aggregate supply (SRAS) curve to shift in
the same direction.
• Shifts in LRAS are an alternative way of
indicating that there has been a shift in the
economy’s production possibilities curve.
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Long and Short-Run Aggregate Supply
• Shifts in SRAS:
Changes that temporarily alter the productive
capability of an economy will shift the SRAS
curve, but not the LRAS curve.

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Shifts in Aggregate Supply
• Factors that increase (decrease) LRAS:
• increase (decrease) in the supply of resources
• improvement (deterioration) in technology and
productivity
• institutional changes that increase (reduce)
the efficiency of resource use
• Factors that increase (decrease) SRAS:
• a decrease (increase) in resource prices
— hence, production costs
• a reduction (increase) in expected inflation
• favorable (unfavorable) supply shocks, such as
good (bad) weather or a reduction (increase) in
the world price of a key imported resource
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Shifts in Aggregate Supply
Price Price
Level Level
SRAS1 SRAS2
LRAS1 LRAS2

Goods & Services Goods & Services

YF1 YF2 (real GDP) (real GDP)

• Such factors as an increase in the stock of capital or an

improvement in technology will expand an economy’s
potential output and shift LRAS to the right (note that when
the LRAS curve shifts, so too does SRAS).
• Such factors as a reduction in resource prices or favorable
weather would shift SRAS to the right (note that here the
LRAS curve will remain constant). Copyright ©2010 Cengage Learning. All rights reserved.
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Questions for Thought:
1. Indicate how the following would influence
U.S. aggregate supply in the short run:
(a) an increase in real wage rates
(b) a severe freeze that destroys half of the
orange crop in Florida
(c) an increase in the expected rate of inflation
(d) an increase in the world price of oil
(e) abundant rainfall during the growing season
of agricultural states

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Questions for Thought:
2. Which of the following would be most likely
to shift the long run aggregate supply curve
(LRAS) to the left?
a. unfavorable weather conditions that reduced
the size of this year’s grain harvest
b. an increase in labor productivity as the result
of improved computer technology and expansion
in the Internet
c. an increase in the cost of security as the result
of terrorist activities
3. How would an increase in the economy’s
production possibilities influence the LRAS?

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Steady Economic Growth and
Anticipated Changes in Long-
Run Aggregate Supply

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The Impact of
Steady Economic Growth
• Expansions in the productive capacity
of the economy, like those resulting from
capital formation or improvements in
technology, will shift the economy's LRAS
curve to the right.
• When growth of the economy is steady
and predictable, it will be anticipated by
decision makers.
• Anticipated increases in output (LRAS)
need not disrupt macroeconomic
equilibrium.

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Growth in Aggregate Supply
Price LRAS1 LRAS2
Level
SRAS1
SRAS2

P100
P95

AD
Goods & Services
YF1 YF2 (real GDP)

• Consider the impact of capital formation or a technological

advancement on the economy.
• Both LRAS and SRAS increase (to LRAS2 and SRAS2);
full employment output expands from Y to Y .
• A sustainable, higher level of real outputF1is theF2result.
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Unanticipated Changes
and Market Adjustments

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Unanticipated Changes
in Aggregate Demand
• In the short-run, output will deviate from full
employment capacity as prices in the goods
and services market deviate from the price
level that people expected.
• Unanticipated changes in aggregate demand
often lead to such deviations.

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Unanticipated Increase
in Aggregate Demand
• Impact of unanticipated increase in AD:
• Initially, the strong demand and higher price
level in the goods & services market will
temporarily improve profit margins.
• Output will increase, the rate of
unemployment will drop below the natural
rate, and output will temporarily exceed the
economy's long-run potential.
• With time, however, contracts will be
modified and resource prices will rise and
return to their competitive position relative
to product prices.
• Once this happens, output will recede to
the economy's long-run potential.
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Increase in AD: Short Run
Price
Level
LRAS SRAS1

Short-run effects of
P105 an unanticipated
increase in AD
P100

AD2
AD1
Goods & Services
YF Y 2 (real GDP)

• In response to an unanticipated increase in AD for goods

& services (shift from AD1 to AD2), prices rise to P105
and output will increase to Y2, temporarily exceeding
full-employment capacity.
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Increase in AD: Long Run
Price
Level SRAS2
LRAS SRAS1

