Eco 104:

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Introduction to
Macroeconomics
Lecture 7-9 (Chapter 7)
Parisa Shakur
Aggregate Demand and
Aggregate Supply
• Just like two sides of a market (Demand and Supply, chapter 3)
there are two sides of an economy (Aggregate Demand and
Aggregate Supply)

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• The AD-AS framework has three parts
1. Aggregate Demand
2. Short run Aggregate Supply
3. Long run Aggregate Supply
Aggregate Demand
• The Aggregate Demand curve illustrates the relationship
between the aggregate price level and the quantity of
aggregate output demanded in the economy by households,
firms, the government and the rest of the world.

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Why is the AD curve
downward sloping?
• The downward slope indicates a negative relationship
between the aggregate price level and the quantity of
aggregate output demanded.
• Why is it downward sloping?

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• The reason Law of Demand (as seen is chapter 3) is a
misleading parallel
• The three main reasons are
1. Real Balance effect (for a change in PL)

1. Interest rate effect (for a change in PL)

2. International Trade effect (for a change in PL)

Change in QD of real GDP vs. a
change in AD
• Change in Qd for a change in Price level leading to movement
along the AD curve

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• Change in AD due to other factors apart from price leading to
shift of the AD curve
Shift of AD curve
• Without any change in Price level, if spending increases then
AD changes.
• If spending increases AD curve shifts to the right and if
spending decreases AD curve shifts to the left.

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• We know (from the expenditure approach of calculating
GDP)that the spending components are C, I, G and NX
Shift factors for AD curve
1. Consumption
• Wealth
• Expectation of future prices and income
• Interest rate
• Income taxes

2. Investment

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• Interest rate
• Expectations about future sales
• Business taxes

3. Net Exports
• Real foreign National Income
• Exchange rate

Money supply can also affect AD through interest rate

Aggregate Supply (AS)
• The Aggregate Supply curve illustrates the relationship
between the aggregate price level and the quantity of
aggregate output supplied in the economy. It is the other side
of the economy. There is a long run AS and short run AS.

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Why SRAS is upward sloping?
1. Sticky Wages: Nominal wages that are slow to fall even in
the face of high unemployment and slow to rise even in the
face of labour shortages
• Real Wage= Nominal Wage/ Price index
• Real wage
Quantity supplied of labour
Real wage
1/ Quantity demanded of labour

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•
*However, wages are not always sticky(informal workers’ wages)
and price are not always flexible(prices of luxury brand
goods)

2. Workers’ misconceptions

These are likely to change in the long run so LRAS will not look
the same
Shift factors for SRAS curve
1. Wage rate
• Profit per unit= Price per unit – cost per unit
2. Price of non labour inputs eg. price of oil
3. Productivity: Output per unit of input employed in a certain
period of time

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Productivity can be increased with the help of
• More educated labour force
• Larger stock of capital goods
• Technological advancements
4. Supply shocks: Major natural or institutional change on the
supply side of the economy that affects AS. Eg. unfavorable
weather, shortage of oil
• Adverse vs. Beneficial
 Shift of the SRAS curve

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Short-run Equilibrium
• Short-run equilibrium is when the quantity of aggregate
output supplied is equal to the quantity demanded
• It is the AD-AS model that is used to understand economic
fluctuations
• How equilibrium is achieved (surplus and shortage)

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Possible short run equilibrium
changes in the economy
• Positive demand shock

• Negative demand shock

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• Positive supply shock

• Negative supply shock

Long-run Aggregate supply
• Reasons for SRAS to be upward sloping do not hold anymore

• Level of Real GDP or Real output changes in the economy to

full-employment Real GDP or Natural Real GDP

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• The supply curve that identifies what economy produces in
the long run is the Long-Run Aggregate Supply (LRAS) curve

• In the long run, changes in price level has no effect on the

quantity of aggregate output supplied

• Long run output level is one where there is only natural rate of
unemployment and all prices are fully flexible
 LRAS curve

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Long-run equilibrium
• Long run equilibrium: Is when the short run equilibrium point
is on the LRAS curve or when wages and prices have adjusted
to their final equilibrium levels and workers have no
misconceptions.

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• Short run equilibrium vs. long run equilibrium

• Disequilibrium: when the economy is in neither short run

equilibrium nor long run equilibrium. It might be moving from
one short run equilibrium to another or from short run to long
run equilibrium.
Short run vs. long run
equilibrium

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