ECON-1221 Chapter 8 - Notes from the Textbook_backup

All credit for this text goes to...

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

Study Session Meta (delete when complete)

LO Coverage & Mastery

LO	Title	Status	Mastery	New Section(s)
1	How price level changes affect AE	✅ Passed	Wealth + trade effect ✓	§1 (wealth effect, trade effect)
2	The AD curve and what shifts it	🟡 In progress	Movement-vs-shift ✓, AD derivation ✓, AD shifters ✓, multiplier in Ch8 context needs revisit (understood Ch7 leakages but confused with Ch8 price-level effect)	§1 (AD derivation) + §2 (AD shocks)
3	The AS curve and what shifts it	✅ Passed	AS slope from intensity ✓, movement-vs-shift ✓, shock classification ✓, PIMP FacTory = shifters not slope (corrected) ✓, excess supply → P falls ✓ (flag resolved during LO4 walkthrough)	§3 (AS curve) + §4 (AS shocks)
4	How AD and AS shocks affect equilibrium	✅ Passed	Shock signatures (demand drags both, supply splits them) ✓, full Shock → Gap → Adjust walkthrough ✓, stagflation dilemma ✓, stabilization policy trade-offs ✓. Flag: always name wealth + trade effects explicitly in Beat 3	§5 (macro equilibrium)

Vocabulary Tracker

Term	Tier	Location	Note
Aggregate demand function (AD)	T1	§1 [!vocab]	Prof required (b)
Why AD has negative slope	T1	§1 [!vocab]	Prof required (o)
Aggregate supply function (AS)	T1	§3 [!vocab]	Prof required (c)
Potential output ($Y^{\ast }$)	T1	§3 [!vocab]	Prof required (h)
AD shock	T1	§2 [!vocab]	Prof required (d)
AS shock	T1	§4 [!vocab]	Prof required (e)
Macro equilibrium	T1	§5 [!vocab]	Prof required (n)
Stabilization policy	T1	§5 [!vocab]	Prof required (g)

Current Position

Status: All sections (§1–§5) content filled from textbook synthesis. All professor-required definitions complete. All four LOs passed.

Session Log

Date	LOs Covered	Mastery Results	Key Clarifications
2026-03-01	LO1 ✅, LO2 (partial)	Wealth effect ✓, trade effect ✓, movement-vs-shift ✓, AD derivation ✓, AD shifters partial ✓	Nominal wealth is FIXED (not changed by P). $Y^D$/$Y^S$/$Y^e$ are points on same axis (superscript, not subscript). “Why” questions want causal chains, not graph descriptions. AD curve = lookup table of (P, Y) pairs from AE equilibria. AD and AS share same axes but different functions (different lookup tables). Under fatigue, reverted to micro reasoning for “why AD slopes down” — caught own mistake. All §1–§5 textbook synthesis complete. Simple multiplier = horizontal shift of AD (at constant P), NOT actual ΔY. Actual ΔY < simple multiplier because AS slopes up → P rises → wealth/trade effects claw back expansion. Kai confused Ch7 leakages (already in formula) with Ch8 price-level effect (new concept) — needs revisit. Two-stage multiplier: Stage 1 = shift AD at constant P, Stage 2 = P rises along AS, AE pushed back down.
2026-03-01	LO3 🟡 (passed with flag)	AS slope logic ✓, movement vs shift ✓, shock classification ✓	LO3 quiz — AS slope logic, movement vs shift, shock classification. Kai correctly identified AS slope from rising unit costs but initially attributed it to PIMP FacTory (corrected: those are shifters, slope comes from intensity of resource use). Correctly classified semiconductor shortage as negative AS shock ($P_{IMP}$↑). Correctly identified infrastructure spending as positive AD shock (G from CIGNX). Correctly identified AI breakthrough as positive AS shock (Technology), but initially said P rises (corrected: excess supply → P falls). Spotted potential dual-shock for AI (job displacement → AD effect) — same pattern as oil-for-Canada trap. LO3 passed with flag: revisit price direction for excess supply.
2026-03-02	LO4 ✅ Passed	Shock signatures ✓, Shock → Gap → Adjust walkthrough ✓, stagflation dilemma ✓, stabilization policy ✓	LO4 quiz — correctly identified shock signatures and why they differ (slope of stationary curve constrains new equilibrium). Walked through full negative AD shock (consumer confidence collapse) with all three beats. Initially read gap vertically instead of horizontally (corrected: read horizontally at prevailing P). Initially missed naming wealth + trade effects in Beat 3 (corrected). Discovered stagflation dilemma for AS shocks through guided reasoning — understood stabilization policy shifts AD not AS. Also covered: AS slope comes from intensity of resource use (not PIMP FacTory), Ch8 is a short-run model (resource pool fixed), Keynesian range = Ch7 demand-determined world because of slack. LO3 flag resolved (excess supply → P falls confirmed during walkthrough). All four LOs now passed.

Note on Organization

This chapter covers the AD-AS model — introducing changing price levels into the Ch7 framework. The core question this chapter answers is: What happens when we drop the constant price level assumption and let prices respond to demand and supply?

Sections are organized by teaching flow, not textbook LO order.

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

LO Mastery Tracker

LO	Description	Status
1	Understand how changes in the price level affect AE	✅ Passed — wealth effect ✓, trade effect ✓
2	Understand the AD curve and what causes it to shift	🟡 In progress — movement-vs-shift ✓, AD derivation ✓, AD shifters ✓, multiplier-in-Ch8 needs revisit (confused leakages with price-level clawback)
3	Understand the AS curve and what causes it to shift	✅ Passed — AS slope from intensity of resource use, PIMP FacTory as shifters (not slope), correctly classified all three shock scenarios. Flag resolved: confirmed excess supply → P falls during LO4 walkthrough.
4	Understand how AD and AS shocks affect GDP and price level	✅ Passed — shock signatures (demand drags both, supply splits them), full Shock → Gap → Adjust walkthrough for negative AD shock, stagflation dilemma for AS shocks, stabilization policy trade-offs. Flag: always name wealth + trade effects explicitly in Beat 3.

