All credit for this text goes to...

Ragan, C. T. S. (2024). Macroeconomics (18th Canadian ed.). Pearson Canada.

Study Session Meta

Status: All sections (S1-S5) complete. All professor-required definitions filled. All four LOs passed.

LO Coverage

LO Title Status Key Notes
1 How price level changes affect AE Passed Wealth + trade effect channels
2 The AD curve and what shifts it Passed Movement-vs-shift, AD derivation, multiplier-in-Ch8 (distinct from Ch7 leakages)
3 The AS curve and what shifts it Passed AS slope from intensity of resource use, PIMP FacTory = shifters not slope, excess supply → P falls
4 How AD and AS shocks affect equilibrium Passed Shock signatures, Shock → Gap → Adjust, stagflation dilemma, stabilization trade-offs. Flag: always name wealth + trade effects in Beat 3

Vocabulary Tracker

Term Tier Location Prof Required
Aggregate demand function (AD) T1 S1 (b)
Why AD has negative slope T1 S1 (o)
Aggregate supply function (AS) T1 S3 (c)
Potential output ( $Y^{*}$ ) T1 S3 (h)
AD shock T1 S2 (d)
AS shock T1 S4 (e)
Macro equilibrium T1 S5 (n)
Stabilization policy T1 S5 (g)

Session Log

Date LOs Covered Key Clarifications
2026-03-01 LO1, LO2 (partial) Wealth effect, trade effect, movement-vs-shift, AD derivation, AD shifters. Nominal wealth is FIXED. $Y^{D}$ / $Y^{S}$ / $Y^{e}$ are points on same axis (superscript, not subscript). AD curve = lookup table. Simple multiplier = horizontal shift of AD, not actual DY. Two-stage multiplier: Stage 1 = shift AD at constant P, Stage 2 = P rises along AS, AE pushed back down. Confused Ch7 leakages (already in formula) with Ch8 price-level effect (new concept).
2026-03-01 LO3 (passed with flag) AS slope from rising unit costs, not from PIMP FacTory (corrected: those are shifters). Correctly classified semiconductor shortage as negative AS shock. Correctly identified AI breakthrough as positive AS shock but initially said P rises (corrected: excess supply → P falls). Spotted dual-shock pattern for AI (job displacement → AD effect).
2026-03-02 LO4 Passed Shock signatures and why they differ (slope of stationary curve constrains new equilibrium). Full negative AD shock walkthrough. Initially read gap vertically instead of horizontally (corrected). Initially missed naming wealth + trade effects in Beat 3 (corrected). Discovered stagflation dilemma through guided reasoning. All four LOs passed.

Prerequisites (reference back if rusty)

AE function assembly and equilibrium → 2. Building the Complete AE Function

Equilibrium and the multiplier → 3. Equilibrium and the Multiplier

Fiscal policy tools → 4. Fiscal Policy

Demand-determined output and its limits → 5. The Boundary — When Is This Model Realistic?

Simple multiplier = $\frac{1}{1 - z}$ where $z = b (1 - t) - m$ → ECON-1221 Chapter 6 - Notes from the Textbook

LO	Title	Status	Key Notes
1	How price level changes affect AE	Passed	Wealth + trade effect channels
2	The AD curve and what shifts it	Passed	Movement-vs-shift, AD derivation, multiplier-in-Ch8 (distinct from Ch7 leakages)
3	The AS curve and what shifts it	Passed	AS slope from intensity of resource use, PIMP FacTory = shifters not slope, excess supply → P falls
4	How AD and AS shocks affect equilibrium	Passed	Shock signatures, Shock → Gap → Adjust, stagflation dilemma, stabilization trade-offs. Flag: always name wealth + trade effects in Beat 3

Term	Tier	Location	Prof Required
Aggregate demand function (AD)	T1	S1	(b)
Why AD has negative slope	T1	S1	(o)
Aggregate supply function (AS)	T1	S3	(c)
Potential output ( $Y^{*}$ )	T1	S3	(h)
AD shock	T1	S2	(d)
AS shock	T1	S4	(e)
Macro equilibrium	T1	S5	(n)
Stabilization policy	T1	S5	(g)

Date	LOs Covered	Key Clarifications
2026-03-01	LO1, LO2 (partial)	Wealth effect, trade effect, movement-vs-shift, AD derivation, AD shifters. Nominal wealth is FIXED. $Y^{D}$ / $Y^{S}$ / $Y^{e}$ are points on same axis (superscript, not subscript). AD curve = lookup table. Simple multiplier = horizontal shift of AD, not actual DY. Two-stage multiplier: Stage 1 = shift AD at constant P, Stage 2 = P rises along AS, AE pushed back down. Confused Ch7 leakages (already in formula) with Ch8 price-level effect (new concept).
2026-03-01	LO3 (passed with flag)	AS slope from rising unit costs, not from PIMP FacTory (corrected: those are shifters). Correctly classified semiconductor shortage as negative AS shock. Correctly identified AI breakthrough as positive AS shock but initially said P rises (corrected: excess supply → P falls). Spotted dual-shock pattern for AI (job displacement → AD effect).
2026-03-02	LO4 Passed	Shock signatures and why they differ (slope of stationary curve constrains new equilibrium). Full negative AD shock walkthrough. Initially read gap vertically instead of horizontally (corrected). Initially missed naming wealth + trade effects in Beat 3 (corrected). Discovered stagflation dilemma through guided reasoning. All four LOs passed.

Note Organization

This chapter drops the constant price level assumption from Ch7. Core question: What happens when prices respond to demand and supply?

Section Covers Textbook LO
1. From AE to AD Price level → AE shifts → AD derivation LO1, LO2
2. What Shifts AD? Demand shocks vs movement along AD LO2
3. The Supply Side AS curve, unit costs, Keynesian range LO3
4. What Shifts AS? Supply shocks, technology, factor prices LO3
5. Macroeconomic Equilibrium AD-AS intersection, shocks, adjustment LO4

Section	Covers	Textbook LO
1. From AE to AD	Price level → AE shifts → AD derivation	LO1, LO2
2. What Shifts AD?	Demand shocks vs movement along AD	LO2
3. The Supply Side	AS curve, unit costs, Keynesian range	LO3
4. What Shifts AS?	Supply shocks, technology, factor prices	LO3
5. Macroeconomic Equilibrium	AD-AS intersection, shocks, adjustment	LO4

What Changed from Chapter 7?

