Economics

LESSON 7 – Aggregate Demand and

Aggregate Supply
Course Overview
• Topics of Economics:
• Week 1: Basic Economic Problem

• Week 2: Demand and Supply

• Week 3: Price Determination: Equilibrium, Elasticity – Normal, Inferior and Giffen Goods

• Week 4: Market Stabilization

• Week 5: Growth and Welfare

• Week 6: Labor Market

• Week 7: Aggregate Demand and Aggregate Supply

• Week 8: Fiscal and Monetary Policy

Key Learning Outcomes
• By the end of this topic, students should be able to:
• Define the key vocabulary that is in the blue/green boxes at the end of the relevant chapters of the Anderton
textbook.

• Explain the components of AD

• Explain the causes of shifts in the AD curve

• Illustrate and interpret AD charts

• Illustrate and interpret AS long run and short run curves.

• Explain the causes of shifts in the AS curve

Aggregate Demand
• Aggregate Demand (AD) is an economic measurement of the sum of all final goods
and services produced in an economy.
• AD expressed as the total amount of money exchanged for those goods and services at
a specific price level and point in time.
• Aggregate demand over the long-term equals Gross Domestic Product (GDP).
Therefore, the AD and GDP increase or decrease together.
• GDP represents the total amount of goods and services produced in an economy while
AD is the demand or desire for those goods.
• AD consist of all consumer goods, capital goods, exports, imports, and government
spending.
Aggregate Demand: Components

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Aggregate Demand: Components

National Expenditure is made up of four components:

1. Consumption (C) This is spending by households on goods and services
2. Investment (I) This is spending by firms on investment goods.
3. Government spending (G) This includes current spending , for instance on wages and salaries. It also
includes spending by government on investment goods like new roads or
new schools.
4. Exports - Imports (X-M)
• Foreigners spend money on goods produced in the DOMESTIC ECONOMY. Therefore, it is part of national
expenditure.
• However, households, firms and governments also spend money on goods produce abroad.
• For instance, a UK households might buy a car produced in Germany, or a German firm might use
components imported from UK, and these Imported Goods do not contribute to national income.
• C, I, G and X all include spending on imported goods, Imports (M) to arrive at a figure for national
expenditure

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Aggregate Demand
Aggregate demand: A circular flow of income
Aggregate demand can be illustrated by reference to the circular flow of income:
• Aggregate demand is generated as income is transferred to spending as a result of the circular flow of
income.

• Income is spent on consumer goods and services (C) plus spending on capital goods by firms (I).

• Spending is also generated by government (G) when it allocates resources to public goods, merit goods and
income transfers, such as pension benefits.

• Finally, there is 'net exports’ (X - M), which is overseas spending on an economy's exports of goods and
services, less what the economy spends on importing goods and services.

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Aggregate demand: A circular flow of income

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Aggregate Demand Curve

• The graph shows the relationship

between the price level and the
level of real expenditure in the
economy

• Why is it downward sloping?

 AD curve: Downward sloping?

• The reasons for the downward‐sloping aggregate demand curve are different from the
reasons given for the downward‐sloping demand curves for individual goods and
services.
• Movements along the curve here happen because a simultaneous change in the prices of
all final goods and services happened .
• The Price Level is defined as the average level of prices in the economy.
• Governments calculate a number of different measures of the price level, one of them
refers to the Consumer Price Index.
(produces monthly data on changes in the prices paid by urban consumers for a
representative basket of goods and services.)
• While Inflation refers to a change (increase) in the price level
AD curve: Downward Sloping?

• The Price Level is defined as the average level of prices in the economy.
• Governments calculate a number of different measures of the price level, one of them
refers to the Consumer Price Index.
(produces monthly data on changes in the prices paid by urban consumers for a
representative basket of goods and services.)
• While Inflation refers to a change (increase) in the price level
AD curve: Downward Sloping?

Let’s consider what happens to the different components of expenditure when prices
rise.

AD = C + I + G + (X – M)
Consumption ( C )

• consumers will need more money → borrow → interest rates will rise → C falls
• decrease in the real wealth of the household → C falls
Investment ( I )
• interest rate increases → investments become less profitable→ I falls
AD curve: Downward Sloping?

