1

SL
AGGREGATE DEMAND and AGGREGATE SUPPLY
(AD-AS MODEL)
(Tragakes Chapter 9 pages 236-264)

Level of prices in an economy determined by interaction of aggregate demand

and aggregate supply

Variable-price-level-model: enables us to analyze changes in both real GDP and

the price level simultaneously (AD/AS Model, neoclassical model))

Fixed-price-level-model: emphasizes changes in real GDP; doesn‟t say

anything about price levels (and inflation as an extension) (AE Model)

AGGREGATE DEMAND
Aggregate Demand – a schedule or curve that shows the amounts of real
output that buyers collectively desire to purchase at each possible price level;
total level of spending in an economy

AD = C + Ig + G + Xn

Inverse relationship between real GDP and Price Level

Price Level  Real GDP Demanded 

Price Level  Real GDP Demanded 

Demand curve for a single product slopes downward basically due to Income
Effect and Substitution Effect.

Income Effect for S/D If Price of individual product

decreases, nominal income
allows greater purchases
(Demand increases); reverse is
also true

Substitution Effect for S/D If the Price of an individual

product decreases, more of the
product is demanded as it
becomes relatively less expensive
than other goods

Notes AD AS Model SL 1213 26 February 2013

 2

In Aggregates, as an economy moves down the Aggregate Demand curve, it

moves to a general lower price level.

1. A decline in price level need not produce an income effect since

wages, rents, interest, and profits (nominal income) would
decrease

2. Also, there is NO overall substitution effect among domestically

produced goods when the price level falls (as the general price
level falls for all goods and services)

A Price Level change causes consumers to reduce or increase spending due to:

1. Real-Balances Effect (real money balances effect): A higher price level

reduces the real value (or purchasing power) of the public‟s
accumulated saving balances and means less consumption spending as
households feel “poorer”; purchases (especially for „big ticket‟ items)
may be deferred (since they feel poorer)

2. Interest-Rate Effect: Assuming the supply of money is fixed, a higher

price level increases the demand for money and, consequently, the
interest rate increases, reducing the amount of real output demanded
since higher interest rates curtail investment spending (I) and interest-
sensitive consumption spending. Interest rate is the price of money.

Investment Demand

i
Interest Rate

Investment (USD billions)

Notes AD AS Model SL 1213 26 February 2013

 3

3. Foreign-Purchase Effect (international substitution effect): A rise in

the price level reduces the quantity of domestically produced goods
demanded as exports when domestic price level relative to foreign
price level increases and cheaper imports may be substituted
domestically (more imports – less exports)

Aggregate Demand Curve

P
Price Level

0 THB

Output (THB billions)

Other things being equal, a change in the price level will change the amount of
aggregate spending and therefore change the amount of output (real GDP)
demanded by the economy. These are movements along a fixed aggregate
demand curve.

Determinants of Aggregate Demand (AD shifters)

If one or more of the following items change, the aggregate demand curve will
shift. These conditions are the determinants of aggregate demand and are:

1. Change in consumer spending (C)

a) Consumer wealth (financial and physical assets) – a sharp increase in

the real value of consumer wealth prompts people to save less and buy
more products, known as wealth effect
b) Consumer confidence (expectations) – expectations as to future real
incomes or the direction of inflation may shift AD curve left or right
c) Household indebtedness – when debt level is higher than normal,
people cut back on expenditures and vice versa
d) Personal Income Taxes – tax cuts increase DY shifting AD to the right
and rises in taxes decrease DY shifting AD to the left
e) Interest rates – influences the purchases of interest-sensitive goods
(“big ticket” items)

Notes AD AS Model SL 1213 26 February 2013

 4

2. Change in Investment spending (Ig) – this depends on the real interest

rate (r) in relation to loanable funds

a) Interest rates – increase in real interest rate decreases AD and a

decrease in real interest rate increases AD
b) Expected returns – higher expected returns causes an increase in Ig and
shifts AD curve right
c) Future business confidence
d) Technology – new & improved may enhance r
e) Degree of excess capacity – operating well below capacity is not an
incentive to build new factories
f) Business taxes – an increase would cause AD curve to shift left
g) Level of corporate indebtedness

