PRINCIPLE OF

ECONOMICS
NOOR SA'ADAH SABUDIN
SEFB
CHAPTER 14
Aggregate
Demand and
Aggregate
Supply
INTHISLECT
URE
After studying this chapter, you will be able:
After studying this chapter, you will be able:
The Aggregate Demand (AD)/Aggregate Supply (AS)
framework can be used to discuss the effectiveness of
policies by looking into the changes in equilibrium
caused by these policies.

Inflation (P) and economic growth (output growth)

(Y) is a concern of macroeconomics.

Aggregate Demand and Aggregate Supply model

which associate price level (P) (proxy for inflation) and
aggregate output (Y) enables us to analyze the issue of
inflation together with economic growth.
AGGREGATE DEMAND

The quantity of real GDP demanded, Y, is the total amount

of final goods and services produced in the economy that
people, businesses, governments, and foreigners plan to
buy.
This quantity is the sum of consumption expenditures, C,
investment, I, government expenditure, G, and net exports,
X – M.
That is,
Y (real GDP) = C + I + G + X – M.
AGGREGATE DEMAND

The Aggregate Demand Curve

Aggregate demand is the relationship between the
quantity of real GDP demanded (Y) and the price level
(P).

The aggregate demand curve (AD) plots the quantity of real

GDP demanded against the price level.
 AGGREGATE DEMAND
Figure 14.1 shows an AD
curve.
The AD curve slopes
downward for three
reasons:
Wealth Effect
The Interest Rate Effect
The
Exchange-Rate/International
Trade Effect
AGGREGATE DEMAND
Wealth Effect
A rise in the price level, other things remaining the
same, decreases the quantity of real wealth (money,
stocks, etc.).

To restore their real wealth, people increase saving and

decrease spending.

The quantity of real GDP demanded (Y) decreases.

Similarly, a fall in the price level, other things remaining the

same, increases the quantity of real wealth, which
increases the quantity of real GDP demanded.
 AGGREGATE DEMAND
Wealth Effect
The change in the purchasing power of dollar-denominated assets that results from a change in the price level.
AGGREGATE DEMAND

Interest Rate Effects

A rise in the price level, other things remaining the
same, decreases the real value of money and raises
the interest rate.
When the interest rate rises, people borrow and spend
less, so the quantity of real GDP demanded (Y)
decreases.
Similarly, a fall in the price level increases the real value of
money and lowers the interest rate.
When the interest rate falls, people borrow and spend
more, so the quantity of real GDP demanded increases.
AGGREGATE DEMAND
Interest Rate Effects
AGGREGATE DEMAND

International Trade / Exchange Rate

Effects
A rise in the price level, other things remaining the
same, increases the price of domestic goods relative to
foreign goods.
So imports increase and exports decrease, which
decreases Y or the quantity of real GDP demanded.
Similarly, a fall in the price level, other things remaining
the same, increases the quantity of real GDP demanded.
AGGREGATE DEMAND
International Trade / Exchange Rate Effects
 AGGREGATE DEMAND