Government Expenditure ( G )
• exogenously determined (=not by economic variables but by government policies)
Net Exports (X – M)
• decrease in competitiveness → Export falls, Import rise (X falls, M rise)

To conclude:
1. AD falls as price rises because increases in interest rates reduce consumption and
investment.
2. A loss in international competitiveness the new higher prices will reduce exports and
increase imports
Shift in the AD Curve

• Aggregate Demand has a relationship between price level and the equilibrium level
of real income and output.
• A change in the price level will results in a movement along Aggregate Demand
Curve.
• Shifting in the AD curve will occur if there is a change in any other relevant variable
apart from the price level.
• Shifting in the AD curve shows that there is a change in real output at any given price
level.
Shift in the AD curve

Caused by changes in the demand for any of the components of real GDP

• Changes in consumption (C)

• Changes in investment (I)

• Changes in government purchases (G)

• Changes in net exports (NX = X-M)

Shift in the AD curve

• A fall in taxes on profits would lead to the

rate of return on investment projects to rise
which will lead to a rise in Investment

• When Government spending increases

(taxation constant) AD shifts to the right.

• A rise in the exchange rate, will lead to a

decrease in exports but an increase in
imports. AD shifts to the left
Shift in the AD curve

• An increase in consumer/business
confidence, leads to more
consumption/investment.

• A fall in income tax would increase disposable

income, leading to a rise in consumption.

• A fall in interest rates will increase

consumption (borrowing is cheaper) and
investment.
Aggregate Supply
• Supply Curve (Microeconomics) we learned so far – the upward sloping
• Supply curve represents a relationship between product price and quantity of product
that a seller is willing and able to supply
• Aggregate – the sum or total
• Aggregate Supply Curve (Macroeconomics)- the relationship between the average
level of prices in the economy and the level of total output.
• The short-run aggregate supply curve (SRAS)
• The long-run aggregate supply curve (LRAS)
Short- Run Aggregate Supply
• The short- run aggregate supply curve shows the relationship between aggregate output
and the average price level, assuming the money wage rates in the economy are
constant.
• In the SR, the aggregate supply curve is upward sloping
• The short run is defined here as the period when money wage rates and the prices of all
other factor inputs in the economy are fixed.
• Assume that firms wish to increase their level of output.
• In the SR, they are unlikely to take on extra works. Because taking on extra staff is an
expensive process. So firms tend to respond increases in demand in the short run by
working their existing labour force more intensively, for instance through overtime.
Short- Run Aggregate Supply
• In the SR, an increase in output by firms is likely to lead to an increase in their cost
which in turn will result in some firms raising prices.
• However, the increase in prices is likely to be small because, given constant prices
(e.g. wage rates and for factor of inputs). The increases in costs are likely to be
fairly small too.
• For this reason, the short run aggregate supply is relatively price elastic.
Short- Run Aggregate Supply
Shifts in the S- R Aggregate Supply
• The short- run aggregate supply curve shows the relationship between aggregate
output and the average price level, assuming that money wage rates in the
economy are constant.
• Discussion question:
But what if wage rate do change, or some other variable which affects
aggregate supply changes?
Shifts in the S- R Aggregate Supply
• But what if wage rate do change, or some other variable which affects aggregate
supply changes?
• Then, just as in the microeconomic theory of the supply curve, the aggregate
supply curve will shift.
• Factors that shift Short-run aggregate supply:
• Wage rages
• Raw Material prices
• Taxation
Wage Rates
• Wages are slow to adjust or are sticky in the short run, and the slow adjustments
is attributable to long term contracts.
• Because wages are a considerable part of a firm’s production cost
• An increase in wage rates will result in firms facing increased cost of production.
• So at any given level of output, a rise in wage rates will lead to a rise in the average
price level.
Raw Material Prices
• A general fall in the prices of raw materials may occur. Perhaps would demand for
commodities falls, or perhaps the value of the euro rises, making the price of
imports cheaper.
• A fall in the price of raw materials will lower industrial costs and will lead to some
firms reducing the prices of their products.
• Therefore there will be a shift in the short-run aggregate supply curve downwards.
Taxation
• An increase in the tax burden on industry will increase costs.
• Hence the short run aggregate supply schedule will be pushed upwards.
Supply Shocks
• When there is a large change in wage rates, raw material prices or taxation, a
supply-side shock is said to occur.
• A supply-side shock, like a doubling of the price of oil, can have a significant
impact on aggregate supply, pushing the short-run aggregate supply curve
upwards.
• Supply shocks affect short run aggregate supply and can also affect a country’s
long-run productivity potential. Examples of such shocks might include:
• Steep rise in oil and gas prices or other commodities
• Political turmoil / strikes
• Natural disasters causing sharp fall in production
• Unexpected breakthroughs in production technology
Shifts in the S- R Aggregate Supply
Long-run Aggregate Supply
• In the Short Run, changes in wage rates or the price of raw materials have an effect on the
aggregate supply curve, shifting the SRAS curve up or down.
• Equally, a rise in real output will lead to a movement along the SRAS curve.
• In the Long Run, however, there is a limit to how much firms can increase their supply
since they run into capacity constraint.