3. Changes in government spending (G) – as long as tax collections and

interest rates do not change as well

a) Political priorities

b) Economic priorities

4. Net export spending (Xn) – a rise in net exports (higher exports than
imports) shifts AD curve to the right

a) National Income Abroad – rising national income abroad encourages

foreigners to buy more goods from other countries

b) Exchange rates

1. Depreciation of $ increases Xn and AD curve shifts right

2. Appreciation of $ decreases Xn and AD curve shifts left

Depreciation of the dollar means that it takes less of another currency

to buy a dollar or one gets more dollars for the same old value of
foreign currency.

c) Changes in the level of protectionism

Notes AD AS Model SL 1213 26 February 2013

 5

AGGREGATE SUPPLY
Aggregate Supply – the level of real domestic output that firms will produce
at each price level; direct relationship between the price level and the
amount of real output that firms offer for sale

Aggregate Supply Curve – shape of the AS curve reflects what happens to

the per unit production cost (average cost of output) as GDP expands
or contracts
Total Input Cost
Per Unit Production Cost = Total Output = Average Total Cost

Average cost of output establishes that output‟s price level because the price
level must cover all the costs of production including normal profit

Assuming wage rates, other input prices, technology and the total supply of
factors of production remain constant, the higher the level of prices the more
will be produced.

Short-run aggregate supply curve (SRAS) curve is upward sloping due to:

1) Diminishing returns – diminishing marginal physical product and

hence an upward sloping marginal cost curve. In macro, we are adding
all the MC curves, hence the AS curve slopes upward

2) Growing shortages of certain variable factors – as firms collectively

produce more, even inputs that can be varied may increasingly come in
short supply

Short-run Aggregate Supply Curve

P
Price Level

0 THB

Output (THB billions)

Notes AD AS Model SL 1213 26 February 2013

 6

Determinates of Aggregate Supply

An existing AS curve identifies the relationship between the price level and
real output, other things equal.

When other things are not equal, determinants come into play, cause per unit
production costs to be higher or lower than before at each price level, and shift
the curve itself

1. Change in input prices – higher input prices increase per unit production
costs and reduce aggregate supply

a. Domestic Resource Availability – increase in supply of these will lower

resource prices and ATC and shift AS curve right (and vice versa)

1. Land – new deposits, irrigation, new tech, or depletion of water

supplies
2. Labor – 75-80% of all business costs, influx of women in labor
force past 20 yrs put downward pressure on wages as did
immigrants; AIDS has the opposite effect and reduces GDP
3. Capital – when society improves or adds to its stock of capital, AS
increases
4. Entrepreneurial Ability – more would cause shift to right

b. Prices of Imported Resources – a decrease in price of imported

resources increases AS and an increase in their price decreases AS;
exchange rate fluctuations come into play here

c. Market Power – ability to set above-competitive prices by sellers of

major inputs (such as OPEC, de Beers)

2. Change in Productivity

Productivity – a measure of the relationship between a nation‟s level

of real output and the amount of resources used to produce it;
measure of real output per unit of input (average real output)

Productivity = Total Output

Total Input

Total Input Cost

Per Unit Production Cost =
Total Output

Notes AD AS Model SL 1213 26 February 2013

 7

Example A Example B Example C

Total Output 10 20 10

Total Input 5 5 2

Price of each Input 2 THB/input 2 THB/input 2 THB/input

Per unit production cost 1 THB/output 0.5 THM/output 0.4 THB/output

Increase in Productivity shifts AS curve to right

Main source of productivity advance is improved production technology.

Other sources of productivity increases:

1. better educated and trained workforce

2. improved forms of business enterprises
3. reallocation of labor resources from less to more productive uses

3. Changes in Legal-Institutional Environment

a. Indirect Business taxes (sales, excise, payroll) – an increase raises

ATC and reduces AS (shift left) and the opposite for a decrease

b. Subsidies (payment or tax break) – decreases ATC and increases

AS (shift right)

c. Government Regulation – more regulation increases ATC and

decreases AS; the opposite for deregulation

(Supply-siders argue that by deregulating, ATC

will decrease and AS will increase – shift right)

4. Supply shocks

A supply shock is an event that suddenly changes the price level in an

economy due to a sudden increase or decrease in the supply of a particular
input, e.g. the oil shock of 1973 in the United States.

A negative supply shock (sudden supply decrease) will raise the price
level and shift the aggregate supply curve to the left. A negative supply
shock can cause stagflation due to a combination of raising prices and
falling output.