Deriving the AD Curve

To derive an aggregate demand curve, we examine
what happens to aggregate output (income) (Y)
when the overall price level (P) changes, assuming
no changes in government spending (G), net taxes
(T), or the money supply (MS).
Figure 14.2 illustrated the impact of an increase in
the overall price level in the economy and assuming
no changes in G, T, and MS.
AGGREGATE DEMAND
Deriving the AD Curve
 AGGREGATE DEMAND
Deriving the AD Curve
An increase in P increases the demand for money (Mdt)
and shifts the money demand (Md)curve to the right as
shown in Figure 14.2(a).
With the quantity of money remaining the same , an
increase in the money demand raises the interest rate
from 6 per cent to 9 per cent. The increase in interest
rate causes investment to fall, as indicated in Figure
14.2(b).
Aggregate expenditure is a composition of consumption
(C), Investment (I), government spending (G) and net
exports (X-M).
 AGGREGATE DEMAND
Deriving the AD Curve
A decrease in planned investment reduces planned
aggregate expenditure (AE) and causes equilibrium
output (Y) to fall [See Figure 14.2 (c)].
An increase in the overall price level causes the level of
aggregate output to fall or vice versa. This effect is called
“interest rate effect.”
In short, the interest rate effect works as follows:
P ↑ »» Md ↑ »» r ↑ »» I ↓ »» Y ↓
 AGGREGATE DEMAND
Aggregate Expenditure and Aggregate
Demand
The total planned aggregate expenditure (AE) consists of the
total planned spending by households (C), firms (I),
government (G) and net exports (X-M).
In a closed economy, at equilibrium, planned aggregate
expenditure (AE ≡ C + I + G) is equal to aggregate output (Y).
Thus, Y = C + I + G (equilibrium condition).
At every point along the aggregate demand curve, the
aggregate quantity of output demanded is exactly equal
to the planned aggregate expenditure.
 AGGREGATE DEMAND
Aggregate Expenditure and Aggregate
Demand
When the overall price level rises, eventually the planned
aggregate expenditure decreases, moving down along the
aggregate demand curve . However, the aggregate demand
curve represents more than just planned aggregate
expenditure.
Each point on the AD curve represents the particular
level of planned aggregate expenditure that is consistent
with equilibrium in the goods market and money market
at the given price.
 AGGREGATE DEMAND
Change in Quantity
Demanded
A change in the quantity
demanded of Real GDP is
graphically represented as a
movement from one point,
A, on AD1 to another point,
B, on AD1.
 A change in the quantity
demanded of Real GDP is
the result of a change in
the price level.
 AGGREGATE DEMAND
Changes in
Aggregate
Demand
A change in aggregate
demand is graphically
represented as a shift
in the aggregate
demand curve from
AD1 to AD2.
Change in aggregate
demand is the result
of other factor other
than price level.
AGGREGATE DEMAND

Factors That Shift Aggregate Demand Curve

AGGREGATE DEMAND
Factors That Shift Aggregate Demand Curve
AGGREGATE DEMAND
Factors That Shift Aggregate Demand
Curve (C)
A change in any influence on buying plans (C+I+G+X-M)
other than the price level changes aggregate demand.

 Wealth: Wealth↑, C ↑, AD ↑.
 Expectations about future prices and income :Expect
higher future prices → C↑ → AD↑, Expect higher future
income → C ↑ → D↑
 Interest Rate: Interest Rate ↓ → C ↑ → AD↑
 Income taxes: Income taxes ↓ → C ↑ → AD↑
AGGREGATE DEMAND

Factors That Shift Aggregate Demand

Curve (I)

 Interest Rate: Interest rates ↓ → I ↑ → AD↑

 Expectation about future sales: Optimistic about future
sales → I ↑ → AD↑
 Business/Corporate Taxes: Business taxes↓ → I↑ →
AD↑
AGGREGATE DEMAND

Factors That Shift Aggregate Demand

Curve (G)

 Foreign Real National Income: Foreign real national

income ↑ → EX↑ → NX↑ →AD↑

 Exchange rate:US $ appreciates → EX↑ and IM ↓ →

NX↑ →AD↑
AGGREGATE DEMAND
Factors That Shift Aggregate Demand Curve
(C,I,G)
 Fiscal Policy
 Monetary policy
AGGREGATE DEMAND

Fiscal Policy and Monetary Policy

Fiscal policy is the government’s attempt to influence the
economy by setting and changing taxes, making transfer
payments, and purchasing goods and services.

A tax cut or an increase in transfer payments increases

households’ disposable income—aggregate income
minus taxes plus transfer payments.

An increase in disposable income increases consumption

expenditure and increases aggregate demand.
AGGREGATE DEMAND
Fiscal Policy and Monetary Policy
Because government expenditure (G) on goods and services
is one component of aggregate demand, an increase in
government expenditure increases aggregate demand.

The Fed’s attempt to influence the economy by changing the

interest rate and adjusting the quantity of money is called
monetary policy.

An increase in the quantity of money increases buying power

and increases aggregate demand.

A cut in interest rates increases expenditure and increases

aggregate demand.
AGGREGATE SUPPLY

Quantity Supplied and Supply

The quantity of real GDP supplied is the total quantity that
firms plan to produce during a given period.

Aggregate supply is the relationship between the quantity of

real GDP supplied and the price level. It is also known as
the price or output response curve.

We distinguish two time frames associated with different

states of the labor market:
 Long-run aggregate supply
 Short-run aggregate supply
 AGGREGATE SUPPLY

Short-Run Aggregate Supply

Short-run aggregate supply is the relationship between the
quantity of real GDP supplied and the price level when the
money wage rate, the prices of other resources, and potential
GDP remain constant.

A rise in the price level with no change in the money wage rate
and other factor prices increases the quantity of real GDP
supplied.