Critical Conceptual Trap — Read Before Starting Ch8

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. Vertical lines from AS points don’t map to the AE panel.

When studying Ch8, 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

Exam Trap — "What happens?" vs. "Why does it happen?"

Question Type	What They Want	What You Might Give Instead
”What happens when P rises?”	Graph description: AE shifts down, equilibrium Y falls, movement along AD	✓ Fine
”Why / Explain the mechanism”	The economic causal chain (wealth effect, trade effect)	✗ Graph description again

If the question says “explain why” or “what is the mechanism,” the professor wants the dominoes — the economic logic — not a description of curves moving. The graph illustrates the mechanism; it isn’t the mechanism.

Axis labels — $Y$, $Y^D$, $Y^S$, $Y^e$

Both the AE diagram and the AD-AS diagram share the same x-axis: Real GDP (Y). It’s one variable.

The professor uses superscript labels to mark specific points on that axis:

Label	Meaning	Read from
$Y^D$	Demand level at a given price	The AD curve
$Y^S$	Supply level at a given price	The AS curve
$Y^e$	Equilibrium level	Where AD and AS intersect

These are NOT different axes or different variables. At a non-equilibrium price, AD gives one $Y$ and AS gives another — the gap is excess supply or demand. At equilibrium: $Y^D=Y^S=Y^e$.

⚠️ 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 ($Y-tY$)	AE model (Ch7)

These are completely different variables. Don’t mix them up on an exam.

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	✗
No government (no taxes)	✓ Assumed	✗ Removed	✗
Constant price level	✓ Assumed	✓ Still assumed	✗ Removed

The critical consequence: the price level is now endogenous.

In Ch7, we assumed firms produce whatever is demanded at a fixed price. Now we ask: what happens when price levels change?

This single change — making the price level a variable to solve for, not an assumption to hold fixed — drives everything new in this chapter.

Prerequisites — already in your vault

Don't re-learn these. 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

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1. From AE to AD (LO1, LO2)

Core question: How do we go from the fixed-price AE model to a curve that shows what happens when prices change?

Section road map

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 (price level, Y) pairs and you get the AD curve.

Vault reference: The AE equilibrium being varied here is the one from 3. Equilibrium and the Multiplier.

Trap — imports change the slope, but the textbook ignores it

When P rises, imports increase — which raises $m$ (marginal propensity to import). A higher $m$ changes the slope of the AE curve, not just its intercept.

You know this from Ch7. You will be tempted to include the slope change in your answer.

Don’t. The textbook (and your professor) treat the AE shift as a parallel shift only — intercept moves down, slope stays the same.

On an exam, stick to the simplification: P↑ → AE shifts down in parallel → new equilibrium Y at the 45° line.

The wealth effect channel

When the price level rises, the dollar amount in your bank account doesn’t change — nominal wealth is fixed. But what those dollars can buy shrinks. That’s the wealth effect.

$$\text{Real Wealth}=\frac{W}{P}$$

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

	Before P↑	After P↑
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

Real wealth is about purchasing power

Nominal wealth = the number you see.

Real wealth = what that number can buy.

The price level doesn’t change your dollars — it changes what your dollars are worth. This is why we divide by P.

The chain: P↑ → nominal wealth fixed → real wealth (W/P) falls → households feel poorer → C̄↓ → AE shifts down

What about bonds? When P rises, bond repayments are worth less in real terms — the lender loses real wealth. But the borrower gains (repaying in cheaper dollars). These cancel in aggregate. Money holdings, however, are a NET loss to the private sector — nobody is on the other side. That’s why the wealth effect works.

Nominal vs. Real — don't confuse the direction

A rise in the price level does not change nominal wealth. It changes real wealth.

Nominal = name only, the face value in dollars. Real = adjusted for purchasing power.

See also ECON-1221 Chapter 4 - Notes from the Textbook and ECON-1221 Chapter 5 - Notes from the Textbook for the nominal vs. real GDP distinction — same logic applied to wealth.

The international trade effect

When the Canadian price level rises and the exchange rate stays constant, Canadian goods become more expensive relative to foreign goods. Think of it as a ratio:

$$\text{Relative price}=\frac{P_{\text{domestic}}}{P_{\text{foreign}}}$$

When $P_{\text{domestic}}$ rises and $P_{\text{foreign}}$ is unchanged, the ratio increases — Canadian goods look expensive.

This triggers two responses:

1. Canadian consumers substitute toward imports (foreign goods are now relatively cheaper)
2. Foreign consumers buy fewer Canadian goods (our exports fall)

Both reduce net exports: NX = X − IM. X̄↓ and IM↑ → NX↓ → AE shifts down.

The foreign trade effect is about relative prices

P↑ (exchange rate constant) → Canadian goods relatively expensive vs. foreign goods.

Canadian consumers import more. Foreign consumers buy fewer Canadian exports.

→ X̄↓, IM↑ → NX↓ → AE shifts down.

Simplification the textbook makes

Strictly, the rise in imports also changes $m$ (marginal propensity to import), which would change the slope of the AE curve, not just its intercept.

The textbook ignores this slope change for simplicity and focuses only on the parallel shift of AE downward.

Deriving the AD curve: each price level gives a different equilibrium Y

The AD curve is a lookup table. Each price level determines where AE sits (via wealth + trade effects), AE crosses the 45° line at some equilibrium Y, and you write down that (P, Y) pair. Do this for every possible price level, plot all the pairs, and you get the AD curve.

You pick a P	Wealth + trade effects position AE	AE crosses 45° 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 points with P on the vertical axis and Y on the horizontal axis. Connect them. That’s the AD curve.