Ch7 operated with a constant price level — the last simplifying assumption from Ch6. Ch8 removes it.

Assumption	Ch6	Ch7	Ch8
Closed economy (no trade)	Assumed	Removed	Removed
No government (no taxes)	Assumed	Removed	Removed
Constant price level	Assumed	Still assumed	Removed

The price level is now endogenous — a variable we solve for, not an assumption we hold fixed. This single change drives everything new in this chapter.

1. From AE to AD (LO1, LO2)

Core question: How does a change in P create a different equilibrium Y?

Ch7 gave us equilibrium Y at ONE fixed price level. This section asks: what if the price level were different? Each price level gives a different AE curve, a different equilibrium Y.

Plot all those (P, Y) pairs and you get the AD curve. The AE equilibrium being varied here is the one from 3. Equilibrium and the Multiplier.

The wealth effect channel

When the price level rises, your dollar amount stays the same but purchasing power shrinks.

Real Wealth = \frac{W}{P}

W stays the same. P gets bigger. The fraction gets smaller.

	Before P up	After P up
Nominal wealth (dollars in account)	$10,000	$10,000 — unchanged
Price level	1.0	1.2
Real wealth (W/P = purchasing power)	$10,000	$8,333 — this fell

The chain: P up → nominal wealth fixed → real wealth (W/P) falls → households feel poorer → C bar down → AE shifts down.

What about bonds? Lender loses real wealth, borrower gains — these cancel in aggregate. But money holdings are a net loss to the private sector (nobody on the other side). That is why the wealth effect works.

Notation trap — superscript vs. subscript

Notation Position Meaning Context
$Y^{D}$ Superscript Demand level of real GDP AD-AS diagram (Ch8)
$Y_{D}$ Subscript Disposable income ( $Y - t Y$ ) AE model (Ch7)

These are completely different variables. $Y^{D}$ , $Y^{S}$ , $Y^{e}$ are specific points on the same Real GDP axis. At equilibrium: $Y^{D} = Y^{S} = Y^{e}$ .

Notation	Position	Meaning	Context
$Y^{D}$	Superscript	Demand level of real GDP	AD-AS diagram (Ch8)
$Y_{D}$	Subscript	Disposable income ( $Y - t Y$ )	AE model (Ch7)

The international trade effect

When the Canadian price level rises and the exchange rate stays constant, Canadian goods become relatively expensive:

Relative price = \frac{P _{domestic}}{P _{foreign}}

P domestic rises, P foreign unchanged, ratio increases. Two responses: (1) Canadian consumers substitute toward imports. (2) Foreign consumers buy fewer Canadian goods. Both reduce NX: X bar down and IM up → NX down → AE shifts down.

Simplification the textbook makes

Strictly, the rise in imports also changes $m$ (slope of AE). The textbook ignores this and treats the AE shift as parallel only — intercept moves down, slope stays the same. On an exam, stick to the simplification.

Deriving the AD curve

The AD curve is built by asking a hypothetical question: “What if the price level were different?” Nothing is actually changing — you’re mapping out what equilibrium Y would be at every possible P.

In Ch7, you were given C-bar = some number, X-bar = some number. You never asked where those numbers came from. Ch8 reveals: C-bar was that number because P was at a certain level. The wealth effect set C-bar; the trade effect set X-bar. If P had been different, those numbers would have been different, AE would have sat at a different height, and equilibrium Y would have been different. Ch7’s AE diagram was one possibility out of many — the version where P happened to be P0.

The AD curve is a lookup table of all those possibilities. Each price level positions AE (via wealth + trade effects), AE crosses the 45-degree line at some equilibrium Y, and you write down that (P, Y) pair.

You pick a P	Wealth + trade effects position AE	AE crosses 45-degree line at	Write down
$P_{0}$ (low)	AE sits high	$Y_{0}$ (large)	$(P_{0}, Y_{0})$
$P_{1}$ (medium)	AE sits lower	$Y_{1} < Y_{0}$	$(P_{1}, Y_{1})$
$P_{2}$ (high)	AE sits even lower	$Y_{2} < Y_{1}$	$(P_{2}, Y_{2})$

Plot these with P on the vertical axis and Y on the horizontal axis. Connect them. That is the AD curve. It adds no new economics — it compresses all possible AE diagrams into a single line.

The professor's notation system

The professor labels each AE line with two subscripts: AE [first], [second]

First subscript = which version of the economy (0 = no shock, 1 = shock happened)

Second subscript = which price level (P0, P1, P2, etc.)

When deriving AD, the first subscript stays at 0 (no shock) and only the second subscript changes (trying different prices). When a shock hits, the first subscript changes to 1 (at the same price).

Only second subscript changes (AE0,P0 → AE0,P1) = movement along AD
Only first subscript changes (AE0,P0 → AE1,P0) = AD shifts

Only second subscript changes (AE0,P0 → AE0,P1)	= movement along AD
Only first subscript changes (AE0,P0 → AE1,P0)	= AD shifts

The AD curve is curved, not straight, because the wealth effect works through a ratio (W/P). Ratios don’t shrink evenly — each equal step up in P causes a smaller drop in real wealth, smaller AE shift, smaller change in Y.

The key relationship between AE and AD diagrams

A change in the price level shifts the AE curve but is a movement along the AD curve.

Each point on the AD curve is an AE = Y equilibrium at that specific price level.

Trap — micro vs. macro reasoning for downward slope

A micro demand curve slopes down because consumers substitute BETWEEN goods when one gets cheaper. The macro AD curve slopes down for entirely different reasons — changes in the overall price level affect aggregate wealth and international relative prices. There is NO substitution between domestic goods when ALL prices change together.