The short-run aggregate supply curve (SAS) is upward

sloping. Indicating a positive relationship between price level
with goods and services supplied.
AGGREGATE SUPPLY

From Short-Run to Long Run Aggregate

Supply
Changes in the quantity of the aggregate output supplied
due to changes of price level is shown by a movement
along the AS curve.

At lower levels of output, which indicates that there is

massive of resources available in the economy, a rise in
AD can be met by firms through increasing outputs.
AGGREGATE SUPPLY

From Short-Run to Long Run Aggregate

Supply
Massive resources available cause the cost changes of
inputs (e.g., wage rates) lagging behind price level
changes of output. Therefore firms can afford to use more
resources to produce more output and minimize increases
in the price level of output.

The percentage of change in output will be greater

than the percentage of change in price. The AS curve,
hence, will be fairly flat at this stage.
 AGGREGATE SUPPLY
From Short-Run to Long Run Aggregate
Supply
As the economy approaches full capacity stage,, firms can hardly
increase their production when there is an increase in AD.

Costs changes of input do not lag much behind the price level
changes of output. Hence, when firms increase the production of
output, the price level of output will be pushed up even higher.

The percentage of change in price level will be greater than the

percentage of change in aggregate output. At this stage, the AS
curve thus will be fairly steep (inelastic), or nearly vertical
(perfectly inelastic).
 AGGREGATE SUPPLY

From Short-Run to Long Run Aggregate

Supply
At full capacity, firms cannot afford to have any increase in
production when there is an increase in AD.

Costs of inputs change immediately, aligned with the change in

the price level of output – no lagging impact. Firms therefore
can only respond to increase in AD by increasing the price
level of output.

The AS curve will be perfectly inelastic, or vertical, indicating

that aggregate supply of output will remain unchanged no matter
how much the changes in price level.
 AGGREGATE SUPPLY
From Short Run to Long-Run Aggregate Supply
AGGREGATE SUPPLY
Long-Run Aggregate Supply
Long-run aggregate supply is the relationship between the quantity of
real GDP supplied and the price level when real GDP equals potential
GDP.

Potential GDP is independent of the price level.

So the long-run aggregate supply curve (LAS) is vertical at potential

GDP.

The output level shown would be a sustainable aggregate output level

without inflation, which sometimes is called potential output or potential
GDP. It is an output level that indicates all resources or factors of
production are fully employed in the economy.
AGGREGATE SUPPLY
Long-Run Aggregate
Supply
The figure shows the LAS
curve.
In the long run, the quantity of
real GDP supplied is potential
GDP.
As the price level rises and
the money wage rate changes
by the same percentage, the
quantity of real GDP supplied
remains at potential GDP.
AGGREGATE SUPPLY

In the short run, the

quantity of real GDP
supplied increases if the
price level rises.

The SAS curve slopes

upward.

A rise in the price level

with no change in the
money wage rate induces
firms to increase
production.
AGGREGATE SUPPLY

With a given money wage

rate, the SAS curve cuts
the LAS curve at potential
GDP.

The price level is 110.

With the given money

wage rate, as the price
level falls below 110 ...

the quantity of real GDP

supplied decreases along
the SAS curve.
AGGREGATE SUPPLY

With the given money

wage rate, as the price
level rises above 110 …

the quantity of real GDP

supplied increases along
the SAS curve.

Real GDP exceeds

potential GDP.
AGGREGATE SUPPLY

Shifting of short-run aggregate supply

curve:
Shifting of the SAS curve is illustrated in Figure (a) and Figure
(b).
•With a decrease in aggregate supply, the short-run AS curve
will shift to the left at any given price level.
•With an increase in aggregate supply, the short-run AS curve
will shift to the right at any given price level.
•Costs of production, economic performances and government
policies, as well as the environment are the factors that shift the
AS curve. Table 15.2 summarizes the shifting of AS curve in
response to the various factors mentioned.
AGGREGATE SUPPLY
Shifting of short-run aggregate supply curve:
AGGREGATE SUPPLY
Shifting of short-run aggregate supply curve:
AGGREGATE SUPPLY

Changes in Potential GDP

When potential GDP increases, both the LAS and SAS
curves shift rightward.

