AGGREGATE DEMAND AND

AGGREGATE SUPPLY
Mrs. Rizka’s Class
AGGREGATE DEMAND
In microeconomics, demand refers to the willingness
and ability of consumers to pay for a particular product
at each price level. In macroeconomics, aggregate
demand (AD) refers to the value of total demand for all
goods and services in the economy, per time period.
The power of Aggregate demand
The power of Aggregate demand
 THE AD CURVE
The AD curve shows the real national output that is purchased at each price
level, per time period. It has a negative slope (i.e. it is downwards sloping) because
when the general level of prices is high, the level of aggregate demand tends to be
low.

The higher the price level, the lower

the level of aggregate demand tends
to be, ceteris paribus.
• Since AD has an inverse
relationship with the general
(average) price level, the AD curve is
downwards sloping.
THE THREE REASONS FOR THE DOWNWARDS-SLOPING AD CURVE
The Pigou wealth effect- English economist Arthur Pigousaid that for any given nominal value
of income, a lower price level allows households, firms and the government greaterpurchasing
power, resultingin greater consumption, investment and government spending

Keynes's interest-rate effect- A fall in the general price level causes interest
rates to drop, thus boosting the demand for money, ceteris paribus. This
results in greater consumption, investment expenditure and government
spending, i.e. higher aggregate demand.

Mundell-Fleming's exchange rate effect - As the general price level falls, the interest rate
also tends to fall, resulting in a depreciation of the exchange rate. This will tend to increase
the demand for net exports because domestic products are cheaper, thus boosting AD.
 THE COMPONENTS OF AD
The components of aggregate demand are consumption expenditure (C), investment
expenditure (I), government spending (G), exports earnings (X), and import
expenditure (M)
Investment is the capital expenditure of firms Government spending is the total
in the economy, for example the purchase of expenditure on goods and services
Consumption is the total spending by the government, including
on goods and services by households fixed assets such as machinery, commercial
vehicles and buildings. This results in a larger education, healthcare, national
in the domestic economy, per time security and social welfare
period. It is the largest component productive capacity in the long run.
schemes.
of aggregate demand.

Net exports, given by the formula X- M,

measures the difference between
the value of exportearnings and import
expenditure.
What innovative approaches
can we use to streamline the
AD = C + I + G + (X-M) product development process?
GDP AND AD?
Gross domestic product (GDP) is often confused
with aggregate demand (AD). Whilst they are similar
concepts, GDP refers to the value of actual
expenditure in the economy over the year, whereas
AD refers to the planned (or the expected)
expenditure in a given time period
 THE DETERMINANTS OF AD COMPONENTS AND SHIFT OF THE
AD CURVE CAUSED BY CHANGES IN THE DETERMINANTS

The determinants of aggregate demand refer to the factors that cause shifts in the AD
curve - for example, lower household and business indebtedness due to reduced interest
rates will shift the AD curve to the right, ceteris paribus.

Factors that cause a change in any component of aggregate demand (AD= C +I+ G + (X -
M)) will cause a shift in the AD curve, ceteris paribus.
SHIFT OF THE AD CURVE CAUSED BY CHANGES IN THE
DETERMINANTS
 SHIFT OF THE AD CURVE CAUSED BY CHANGES IN THE DETERMINANTS

CONSUMPTION

Factors that cause a change in consumption

include consumer confidence, interest rates,
wealth, income taxes, level of household
indebteness and expectations of the future price
level.
 SHIFT OF THE AD CURVE CAUSED BY CHANGES IN THE DETERMINANTS

CONSUMPTION
 SHIFT OF THE AD CURVE CAUSED BY CHANGES IN THE DETERMINANTS

INVESTMENT
 SHIFT OF THE AD CURVE CAUSED BY CHANGES IN THE DETERMINANTS

GOVERNMENT SPENDING

Factors that affect the level of government include the following:

Political priorities - government spending will vary depending on the political
priorities, for example, increased national defense expenditure during a war, or
more spending on education and healthcare before a general election (in order
to win political votes).
Economic priorities - the austerity measures following the global financial crisis
of 2008 have meant that governments across Europe and many other parts of
the world need to cut their spending to reduce their budget deficits.
 SHIFT OF THE AD CURVE CAUSED BY CHANGES IN THE DETERMINANTS

NET EXPORT

Factors that affect the level of net exports include the following:
The income of trading partners - due to globalisation and interdependence,
when a country suffers from an economic downturn, there are negative impacts
on its trading partners.
Exchange rates - a higher exchange rate tends to reduce the demand for
exports (as they become more expensive for foreign buyers), and vice versa.
Changes in the level of protectionism - trade barriers such as tariffs and quotas
raise the price of imports, thus tending to reduce the demand for foreign goods
and services.
AGGRERATE SUPPLY
Aggregate supply (AS) refers to the amount of real
national output that firms are willing and able to
produce at each price level. It is a measure of an
economy's potential output.
 THE SHORT-RUN AGGREGATE SUPPLY (SRAS)
The short-run aggregate supply (SRAS)
curve shows the total planned national
output at different price levels, ceteris
paribus.