If a question says “explain why” or “what is the mechanism,” the professor wants the dominoes (wealth effect, trade effect) — not a description of curves moving.

Why the AD curve has a negative slope (Professor's required definition o)

A higher price level reduces equilibrium real GDP demanded through two channels: (1) the wealth effect — higher P reduces real value of money holdings (W/P down), reducing desired consumption; (2) the international trade effect — higher domestic P makes Canadian goods relatively expensive, reducing net exports. A third channel (interest rates) comes in later chapters.

Key: These are macro reasons. NOT micro substitution/income effects.

Foundation: The AE model is the engine. Changes in P shift AE, producing different equilibrium Y values — each (P, Y) pair is one point on AD.

Aggregate demand function (AD) (Professor's required definition b)

The AD function relates the price level to the equilibrium level of real GDP demanded. Each point on AD represents an AE = Y equilibrium at that specific price level. AD is derived by varying P, observing how AE shifts (via wealth and trade effects), finding the new equilibrium Y, and plotting all resulting (P, Y) pairs.

Key: AD is NOT the same as AE. AE holds price constant. AD shows how equilibrium Y changes when you VARY the price level.

Connects to: 3. Equilibrium and the Multiplier

Trap — AE is NOT AD

The AE panel only drives the AD curve (demand side), not the AS curve. The AS curve comes from firm profit maximization and has no connection to the AE diagram. Keep these on separate mental shelves:

AE diagram → holds price level constant → one point on the AD curve

AD curve → derived FROM the AE diagram by varying price level

AS curve → completely separate origin — firm behavior, NOT the AE diagram

2. What Shifts AD? (LO2)

Core question: Movement along vs. shift of — what is the test?

S1 showed that price level changes MOVE you along the AD curve. This section asks: what SHIFTS the entire curve? Answer: anything that changes autonomous expenditure at a GIVEN price level. Fiscal policy tools that shift AE are from 4. Fiscal Policy.

Movement along AD vs shift of AD

This is the single most confusing distinction in Ch8 — because AE shifts in both cases. What differs is the effect on AD.

	What Changes	AE Shifts?	AD Result
Movement along AD	Price level (P)	Yes — down if P up	Movement up-left along AD
Shift of AD	Autonomous expenditure (A) at constant P	Yes — up if A up	AD shifts right

The test: Did the price level cause this? If yes → movement along AD. If no → shift of AD. Same logic as micro supply and demand: own-price = movement along, everything else = shift.

The exogenous/endogenous frame resolves the confusion

The word “autonomous” is misleading here — $\overset{ˉ}{C}$ is called “autonomous consumption,” but it responds to P through the wealth effect. So when P rises and $\overset{ˉ}{C}$ falls, it looks like “an autonomous component changed → AE shifts → AD should shift.” But it doesn’t shift AD. Why?

Because the change was endogenous — caused by the model’s own variables. Use the exo/endo test:

Event What caused it? Exogenous or endogenous? Effect on AD
G increases Parliament voted for it — nothing in the model caused this Exogenous AD shifts
P rises Excess demand at old equilibrium — the model produced this Endogenous Movement along AD
$\overset{ˉ}{C}$ falls because P rose P is endogenous, so everything P causes is too Endogenous Movement along AD

“Autonomous” means independent of Y (national income). It does NOT mean independent of P. $\overset{ˉ}{C}$ doesn’t change when Y changes — that’s why it’s in the intercept. But $\overset{ˉ}{C}$ DOES change when P changes — that’s what gives the AD curve its downward slope. The AD curve was derived knowing this dependency. When P actually changes and $\overset{ˉ}{C}$ responds, you’re just arriving at a point the curve already calculated.

Only exogenous changes shift curves. Endogenous changes are movement along them.

Event	What caused it?	Exogenous or endogenous?	Effect on AD
G increases	Parliament voted for it — nothing in the model caused this	Exogenous	AD shifts
P rises	Excess demand at old equilibrium — the model produced this	Endogenous	Movement along AD
$\overset{ˉ}{C}$ falls because P rose	P is endogenous, so everything P causes is too	Endogenous	Movement along AD

Trap — the two appearances of wealth/trade effects

Wealth and trade effects show up twice in the Ch8 story:

First appearance (building AD): You ask “what if P were 80? 100? 120?” At each price, wealth/trade effects set C-bar and X-bar. This builds the curve. Hypothetical — nothing actually happened.

Second appearance (after a shock): G increases → AD shifts right → excess demand → P rises → wealth/trade effects reduce C-bar and X-bar → quantity demanded falls as the economy moves to the new equilibrium.

Why the second appearance doesn’t shift AD left: Because the price rise was endogenous — caused by the model’s own excess demand. Everything that follows from an endogenous price change is also endogenous. Endogenous changes don’t shift curves — they’re movement along them. If endogenous changes shifted curves, no curve could ever hold still and no equilibrium could ever be reached.

The two appearances look identical mechanically (P changes → C-bar and X-bar respond). The difference: first is building the map, second is following the map. In both cases, AD stays put.

The "did the curve already know?" test — why the multiplier overstates

The AD curve is built by calculating equilibrium Y at every possible P. At each P, wealth and trade effects adjust C̄ and NX for that P. These effects are what give AD its downward slope — they’re inside the curve, not separate from it.

The test: When something changes, ask “did the AD curve already know this would happen?”

C̄ fell because P rose → Yes. The point at the higher P was calculated with the lower C̄. You’re reading a different point on the same curve. Movement along.

G̅ changed because parliament voted → No. Every point was calculated with the old G̅. Every point is now wrong. The curve must be rebuilt. Shift.

Why this explains the multiplier overstatement: The simple multiplier tells you how far AD shifts right (horizontal distance). But AS slopes up, so the actual equilibrium is at a higher P — further UP along the new AD curve. At that higher P, the curve already reflects lower C̄ and NX (baked in). So equilibrium Y at the new P is less than equilibrium Y would be at the old P. Actual ΔY < multiplier prediction because the economy moved up along AD, not straight across.