P110
Long-run effects of
P105 an unanticipated
increase in AD
P100

AD2
AD1
Goods & Services
YF Y 2 (real GDP)

• With time, resource market prices, including labor, rise due

to the strong demand. Higher costs reduce SRAS1 to SRAS2.
• In the long-run, a new equilibrium at a higher price level,
P110, and output consistent with long-run potential will occur.
• So, the increase in demand only temporarily expands output.
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Unanticipated Decrease
in Aggregate Demand
• Impact of unanticipated reduction in AD:
• Weak demand and lower prices in the goods
& services market will reduce profit margins.
Many firms will incur losses.
• Firms will reduce output, the unemployment
rate will rise above the natural rate, and
output will temporarily fall short of the
economy's long-run potential.
• With time, long-term contracts will be
modified.
• Eventually, lower resource prices and lower
real interest rates will direct the economy
back to long-run equilibrium, but this may be
a lengthy and painful process.
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Decrease in AD: Short Run
Price
Level LRAS SRAS1

Short-run effects of
an unanticipated
reduction in AD
P100
P95

AD2 AD1
Goods & Services
Y2 YF (real GDP)

• The short-run impact of an unanticipated reduction in AD

(shift from AD1 to AD2) will be a decline in output (to Y2),
and a lower price level (P95).
• Temporarily, profit margins decline, output falls, and
unemployment rises above its natural rate.
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Decrease in AD: Long Run
Price
Level LRAS SRAS1
SRAS2

Long-run effects of
an unanticipated
P100 reduction in AD
P95
P90
AD2 AD1
Goods & Services
Y2 YF (real GDP)

• In the long-run, weak demand and excess supply in the

resource market lead to lower resource prices (including
labor) resulting in an expansion in SRAS (SRAS1 to SRAS2).
• A new equilibrium at a lower price level, P90, and an output
consistent with long-run potential will result.
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Unanticipated Changes in
Short-Run Aggregate Supply
• Unanticipated changes in short-run aggregate
supply (SRAS) can catch people by surprise.
• Thus, they are often referred to as supply
shocks.
• A supply shock is an unexpected event that
temporarily increases or decreases aggregate
supply.

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Impact of Increase in SRAS
• SRAS shifts to the right – output temporarily
exceeds the economy's long-run potential.
• Since the temporarily favorable supply
conditions cannot be counted on in the
future, the economy’s long-term production
capacity will not be altered.
• If individuals recognize that they will be
unable to maintain their current high level
of income, they will increase their saving.
Lower interest rates, and additional capital
formation may result.

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Unanticipated Increase in SRAS
Price LRAS
Level SRAS1
SRAS2

P100
P95

AD
Goods & Services
YF Y 2 (real GDP)

• Consider an unanticipated, temporary, increase in SRAS, such

as may result from a bumper crop from good weather.
• The increase in aggregate supply (to SRAS2) would lead to
a lower price level P95 and an increase in current GDP to Y2.
• As the supply conditions are temporary, LRAS persists.
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Impact of Decrease in SRAS
• SRAS shifts to the left – output falls short of
the economy's long-run potential temporarily.
• If an unfavorable supply shock is expected to
be temporary, long-run aggregate supply will
be unaffected.
• Households may reduce their current saving
(dip into past savings).

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Supply Shock: Resource Market
Resource
Price S2 Market
Level

S1
Pr2

Pr1

D
Quantity of
Q2 Q1 resources
• Suppose there is an adverse supply shock, perhaps as the
result of a crop failure or a sharp increase in the world price
of a major resource, such as oil.
• Here we show the impact in the resource market: prices
rise from Pr1 to Pr2. Copyright ©2010 Cengage Learning. All rights reserved.
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Supply Shock: Product Market
Price LRAS
Level SRAS2 (Pr2 )
SRAS1 (Pr1 )

P110

P100

AD
Goods & Services
Y2 YF (real GDP)

• As shown here, the higher resource prices shift SRAS to the

left in the product market; in the short-run, the price level
rises to P110 and output falls to Y2.
• What happens in the long-run depends on whether the supply
shock is temporary or permanent.
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Effects of Adverse Supply Shock
Price LRAS
Level SRAS2 (Pr2 )
SRAS1 (Pr1 )
B
P110

