Topic 11: Topic OUTLINE

11.1 Aggregate Demand Curve

AGGREGATE DEMAND (AD) –
AGGREGATE SUPPLY (AS) 11.2 Aggregate Supply Curve
MODEL
11.3 Equilibrium & Changes

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11.1 AGGREGATE DEMAND (AD)

• Aggregate Demand (AD) is the total
demand for all final goods and services in
the economy. AD = C + I + G + NX
• AD curve plots RGDP demanded or output AD = C + I + G + ( X-M )
demanded (Y) against price level (PL).

• A D c u r v e i s a c u r v e t h at s h o ws t h e
negative relationship (downward slopping).
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How Real GDP (RGDP) demanded or output The Aggregate Demand Curve
demanded (Y) affected by the Price Level
(PL)? Price Level

• The AD curve slopes downward, which PL1 B

means that there is an inverse or opposite
relationship between the Price Level (PL) A
PL0
and output demanded (Y) .

PL ↑output demanded (Y) ↓

C
PL2

AD

PL ↓ output demanded (Y) ↑ Y1 Y0 Y2

Y

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 Real Wealth Effect
Why the AD is Downward Sloping?
Higher price level:
• reduces real wealth (holdings of money)
• reduces purchasing power; ↓ C
(i) Real wealth effect • reduces output demanded (Y).
(ii) Interest rate effect • PL ↑ real wealth ↓ purchasing power↓ C↓ Y↓

(iii) Open economy effect Lower price level:

• increases real wealth (holdings of money)
• increases purchasing power; C↑
• increases output demanded (Y).
• PL ↓ real wealth ↑ purchasing power ↑ C↑ Y↑

Interest Rate Effect

Open Economy Effect
Higher price level:
• domestic goods and services become relatively more
expensive than foreign goods and services
• foreigners will buy fewer domestic goods and services
(export ↓)
• reduces output demanded (Y)
• PL ↑ export ↓ import ↑ NX ↓ Y↓

Lower price level:

• domestic goods and services become relatively cheaper
than foreign goods and services
• foreigners will buy more domestic goods and services
• increases output demanded (Y)
• PL ↓ export↑ import ↓ NX ↑ Y↑
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Changes in AD: (i) Movement along the AD Curve

Changes in RGDP demanded or output demanded (Y): Price Level

(i) Movement along the AD curve from one point to another

point because of change in Price Level (PL) PL1 B

(ii) Shift to the right or shift to the left due to change in other
A
factors (5 + 1): PL0
• Consumption expenditures (C) (+ve)
• Investment expenditures (I) (+ve)
C
• Government purchases (G) (+ve) PL2

• Net Exports (NX) (+ve)

AD
• Money Supply (MS) (+ve)
Y
• Income Tax C↓ (-ve) Y1 Y0 Y2

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 (ii) Shift in the AD Curve
• An increase in any component of GDP (C, I, G, and
X – M), increase in money supply or decrease in
tax will shift AD curve rightward.
• A decrease in any component of GDP (C, I, G, and
X – M) , decrease in money supply or increase in
tax will shift the AD curve leftward.
Investment
• An increase in investment spending by
private sector (I) shifts the aggregate
demand (AD) curve to the right.
• A decrease in investment spending by
private sector (I) shifts the aggregate
demand (AD) curve to the left.
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Net Exports (NX)
• An increase in net export shifts the
aggregate demand (AD) curve to the right.
• An decrease in net export shifts the
aggregate demand (AD) curve to the left.
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Consumption
• An increase in consumption by household
(C) shifts the aggregate demand (AD)
curve to the right.
• A decrease in consumption by household
(C) shifts the aggregate demand (AD)
curve to the left.
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Government Purchases and Tax
• An increase in government purchases (G)
or a decrease in net taxes (T) shifts the
aggregate demand (AD) curve to the right.
• A decrease in government purchases (G)
or an increase in net taxes (T) shifts the
aggregate demand (AD) curve to the left.
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Money supply (MS)
• An increase in the money supply (M S )
shifts the aggregate demand (AD) curve
to the right.
• An decrease in money supply (MS) shifts
the aggregate demand (AD) curve to the
left.
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 Shift in the AD Curve
11.2 AGGREGATE SUPPLY (AS)
Price Level

Aggregate Supply (AS):

The total supply for all final goods & services
in the economy.