Potential GDP changes for three reasons:

An increase in the full-employment quantity of labor
An increase in the quantity of capital (physical or human)
An advance in technology
Supply shocks (positive and negative)
AGGREGATE SUPPLY

The figure shows the

effect of an increase
in potential GDP.
The LAS curve shifts
rightward and the
SAS curve shifts
along with the LAS
curve.
AGGREGATE SUPPLY

Changes in the
Money Wage
Rate
The figure shows the
effect of a rise in the
money wage rate.
Short-run aggregate
supply decreases and
the SAS curve shifts
leftward.
Long-run aggregate
supply does not
change.
MACROECONOMIC EQUILIBRIUM IN
THE SHORT RUN
Short Run
Equilibrium
In short-run equilibrium,
real GDP can be greater
than or less than
potential GDP.
MACROECONOMIC EQUILIBRIUM IN
THE LONG RUN
Long-Run Equilibrium
Long-run macroeconomic equilibrium occurs when real
GDP equals potential GDP—when the economy is on its
LAS curve.

Long-run equilibrium occurs at the intersection of the AD

and LAS curves.
MACROECONOMIC EQUILIBRIUM IN
THE LONG RUN
The figure illustrates the
adjustment to long-run
equilibrium.

Initially, the economy is at

below-full employment
equilibrium.

In the long run, the

money wage falls until the
SAS curve passes
through the long-run
equilibrium point.
MACROECONOMIC EQUILIBRIUM IN
THE LONG RUN
Initially, the economy is
at an above-full
employment
equilibrium.

In the long run, the

money wage rate rises
until the SAS curve
passes through the long-
run equilibrium point.
MACROECONOMIC EQUILIBRIUM IN
THE LONG RUN
Economic Growth and
Inflation in the AS-AD
Model
The figure illustrates
economic growth.
Because the quantity of
labor grows, capital is
accumulated, and
technology advances,
potential GDP increases.
The LAS curve shifts
rightward.
MACROECONOMIC EQUILIBRIUM IN
THE LONG RUN
The figure also illustrates
inflation.

If the quantity of money

grows faster than potential
GDP, aggregate demand
increases by more than
long-run aggregate
supply.

The AD curve shifts

rightward faster than the
rightward shift of the LAS
curve.
MACROECONOMIC EQUILIBRIUM IN
THE LONG RUN
The Business Cycle in the AS-AD Model
The business cycle occurs because aggregate demand
and the short-run aggregate supply fluctuate, but the
money wage does not change rapidly enough to keep real
GDP at potential GDP.

An above full-employment equilibrium is an equilibrium

in which real GDP exceeds potential GDP.

A full-employment equilibrium is an equilibrium in which

real GDP equals potential GDP.

A below full-employment equilibrium is an equilibrium in

which potential GDP exceeds real GDP.
MACROECONOMIC EQUILIBRIUM IN
THE LONG RUN
Figures (a) and (d) illustrate
above full-employment
equilibrium.
The amount by which
potential GDP exceeds real
GDP is called an
inflationary gap.
Figures (b) and (d) illustrate
full-employment equilibrium.
MACROECONOMIC EQUILIBRIUM IN
THE LONG RUN
Figures (c) and (d)
illustrate below full-employment
equilibrium.

The amount by which real GDP

is less than potential GDP is
called a recessionary gap.

Figure (d) shows how, as the

economy moves from one type
of short-run equilibrium to
another, real GDP fluctuates
around potential GDP in a
business cycle.
MACROECONOMIC EQUILIBRIUM IN
THE LONG RUN
Changes in
Aggregate Demand
The figure shows the
effects of an increase in
aggregate demand.
An increase in aggregate
demand shifts the AD
curve rightward.
Firms increase production
and the price level rises in
the short run.
MACROECONOMIC EQUILIBRIUM IN
THE LONG RUN
At the short-run equilibrium,
there is an inflationary gap.
The money wage rate begins
to rise and the SAS curve
starts to shift leftward.
The price level continues to
rise and real GDP continues
to decrease until it equals
potential GDP.
MACROECONOMIC EQUILIBRIUM IN
THE LONG RUN
Changes in Aggregate
Supply
The figure shows the
effects of a rise in the price
of oil.

The SAS curve shifts

leftward.

Real GDP decreases and

the price level rises.