The AD curve adds no new economics. It just compresses all possible AE diagrams — one for each price level — into a single line.

Why the AD curve is curved, not straight

The wealth effect works through a ratio: Real Wealth = W/P.

Ratios don’t shrink evenly. Going from P = 100 to P = 110 reduces real wealth by $\mathrm{9.10.}GoingfromP=110toP=120reducesitbyonly$7.60.

Each equal step up in P causes a smaller drop in real wealth → smaller shift in AE → smaller change in Y.

That’s what creates the curve. At low P, a price increase hits hard. At high P, the same size increase barely moves 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.

The AD curve doesn’t add new economics — it’s a summary of what the AE model already tells you, displayed differently.

Why AD slopes down (macro reasons, NOT micro)

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

Definition: The AD curve has a negative slope because a higher price level reduces equilibrium real GDP demanded through two transmission channels: (1) the wealth effect — higher P reduces the real value of money holdings (W/P↓), reducing desired consumption; and (2) the international trade effect — higher domestic P (with constant exchange rate) makes Canadian goods relatively expensive, reducing net exports.

The two macro reasons (for now):

1. Wealth effect: P↑ → real wealth↓ → desired C↓ → equilibrium Y↓
2. International trade effect: P↑ → domestic goods relatively expensive → NX↓ → equilibrium Y↓

A third reason (through interest rates) is introduced in later chapters after money and banking.

Key: This is NOT the same as “demand curves slope down because of substitution/income effects.” Those are micro reasons for individual goods (relative price changes). AD slopes down for macro reasons — changes in the OVERALL price level affecting wealth and international competitiveness.

Foundation from Ch7: The AE model IS the engine. Changes in the price level shift the AE curve, producing different equilibrium Y values — each (price level, Y) pair is one point on the AD curve.

The Trap

Don’t import micro reasoning into macro.

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.

The aggregate demand function

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

Definition: The aggregate demand function relates the price level to the equilibrium level of real GDP demanded. Each point on the AD curve represents an AE = Y equilibrium at that specific price level. The entire AD curve is derived by varying the price level, observing how the AE curve 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. Each point on the AD curve IS an AE = Y solution — but at a different price level.

Foundation from Ch7: The AE model (3. Equilibrium and the Multiplier) gives equilibrium Y at one fixed price level. Changing the price level shifts AE, giving a different equilibrium Y. Plot all those (price level, Y) pairs and you get the AD curve.

Connects to: 3. Equilibrium and the Multiplier

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2. What Shifts AD? (LO2)

Core question: What’s the difference between moving along AD and shifting AD?

Section road map

Section 1 showed that price level changes MOVE you along the AD curve. This section asks: what SHIFTS the entire AD curve? Answer: anything that changes autonomous expenditure at a GIVEN price level.

Vault reference: 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. The AE curve moves whether the cause is a price level change or an autonomous expenditure change. What differs is the effect on AD.

	What Changes	AE Shifts?	AD Result	LO
Movement along AD	Price level (P)	Yes — down if P↑	Movement up-left along AD	LO1
Shift of AD	Autonomous expenditure (A) at constant P	Yes — up if A↑	AD shifts right	LO2

Both cause AE to shift — the CAUSE determines the AD result

Price level change → movement along AD. You’re tracing out the AD curve — each price level gives a different AE equilibrium, and the AD curve IS the collection of all those (P, Y) pairs.

Anything else that shifts AE → shift of AD. You’re moving the entire AD curve because at every price level, the equilibrium Y is now different.

Why this is confusing

You see the AE curve shift. You think “the AD curve should move.” But it depends on what caused AE to shift.

If it was P → you’re drawing AD. If it was G, I, X, or consumer confidence → you’re shifting AD.

The graph looks similar in the AE panel either way. The difference is entirely about causation.

What shifts AE (and therefore AD)?

Any change in autonomous expenditure at a given price level shifts the AE curve, which shifts the AD curve. The price level must NOT be the cause — otherwise it’s movement along AD, not a shift.

Source of AD Shift	What Changes	Direction
Consumer confidence ↑	Autonomous C̄↑	AD shifts right
Business confidence ↑	Autonomous I↑	AD shifts right
Government purchases ↑	G↑	AD shifts right
Foreign income ↑	Autonomous X̄↑	AD shifts right
Tax rate ↓	Slope of AE rises (z↑)	AD shifts right
Exchange rate depreciation	X̄↑, IM↓	AD shifts right

Reverse each for leftward AD shifts.

The test for "shift vs. movement along"

Ask: did the price level cause this?

If yes → movement along AD. If no → shift of AD.

This is the same logic as micro supply and demand: own-price = movement along, everything else = shift.

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.

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

If autonomous expenditure rises by $\Delta A$, the AD curve shifts right by $\frac{\Delta A}{1-z}$ at every price level. This is because: at the original price level, AE shifts up by $\Delta A$, and the Ch7 multiplier process gives a new equilibrium Y that is $\frac{\Delta A}{1-z}$ higher.

But 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 (covered in §5).

The Trap

The simple multiplier gives the horizontal shift of AD, not the actual change in equilibrium GDP.

The actual change in Y depends on where the new AD intersects the AS curve. If AS is flat (Keynesian range), you get the full multiplier. If AS slopes up, part of the demand increase goes into higher prices, and the actual multiplier is smaller. This is resolved in §5.

Study Session Trap — Ch7 leakages ≠ Ch8 price-level effect

When asked “why is actual ΔY less than the simple multiplier?”, you answered: “because of the leaks — imports and taxes.”

That’s the Ch7 answer. Leakages are already baked into the formula $\frac{1}{1-z}$ (that’s what $z$ accounts for).

The Ch8 answer is about price level: AS slopes up → P rises → wealth and trade effects push AE back down → actual ΔY 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

Revisit this before the exam.