Ch7 (flat AS) → economy stays at old P → full horizontal distance realized → multiplier exact. Ch8 (upward AS) → economy moves to higher P → only part of horizontal distance realized → multiplier overstates.

What shifts AE (and therefore AD)?

Any change in autonomous expenditure at a given price level shifts AE, which shifts AD. Use CIGNX (“Can I Get Net Exports”) as the mnemonic:

Source of AD Shift	What Changes	Direction
Consumer confidence up	Autonomous C bar up	AD shifts right
Business confidence up	Autonomous I up	AD shifts right
Government purchases up	G up	AD shifts right
Foreign income up	Autonomous X bar up	AD shifts right
Tax rate down	Slope of AE rises (z up)	AD shifts right
Exchange rate depreciation	X bar up, IM down	AD shifts right

Reverse each for leftward AD shifts.

The simple multiplier and AD shifts

The simple multiplier from Ch7 measures the horizontal shift of the AD curve — not the actual change in equilibrium GDP.

Horizontal shift of AD = \frac{Δ A}{1 - z}

The actual change in equilibrium GDP depends on where the new AD intersects the AS curve. Since AS slopes upward, the price level rises, which partially offsets the demand increase. The actual multiplier is therefore smaller than the simple multiplier. How much smaller depends on the slope of AS (resolved in S5).

Trap — Ch7 leakages are NOT the Ch8 price-level effect

“Why is actual DY less than the simple multiplier?” The Ch7 answer (leakages — imports and taxes) is already baked into $\frac{1}{1 - z}$ . The Ch8 answer is new: AS slopes up → P rises → wealth and trade effects push AE back down → actual DY shrinks.

What reduces the multiplier Already in the formula? Chapter
Leakages (saving, taxes, imports) Yes — they determine $z$ Ch7
Rising price level along AS No — this is the NEW Ch8 insight Ch8

What reduces the multiplier	Already in the formula?	Chapter
Leakages (saving, taxes, imports)	Yes — they determine $z$	Ch7
Rising price level along AS	No — this is the NEW Ch8 insight	Ch8

Aggregate demand shock (Professor's required definition d)

An AD shock is any exogenous event that shifts the AD curve by changing autonomous expenditure at a given price level. Positive: AD shifts right (more Y demanded at any P). Negative: AD shifts left (less Y demanded at any P). Examples: changes in G, I, X, consumer confidence, tax rates.

Key: These originate from the DEMAND side — anything that changes A or z in the AE function.

Connects to: 4. Fiscal Policy

3. The Supply Side (LO3)

Core question: Why does AS slope up, and why is it separate from AE?

S1-2 built the demand side (AD). This section introduces a completely separate origin. The AS curve comes from firm profit maximization and unit costs, NOT from the AE diagram. Ch7’s assumption that output is demand-determined (5. The Boundary — When Is This Model Realistic?) is what we are now relaxing.

Unit costs and output: why costs rise as Y increases

The AS curve is drawn holding two things constant: (1) factor prices and (2) the state of technology. Even with both fixed, unit costs still rise as firms expand output:

As output rises…	What happens	Cost effect
Standby plants activated	Less efficient equipment brought online	Unit costs up
New workers hired	Less productive workers drawn from shrinking labour pool	Unit costs up
Existing workers do overtime	Overtime wages exceed regular rates	Unit costs up

This is the law of diminishing returns at the macro level. Fixed factor prices + fixed technology does NOT mean flat costs. As output rises → less efficient plants, workers, overtime → unit costs rise. Firms will not produce more unless the selling price rises enough to cover those higher unit costs. Therefore: AS slopes upward.

Why "less efficient" means "higher cost" — the full chain

“Less efficient” doesn’t mean the resource is more expensive to hire. Factor prices are frozen. It means the resource needs more inputs per unit of output:

An older machine runs slower, breaks down more, wastes more raw material, needs more maintenance — more electricity, more repair parts, more supervision time per unit produced

A less skilled worker takes longer, makes more errors that need rework, requires more oversight — more labour-hours per unit produced

Overtime means paying premium rates for the same work — more wage cost per hour

Same input prices × more inputs consumed per unit = higher unit cost of production. The price per input didn’t change — the quantity of inputs needed per unit of output increased.

Connection to the PPB: The PPB bows outward for the same root reason — resources are not equally efficient at producing different goods. The Keynesian range of AS (flat portion) corresponds to operating far inside the PPB, where plenty of good idle resources exist and bringing them online barely raises costs. The steep portion of AS corresponds to approaching the PPB boundary ( $Y^{*}$ ), where you’re activating the worst remaining resources and each additional unit costs sharply more.

"Constant factor prices" does NOT mean "constant unit costs"

Factor prices (wages, rent) are held constant when drawing AS. But unit costs still rise because you are using inputs less efficiently as you push output higher. The slope comes from intensity of resource use, not from factor price changes.

The AS curve shape: three ranges

Range	Output level	Firm situation	AS slope	What happens to unit costs
Flat (Keynesian)	Well below $Y^{*}$	Excess capacity, idle plants, unemployed workers	Nearly horizontal	Barely rise — spare resources absorbed cheaply
Intermediate	Approaching $Y^{*}$	Capacity tightening, hiring from thinner labour pool	Moderate upward	Rise noticeably with each increment of output
Steep	At or above $Y^{*}$	Overtime, standby plants, all resources stretched	Very steep	Rise sharply — each extra unit costs much more

The higher output already is, the faster unit costs rise with each additional unit. That is why AS curves upward with increasing steepness.

Reading the AS curve — it is a menu, not a cause

The AS curve does NOT say “price rises, therefore quantity rises.” It says: “If you want me to produce THIS much, you need to pay me THIS price.” Pick any point on the horizontal axis. AS tells you the minimum price level firms require to cover their unit costs at that output level.