P100 A

AD
Goods & Services
Y2 YF (real GDP)

• If the adverse supply shock is temporary, resource prices will

eventually fall in the future, shifting SRAS2 back to SRAS1,
returning equilibrium to (A).
• If the adverse supply factor is permanent, the productive
potential of the economy will shrink (LRAS shifts left and Y2
becomes YF2) and (B) will become the long-run equilibrium.
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The Price Level, Inflation,
and the AD-AS Model

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Price Level, Inflation,
and the AD-AS Model
• The basic AD-AS model focuses on how the
general level of prices influences the
choices of business decision makers.
• If the price level in the product market
changes, this indicates that this price has
changed relative to other markets.
• This structure implicitly assumes that the
actual and expected rates of inflation are
initially zero.
• When inflation is present this model can be
recast in a dynamic setting.

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Price Level, Inflation,
and the AD-AS Model
• When the actual and expected rates of
inflation are equal:
• Inflation will be built into long term
contracts.
• Prices will rise in both resource and product
markets, but the relative price between the
two will be unchanged.

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Actual and Expected Rates of
Inflation Differ
• An actual rate of inflation that is less than
anticipated is the equivalent of a reduction
in the price level. As a result, firms will
incur losses and reduce output.
• An actual rate of inflation that is greater
than anticipated is the equivalent of an
increase in the price level. Profits will be
enhanced and firms will expand output.

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Unanticipated Changes,
Recessions, and Booms

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The AD-AS Model and Instability
• The AD-AS model indicates that
unanticipated changes will disrupt macro
equilibrium and result in economic instability.
• Recessions occur because prices in the goods
and services market are low relative to the
costs of production and resource prices.
• The two causes of recessions are:
• unanticipated reductions in AD, and,
• unfavorable supply shocks.
• An unsustainable boom occurs when prices in
the goods and services market are high relative
to resource prices and other costs.
• The two causes of booms are:
• unanticipated increases in AD, and,
• favorable supply shocks.

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Two Forces Directing the
Economy Back to Equilibrium
• The AD-AS model indicates that there are
two forces that will help direct an economy
back to long-run equilibrium:
• Changes in real resource prices:
• During a recession, real resource prices
will tend to fall because the demand for
resources will be weak and the rate of
unemployment high.
• During a boom, real resource prices will
tend to rise because demand for resources
will be strong and the unemployment rate
low.

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Two Forces Directing the
Economy Back to Equilibrium
• The AD-AS model indicates that there are
two forces that will help direct an economy
back to long-run equilibrium:
• Changes in real interest rates:
• During a recession, real interest rates
will tend to decline because of the weak
demand for investment. The lower interest
rates will stimulate AD and help direct the
economy back to full employment.
• During a boom, real interest rates will
tend to rise because of the strong demand
for investment. The higher rates will
retard AD and help direct the economy
back to full employment.
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 The Macro-Adjustment Process
Price
Level LRAS Lower resource
SRAS1 prices increase SRAS

In the short-run, SRAS2

output may exceed
or fall short of
the economy’s P100
full-employment Lower real interest
capacity (YF). rates increase AD
AD2
AD1
Goods & Services
Y1 YF (real GDP)

• If output is temporarily less than long-run potential YF …

falling interest rates will shift AD (from AD1 to AD2) …
while lower resource prices decrease production costs and
thereby increase SRAS (from SRAS and so1 direct
to SRASoutput
2) …
toward its
full-employment potential (YF).
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 The Macro-Adjustment Process
Price
Level LRAS Higher resource
SRAS2 prices reduce SRAS

In the short-run,
SRAS1
output may exceed
or fall short of P100
the economy’s Higher real interest
full-employment rates reduce AD
capacity (YF).
AD1
AD2
Goods & Services
YF Y1 (real GDP)

• If output is temporarily greater than long-run potential YF …

higher interest rates will reduce AD (from AD1 to AD2) …
while higher resource prices increase production costs and
thereby reduce SRAS (from directing
SRAS1 tooutput
SRAS2toward ) … its full-
employment potential (YF). Copyright ©2010 Cengage Learning. All rights reserved.
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Questions for Thought:
1. Suppose consumers and investors suddenly
become more pessimistic about the future and
therefore decide to reduce their consumption
and investment spending. How will a market
economy adjust to this increase in pessimism?
2. “If the general level of prices is higher than
business decision makers anticipated when
they entered into long-term contracts for raw
materials and other resources, profit margins
will be abnormally low and the economy will
fall into a recession.” Is this statement true?

