Ch. 30 - AD/AS Inst.

: Eliane Haykal

* Aggregate Demand (AD):

AD represents the behavior of consumers, businesses, gvt, & the ROW when the price level changes. It is
the total quantity of output that is willingly bought at different levels of prices, ceteris paribus (= other
things held constant).

AD = C + I + G + NX

A change in PL leads to a change in Q of AD: it’s a

mvt along the AD curve. (If any other determinant
of AD changes, there will be a shift of the whole
AD curve).

PL and Q of AD are negatively related, AD is a

downward-sloping curve.

* Reasons behind the negative slope of AD (=

why does AD slope down?= Why is it that when
PL ↑, QAD ↓?):

1- Real Balance Effect:

When PL goes up, the value of real assets and savings decreases ==> purchasing power decreases
as households feel poorer and so decrease consumption which is a component of AD ==> Qad
decreases.

2- Interest Rate Effect:

If PL increases and knowing that MS is constant, demand for money will increase ==> price of
money which is the interest rate will increase ==> investment decreases because it costs
businesses more to borrow and households will also find it more expensive to take personal loans
==> C decreases ==> Qad decreases.

3- Foreign Purchases Effect:

If Pl in US increases ==> foreign counties will decrease their purchases from US as US-made gds
are more expensive ==> X decrease
Plus, americans find it cheaper to buy gds from abroad instead of local gds ==> M increase

==> NX decrease ==> Qad decreases.

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Determinants of AD:

A change in any determinant leads to a shift of AD. If AD shifts to the right, it will be partly due to a
change in one of its components and partly due to the multiplier effect.

First, there will be a shift due to the autonomous variable change, and then a change in induced C, which
is the multiplier effect.

A- Determinants affecting C:

(review them from C and S chapter)

1- Consumer wealth:
If wealth increases (lottery, land, …), people’s confidence in the future increases and they
start saving less and consuming more, so C increases ==> AD increases ==> AD shifts to the
right.
2- Borrowing: explain in details ==> …
3- Consumer Expectations: review from C & S
- Health of the Economy (recession or expansion)
- Future Income
- PL expectation (expectation of inflation or deflation). Shift not mvt because PL still
didn’t change yet.
4- Personal Taxes: (income taxes or direct taxes)
If T increase ==> Yd = Y – T + t will decrease ==> people will have less money to spend so
C decreases ==> AD decreases ==> Ad shifts to the left

5- Interest rate:
If r decreases ==> households will consume more because: they withdraw their deposits as
they’re not earning as much as before AND they will take more personal loans, car loans,…
as they are less expensive ==> AD increases ==> AD shifts to the right.

B- Determinants affecting I:
(review them from C and S chapter)
1- Real interest rate: If r decreases, businesses will be encouraged to invest more because it’s
less expensive to borrow ==> I increases ==> AD = C + I + G + NX, AD increases, AD shifts
to the right.

2- Future Expectations:
- Future profits
- Health of economy
- Political risk

3- Business Taxes
4- Technology
5- Available capital stock

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C- Determinants affecting G:

Fiscal Policy:

3 Tools: G, T, t

It can be an Expansionary FP (G increases, T decreases, t increases) with the goal to induce

expansion/ take an economy out of a recession, or a contractionary FP (G decreases, T increases, t
decreases) with the objective of controlling inflation.

a- Expansionary:
• Gvt decides to decrease taxes ==> Yd = Y – T + t, Yd increases ==> C increases as
people have more money to spend ==> AD = C + I + G + NX, AD increases ==> shifts to
the right:
• Gvt decides to increase t ==> same analysis.
• Gvt consumption or investment increases ==> G increases ==> AD = C + I + G + NX,
AD increases ==> same continuation.
b- Contractionary: vice versa for the 3 bullets.

D- Monetary Policy: Controlled by the Central Bank

MD: Money demand is a downward-sloping curve: r &
Qd of money are negatively related. If r increases, Q of
money demanded decreases as it’s more expensive to
get loans.

MS is vertical because it only depends on the

decision of the Central Bank.

Intersection between MD & MS is the

equilibrium in the money market.

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 MP can also Expansionary or Contractionary.
1- Expansionary MP or Lax MP:
CB decides to adopt a lax MP ==> MS increases
==> MS shifts to the right:

==> r decreases ==> consumers increase C

because they’re earning less on deposits so they withdraw
them and because personal loans, car loans, etc. are now
cheaper to obtain. Businesses will also invest more
because it’s less expensive to borrow ==> C & I increase
==> AD = C + I + G + NX, AD increases, AD shifts to the
right:

2- Contractionary MP or Tight MP: vice versa.

E- Determinants affecting NX or Rest of the World effect:

a- Economic situation abroad:
Expansion abroad ==> foreign incomes increase ==> they will demand more of our products ==>
our exports increase ==> AD = C + I + G + NX, AD increases, AD shifts to the right & graph.

b- Exchange rates:
• Depreciation of LBP:
1LBP = $5
1LBP = $1

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 ==> Our local products become cheaper for foreigners & foreign products are more
expensive for us (it costs foreigners less to buy our good & it costs us more to buy their
products) ==> X increases & M decreases ==> NX increases ==> AD = C + I + G + NX, AD
increases, AD shifts to the right & graph.