The SRAS curve is upward-sloping as

higher prices attract more firms to raise
their output level(recall from
microeconomics that the supply curve for
The slope of the SRAS curve depends on the extent to
a single firm is upwards for the same
which there is spare capacity in the economy. The
reason).
flatter the SRAS curve, the greater the degree of spare
capacity (underutilized resources). This means that the
SRAS curve is relatively price elastic, and vice versa.
 THE SHORT-RUN AGGREGATE SUPPLY (SRAS)
In the short run, a change in non-price factors that affect AS will shift the SRAS curve. These
factors, which affect the cost of production, include:
■ changes in resource prices - for example, the price of oil or other raw materials changes
drastically
■ changes in business taxes -for example, higher corporation taxes shift the SRAS curve to
the left
■ changes in subsidies - for example, an increase in subsidies in numerous
industries will shift the SRAScurve to the right
■ supply shocks - for example, a war, financial crisis, natural disasters, oil shortages, or an
outbreak of an epidemic (such as swine flu, malaria, or dengue fever) will shift the SRAS curve
to the left.
CHANGES IN SHORT-RUN AGGREGATE SUPPLY (SRAS)

Favourable changes in non-price factors Adverse changes in non-price factors

that affect AS will shift the AS curve to that affect AS will shift the AS curve
the right, from AS1 to AS2. to the left, from AS1 to AS2.
ALTERNATIVE VIEWS OF Monetarists (or new classical economists)
AGGREGATE SUPPLY differ in their view of the long-run
aggregate supply (LRAS) curve from that of
Monetarists believe that the LRAS curve is vertical at the full Keynesian economists.
employment level of output. LRAS is independent of the price
level, as this represents the maximum (potential) level of
national output of the economy, per time period.

The quantity and quality of factors of production

affect the LRAS
 THE LONG-RUN AGGREGATE SUPPLY (LRAS)
According to the new classical model of
LRAS, aggregate supply is independent of
the price level in the long run, i.e., it is
perfectly price inelastic at the full
employment level of output (Yf).

A rightwards shift of the LRAS curve

results from an increase in the productive
capacity of the economy, e.g. an increase
in the quantity and
quality of factors of production, including
technological progress.
 KEYNESIAN AS CURVE
By contrast, Keynesians believe that the AS curve has three sections, mainly due to the varying
degrees of spare capacity in the economy.

Keynesians argue that wages are 'sticky downwards' (labor market inflexibility) for the following
reasons:
Firms may prefer to cut employment rather than wages because pay cuts can reduce worker
morale and productivity.
Existing employment contracts can also prevent wages from falling below the agreed level.
Workers get used to a certain wage rate and are inflexible, through trade union action, in
accepting pay cuts.
It is not legally possible to cut wages below the national minimum wage, even during a major
economic downturn.
KEYNESIAN AS CURVE
There is spare capacity in the economy up to the Y1 level of
national output, perhaps due to a recession, high
unemployment, and 'sticky' wages. Hence, the price level is
stable even if national output changes.

The upwards-sloping section of the Keynesian AS curve shows

increasing demand for resources and labor shortages, thereby
causing the price level to rise as national output increases.

At the full employment level of national output (Yr), firms

compete for limited resources as the economy is at full
capacity, thereby forcing up the general price level even
though the economy cannot produce beyond its productive
capacity.
 SHIFTS IN THE AGGREGATE SUPPLY CURVE
Changes in the quantity and/or quality of factors of production result in permanent shifts to
the LRAS curve.

Examples of such changes that shift the AS curve include:

improvements in efficiency - higher productivity of resources will shift the AS curve to the
right
new technology - technological progress and innovations shift the LRAS curve rightwards
reduction in unemployment - a fall in the number of unemployed people means that the
productive capacity of the economy can increase, thus shifting the AS curve to the right
institutional changes - better infrastructure, such as improved road, rail and air networks,
enhance the economy's productive capacity, thus shifting the AS curve outwards.
SHIFTS IN THE AGGREGATE SUPPLY CURVE
The quantity of factors of production can
also be increased by discovering new
supplies (such as oil or other natural
resources) or by a larger workforce
(perhaps due to the migration of workers).

The quality of labour resources can be

increased by improved education, training,
and work practices.