Curiosity 5.1: How Do AD and AS Curves Differ from Microeconomic Curves?
Unfortunately, despite superficial similarities, microeconomic demand curves and the aggregate demand curve are quite different concepts, a fact often hidden from students. A microeconomic demand curve is defined as showing how demand for the good or service in question changes as price changes, ceteris paribus (i.e., holding all other influences on demand constant). This ceteris paribus condition is not maintained for the aggregate demand curve, which shows how aggregate demand for all goods and services changes as the overall price level changes. allowing the economy's output level to change to maintain equality with aggregate demand. Consequently, the aggregate demand curve is more accurately described not as a demand curve but as a curve that shows combinations of price and output that correspond to equilibrium in the goods and services market.
Earlier use of the aggregate-supply/aggregate-demand diagram should also have made clear that the aggregate supply curve was really concerned with what was going on in the labor market: were workers misinformed? did they have contractual obligations? and so on. Consequently, the aggregate supply curve is more accurately described not as a supply curve but as a curve that shows combinations of price and output that correspond to equilibrium in the labor market.
The beauty of the aggregate-supply/aggregate-demand diagram is that it allows two markets the goods and services market and the labor market to be illustrated in one diagram, simplifying our discussion of the macroeconomy. In fact, it does more. Contributions to aggregate demand from activity in the money/bond market and the foreign exchange market (discussed in chapters 9 and 16, respectively) are also incorporated in the aggregate demand curve, allowing this single diagram to represent simultaneous activity in the four major macroeconomic submarkets. Further discussion of this topic can be found in the second half of appendix A at the end of this book.
Another policy lesson might not be so evident. Suppose the government underestimates the NRU, believing for example that it is 5 percent when it is actually 6 percent. A 5 percent unemployment rate corresponds to a higher level of output than a 6 percent unemployment rate, so the government thinks that the LRAS curve lies to the right of the actual LRAS curve. Policy designed to push the economy to this underestimated NRU (and corresponding higher output level) requires continued rightward shifts of the AD curve to counteract the economy's movements back to the actual LRAS curve. This process creates continued price increases an inflation and is the first of several examples we will encounter of how inappropriate government policy can lead to inflation.
5.6 Moving Into a Recession
Let us now look at an economy in equilibrium at point AA in figure 5.4 and postulate an exogenous fall in aggregate demand for goods and services shifting AD to AD'. If the economy's reaction were a mirror image of the reaction described earlier for a move into a boom,