A positive supply shock (an increase in supply) will lower the price level
and shift the aggregate supply curve to the right. A positive supply shock
could be an advance in technology (a technology shock) which makes
production more efficient, thus increasing output.

Notes AD AS Model SL 1213 26 February 2013

 8

Alternative Views of Aggregate Supply

Keynesian Model of the AS Curve

P
Price Level

0 Qu Qfe Qc

Real Domestic Output (Real GDP)

1. Horizontal Range (ab)

Levels of real output less than full employment output (Qf)

Economy in a recession or depression; large amounts of unused machinery

& equipment; large amounts of unemployed workers

Producers can acquire labor & other inputs at stable prices

AC (average costs) will stay constant as firms expand up to Qu

Firms have no reason to raise prices

2. Intermediate (up-sloping) Range (bc)

Expansion of real output accompanied by a rising price level

Per unit production costs increase – shortage of raw materials, use of

inefficient machinery, less capable workers may be hired, perhaps shortage
of skilled workers

Increase in AC and boost in price levels as some industries pay more for
resources or are working near plant capacity; higher product prices are
needed to be profitable

Notes AD AS Model SL 1213 26 February 2013

 9

Once Qfe (full-employment level of GDP) is reached, further price level

increases may bring about increases in real GDP (output) for a time

Rising price level accompanies rising real output

Full capacity real output reached at „c‟; physical limit of economy (PPC)

3. Vertical Range (cd)

Since economy is already operating at full capacity, increases in the price

level will produce no additional real output

Bidding for resources will raise resource prices (costs) and ultimately
boost product prices, but real output will remain unchanged; one firm‟s
gain is at the expense (loss) of another firm

Monetarist/Neoclassical Model
Long-run Aggregate Supply Curve
P
Price Level

0 THB

Output (THB billions)

Long-run aggregate supply curve (LRAS) is vertical at the level of potential

output (full employment output) because aggregate supply in the long run is
independent of the price level

Notes AD AS Model SL 1213 26 February 2013

 10

Equilibrium real output and price level

Intersection of AD & AS curves determines an economy‟s equilibrium price
level and equilibrium real output

SR AD/AS Equilibrium
P
Price Level

0 THB

Output (THB billions)

Monetarist/Neoclassical Model Equilibrium

P
Price Level

0 THB

Output (THB billions)

LR equilibrium occurs at the full-employment level of output.

While there may be SR fluctuations in output, the economy will always return
to the full-employment level of output in the long run.

Notes AD AS Model SL 1213 26 February 2013

 11

LRAS is vertical because potential GDP is independent of the price level

Price level, the wage rate and other resource prices all change by the same
percentage, and relative prices and the real wage rate remain constant

Reasons for change in Real GDPfe:

1. change in the full-employment quantity of labor

2. change in the quantity of capital (physical and human)
3. advance in technology

(differentiate between fluctuations around real GDPfe and changes in real GDPfe
which cause a shift of the LRAS curve)

A change in the money wage rate does not change LRAS, because on the
LRAS curve, the change in the money wage rate is accompanied by an equal
percentage change in the price level.

However, the money wage rate (and other resource prices) affects
SRAS because they influence firms‟ costs

P
Price Level

0 THB

Output (THB billions)

When potential GDP changes, both LRAS and SRAS change. LRAS would
not change without a change in SRAS.

Notes AD AS Model SL 1213 26 February 2013

 12

Keynesian Model and Equilibrium

P
Price Level

0 Q

Real Domestic Output (Real GDP)

AD in horizontal range (graph above)

Producers would not be willing to supply Q2 as inventories would build up;

nor would producers supply at Q1 as inventories would become depleted

P
Price Level

0 Q

Real Domestic Output (Real GDP)

AD in intermediate range (graph above)

At P1, AD = Q2 but as producers supply more the price level rises from
competition among buyers to purchase the lesser available real output of Q1,
pulling up price level to Pe, encouraging producers to increase supply to Qe
and buyers to scale back purchases to Qe.

