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9,000. The orange line shows full-employment or potential output. 8,000. 7,000. Actual and Potential Real GDP (Billions of 1996 Dollars). 6,000. The green line shows actual output. During recessions, output declines. 5,000. 4,000. During expansions, output rises—sometimes rapidly.

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figure 1a potential and actual real gdp 1960 2001

9,000

The orange line shows full-employment or potentialoutput.

8,000

7,000

Actual and Potential Real GDP (Billions of 1996 Dollars)

6,000

The green line showsactualoutput.

During recessions, output declines.

5,000

4,000

During expansions, output rises—sometimes rapidly.

3,000

2,000

1960

1965

1970

1975

1980

1985

1990

1995

2000

2003

Figure 1a: Potential and Actual Real GDP, 1960-2001
figure 2a deriving the aggregate demand curve

Interest Rate

As the price level rises, money demand increases and interest rate rises.

9%

6%

Money ($ Billions)

Figure 2a: Deriving the Aggregate Demand Curve

(a)

Ms

H

E

500

figure 2b c deriving the aggregate demand curve

On the AD curve, a higher price level is associated with a lower real GDP.

The rise in the interest rate causes real GDP to fall.

Figure 2b/c: Deriving the Aggregate Demand Curve

(c)

(b)

Price

Level

AEr = 6%

H

AEr= 9%

140

E

Aggregate Expenditure

($ Trillions)

E

100

H

AD

Real GDP

($ Trillions)

Real GDP

($ Trillions)

6

10

6

10

figure 3 a spending shock shifts the ad curve

Since real GDP is higher at the given price level, the AD curve shifts rightward.

At any given price level, an increase in government purchases shifts the AE line upward, raising real GDP.

Figure 3: A Spending Shock Shifts the AD Curve

(a)

(b)

Price

Level

AE2

AE1

H

Real Aggregate Expenditure

($ Trillions)

100

H

E

E

AD1

AD2

Real GDP

($ Trillions)

Real GDP

($ Trillions)

10

13.5

10

13.5

figure 4a effects of key changes on the aggregate demand curve

Price level ↑moves us leftward along the AD curve

Price level ↓moves us rightward along the AD curve

Figure 4a: Effects of Key Changes on the Aggregate Demand Curve

(a)

Price Level

P3

P1

P2

AD

Real GDP

Q3

Q1

Q2

figure 4b effects of key changes on the aggregate demand curve

Entire AD curve shifts rightward if:

  • a, IP, G, orNXincreases
  • Net taxes decrease
  • The money supply increases
Figure 4b: Effects of Key Changes on the Aggregate Demand Curve

(b)

Price Level

AD2

AD1

Real GDP

figure 4c effects of key changes on the aggregate demand curve

Entire AD curve shifts leftward if:

  • a, IP, G, orNXdecreases
  • Net taxes increase
  • The money supply decreases
Figure 4c: Effects of Key Changes on the Aggregate Demand Curve

(c)

Price Level

decreases

AD1

AD2

Real GDP

figure 5 the aggregate supply curve

Starting at point A, an increase in output raises unit costs. Firms raise prices, and the overall price level rises.

Starting at point A, a decrease in output lowers unit costs. Firms cut prices, and the overall price levelfalls.

Figure 5: The Aggregate Supply Curve

Price Level

AS

130

B

100

A

80

C

Real GDP ($ Trillions)

6

10

13.5

movements along the as curve
Movements Along the AS Curve
  • When a change in output causes price level to change, we move along economy’s AS curve
    • What happens in economy as we make such a move?
    • As we move upward along AS curve, we can represent what happens as follows
figure 6 shifts of the aggregate supply curve

When unit costs rise at any given real GDP, the AS curve shifts upward–e.g., an increase in world oil prices or bad weather for farm production.

Figure 6: Shifts of the Aggregate Supply Curve

AS2

Price Level

AS1

L

140

100

A

Real GDP ($ Trillions)

10

figure 7a effects of key changes on the aggregate supply curve

Real GDP ↑ moves us rightward along the AS curve

Real GDP ↓ moves us leftward along the AS curve

Figure 7a: Effects of Key Changes on the Aggregate Supply Curve

(a)

Price Level

AS

P3

P1

P2

Real GDP

Q2

Q1

Q3

figure 8 short run macroeconomic equilibrium
Figure 8: Short-Run Macroeconomic Equilibrium

AS

Price Level

B

140

E

100

F

AD

Real GDP ($ Trillions)

6

10

14

figure 9 the effect of a demand shock
Figure 9: The Effect of a Demand Shock

AS

Price Level

130

H

115

J

100

E

AD2

AD1

Real GDP($ Trillions)

10

13.5

12.5

an increase in government purchases
An Increase in Government Purchases
  • Can summarize impact of price-level changes
    • When government purchases increase, horizontal shift of AD curve measures how much real GDP would increase if price level remained constant
      • But because price level rises, real GDP rises by less than horizontal shift in AD curve
an increase in the money supply
An Increase in the Money Supply
  • Although monetary policy stimulates economy through a different channel than fiscal policy
    • Once we arrive at AD and AS diagram, two look very much alike
    • Can represent situation as follows
figure 10 the long run adjustment process
Figure 10: The Long-Run Adjustment Process

Price Level

AS2

AS1

P4

K

J

P3

P2

H

P1

E

AD2

AD1

YFE

Y3

Y2

Real GDP

demand shocks adjusting to the long run
Demand Shocks: Adjusting to the Long Run
  • For a positive demand shock that shifts AD curve rightward, self-correcting mechanism works like this
figure 11 long run adjustment after a negative demand shock
Figure 11: Long-Run Adjustment After A Negative Demand Shock

Price Level

AS1

AS2

P1

E

P2

N

P3

M

AD1

AD2

Real GDP

Y2

YFE