Trap — PIMP FacTory gives the SHIFTERS, not the slope

PIMP FacTory items (factor prices, input prices, technology) are held constant along the AS curve. They SHIFT the whole curve (S4). The slope comes from intensity of resource use at given prices: same wage rate but paying overtime, same rent but cramming more production, same equipment but running older machines. Same prices, worse productivity per unit → unit costs rise → firms need higher P.

The Keynesian range

The flat portion of AS exists when the economy has significant excess capacity. Firms expand output by putting idle resources to work with no pressure on unit costs — they do not need a higher price. Output is truly demand-determined: this is exactly the world Ch7 assumed.

Ch7 treated the entire economy as if it were in the Keynesian range. Ch8 reveals this is only true over a limited portion of AS. Once you leave the flat range, the constant-price assumption breaks down. Ch7 = special case. Ch8 AD-AS = general case.

Ch8 is a short-run model

The resource pool is fixed, factor prices are held constant, and PIMP FacTory items are exogenous because Ch8’s AS curve is a short-run construct. You cannot build new factories or train new workers fast enough to matter. Firms squeeze what they have, rather than creating more. Later chapters (Ch9+): factor prices become endogenous — they respond to the output gap.

AD vs AS origin comparison

	AD curve	AS curve
Origin	The AE model (Ch6-7)	Firm profit maximization and unit costs
Logic	P changes → AE shifts → different equilibrium Y	Output changes → unit costs change → firms need different P
What it answers	”How much do buyers want to purchase at each P?"	"How much do firms want to produce and sell at each P?”
Diagram source	Derived from the 45-degree line AE diagram	Has NO connection to the AE diagram

The only thing AD and AS share is their axes: price level (vertical) and real GDP (horizontal).

Aggregate supply function (AS) (Professor's required definition c)

The AS function relates the price level to the quantity of real GDP firms want to produce and sell, drawn for given factor prices and given technology. Positively sloped because higher output raises unit costs, and firms only supply more if P rises enough to cover those costs.

Key: AS comes from firm profit maximization. No connection to AE. Two things held constant: (1) factor prices, (2) state of technology.

Connects to: 5. The Boundary — When Is This Model Realistic?

Potential aggregate output ( $Y^{*}$ ) (Professor's required definition h)

Potential output ( $Y^{*}$ ) is the level of real GDP the economy would produce if all factors of production were employed at their normal rates of utilization. It is NOT maximum output — the economy can temporarily exceed $Y^{*}$ (overtime, extra shifts), but at sharply rising costs that are not sustainable.

Key: Demand-determined output works when $Y < Y^{*}$ . When Y approaches $Y^{*}$ , firms hit capacity constraints and start raising prices.

Connects to: 5. The Boundary — When Is This Model Realistic?, output gap concept from Ch4

4. What Shifts AS? (LO3)

Core question: PIMP FacTory — what shifts the curve vs. moves along it?

S3 drew the AS curve for given factor prices and technology. This section asks: what happens when those things change?

Mnemonic: “The PIMP FacTory shifts AS”

AS shifters mnemonic — PIMP FacTory

AD has CIGNX (“Can I Get Net Exports”). AS has PIMP FacTory:

Letter(s) Shifter Direction when up
P_IMP Price of inputs to production ( $P_{I MP}$ ) — oil, raw materials, energy AS shifts left (costs up)
Fac Factor prices — wages (L), rent (land), capital costs (K) AS shifts left (costs up)
T(ory) Technology — efficiency of turning inputs → output AS shifts right (costs down)

From the professor’s lecture notation: $P_{I MP}$ = price of inputs to production. Combined with Factor prices and Technology = PIMP FacTory.

Memory hook: A factory is where supply happens. The PIMP FacTory tells you what shifts the supply curve.

Reverse for direction: $P_{I MP}$ up and Fac up shift AS left (higher costs). Tech up shifts AS right (lower costs). Costs up = bad for supply. Efficiency up = good for supply.

Letter(s)	Shifter	Direction when up
P_IMP	Price of inputs to production ( $P_{I MP}$ ) — oil, raw materials, energy	AS shifts left (costs up)
Fac	Factor prices — wages (L), rent (land), capital costs (K)	AS shifts left (costs up)
T(ory)	Technology — efficiency of turning inputs → output	AS shifts right (costs down)

Movement along AS vs shift of AS

	What changes	AS result	Example
Movement along AS	Price level (P)	Firms adjust quantity along existing curve	P rises → firms produce more (moving up AS)
Shift of AS	Cost structure (factor prices or technology)	At EVERY price level, firms supply a different quantity	Oil prices spike → at every P, firms produce less → AS shifts left

The test: Did the price level cause this change in quantity supplied? If yes → movement along AS. If no → shift of AS.

Factor prices and technology as AS shifters

Change	Unit cost effect	AS shift	Shock type
Wages rise	Costs up at every output level	AS shifts up/left	Negative AS shock
Oil prices spike	Costs up (oil is input to many industries)	AS shifts up/left	Negative AS shock
Raw material prices fall	Costs down at every output level	AS shifts down/right	Positive AS shock
New efficient process	Same output at lower unit cost	AS shifts down/right	Positive AS shock
Drought (agriculture)	Less output per input → higher unit costs	AS shifts up/left	Negative AS shock
Pandemic lockdown	Cannot combine inputs effectively → higher unit costs	AS shifts up/left	Negative AS shock

Think of “up/left” and “down/right” as two descriptions of the same shift: up = same output, firms need higher price; left = same price, firms can only produce less.

Aggregate supply shock (Professor's required definition e)

An AS shock is any exogenous event that shifts AS by changing either factor prices or the state of technology. Positive: AS shifts right (more output at any P). Negative: AS shifts left (less output at any P).

Key: These originate from the SUPPLY side — input prices, technology, productivity. NOT from AE. In Ch8, treat factor price changes as exogenous. In Ch9+, they become endogenous.

Important: Some events are BOTH AD and AS shocks (see oil-for-Canada dual shock below).

