THE AGGREGATE

DEMAND AND
AGGREGATE SUPPLY
MODEL
Aggregate Demand – Aggregate Supply Model
■ In the Keynesian model, we assumed an economy
where prices, interest rates, and wages were fixed.
■ Relaxing these assumptions is done under the
aggregate demand and aggregate supply model.
■ Aggregate Demand – This is the total demand of
everything in the economy (sugar, citrus, clothing etc)
■ Aggregate demand is dependent on the general price
level in the economy. 𝑃
■ The aggregate demand curve is downward sloping,
meaning the quantity of goods and services increase
as the general price level falls.
Aggregate Demand Curve
■ There are three main
reasons for resulting in the
aggregate demand curve
being downward sloping:
1. The Wealth Effect
2. The Interest Rate Effect
3. The International Trade
Effect

Figure 1 – Aggregate Demand and Aggregate Supply Curves

Aggregate Demand Curve
The Wealth Effect
■ When general prices go down, ceteris paribus, people
will general feel wealthy because they can now afford
more goods and services.
■ The real value of their incomes increases, they can now
afford to buy more.
■ This feeling of being wealthier, encourages them to
spend more, implying that Consumption 𝐶 spending
increases, leading to an increase to aggregate
spending 𝐴
Aggregate Demand Curve
The Interest Rate Effect
■ When prices fall, individuals can spend less on goods
and services and can have some income to save more.
■ The savings are learnt out to other people, the supply
of money to be learnt increases, leading to the price of
borrowing money to go down.
■ Firms are able to borrow the cheap funds at a low
interest rate to invest in producing more goods and
services.
↓ 𝑃 →↑ 𝑆 →↑ 𝑀𝑆 →↓ 𝑖 →↑ 𝐼 →↑ 𝑂𝑢𝑡𝑝𝑢𝑡
Aggregate Demand Curve
The International Trade Effect or Foreign Exchange Effect
■ When prices fall, interest rates go down
■ Individuals convert of the currency, i.e they take most
of their money out of the country (capital outflow)
■ The domestic currency will weaken relative to other
currencies (depreciates)
■ This will make the domestic goods to be more
attractive as compared to goods of other countries.
■ This will lead to more exports (increase in output)
↓ 𝑃 →↓ 𝑖 → 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 →↑ 𝑒𝑥𝑝𝑜𝑟𝑡𝑠 →↑ 𝑂𝑢𝑡𝑝𝑢𝑡
Aggregate Demand Curve – Shift Parameters
■ All the variables that influence total expenditure 𝐴 in the
economy, also influence aggregate demand.
■ 𝐴=𝐶+𝐼+𝐺+𝑋−𝑍
■ All these parameters shift the aggregate demand curve
■ Shifts that may arise from Consumption 𝑪
– Increase in household saving rate → shift leftwards of
AD curve
– Expectation of future price hikes → rightward shift of
AD curve
– Increase in interest rates by Central bank → less
spending → leftward shift of AD curve.
Aggregate Demand Curve – Shift Parameters
■ Shifts that may arise from Investment 𝑰
– Natural resource find that may result in companies
opening shop in a country → rightward shift in AD
curve
– Health pandemic arising in a country → businesses
feeling vulnerable → less investments → leftward
shift of AD curve.
■ Shifts that may arise from Government Spending 𝑮
– Any change in real government spending, e.g
building a new highway.
Aggregate Demand Curve – Shift Parameters
■ Shifts that may arise from Net Exports 𝑿 − 𝒁
– A recession in a major trading partner will shift the
𝐴𝐷 curve. For instance, if a country that takes huge
portion of our exports enters a recession, the AD
curve shifts to the left
– Movements in the value of the domestic currency
has a tendency to affect aggregate demand. An
appreciate hampers domestic production, and a
depreciation encourages exports, hence an
increase in output.
Determinants of Aggregate Demand Curve

Table 1 – Determinants of Aggregate Demand

Aggregate Supply Curve
■ The aggregate supply curve 𝐴𝑆 shows the total
quantity of goods and services supplied at each
general price level in the economy.
■ The 𝐴𝑆 curve is distinguished between the short run
𝐴𝑆 curve 𝑆𝑅𝐴𝑆 and long run 𝐴𝑆 curve 𝐿𝑅𝐴𝑆 .
■ The 𝑆𝑅𝐴𝑆 curve is upward sloping (refer to figure 1)
■ The 𝐿𝑅𝐴𝑆 curve is vertical
Short Run Aggregate Supply Curve
■ The upward sloping short run aggregate supply curve is
a macro-level phenomenon, however synonymous with
the micro-level supply curve.
■ The aggregate supply deals with the supply of all goods
and services in the economy, whereas the micro level
supply curve deals with only one good.
■ In the aggregate supply curve, costs of production are
governed by factor prices (wages, salaries, profits etc)
■ For any given factor price, there is an upward sloping
aggregate supply curve.
Short Run Aggregate Supply Curve
■ Say for a given nominal wages in the economy, the
general price level increases, leading to a fall in real
wages.
➢ What are real wages?

Real wages are measured as the nominal wage divided by the

general price level.
𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝑊𝑎𝑔𝑒ൗ
𝑅𝑒𝑎𝑙 𝑊𝑎𝑔𝑒 = 𝑃𝑟𝑖𝑐𝑒 𝐿𝑒𝑣𝑒𝑙
Real wages measure buying or purchasing power rather than just
the number of money units a person has.
Short Run Aggregate Supply Curve
■ So if the general price level increases, then:
■ Firms have an incentive to hire more labour and
increase output.
■ So a higher general price level in the economy is
associated with a higher level of output.
■ The position and shift parameters of the aggregate
supply curve are depicted in the following table, which
are:
– Factors of production and other inputs, i.e
availability, price, and productivity
Short Run Aggregate Supply Curve

Table 2 – Determinants of Aggregate Supply

Long Run Aggregate Supply Curve (LRAS)
■ The quantity of goods and
services supplied in the long
run is independent of the
general price level in the
economy.
■ So the 𝐿𝑅𝐴𝑆 curve is vertical
at the full employment level of
output 𝑌𝐹
Equilibrium in 𝑨𝑫/𝑨𝑺 Model
■ Equilibrium is achieved where
the aggregate demand and
aggregate supply curves meet
(short run curves)
■ At say, a lower price level 𝑃1 ,
there exists a general excess
demand of goods and
services in the economy.
■ Suppliers will tend to increase
prices whilst increasing
production.
■ At a higher price 𝑃2 , there
exists excess supply, suppliers
will tend to cut down on
production, whilst lowering the
price to deplete excess stocks
Changes in Aggregate Demand – Short Run
■ Say increase in aggregate
demand as a result of the
shift parameters in table 1
■ Increase in aggregate demand
causes a rightward shift from
𝐴𝐷1 to 𝐴𝐷2 .
■ Output level and price
increase and a new
equilibrium 𝐸2 is achieved.
■ Price level increases due to
excess demand.
■ Real wages decrease,
prompting suppliers to hire
more labour and increase
supply.
Changes in Aggregate Supply
■ Say increase in aggregate
supply as a result of the shift
parameters in table 2, e.g a
drought.
■ The 𝐴𝑆 curve shifts leftwards,
and at the initial equilibrium
𝐸1 , there is excess demand in
the economy.
■ Prices increase, and an
increase in price is a
movement along the 𝐴𝐷
curve.
■ The new equilibrium is
achieved at 𝐸2 , where output
has fallen to 𝑌2 .
■ The result is Stagflation.