Remark: when LBP depreciates, the $ appreciates: its value in terms of LBP increases.
• Appreciation of the Euro: vice versa.

c- Trade Agreements:

Decrease tariffs or other agreements. Different actual situations:

X increases & M decreases ==> NX increases ==> AD…

X decreases & M increases ==> NX decreases ==> AD…

X ct & M increases ==> NX decreases

X increases & M increases more ==> NX decreases

X decreases & M decreases more ==> NX increases

*Aggregate Supply:

It describes the behavior of the production side of the economy. It shows the levels of output that will be
produced at every PL, ceteris paribus.

1- Immediate short run: prices of output and prices of inputs are sticky/inflexible.
2- Short run: prices of output flexible and prices of inputs sticky.
3- Long run: prices of outputs and inputs are flexible.

More about the 3 time frames:

1- If there’s more demand on output, firms can’t increase prices, so they increase output:

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2- At a given PL, output (Qas) is known. If PL increases, it’s an
incentive for firms to produce more because prices of inputs are
not changing but prices of output are increasing ==> opportunity
to increase profit if more is produced ==> Qas increases. We are
dealing with a mvt along the same curve. When PL changes,
ceteris paribus, Qas changes in the same
direction.

3- In the LR, wages and other input

prices adjust to the levels of prices of
output ==> it’s no more beneficial for
producers to increase production. (If PL
increased by 20% in the SR, costs will
eventually catch up to this 20% increase in
the LR).
Since we got to potential GDP, we don’t have to increase production
(overemployment), plus we have scarcity of resources.

AS curve (2 acceptable formats):

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 Determinants of AS:

A- Group affecting potential GDP:

Rightward shift:
- Discovering new resources
- Human capital is enhanced (level of knowledge, experience, …)
- Increase in capital stock
- Technological advance
- Brain Drain is reversed
- Increase in productivity (linked to 2 & 3)

Any of those changes will lead to an increase in

potential GDP ==> LAS increases and pulls SAS
with it: shift to the right. (potential GDP affects
LRAS)

Leftward shift:
- Brain Drain
- Decrease in capital stock
- Natural resources dry out or get depleted
- War or natural disaster (people die,
factories get destroyed, ..)

Vice versa.

B- Group affecting cost of production:

1- Price of inputs (such as oil): Oil is one of the
raw materials used in the majority of
productions, so when the price of oil
increases, the cost of production increases in
the country ==> producers start producing
less because it’s more costly ==> SAS
decreases ==> SAS shifts to the left. (not
LAS bc potential GDP is the same)
2- Minimum wage rate:…
3- Prices of raw materials: It can happen due to
tariffs or the exchange rate.

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* Equilibrium Output / Macroeconomic
Equilibrium:

Eq.: what’s being demanded (Qad) is just

equal to what’s being supplied (Qas) in this
economy ==> eq. is a point of stability, it
doesn’t change if nothing else changes.

Any point other than equilibrium is

disequilibrium ==> instability ==>
adjustments will occur.

If PL = 130 ==> at this high PL, producers are willing

to supply more than what spenders (different sectors)
are willing to buy ==> Qad < Qas ==> stocks of
unsold of inventories ==> like a case of surplus ==>
downward pressure on PL, as PL decreases Qad increases & Qas decrease until they equalize at eq.

If PL = 100 ==> at this low PL, producers are willing to supply less than what spenders (different sectors)
are willing to buy ==> Qad > Qas ==> sales are brisk ==> like a case of shortage ==> upward pressure on
PL, as PL increases Qas increases & Qad decrease until they equalize at eq.

At

equilibrium, the gvt &/or CB may interfere to induce growth because actual is lower than potential GDP,
or to control inflation in case of an inflationary gap. There are 3 cases of equilibrium:
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.

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Problems:

Starting with initial LR equilibrium (full-employment equilibrium), describe what happens in the
economy if:

a- Price of oil increases

b- Taxes decrease
c- Brain drain is reversed
d- decreased gvt spending

a- As price of oil increases, the cost of production increases in the country ==> producers start
producing less because it’s more costly ==> SAS decreases ==> SAS shifts to the left (or AS
shifts up):

So GDP decreases, PL increases (cost-push inflation), and unemployment increases as the

negative GDP gap is bigger: case of stagflation.

b- Taxes decrease ==> Yd = Y – T + t, Yd increases ==> C increases as people have more money to
spend ==> AD = C + I + G + NX, AD increases ==> shifts to the right:

So GDP increases, PL increases (demand-pull inflation), and unemployment decreases as GDP

gap is smaller: case of expansion.

c- Brain drain is reversed, this leads to an increase in potential GDP ==> LAS increases and pulls
SAS with it: shift to the right…. ==> GDP increases, PL decreases, unemployment
decreases/increases/constant depending on the magnitude of shift.

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d- Vice versa of b.

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