Aggregate demand shocks

Aggregate demand shock (Professor's required definition d)

Definition: An aggregate demand shock is any exogenous event that shifts the AD curve by changing autonomous expenditure at a given price level. It causes a change in equilibrium real GDP at every price level, shifting the entire AD curve horizontally.

Positive AD shock: Shifts AD rightward → at any given price level, more real GDP is demanded. Examples: ↑G, ↑I, ↑X, ↑consumer confidence, tax cuts that ↑C.

Negative AD shock: Shifts AD leftward → at any given price level, less real GDP is demanded. Examples: ↓G, ↓I, ↓X, ↓consumer confidence, tax increases.

Foundation from Ch7: Anything that changes autonomous expenditure ($A$) or the slope of AE ($z$) in Ch7 would shift AE, which shifts AD. Changes in G, I, X, consumer confidence, $t$, $m$ — all create AD shocks.

Connects to: 4. Fiscal Policy

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3. The Supply Side (LO3)

Core question: Why can’t firms just produce whatever is demanded? What constrains them?

Section road map

Sections 1–2 built the demand side (AD). This section introduces the supply side — a completely separate origin. The AS curve comes from firm profit maximization and unit costs, NOT from the AE diagram.

Vault reference: Ch7’s assumption that output is demand-determined (5. The Boundary — When Is This Model Realistic?) is what we’re now relaxing. When Y approaches $Y^{\ast }$, firms can’t just produce more — they start raising prices. That’s where AS enters.

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. Why?

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

This is the law of diminishing returns applied at the macro level — squeezing more output from a fixed stock of capital equipment yields progressively less output per additional unit of input, driving up cost per unit.

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

Factor prices (wages, rent, etc.) are held constant when drawing AS. But unit costs still rise because you’re using inputs less efficiently as you push output higher.

Don’t confuse the two on an exam.

The core logic of AS

Fixed factor prices + fixed technology does NOT mean flat costs.

As output rises → less efficient plants, workers, overtime → unit costs rise.

Firms won’t produce more unless the selling price rises enough to cover those higher unit costs.

Therefore: higher output requires higher price level → AS slopes upward.

The AS curve shape: positively sloped with increasing steepness

The AS curve is not a straight line — it gets progressively steeper as output rises. Think of it in three ranges:

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

The key intuition: the higher output already is, the faster unit costs rise with each additional unit. That’s why the AS curve doesn’t just slope up — it curves upward, getting steeper and steeper.

Study Session Trap — PIMP FacTory ≠ the slope of AS

PIMP FacTory items (factor prices, input prices, technology) are held constant along the AS curve. They are the shifters — they move the whole curve.

The slope comes from something different: intensity of resource use at given prices.

Factor prices stay the same, but as output rises, firms need more and more resources per unit of output:

• Same wage rate, but paying overtime hours
• Same rent, but cramming more production into the same space
• Same equipment, but running the older, less efficient machines

Same prices, worse productivity per unit → unit costs rise → firms need higher P.

One sentence: AS slopes up because output↑ → resource use intensifies → unit costs rise → firms need higher P. All while factor prices and technology are held constant.

Reading the AS curve — it's 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.”

It’s a cost schedule for the whole economy:

• At Y = 200 → lots of slack, cost per unit low → firms only need P = 60
• At Y = 400 → slack thinning, overtime, less productive workers → firms need P = 100
• At Y = 600 → everything stretched, backup machines, thin labour pool → firms need P = 200

Pick any point on the horizontal axis. The AS curve tells you the minimum price level firms require to cover their unit costs at that output level.

Ch8's AD-AS model is a short-run model

The reason the resource pool is fixed, the reason factor prices are held constant, the reason PIMP FacTory items are treated as exogenous — all of it is because Ch8’s AS curve is a short-run construct.

Short run: You can’t build new factories, train new workers, or discover new technology fast enough to matter. Firms are stuck with the existing pool of resources. That’s why intensity of resource use drives the slope — firms squeeze what they have, rather than creating more.

Later chapters (Ch9+): Factor prices become endogenous — they respond to the output gap (e.g., wages rise when unemployment is low). This changes the adjustment process and introduces the long-run equilibrium story.

For now: treat factor prices and technology as given. The AS curve is a short-run cost schedule.

The Keynesian range: flat portion where spare capacity exists

The horizontal (flat) portion of the AS curve is called the Keynesian range. It exists when the economy has significant excess capacity — idle factories, unemployed workers, unused equipment.

In this range, firms can expand output by simply putting idle resources to work. Since these resources are readily available, there is little or no pressure on unit costs. Firms don’t need a higher price to produce more — they’re happy to sell more at the current price because their costs haven’t changed.

This means output is truly demand-determined: however much buyers want to purchase, firms will produce, with no price increase. This is exactly the world Ch7 assumed.

The range is named after John Maynard Keynes (1883-1946), who built his macroeconomic theory to explain economies stuck in depression — high unemployment, excess capacity, and firms willing to produce more at existing prices if only someone would buy.

The Keynesian range is the special case, not the general case

Ch7 treated the entire economy as if it were in the Keynesian range (constant price level, demand-determined output). Ch8 reveals this is only true over a limited portion of the AS curve.

Once you leave the flat range, the constant-price assumption breaks down and you need the full AD-AS model.

When is the Ch7 model valid?

The Ch7 demand-determined model (constant price level, simple multiplier gives actual change in Y) works only in the flat Keynesian range of AS.

In the Keynesian range: excess capacity → firms expand output freely → no price increase → AE = Y determines everything.

Once the economy moves into the upward-sloping portion of AS, the price level starts to rise, AE gets pushed back down, and the simple multiplier overstates the actual change in GDP.

Ch7 = special case. Ch8 AD-AS = general case.

Why the Keynesian range exists — the slack connection

In a recession: workers are idle, factory floors are empty, equipment sits unused.