Trap — oil-for-Canada dual shock

A drop in the price of oil is two shocks at once for an oil-exporting economy like Canada:

Positive AS shock — oil is an input to production ( $P_{I MP}$ down) → unit costs fall → AS shifts right

Negative AD shock — oil is also an export ( $\overset{ˉ}{X}$ down) → export revenues fall → AD shifts left

Result: The model clearly predicts P falls (inflation declines). But the effect on GDP is ambiguous — it depends on which shock is larger:

If AS shift > AD shift GDP rises Net positive for output
If AD shift > AS shift GDP falls Net negative for output
If AS shift = AD shift GDP unchanged Effects cancel out

The professor says: “If you were the Minister of Finance… our model cannot help us” predict what happens to GDP. You would have to wait and observe.

Real-world examples: the 1997 Asian financial crisis and the 2020 COVID-19 oil price collapse both created this dual-shock scenario for Canada.

Structural trap — doing the adjustment in between the shock stories (Assignment 2 Q3):

The confusion: Supply-side shock → adjustment → demand-side shock → another adjustment. Two adjustments that feel like they loop forever, because the second one undoes the equilibrium the first one found. The fix: do NOT adjust until every curve that’s going to shift has shifted. Instead:

Tell all shock stories first (Beat 1 for each — both curves shift at $P_{0}^{e}$ )

Then identify the combined gap (Beat 2 — one gap, on the final curves)

Then do the adjustment once (Beat 3 — movement along $A D_{1}$ and $A S_{1}$ to one new equilibrium)

The phrase that makes it click: “With AS shifted left and AD shifted right, at the original price level $P_{0}^{e}$ …” — Price doesn’t change until after both stories are told. Both shock stories happen at $P_{0}^{e}$ . The adjustment (P changing) only starts once every curve that’s going to shift has shifted.

Defence: “Shift first, adjust once.”

If AS shift > AD shift	GDP rises	Net positive for output
If AD shift > AS shift	GDP falls	Net negative for output
If AS shift = AD shift	GDP unchanged	Effects cancel out

5. Macroeconomic Equilibrium (LO4)

Core question: What happens when AD and AS interact?

S1-2 built AD. S3-4 built AS. Now we combine them. The intersection determines BOTH the price level and real GDP simultaneously. The multiplier from 3. Equilibrium and the Multiplier still applies but is modified by the price level response.

AD-AS intersection: simultaneous determination of Y and P

Macroeconomic equilibrium requires two conditions simultaneously:

Condition	What it means	Where satisfied
(1) AE = Y at the prevailing price level	Desired spending equals actual output	Everywhere along AD
(2) Firms want to produce Y at the prevailing price level	Firms’ desired output matches actual GDP	Everywhere along AS

Only at the intersection are both conditions met. Away from equilibrium:

P below equilibrium: desired expenditure exceeds what firms will supply (excess demand) → prices bid up
P above equilibrium: firms want to supply more than buyers will spend (excess supply) → prices fall

Equilibrium of the macro economy (Professor's required definition n)

Macroeconomic equilibrium is the simultaneous determination of P and Y at the intersection of AD and AS. Two conditions hold: (1) desired aggregate expenditure equals actual GDP at the prevailing P, and (2) firms want to produce exactly that level of GDP at that P.

Key: Ch7’s equilibrium (AE = Y) is partial — it holds P fixed. The AD-AS equilibrium is the general equilibrium of the macro model.

Connects to: 3. Equilibrium and the Multiplier

Trap — read the gap HORIZONTALLY, not vertically

To identify excess demand or supply, draw a horizontal line at the current price level $P_{0}^{e}$ and compare quantities:

How much do buyers want at this price? (read off AD)

How much do sellers want at this price? (read off AS)

Whichever quantity is larger tells you the gap.

Do not pick a Y value and compare prices vertically. That compares what price each side would need at that output level — a different question entirely. The gap is always: at the prevailing price, who wants more — buyers or sellers?

Shock → Gap → Adjust (use this for EVERY shock question)

The professor grades the chain, not just the final answer. Every cause before the effect — never jump ahead. Three beats:

Beat 1 — THE SHOCK (curve shifts, prices unchanged):

Identify root cause → classify it (AD or AS shock, positive or negative) → show curve shifts at original $P_{0}^{e}$
AD shock: root cause changes autonomous expenditure (CIGNX) → AE shifts → AD shifts
AS shock: root cause changes unit costs (PIMP FacTory) → firms re-optimize → AS shifts
A shock is always a shift of a curve, never movement along a curve
Key phrase: “[Root cause] is a [positive/negative] [AD/AS] shock. At the original price level $P_{0}^{e}$ , [demand/supply] jumps from $Y_{0}^{e}$ to ___. The [AD/AS] curve shifts [right/left].”

Beat 2 — THE GAP (reason prices will change):

At original P, demand does not equal supply. Name the gap explicitly.
$Y^{D} > Y^{S}$ = excess demand → prices bid up
$Y^{S} > Y^{D}$ = excess supply → prices pushed down
Key phrase: “At $P_{0}^{e}$ , there is now excess [demand/supply]. Therefore, the price level will [rise/fall].”
This beat is the one most students skip. The professor wants to see you name the gap and explain WHY prices change.

Beat 3 — THE ADJUSTMENT (movement along BOTH curves):

AD side (always name these two channels): P up → real wealth (W/P) down → C bar down (wealth effect); P up → domestic goods relatively expensive → NX down (foreign trade effect). Result: movement along AD.
AS side: P up → price now exceeds unit cost per unit → firms produce more → Q up. Result: movement along AS.
Both sides converge at $(P_{1}^{e}, Y_{1}^{e})$ .
Key phrase: “As prices [rise/fall], on the AD side: [wealth + trade effects cause movement along AD]. On the AS side: [firms re-optimize, causing movement along AS]. Both adjust until new equilibrium at $(P_{1}^{e}, Y_{1}^{e})$ .”

The whole chain in one sentence:

Shock shifts [AD/AS] → creates excess [demand/supply] at $P_{0}^{e}$ → price [rises/falls] → movement along BOTH curves → new equilibrium at $(P_{1}^{e}, Y_{1}^{e})$ .