Aggregate Supply Curve:

AS curve plots RGDP supplied or output
AD1 supplied (Y) against price level (PL).
AD0
AD2
Y
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• In fact, there are two aggregate supply Short Run AS Curve

(AS) curves: Price Level
SRAS

PL1

(i) Short-run aggregate supply (SRAS)

–AS is upward sloping PL0

(ii) Long-run aggregate supply (LRAS) PL2

–AS is vertical (perfectly inelasic)

Y
Y2 Y0 Y1

Long run AS Curve Factors That Shift the AS curve

Price Level LRAS
(i) Input prices
PL1 • The aggregate supply curve is shifted to
the left by an increase in the price of
any inputs to the production process.
PL0

• The aggregate supply curve is shifted to

PL2
the right by any decrease in the price of
any inputs to the production process.
Y
YNR

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(ii) Government Policy (iii) Economic Growth
• More regulation therefore tends to increase
• Increase in technology, labor and capital
per-unit production cost and shift the AS
curve to the left.
stock, the AS curve shifts to the right,
meaning that more output can be
• E.g:Increase in the tax (on seller) will shift the
produced.
AS curve to the left.

• Deregulation will reduce the per-unit cost and • Decrease in labor (immigrate) and capital
shift the AS to the right. stock, the AS curve shifts to the left,
• E.g: Tax (on seller) cuts will shift the AS meaning that less output can be produced.
curve to the right.

Factors That Shift the AS curve

(iv) Weather, Wars and Natural disaster. An increase in AS
(Shift Right)
• Change in weather can shift the AS curve.
• Lower input prices (Lower
costs)
• If an economy is damaged by war or • Government Policy; Tax
(on seller) cuts
natural disaster, the AS curve will shift to • Economic Growth
the left. • Increase in labor
• Investment in capital stock
• Improvements in
• Whenever part of the resource base of an technology
• Good Weather
economy is reduced or destroyed, AS
curve shift to the left.
A decrease in AS
(Shift Left)
• Higher input prices
(Higher costs)
• Government Policy; Tax
(on seller) increases
• Economic Growth
• Decrease in labor
(immigrate)
• Lack of investment in
capital stock
• Bad Weather
• Wars
• Natural Disaster

Shift in SRAS Curve 11.3 EQUILIBRIUM & CHANGES

Price Level
SRAS2 Equilibrium price level:
SRAS0
SRAS1
• The condition that exists in the economy
when the RGDP demanded (output
dem an ded) eq ual s the RG DP su ppl ie d
(output supplied).

• The point at which the aggregate demand

(AD) and aggregate supply (AS) curves
intersect.
Y
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 Short Run Macroeconomic Equilibrium Long Run Macroeconomic Equilibrium
Price Level Price Level LRAS
SRAS SRAS

PL0 PL

AD0 AD
Y Y
Y0 YNR

Equilibrium price level:

• A change in AD or AS or both will affect the 1. Decide whether the events shift AD or AS or
price level and/or Real GDP (Y). both

2. Decide in which direction the curve shifts

• E.g. An increase in AD raises the equilibrium
price level, and RGDP (Y).
• As the macroeconomic equilibrium changes, the
economy experiences problem with inflation and
unemployment.
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3. Use diagram to see how the shift will changes
output and the price level in the short run
4. Use diagram to see how the shift will changes
output and the price level in the long run
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Changes in AD: Causes of Inflation

Inflation : An increase in the overall price level.
• Aggregate Demand (AD) shift to the right if:
• Increase in government spending (1) Demand-Pull Inflation:
• A tax cut • Inflation that is initiated by an increase in aggregate
• Increase in (MS) demand (AD curve shift rightward).
• AD increases as C, I, G, NX, Ms increase and tax
• Increase in consumption
decrease.
• Increase in investment
• Increase in net export (2) Cost-Push Inflation:
• Inflation that is initiated by a decrease in aggregate supply
(AS curve shift leftward).
• Those factors could increase the output • AS decreases may be due to increase in the cost (price of
while pushing the price up or causing input), natural disaster and so on.
inflation.
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 Demand-Pull • An increase in AD towards full
Changes in AS:
Inflation employment (Y NR ) from AD 0 to
• Aggregate Supply (AS) shift to the left.
AD 1 shows and increase in the
PL
AS
price level (PL) from PL0 to PL1. • Two main sources of decrease in
• Increase in AD above full aggregate supply are
employment from AD 1 to AD 2
increases price level to PL2. (i) An increase in wage rates
• At Y NR, real output has reached
PL2 the maximum limit but prices are
(ii) An increase in the prices of raw
PL1
still increasing. materials
• The increase in the price level is
AD2
PL0 the demand pull inflation.
AD1 • Further increase in demand will • Those factors could reduce the output
cause hyperinflation.
AD0 while pushing the price up or causing
Y
Y1 YNR
inflation. 38

• AS curve shift to the left from

Cost-Push AS0 to AS1 shows and increase
Inflation in the price level (PL) from PL0
to PL1.
PL • The equilibrium output will
decrease from Y0 to Y1.
AS2
• The further shift of AS curve to
AS1
the left from AS1 to AS2.
PL2 AS0
• Creates a further increase in
PL1 the price level to PL2 and
PL0
further decrease in output (Y2).
• Continues of this situation may
AD lead to stagflation (output is
falling at the same time the
Y
Y2 Y1 Y0 prices are rising).
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