The economy experiences

stagflation.
MONETARY POLICY AND AD-AS
MODEL
Monetary Policy Tools
The Central Bank influence Ms (increase or decrease) in 3
ways:
1. Open Market Operations (OMO)
2. Reserve requirement rate (RR)
3. Discount Rate (DR)
MONETARY POLICY AND AD-AS
MODEL
Expansionary Monetary Policy
•Implemented during the economic recession / deflation or high
unemployment.
•Objective: to increase output / income / real GDP of the country.
•Using monetary policy tools for example buy bonds in the OMO,
decreased RR and DR. This will lead to increased in Ms.
•When Ms rise, r fall, C increases, I increases, AD increases, Y
increases.
MONETARY POLICY AND AD-AS
MODEL
Expansionary Monetary Policy
r r AE P
Y=AE
Ms0 Ms1

AE1=C0+I1+G0 AD1
r0 e0 r0 e0 e1
AE0=C0+I0+G0 AD0
r1 e1 e1 e0
r1 P0 e0 e1
Md0
I0

Y0 Y1 Y
M0 M1 M I0 I1 I Y0 Y1 Y
a) Money Market (Md=Ms) b) Investment Curve c) Y=AE Curve d) AD Curve

Figure 8.1 Expansionary Monetary Policy

MONETARY POLICY AND AD-AS
MODEL
The Effects of Expansionary Monetary Policy on the AD-AS Equilibrium

Figure 8.5

Price Level (P)

Expansionary Monetary Policy

LAS The figure shows the effects of

expansionary monetary policy during
the economic downturn and high
unemployment. P0 and Y0 is the initial
equilibrium level in the economy (AD0
SAS0 intersect with SAS0 and LAS0). When
CB implement expansionary MP (buy
bonds in the OMO, lower RR, lower
P1 DR), Ms increases, r will fall, I will rise,
E0 E1 AD increased. When there is an
P0 AD1 increase in AD (AD0 to AD1), the level
AD0 of output increases from Y0 to YGTP.
The same goes for a price level.

Y 0 Y GTP Real GDP (Y)

MONETARY POLICY AND AD-AS
MODEL
Contractionary Monetary Policy

•Implemented during the peak / inflation.

•Objective: to reduce output / income / real GDP of the
country.
•Using monetary policy tools such as selling bond in
OMO, raise RR and DR to reduce Ms.
•When Ms fall, r increased, C decreased, I decreased,
AD decreased, Y decreased.
MONETARY POLICY AND AD-AS
MODEL
Contractionary Monetary Policy
r r AE P
Y=AE
Ms1 Ms0

AE0=C0+I0+G0 AD0
r1 e1 r1 e1 e0
AE1=C0+I1+G0 AD1
r0 e0 r0 e0 e1 e1 e0
P0
Md0
I0

Y1 Y0 Y
M1 M0 M I1 I0 I Y1 Y0 Y
a) Money Market (Md=Ms) b) Investment Curve c) Y=AE Curve d) AD Curve

Figure8.2 Contractionary Monetary Policy

MONETARY POLICY AND AD-AS
MODEL
The Effects of Contractionary Monetary Policy on the AD-AS Equilibrium

Price Level (P) Figure 8.6

LAS Contractionary Monetary Policy

Figure shows the effect of a

contractionary monetary policy during
inflation. P0 and Y0 is the initial
equilibrium level in the economy (AD0
SAS0
is the initial equilibrium level in the
P0 E0 economy SAS0 and LAS0). When CB
AD0 implement contractionary MP (sell
P1 E1 bonds in the OMO, raise RR, raise
AD1 DR), Ms will fall, r will rise, I will fall,
AD fall. When AD decreased (AD0 to
AD1), the level of output falls from Y 0 to
YGTP. The same goes for the price
YGTP Y 0 Real GDP (Y) level.
GOVERNMENT BUDGET AND FISCAL
POLICY
Budget Definition
The budget is " an expression of the Estimates of Revenue
and Expenditure for the year is used as a tool for planning
and management of economic resources to meet people's
needs '
GOVERNMENT BUDGET AND FISCAL
POLICY
Element of Budget
• Policies , goals and strategies of the government to be implemented in the next
year budget.
• The program , activities and projects that will be implemented to achieve the
strategy and goals set.
• Distribution of financial resources in accordance with the programs, activities and
projects.
• How and how revenue collected to finance the programs, activities and projects
planned.
• Total financing from lending sources , and
Target output / impact .
GOVERNMENT BUDGET AND FISCAL
POLICY
Budget Components, Government Revenue & Expenditure

Budget Components

It comprises the Consolidated Fund which consists of:

• Revenue Components
• Loan Component
• Expenditure Components
GOVERNMENT BUDGET AND FISCAL
POLICY
Budget Components, Government Revenue & Expenditure

Revenue Components

These components consist of:

1) Tax Revenue
2) Non-Tax Revenue
3) Non Revenue Receipts
4) Revenue from the Federal Territories
GOVERNMENT BUDGET AND FISCAL
POLICY
Budget Components, Government Revenue & Expenditure

Expenditure Components

Government expenditure consists of : -

• Operating Expenditure
•Liability expenditure
•Supplies Expenditure
•Development Expenditure
•Direct Development Expenditure
•Loan
GOVERNMENT BUDGET AND FISCAL
POLICY
Types of Budget

• Budget Balanced ( Balanced ) : spending = revenue.