The professor says the adjustment is “stepwise” — in the real world, price moves a little, both sides adjust a little, the gap shrinks, repeat. Our model skips to the final answer, but the process is gradual.

Professor’s emphasis: Nobody in the economy sees or cares about equilibrium. Firms act because they see profit opportunities. Consumers act because they feel wealthier or poorer. These uncoordinated, self-interested actions naturally close the gap through the price mechanism.

Visualizing: Positive AD shock

left=0; right=700; bottom=0; top=250;
---
y=200-0.25x|blue
y=237.5-0.25x|orange
y=0.0005x^2+20|red
(400,100)|label:E₀ (original)
(455,124)|label:E₁ (new equil)
(550,100)|orange|open|label:Gap: excess demand (AD₁ at P₀ᵉ)
y=100|black|dashed|400<x<550
(200,150)|blue|label:AD₀
(200,187.5)|orange|label:AD₁
(580,188.2)|red|label:AS₀

Reading the graph — positive AD shock

Beat 1 (SHOCK): AD shifts right from AD0 (blue) to AD1 (orange). At the original price (dashed line), demand jumps rightward.

Beat 2 (GAP): At the original P, demand (on AD1) is to the RIGHT of supply (on AS0). The distance is excess demand. Prices will rise.

Beat 3 (ADJUST): The economy slides diagonally up AS (red) from E0 to E1. Both P and Y increase. Meanwhile, demand slides up-left along AD1. They meet at E1.

Visualizing: Positive AS shock

left=0; right=700; bottom=0; top=250;
---
y=200-0.25x|blue
y=0.0005x^2+20|red
y=0.0005(x-150)^2+20|orange
(400,100)|label:E₀ (original)
(490,77.5)|label:E₁ (new equil)
(550,100)|orange|open|label:Gap: excess supply (AS₁ at P₀ᵉ)
y=100|black|dashed|400<x<550
(100,175)|blue|label:AD₀
(580,188.2)|red|label:AS₀
(620,130.45)|orange|label:AS₁

Reading the graph — positive AS shock

Beat 1 (SHOCK): AS shifts right from AS0 (red) to AS1 (orange). At the original P, supply jumps rightward.

Beat 2 (GAP): At the original P, supply (on AS1) is to the RIGHT of demand (on AD0). The distance is excess supply. Prices will fall.

Beat 3 (ADJUST): The economy slides down the AD curve (blue) from E0 toward E1. P falls and Y rises — the “supply splits them” signature. Supply slides down-left along AS1. They meet at E1.

Shock signatures: AD vs AS

Shock type	Y direction	P direction	Mnemonic
AD shock	Y and P move together	Same direction	”Demand drags both along”
AS shock	Y and P move apart	Opposite directions	”Supply splits them”

Expanded:

Shock	Y	P	Real-world feel
Positive AD shock	up	up	Boom with rising prices
Negative AD shock	down	down	Recession with falling prices
Positive AS shock	up	down	Best of both worlds
Negative AS shock	down	up	Stagflation — worst case

Why the signatures differ — the stationary curve constrains the answer

When a shock hits, one curve moves and one stays put. The new equilibrium must land on the stationary curve. Its slope determines the signature:

AD shock → new equilibrium slides along AS (slopes up) → Y and P move same direction

AS shock → new equilibrium slides along AD (slopes down) → Y and P move opposite directions

The shock picks which curve moves. The slope of the OTHER curve determines whether Y and P are friends or enemies.

What "P falls" really means in the real world

When the model shows P declining, the proper real-world interpretation is usually that the inflation rate declines (prices rise more slowly), not that prices literally fall. Actual deflation is rare and extreme.

The two-stage multiplier (how price-level response shrinks the multiplier)

Stage 1 — The simple multiplier (P held constant at $P_{0}$ ):

Autonomous expenditure rises by $Δ A$ .
AE shifts up by $Δ A$ .
Through the Ch7 multiplier process, equilibrium Y rises by $\frac{Δ A}{1 - z}$ at the original price level.
This is the horizontal rightward shift of AD by $\frac{Δ A}{1 - z}$ .

$Horizontal shift of AD = \frac{Δ A}{1 - z}$

If AS were flat, this would be the actual change in Y. But AS slopes up.

Stage 2 — The price level responds (AS slopes up):

New AD intersects upward-sloping AS at a higher price level $P_{1} > P_{0}$ .
This rise in P reduces real wealth and net exports (the same wealth + trade channels from S1).
Those reductions shift AE back down partially — undoing some of Stage 1.
Actual equilibrium Y is less than the simple multiplier predicted.

$Actual \frac{Δ Y}{Δ A} < \frac{1}{1 - z}$

The steeper the AS curve, the more P rises, the more it claws back, and the smaller the actual multiplier becomes.

How the AS curve shape distributes the push

The shape of AS determines how any AD shock gets split between output change and price change:

AS range	Slope	AD shock splits into…	Actual multiplier	Intuition
Flat (Keynesian)	Horizontal	Almost all output, almost no price change	$\approx$ simple multiplier	Excess capacity — firms expand freely
Intermediate	Moderate upward	Appreciable changes in both Y and P	Positive but smaller than simple	Some capacity pressure — costs rising
Steep (near capacity)	Very steep	Mostly price change, little output change	Near zero	Economy near $Y^{*}$ — almost no room to expand
Vertical (extreme)	Infinite	ALL price, NO output change	Exactly zero	Maximum capacity — more demand just inflates

The AD shock is a fixed “push.” The AS curve determines how that push is distributed. A flat AS absorbs the push as output. A steep AS deflects the push into prices.

Policy: recessionary gaps and the stagflation dilemma

Stabilization policy (Professor's required definition g)

Stabilization policy is any government attempt to use fiscal policy (changes in G and t) or monetary policy (changes in interest rates and money supply) to reduce output fluctuations and keep real GDP close to $Y^{*}$ .