• There is a limit to the amount of labour that can be hired in an economy.

• Capital equipment is fixed in supply
• Labour productivity has been maximised

• Therefore, it can be argued that in the Long Run Aggregate Supply is fixed at a given
level of real output.
Long-run Aggregate Supply
• This graph shows the productive potential of
the economy.
• It shows how much real output can be
produced over a period of time with a given
level of factors inputs.
• The LRAS is the level of output associated
with the production possibility frontier of
an economy.
• the economy`s labour capital, natural
resources and technology determine the
total quantity of goods and services
supplied, and this quantity is the same
regardless of what the price level happens
to be.
Long-run Aggregate Supply

• The LRAS curve is the level of output shown by the trend or long term average rate
of growth in an economy.
• When Output is below/above this long term trend level, an output gap is said to
exist. Remember Business Cycles and Output Gaps
• The LRAS curve shows the level of FULL CAPACITY output of the economy. At full
capacity, there are no underutilised resources in the economy.
• Production is at its long run maximum. In the short run an economy might operate
beyond full capacity, creating a positive output gap.
• However, this is unsustainable and the output in the economy must fall back to its
full capacity.
LR Aggregate Supply and Output Gap
Shifts in the LR AS
 Classical vs Keynesian
• The vertical LRAS curve is called the classical long run aggregate supply curve
• The LRAS based on the classical view that markets tend to correct themselves fairly
quickly when the are pushed into disequilibrium by some shock.
• In the long run, product markets like the markets for oil, cameras will be in
equilibrium.
• If all markets are in equilibrium, there can be no unemployed resources. Hence, the
economy must be operating at full capacity on its production possibility frontier
Classical vs Keynesian
• Keynesian economists point out that there have been times when markets have failed
to clear for long periods of time.

• Keynesian economics was developed out of the experience of Great Depression of

1930 when large scale unemployment lasted for a decade.

• They argue that aggregate supply in the long run has an inverted L shape.
Classical vs Keynesian
Equilibrium output
• The economy is in equilibrium when AD equals AS.

• In short run, the AD curve is downward sloping while AS is upward sloping.

• The equilibrium level of output in the short run occurs at the inter-section of AD and AS.
Equilibrium output

AD is made up of C,I, G, (X-M)

• Therefore an increase in AD will result
from an increase in one of these
components.

For example:
• A fall in Interest Rates
• A fall in exchange rate
Shifts in SRAD Curve
• Equilibrium Output rises From Y to Y1

• While the price level rises from P to P1

• A rise in AD increase both the price

level and level of output in the short
run.
• What about a fall in AD?
Shifts in SRAS Curve

• A fall in the short run aggregate supply will shift the SRAS curve upwards
and to the left.

• Factors affecting this shift:

• Wages of workers rise

• Raw materials prices rise
• Taxes on goods and services might be raised by the government.
Shifts in SRAS Curve

• A decrease in SRAS leads to a fall in

equilibrium output from Y1 to Y2
• A rise in the price level from P1 to P2.

• What happens when SRAS

increases?
LR Equilibrium Output

• In the LR the impact of changes in AD and AS are affected by the shape of the LR AS
Curve

• Different views from Keynesian Economist and Classical Economists.

LR Equilibrium Output (Classical)

• We assume that enough time has

passed that the economy is also on the
LRAS curve.

• Short run aggregate output is equal to

potential output.

• The economy is in long-run

macroeconomic equilibrium at ELR :
full employment level of output
Changes in LR Equilibrium Output: A rise in AS

• Therefore, a Shift in LRAS to the

right causes a decrease in price
level, and an increase in total
output
Changes in LR Equilibrium Output: A rise in AD
• In the classical model :

• Increase in prices, but no change in the

output

• In the classical model no amount of

extra demand can raise the long run
aggregate equilibrium output
LR Equilibrium Output (Keynesian)
• Long run equilibrium output, Y* may be
below the full employment level of
output if wages do not fall when there is
unemployment.

• Keynesian economists argue that wages

are sticky downwards.
Changes in LR Equilibrium Output: A rise in AS
• The Keynesian model

• Effect depends upon position of the AD

curve

• At or near full employment: rise in

output and lower prices.
• In recession: no impact in the economy!
• in favor of demand side policies
Changes in LR Equilibrium Output: A rise in AD
• Recession: rise in output without an
increase in prices

• At full employment: inflation without

increase in output

• Little below full unemployment:

increase in equilibrium output and
prices