Firms can scale up without bidding up wages or stretching resources — they just put idle inputs to work. Adding output is effectively cheap because unemployed workers will accept current wages (better than no wages), and empty capacity costs nothing extra to use.

That’s why AS is flat in this range: costs barely move → firms don’t need a higher price → output is purely demand-determined (Ch7 world).

Once the slack runs out, the intensity effect kicks in and AS starts sloping up.

Why AS is completely separate from the AE diagram

This is worth hammering home: AD and AS come from completely different places.

	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). That shared axis system is what lets you plot them on the same graph and find equilibrium in §5.

Don't cross-contaminate the diagrams

You cannot derive AS from the AE panel. You cannot read AS points off the 45-degree line. AS is a separate function from separate economics (firm costs and profit-seeking behavior).

If you find yourself drawing AS on an AE diagram, stop — you’ve mixed up the panels.

Aggregate supply function

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

Definition: The aggregate supply function relates the price level to the quantity of real GDP that firms want to produce and sell, drawn for given factor prices and given technology. It is positively sloped because higher output raises unit costs, and profit-seeking firms will only supply more if the price level rises enough to cover those costs.

Key: The AS curve comes from firm profit maximization. It has NO connection to the AE diagram. Do not try to derive it from the 45-degree-line model.

Two assumptions held constant: (1) Factor prices, (2) State of technology. Changes in either shift AS (covered in §4).

Foundation from Ch7 LO6: Ch7 assumed demand-determined output — firms just produce whatever is demanded. Ch8 asks: what if they CAN’T or WON’T? That’s where AS enters.

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

Potential output

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

Definition: Potential output ($Y^{\ast }$) is the level of real GDP the economy would produce if all factors of production — land, labour, and capital — were employed at their normal rates of utilization. It is NOT maximum output. The economy can temporarily exceed $Y^{\ast }$ (through overtime, extra shifts, running equipment beyond normal schedules), but at sharply rising costs that are not sustainable.

Key: $Y^{\ast }$ is NOT maximum possible output — it’s the level consistent with “normal” utilization. The economy CAN temporarily exceed $Y^{\ast }$ (overtime, extra shifts), but costs rise sharply and it’s not sustainable.

Foundation from Ch7 LO6: Demand-determined output works when $Y<Y^{\ast }$. When Y approaches $Y^{\ast }$, firms hit capacity constraints and start raising prices. That’s when the constant price level assumption breaks.

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

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4. What Shifts AS? (LO3)

Core question: What moves the entire AS curve vs. moving along it?

Section road map

§3 drew the AS curve for given factor prices and technology. This section asks: what happens when those things change? Answer: the AS curve shifts, and we call those shifts aggregate supply shocks.

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 ↑
P_IMP	Price of inputs to production ($P_{IMP}$) — oil, raw materials, energy	AS shifts left (costs ↑)
Fac	Factor prices — wages (L), rent (land), capital costs (K)	AS shifts left (costs ↑)
T(ory)	Technology — efficiency of turning inputs → output	AS shifts right (costs ↓)

From the professor’s lecture notation: $P_{IMP}$ = 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: $P_{IMP}$↑ and Fac↑ shift AS left (higher costs). Tech↑ shifts AS right (lower costs). Costs up = bad for supply. Efficiency up = good for supply.

Movement along AS vs shift of AS

The same movement-vs-shift logic from AD applies here:

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

A movement along AS means the underlying cost structure is unchanged — you’re just reading off a different point on the same curve as P changes.

A shift of AS means the cost structure itself has changed — the entire relationship between P and desired output is different. Every row in the “lookup table” has a new output value.

The test for movement vs. shift of AS

Ask: did the price level cause this change in quantity supplied?

If yes → movement along AS (same cost structure, different P).

If no → shift of AS (cost structure changed via factor prices or technology).

Changes in factor prices → AS shifts

Factor prices are what firms pay for their inputs: land (rent, raw materials), labour (wages), and capital (equipment costs, interest). When these change, unit costs change at every output level, and the entire AS curve shifts.

Factor price change	Effect on unit costs	AS shift	Type of shock
Wages rise	Costs ↑ at every output level	AS shifts up/left	Negative AS shock
Oil prices spike	Costs ↑ (oil is input to plastics, chemicals, energy, transport)	AS shifts up/left	Negative AS shock
Raw material prices fall (copper, iron ore)	Costs ↓ at every output level	AS shifts down/right	Positive AS shock
Rent on commercial land falls	Costs ↓	AS shifts down/right	Positive AS shock

Raw materials deserve special emphasis. Oil, copper, iron ore, and lumber are inputs to many industries. When the world price of oil fell 50% in 2014, it was a positive AS shock for oil-using firms (costs fell, AS shifted right). When OPEC restricted output in the 1970s and oil prices spiked, it was a negative AS shock worldwide.

Think of “up/left” and “down/right” as two ways to describe the same shift:

• Up = same output, but firms need a higher price to cover higher costs
• Left = same price, but firms can only afford to produce less output

Factor price changes as AS shifters

Factor prices ↑ → unit costs ↑ at every output level → firms need higher P for same output → AS shifts up/left (negative shock).

Factor prices ↓ → unit costs ↓ at every output level → firms can offer same output at lower P → AS shifts down/right (positive shock).

This includes wages, rent, raw material prices (oil, copper, lumber), and capital costs. Anything firms pay for as an input.

Technology improvements → AS shifts right

Technology improvements allow firms to produce the same output at lower unit cost (or more output at the same cost). This shifts AS down/right — a positive supply shock.

Example: a new manufacturing process lets a factory produce 1000 units for $80/unit instead of $100/unit. At any given price level, the firm can now profitably supply more. Multiply this across the economy and AS shifts right.