Key: Stabilization policy works by shifting AD. The government controls demand-side levers: expansionary (up G or down t → AD shifts right) and contractionary (down G or up t → AD shifts left).

Connects to: 4. Fiscal Policy

Recessionary gap policy recommendation

If $Y^{*} > Y_{e}$ , the economy is in a recessionary gap. Recommend expansionary fiscal policy (up G or down t) to shift AD right toward $Y^{*}$ .

If $Y_{e} > Y^{*}$ , the economy is in an inflationary gap. Recommend contractionary fiscal policy (down G or up t) to shift AD left toward $Y^{*}$ .

The stagflation dilemma — why AS shocks are uniquely hard

AD shocks are straightforward to fix. Y and P move in the same direction, so one policy addresses both:

Negative AD shock (Y down, P down) → expansionary policy → AD shifts right → both recover

Positive AD shock (Y up, P up) → contractionary policy → AD shifts left → both cool

AS shocks create a dilemma. Y and P move in opposite directions, so every policy helps one and hurts the other:

Government priority Policy Fixes Makes worse
Restore output (Y) Expansionary → AD right Y recovers P rises even more (inflation worsens)
Fight inflation (P) Contractionary → AD left P comes down Y falls further (recession deepens)

You cannot fix both at once. This is the stagflation dilemma — stagnation (falling Y) plus inflation (rising P) with no clean policy answer.

Key: Stabilization policy shifts AD, not AS. When the problem originates on the supply side, the government is stuck choosing which problem to make worse.

Government priority	Policy	Fixes	Makes worse
Restore output (Y)	Expansionary → AD right	Y recovers	P rises even more (inflation worsens)
Fight inflation (P)	Contractionary → AD left	P comes down	Y falls further (recession deepens)

Dual-shock worked example (exam prep for Q4m-style questions)

Scenario: Fiscal expansion (positive AD shock) + exogenous labour cost increase (negative AS shock) happen simultaneously.

Shock Y effect P effect
Fiscal expansion (AD shifts right) Y up P up
Labour cost increase (AS shifts left) Y down P up

Both shocks push P up — P rise is certain.

But they push Y in opposite directions — Y direction is ambiguous, depends on relative magnitudes:

If AD shift dominates: Y rises (net boom with higher prices)

If AS shift dominates: Y falls (stagflation)

If roughly equal: Y unchanged, only P rises

The test: When two shocks push a variable in the SAME direction, that variable’s direction is certain. When they push in OPPOSITE directions, the result is ambiguous without knowing magnitudes.

Shock	Y effect	P effect
Fiscal expansion (AD shifts right)	Y up	P up
Labour cost increase (AS shifts left)	Y down	P up

Appendix

Vocabulary Reference

#	Term	One-line definition	Section
b	Aggregate demand function (AD)	Relates P to equilibrium real GDP demanded; each point is an AE = Y solution at that P	S1
o	Why AD slopes down	Wealth effect (W/P down → C down) and trade effect (relative price up → NX down)	S1
c	Aggregate supply function (AS)	Relates P to real GDP firms want to produce, for given factor prices and technology; slopes up because unit costs rise with output	S3
h	Potential output ( $Y^{*}$ )	Real GDP at normal utilization of all factors; not maximum, but sustainable level	S3
d	AD shock	Exogenous event shifting AD by changing autonomous expenditure at given P	S2
e	AS shock	Exogenous event shifting AS by changing factor prices or technology	S4
n	Macro equilibrium	Simultaneous determination of P and Y at the AD-AS intersection	S5
g	Stabilization policy	Government use of fiscal/monetary policy to keep Y close to $Y^{*}$ by shifting AD	S5

Completion Checklist

#	Concept	Status	Where
b	Aggregate demand function	Done	S1
c	Aggregate supply function	Done	S3
d	AD shock (positive/negative)	Done	S2
e	AS shock (positive/negative)	Done	S4
g	Stabilization policy	Done	S5
h	Potential aggregate output	Done	S3
n	Equilibrium of the macro economy	Done	S5
o	Why AD has negative slope	Done	S1

Direction	Link	Relationship
North (prior chapter)	ECON-1221 Chapter 7 - Notes from the Textbook	AE model with constant price level → foundation for AD derivation
South (next chapter)	ECON-1221 Chapter 9 - Notes from the Textbook	Short run to long run — factor price adjustment, output gap closure
East (demand side)	ECON-1221 Chapter 6 - Notes from the Textbook	Simple AE model → building block for the multiplier used here
West (supply side)	ECON-1221 Chapter 5 - Notes from the Textbook	GDP measurement — the C, I, G, NX categories that form both AE and AD

Kai Mallari's Notes'

Explorer

ECON-1221 Chapter 8 - Notes from the Textbook

LO Coverage

Vocabulary Tracker

Session Log

Prerequisites (reference back if rusty)

What Changed from Chapter 7?

1. From AE to AD (LO1, LO2)

The wealth effect channel

The international trade effect

Deriving the AD curve

2. What Shifts AD? (LO2)

Movement along AD vs shift of AD

What shifts AE (and therefore AD)?

The simple multiplier and AD shifts

3. The Supply Side (LO3)

Unit costs and output: why costs rise as Y increases

The AS curve shape: three ranges

The Keynesian range

AD vs AS origin comparison

4. What Shifts AS? (LO3)

Mnemonic: “The PIMP FacTory shifts AS”

Movement along AS vs shift of AS

Factor prices and technology as AS shifters

5. Macroeconomic Equilibrium (LO4)

AD-AS intersection: simultaneous determination of Y and P

Shock → Gap → Adjust (use this for EVERY shock question)

Visualizing: Positive AD shock

Visualizing: Positive AS shock

Shock signatures: AD vs AS

The two-stage multiplier (how price-level response shrinks the multiplier)

How the AS curve shape distributes the push

Policy: recessionary gaps and the stagflation dilemma

Appendix

Vocabulary Reference

Completion Checklist

Compass Navigation

Graph View

Table of Contents

Backlinks