Notes AD AS Model SL 1213 26 February 2013

 13

Changes in Equilibrium
Price level ↑ in intermediate & vertical ranges = demand-pull inflation

Increases in AD: Demand-Pull Inflation AD ↑ in horizontal range

Increases real
output but leaves
price level
Price Level

unchanged

0 Q

Real Domestic Output (Real GDP)

Increases in AD: Demand-Pull Inflation AD ↑ in intermediate range

Increases both
real output and
Price Level

price level

0 Q

Real Domestic Output (Real GDP)

Notes AD AS Model SL 1213 26 February 2013

 14

Increases in AD: Demand-Pull Inflation AD ↑ in vertical range

Increases price
level but cannot
increase real
Price Level

output as full
capacity has been
attained

0 Q

Real Domestic Output (Real GDP)

Decreases in AD: Recession and Cyclical Unemployment AD ↓

A decline in real output with no change in the price level (horizontal

range) constitutes a recession and since fewer workers are needed to
produce the lower output, cyclical unemployment arises.

Idle production capacity

Price Level

Cyclical unemployment

Deflationary gap

0 Q

Real Domestic Output (Real GDP)

Notes AD AS Model SL 1213 26 February 2013

 15

This economic condition exists due to downward price inflexibility (“sticky”

or inflexible in a downward direction for a considerable amount of time) for
resources and products for a considerable period of time because of:

1. wage contracts – usually only adjust each yr (though 3 yr union

contracts common)

2. impairment of morale, effort, productivity

efficiency wages - wages that elicit maximum work effort and

minimize labor cost per unit of output

3. minimum wage – legal floor

4. menu costs – costs of determining new price structure, re-pricing,

printing & mailing catalogues, communicating (via
advertising)

5. fear of price wars

Increase in AS: Full Employment & Price Stability

P
Price Level

0 Q

Real Domestic Output (Real GDP)

First, AD  from AD1 to AD2

P does not increase from P1 to P2 due to increased productivity gains which

shifts the AS curve from AS1 to AS2 such that mild inflation would exist
moving from P1 to P3

Notes AD AS Model SL 1213 26 February 2013

 16

Decreases in AS: Cost-Push Inflation

Increased costs and reduced supply

P
Price Level

0 Q

Real Domestic Output (Real GDP)

When AS  with no change in AD, price level  = cost-push inflation

Real output declines from Q1 to Q2

Price Level rises from P1 to P2

Recession comes about

Short-run AS is usually shown as intermediate range of the AD-AS Model

Short-run equilibrium is the normal state of the economy as it fluctuates

around potential GDP

Long-run equilibrium is the state toward which the economy is headed

Notes AD AS Model SL 1213 26 February 2013

 17

Long-run Aggregate Supply

The Q of real GDP at the vertical region is the physical limit of the economy
(corresponding to PPC) which is different than FE (full employment) level of
output

Real GDP, in turn, depends on the FE quantity of labor, the quantity of capital,
and the state of technology

Long-run Aggregate Supply Curve

LRAS curve is
P
always vertical
and is located at
Real GDP at FE
or as the vertical
portion of the AS
Price Level

curve

Potential GDP is
independent of
price level

0 Q

Real Domestic Output (Real GDP)

Notes AD AS Model SL 1213 26 February 2013

 18

A change in Resource Prices

A change in
resource prices
Price Level

affects the SRAS

curve, not the LRAS

0 Q

Real Domestic Output (Real GDP)

Long-run AD-AS Equilibrium

LR macroeconomic
equilibrium exists
Price Level

where real GDP

equals real GDPfe

0 Q

Real Domestic Output (Real GDP)

Real GDPfe = LRAS

Real GDP is where the AD curve intersects the LRAS and the SRAS curves,
all at the same point

Notes AD AS Model SL 1213 26 February 2013

 19

Deflationary (Recessionary) Gap and Inflationary Gap

Price Level P

0 THB

Real GDP

Inflation – a rise in an economy‟s price level

Stagflation – the combination of stagnation (low growth and high

unemployment) and high inflation; simultaneous increases in
the price level and the unemployment rates

Deflation – decline in an economy‟s price level

Inflationary gap – the excess of national expenditure over income (and

injections over withdrawals) at the full-employment level of
national income; multiplier effect shows change in RGDP

Deflationary (recessionary) gap – the shortfall of national expenditure below

national income ( and injections below withdrawals) at the full-
employment level of national income; multiplier effect shows
change in RGDP

Reflationary policy – fiscal or monetary policy designed to increase the

rate of growth of aggregate demand

Notes AD AS Model SL 1213 26 February 2013