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Questions for Thought:
3. Which of the following would be most likely
to throw the U.S. economy into a recession?
a. a reduction in transaction costs as the result
of the growth and development of the Internet
b. an unanticipated reduction in the world price
of oil
c. an unanticipated reduction in AD as the result
of a sharp decline in consumer confidence

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Expansions and Recessions: the
Historical Record

• During the past six decades, economic

expansions have been far more lengthy than
recessions.
• The depth and severity of the recession that
started in December 2007 highlights the
issue of economic instability and recovery
from a recession.

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 Expansions and Recessions, 1950-
2009
Length Length
Period of Expansion (in Months) Period of Recession (in Months)
Oct ‘49 to Jul ’53 44 Jul ‘53 to May ’54 10
May ‘54 to Aug ’57 39 Aug ‘57 to Apr ’58 9
Apr ‘58 to Apr ’60 24 Apr ‘60 to Feb ’61 10
Feb ‘61 to Dec ’69 105 Dec ‘69 to Nov ’70 10
Nov ‘70 to Nov ‘73 36 Nov ‘73 to Mar ’75 16
Mar ‘75 to Jan ’80 58 Jan ‘80 to Jul ’80 6
Jul ‘80 to Jul ’81 12 Jul ‘81 to Nov ’82 16
Nov ‘82 to Jul ’90 92 Jul ‘90 Mar ’91 9
Mar ‘91 to Mar ’01 120 Mar ‘01 to Nov ’01 8
Nov ‘01 to Nov ’07 73 Dec ‘07 to ? ?

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Using the AD-AS Model to
Think about the Business
Cycle and the Crisis of 2008

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Why Did Economic Conditions
Deteriorate so Rapidly in 2008?
• Between 2002 and mid-year 2006, housing
prices rose by almost 90%. Stock prices
also rose rapidly. As a result, wealth
expanded and AD increased, leading to an
economic boom.
• But the situation changed in the second half
of 2006. Housing prices began to fall. Both
mortgage default and housing foreclosure
rates increased. This reduced aggregate
demand.
• Beginning in October 2007, stock prices fell
and they plunged during 2008. This also
reduced wealth and AD.
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Why Did Economic Conditions
Deteriorate so Rapidly in 2008?
• During 2007 and the first half of 2008,
crude oil and other energy prices soared,
and this generated an unanticipated
reduction in SRAS.
• These forces led to a sharp reduction in
consumer and investor confidence, further
reducing AD.
• The reductions in both AD and SRAS
reduced output and employment just as the
AD-AS model implies.

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 Changes in Stocks and Housing
During Expansions

Note: Price changes are for the 24 months subsequent to the end of the recession

• Both stock and housing prices generally rise prior to and

during expansions.
• This leads to increases in AD.

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 Changes in Stocks and Housing
During Recessions

• In contrast, stock and housing prices generally fall prior to

and during recessions, and this reduces AD.
• The wealth effects associated with the swings in stock and
housing prices are a contributing factor to the ups and downs
of the business cycle. Copyright ©2010 Cengage Learning. All rights reserved.
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 Changes in Stocks and Housing
During Recessions

• Note, the reduction in housing prices for the 2008-2009

recession were far greater than other recessions. Stock price
reductions were also substantial.
• These price reductions increased the severity of the recent
downturn. Copyright ©2010 Cengage Learning. All rights reserved.
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Questions for Thought:
1. During the first half of 2008, the world price of
oil soared while stock and housing prices
plunged. Within the framework of the AD-AS
model, how would these two changes influence
the U.S. economy? Explain the expected
impact on output and the price level.
2. When actual output is less than the economy’s
full employment level of output, how will real
resource prices and real interest rates adjust?
3. Construct the AD, SRAS, and LRAS curves for
an economy experiencing:
(a) full employment equilibrium
(b) an economic boom
(c) a recession
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 End
Chapter 10

Copyright ©2010 Cengage Learning. All rights reserved.

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