Technology deteriorations are rare — firms don’t voluntarily adopt worse methods. But they can happen:

• Bad weather in agriculture is modeled as a technology deterioration. A drought doesn’t change the farmer’s land, labour, or capital — but it reduces the output those inputs can produce. That’s exactly what a negative technology shock does: same inputs, less output, higher unit costs.
• The COVID-19 lockdowns functioned as a technology deterioration — the economy’s ability to combine land, labour, and capital was severely reduced even though the physical inputs still existed.

Technology change	Unit cost effect	AS shift	Shock type
New efficient process	Costs ↓	AS shifts down/right	Positive
Drought (agriculture)	Costs ↑ (less output per input)	AS shifts up/left	Negative
Pandemic lockdown	Costs ↑ (can’t combine inputs)	AS shifts up/left	Negative

Aggregate supply shocks

Aggregate supply shock (Professor's required definition e)

Definition: An aggregate supply shock is any exogenous event that shifts the AS curve by changing either factor prices or the state of technology. It alters firms’ unit costs at every level of output, changing the quantity of real GDP firms want to produce and sell at each price level.

Positive AS shock: Shifts AS rightward (down) → more output supplied at any given price level → higher Y and lower price level in new equilibrium. Examples: technological improvement, fall in oil prices, fall in wages.

Negative AS shock: Shifts AS leftward (up) → less output supplied at any given price level → lower Y and higher price level in new equilibrium. Examples: oil price spike, rise in wages, agricultural disaster.

Key: These originate from the SUPPLY side — input prices, technology, productivity, factor markets. NOT from the AE diagram.

Important note: In the real world, factor prices are often ENDOGENOUS (they change in response to the output gap). This becomes important in Ch9. For Ch8, treat factor price changes as exogenous.

The Trap

Some events are BOTH AD and AS shocks.

Example: a fall in world oil prices is a positive AS shock (lower input costs for firms that use oil) but also a negative AD shock for oil-producing countries like Canada (lower export revenue).

The overall effect on GDP depends on which shock is larger. Always check both sides.

Professor's example — oil price drop for Canada

The professor walks through this in detail: a drop in the price of oil is two shocks at once for an oil-exporting economy like Canada:

1. Positive AS shock — oil is an input to production ($P_{IMP}$↓) → UCP falls → firms produce more at same price → AS shifts right
2. Negative AD shock — oil is also an export ($\bar{X}$↓) → 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’d have to wait and observe.

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

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5. Macroeconomic Equilibrium (LO4)

Core question: What happens when AD and AS interact? How do shocks play out?

Section road map

§1–2 built AD. §3–4 built AS. Now we combine them. The intersection of AD and AS determines BOTH the price level and real GDP simultaneously — the full macro equilibrium. This section then analyzes how shocks shift these curves and change the equilibrium.

Vault reference: The multiplier concept from 3. Equilibrium and the Multiplier still applies but is now modified by the price level response.

AD-AS intersection: simultaneous determination of Y and P

Macroeconomic equilibrium requires two conditions to hold simultaneously:

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

Only at the intersection of AD and AS are both conditions met at the same time. At any other (P, Y) combination, either buyers want to spend a different amount than firms want to produce, or firms want to produce a different amount than buyers want to spend.

Consider what happens away from equilibrium:

• If P is below the equilibrium price: desired expenditure exceeds what firms are willing to supply (excess demand). Prices get bid up.
• If P is above the equilibrium price: firms want to supply more than buyers want to spend (excess supply). Prices fall.

Only at the intersection does everything line up: firms produce Y, that production generates income of Y, and at the prevailing P, buyers want to spend exactly Y.

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

Definition: Macroeconomic equilibrium is the simultaneous determination of the price level and real GDP at the intersection of the AD and AS curves. At this point, (1) desired aggregate expenditure equals actual GDP at the prevailing price level (demand-side consistency), and (2) firms want to produce exactly that level of GDP at that price level (supply-side consistency). Both conditions hold only at the intersection.

Foundation from Ch7 §3: AE = Y gives equilibrium at a GIVEN price level. The full macro equilibrium requires AD = AS, which determines BOTH Y and the price level.

Key: Ch7’s equilibrium (AE = Y) is a partial equilibrium — it holds the price level fixed. The AD-AS equilibrium is the general equilibrium of the macro model. Two conditions must hold: (1) desired expenditure = actual GDP, (2) firms want to supply exactly that GDP at the prevailing price level.

Connects to: 3. Equilibrium and the Multiplier

Study Session 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.

Don’t 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?

EXAM WALKTHROUGH — 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. Use these three beats for every shock analysis on homework and exams.

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

What you write: Identify the root cause → classify it (AD or AS shock, positive or negative) → show that the curve shifts at the original price level $P_0^e$.

If AD shock	If AS shock
Root cause changes autonomous expenditure (CIGNX)	Root cause changes unit costs (PIMP FacTory)
AE shifts → $Y^D$ changes at $P_0^e$	Firms re-optimize production → $Y^S$ changes at $P_0^e$
AD curve shifts (left or right)	AS curve shifts (left/up or right/down)

Remember: A shock is always a shift of a curve, never movement along a curve. Prices have NOT changed yet — this is the cause that will make prices move.

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].”

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

What you write: At the original price, demand ≠ supply. Name the gap explicitly. This is the engine that makes prices move.

Situation	What it’s called	What it does to prices
$Y^D>Y^S$	Excess demand for goods and services	Prices get bid up (buyers compete)
$Y^S>Y^D$	Excess supply of goods and services	Prices get pushed down (sellers compete)

Key phrase: “At $P_0^e$, there is now excess [demand/supply] of goods and services. Therefore, the price level will [rise/fall].”

⚠️ This beat is the one most students skip. Don’t. The professor wants to see you name the gap and explain WHY prices change — not just that they do. The gap is the bridge between the shock and the adjustment.

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

What you write: As P changes, show what happens on BOTH the AD side and the AS side. Then state the new equilibrium.