• Budget Surplus ( Surplus) : revenue > spending.
• Budget Deficit ( Deficit ) : spending > revenue.
FISCAL POLICY AND AD-AS MODEL
Fiscal Policy Tools

• Through fiscal policy, the government influence the

economy with government spending (G) and taxes (T),
which will affect income and influence other variables in
the product market and money market.
• Both can be implemented separately or simultaneously.
FISCAL POLICY AND AD-AS MODEL
Expansionary Fiscal Policy

• Expansionary policies (during recession / high

unemployment): raise G and lower T.
• G rises, AD increases, Y increases.
• T falls, Yd (Y-T) increases, C increases, AD increases, Y
increases.
FISCAL POLICY AND AD-AS MODEL
Contractionary Fiscal Policy

• Contractionary policies (inflation/peak): lower G and

raise T.
• G decreased, AD decreases, Y decreases.
• T rises, Yd (Y-T) decreases, C decreases, AD
decreases, Y decreases.
FISCAL POLICY AND AD-AS MODEL
The Effects of Expansionary Fiscal Policy on the AD-AS Equilibrium

Price Level (P) Figure 8.7

LAS Expansionary Fiscal Policy

Figure shows the effect of

expansionary fiscal policy during the
economic downturn and high
SAS0 unemployment. P0 and Y0 is the initial
equilibrium level in the economy (AD0
intersect with SAS0 and LAS0). When
P1 E1 government implement expansionary
P0 E0 FP (Raise G, lower T) AD increased.
AD1
When there is an increase in AD (AD0
AD0 to AD1), the level of output increases
from Y0 to YGTP. The same goes for the

Y 0 Y GTP Real GDP (Y) price level.

FISCAL POLICY AND AD-AS MODEL
The Effects of Contractionary Fiscal Policy on the AD-AS Equilibrium

Price Level (P) Figure 8.8

LAS Contractionary Fiscal Policy

Figure shows the effect of a

contractionary monetary policy during
inflation. P0 and Y0 is the initial
equilibrium level in the economy (AD0
SAS0
intersect with SAS0 and LAS0). When
P0 E0 the governments implement contracted
AD0 FP (Lower G and raise T), AD fall.
P1 E1 When AD fall (AD0 to AD1), the level of
AD1 output falls from Y0 to YGTP The same
goes for the price level.

YGTP Y 0 Real GDP (Y)

FISCAL POLICY AND AD-AS MODEL
Crowding Out Effect
That is a reciprocal effect on private consumption (C and I) when the
government impose fiscal policy.
Some economists believe that if the government implemented an
expansionary fiscal policy, G will increase, thus leading to increased in
AD and Y. Increased in Y will cause an increase in Mdt and thus Md,
interest rates (r) will rise and eventually C and I will fall. This will cause
AD to fall and Y also fell. Fiscal policy fail to increased Y/real GDP.
3 Types
1) Complete crowding out effect (increase in G will offset by the fall of
one or more private spending)
2) Zero crowding out effect (no effect stuffing out)
3) Incomplete crowding out effect (increase in G will only reduced
part of private spending/expenditure)
FISCAL POLICY AND AD-AS MODEL
Figure 8.9

Crowding Out Effect Crowding Out Effect

The diagram shows how crowding out

Price Level (P) effects happen. P0 and Y0 is the initial
equilibrium level in the economy (AD0
LAS intersect with AS0). Expansionary fiscal
policy shifts the AD curve from AD 0 to
SAS0 ADN, the level of output increases from
Y0 to YN. This shows zero crowding out
effect.
PN EN In the event of incomplete crowding
P1 E1 out effect, AD will only turned into AD 1
P0 E0 because of the initial increase in AD
ADN compensated by the fall in C or I. So
AD1 there is only a small change in Y, from
Y0 to Y1. In the event of a complete
AD0 crowding out effect, , the initial
increase in AD will fully compensated
with fell in C and I. AD back to normal
Y0 Y1 YN Real GDP (Y) and Y unchanged.