AD side (always the same two channels):

• Wealth effect: P↑ → real wealth (W/P)↓ → C̄↓ (or reverse if P↓)
• Foreign trade effect: P↑ → domestic goods relatively expensive → NX↓ (or reverse if P↓)
• Result: movement along the AD curve

AS side (firms re-do profit maximization):

• P↑ → price now exceeds UCP → firms have incentive to produce more → Q↑ (or reverse if P↓)
• Result: movement along the AS curve

Both sides converge: Demand adjusts toward supply along one curve. Supply adjusts toward demand along the other curve. The gap closes at the new equilibrium $(P_1^e,Y_1^e)$.

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 sides adjust until demand matches supply at the new equilibrium $(P_1^e,Y_1^e)$.”

⚠️ Movement along BOTH curves, not just one. The professor explicitly walks through both the AD-side response and the AS-side response to the price change. You must show both on an exam.

⚠️ Name the channels — don’t just say “prices change so demand changes.” The professor wants to see you write “wealth effect” and “foreign trade effect” by name. Saying “P falls so demand rises” is incomplete. Saying “P falls → real wealth rises → C increases (wealth effect), and domestic goods become cheaper relative to foreign goods → NX increases (foreign trade effect)” is what earns the marks.

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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 $(P_1^e,Y_1^e)$.

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”Stepwise” — what the professor means

The professor says the adjustment happens “stepwise.” This does NOT mean it jumps in one leap. In the real world:

• Price moves a little → firms adjust a little, consumers adjust a little → gap shrinks a little
• Price moves a little more → both sides adjust more → gap shrinks more
• This continues step by step until the gap fully closes at $(P_1^e,Y_1^e)$

Our model skips straight to the final answer, but the professor wants you to understand the process is gradual — many small adjustments, not one big jump.

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

Visualizing: Positive AD shock — Shock → Gap → Adjust

left=0; right=700; bottom=0; top=250;
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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 — the three beats

Beat 1 (SHOCK): AD shifts right from AD₀ (blue) to AD₁ (green). At the original price P₀ᵉ (dashed line), demand jumps rightward — that’s the horizontal arrow at constant P.

Beat 2 (GAP): At P₀ᵉ, demand (on AD₁) is now to the RIGHT of supply (on AS₀). The distance between them is excess demand. This is why prices will rise.

Beat 3 (ADJUST): The economy slides diagonally up the AS curve (red) from E₀ to E₁. Both P and Y increase. Meanwhile, demand slides up-left along AD₁ (green). They meet at E₁ — the new equilibrium. Both curves are involved in the adjustment.

Visualizing: Positive AS shock — Shock → Gap → Adjust

left=0; right=700; bottom=0; top=250;
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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 — AS shock version

Beat 1 (SHOCK): AS shifts right from AS₀ (red) to AS₁ (orange). At P₀ᵉ, supply jumps rightward — firms produce more at the same price.

Beat 2 (GAP): At P₀ᵉ, supply (on AS₁) is now to the RIGHT of demand (on AD₀). The distance is excess supply. Prices will fall.

Beat 3 (ADJUST): The economy slides diagonally 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.

AD shocks: Y and P move in the same direction

When the AD curve shifts, the new equilibrium is found by moving along the AS curve. Since AS slopes upward, Y and P always move in the same direction after an AD shock.

Positive AD shock (e.g., government increases G, or business investment rises):

1. AD shifts right — at every P, more output is demanded.
2. The new AD intersects AS at a point that is up and to the right of the original equilibrium.
3. Result: Y rises AND P rises.

Negative AD shock (e.g., consumer confidence collapses, exports fall):

1. AD shifts left — at every P, less output is demanded.
2. The new AD intersects AS at a point that is down and to the left.
3. Result: Y falls AND P falls.

The key signature: after any AD shock, you slide along the upward-sloping AS curve, so output and the price level always move together.

Why they move in the same direction

The AS curve slopes up. If you shift AD right, you travel up the AS curve: higher P, higher Y. If you shift AD left, you travel down the AS curve: lower P, lower Y.

The upward slope of AS is what links Y and P together after a demand shock.

AD shock signature — "Demand drags both along"

AD shocks cause Y and P to move in the same direction.

Positive AD shock: Y↑ and P↑ (boom with rising prices).

Negative AD shock: Y↓ and P↓ (recession with falling prices).

Why? You’re sliding along the upward-sloping AS curve. Up-right or down-left — Y and P are tied together.

AS shocks: Y and P move in opposite directions

When the AS curve shifts, the new equilibrium is found by moving along the AD curve. Since AD slopes downward, Y and P move in opposite directions after an AS shock.

Negative AS shock (e.g., oil price spike, wage increase):

1. AS shifts up/left — at every P, firms supply less output.
2. The new AS intersects AD at a point that is up and to the left of the original equilibrium.
3. Result: P rises but Y falls. This toxic combination is called stagflation — stagnation (falling output) plus inflation (rising prices).

Positive AS shock (e.g., technology improvement, fall in raw material prices):

1. AS shifts down/right — at every P, firms supply more output.
2. The new AS intersects AD at a point that is down and to the right.
3. Result: P falls and Y rises. The best of both worlds.

The key signature: after any AS shock, you slide along the downward-sloping AD curve, so output and the price level always move in opposite directions.

Why they move in opposite directions

The AD curve slopes down. If AS shifts left, you travel up the AD curve: higher P, lower Y. If AS shifts right, you travel down the AD curve: lower P, higher Y.

The downward slope of AD is what forces Y and P apart after a supply shock.

AS shock signature — "Supply splits them"

AS shocks cause Y and P to move in opposite directions.

Negative AS shock: Y↓ and P↑ — stagflation (the worst-case scenario for policymakers).

Positive AS shock: Y↑ and P↓ — the best-case scenario (more output at lower prices).

Why? You’re sliding along the downward-sloping AD curve. Up-left or down-right — Y and P are pulled apart.

What "P falls" really means in the real world

The professor clarifies: 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 price level decreases (deflation) are rare and extreme cases. In normal times, “P falls” in the model = inflation slows down.

The Trap

Don’t confuse the shock signatures.

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”

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.

The two-stage multiplier adjustment (partial multiplier with rising prices)

The adjustment from an AD shock happens in two stages. Understanding both is critical for exam questions about the multiplier.

Stage 1 — The simple multiplier (price level held constant at $P_0$):

1. Autonomous expenditure rises by $\Delta A$ (e.g., government increases G).
2. AE shifts up by $\Delta A$.
3. Through the multiplier process (Ch7), equilibrium Y rises by $\frac{\Delta A}{1-z}$ — at the original price level.
4. This shows up as a horizontal rightward shift of the AD curve by $\frac{\Delta A}{1-z}$.

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

If the story ended here (flat AS), this would be the actual change in Y. But it doesn’t end here.

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

1. The new AD intersects the upward-sloping AS at a higher price level $P_1>P_0$.
2. This rise in P reduces real wealth and net exports (the same channels from §1).
3. Those reductions shift the AE curve back down partially — undoing some of Stage 1.
4. The actual equilibrium Y is less than what the simple multiplier predicted.

$\text{Actual }\Delta Y=\frac{\Delta Y}{\Delta A}\times \Delta A\text{where }\frac{\Delta Y}{\Delta A}<\frac{1}{1-z}$

The actual multiplier (ratio of actual $\Delta Y$ to $\Delta A$) is smaller than the simple multiplier because the price level rise claws back some of the initial expansion.

Exam trap — don't confuse the two multipliers

The simple multiplier $\frac{1}{1-z}$ tells you the horizontal shift of AD.

The actual multiplier tells you the actual change in equilibrium Y after the price level responds.

They’re only equal when AS is perfectly flat (Keynesian range). Otherwise, actual < simple.

The multiplier is reduced by price level changes

Simple multiplier $\frac{1}{1-z}$ = the horizontal shift of AD = the change in Y if prices stayed constant.

Actual multiplier = the actual $\Delta Y$ after the price level rises and partially offsets the demand expansion.

With upward-sloping AS: price level rises → AE shifts back down → actual $\Delta Y$ < simple multiplier $\times$ $\Delta A$.

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

The importance of the AS curve shape

The shape of the AS curve determines how any AD shock gets split between a change in output and a change in the price level. This is one of the most important insights in Ch8.

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 start rising
Steep (near capacity)	Very steep	Mostly price change, little output change	Near zero	Economy near $Y^{\ast }$ — almost no room to expand
Vertical (extreme case)	Infinite	ALL price, NO output change	Exactly zero	Maximum capacity — more demand just inflates prices

Think of it this way: the AD shock is like 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.

Exam trap — "What is the multiplier in the Keynesian range?"

In the Keynesian (flat) range, the actual multiplier equals the simple multiplier $\frac{1}{1-z}$ because there is NO price level change to offset the expansion.

This is the one case where the Ch7 model gives the correct answer. Everywhere else, the actual multiplier is smaller.

Stabilization policy in the AD-AS framework

Stabilization policy (Professor's required definition g)

Definition: Stabilization policy is any government attempt to use fiscal policy (changes in government purchases G and tax rates t) or monetary policy (changes in interest rates and the money supply) to reduce the size of output fluctuations and keep real GDP close to potential output $Y^{\ast }$.

In the AD-AS framework: Stabilization policy works by shifting the AD curve to offset shocks. If a negative AD shock hits → expansionary fiscal/monetary policy shifts AD back right. If a positive AD shock causes overheating → contractionary policy shifts AD back left.

Complication with AS shocks: AS shocks create a dilemma — Y and P move in opposite directions. Expansionary policy to restore Y would raise P further. Contractionary policy to fight inflation would reduce Y further. No easy answer.

Foundation from Ch7 §4: Fiscal policy introduced — ↑G or ↓t for expansion, ↓G or ↑t for contraction. Monetary policy is the other arm (later chapters).

Connects to: 4. Fiscal Policy

The stagflation dilemma — why AS shocks are uniquely hard

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

• Negative AD shock (Y↓, P↓) → expansionary policy → AD shifts right → Y recovers AND P recovers. Done.
• Positive AD shock (Y↑, P↑) → contractionary policy → AD shifts left → Y cools AND P cools. Done.

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 can’t fix both at once. This is the stagflation dilemma — stagnation (falling Y) plus inflation (rising P) at the same time, with no clean policy answer.

Key: Stabilization policy works by shifting AD. It cannot shift AS. So when the problem originates on the supply side, the government is stuck choosing which problem to make worse.

How stabilization policy actually works

Stabilization policy shifts the AD curve — not AS. The government controls demand-side levers:

• Expansionary: ↑G or ↓t → more autonomous spending → AD shifts right
• Contractionary: ↓G or ↑t → less autonomous spending → AD shifts left

This works cleanly for AD shocks (shift AD back to where it was). It creates trade-offs for AS shocks (you’re moving the wrong curve).

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Completion Checklist

The following definitions are specifically required by the professor for "the most complete macroeconomic model we have studied." Track coverage here.

#	Concept	Status	Where
b	Aggregate demand function	✅ Filled	§1 [!vocab]
c	Aggregate supply function	✅ Filled	§3 [!vocab]
d	AD shock (positive/negative)	✅ Filled	§2 [!vocab]
e	AS shock (positive/negative)	✅ Filled	§4 [!vocab]
g	Stabilization policy	✅ Filled	§5 [!vocab]
h	Potential aggregate output	✅ Filled	§3 [!vocab]
n	Equilibrium of the macro economy	✅ Filled	§5 [!vocab]
o	Why AD has negative slope	✅ Filled	§1 [!vocab]

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Compass Navigation

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