CHAPTER 17

AGGREGATE DEMAND AND AGGREGATE SUPPLY

AGGREGATE DEMAND
is a schedule or curve that shows the amounts of real output/ GDP that buyers collectively
desire to purchase at each possible price level.
The relationship between the
price level and the amount
of real GDP demanded is
inverse or negative.

1) Suppose that the economy’s

price level is P1 and its
aggregate expenditures
schedule is AE1. The equilibrium
GDP is indicated with a yellow
dot where the curve intersects
with the 45º line.
2) Now assume that the price
level rises from P1 to P2. The
aggregate expenditures
schedule will fall from AE1 to
AE2.
Therefore, increase in the
economy’s price level will shift
its aggregate expenditures
schedule downwards and will
reduce real GDP.
 Shift of the AD curve = Other things equal, this higher
Initial change in price level will:
spending x (a) decrease the value of wealth,
multiplier decreasing consumption
expenditures
(b) increase the interest rate,
reducing investment
(c) increase imports and
decrease exports, reducing net
export expenditures.
With the price level held constant,
increases in consumption,
investment, government and net
export expenditures shift the
aggregate expenditures schedule
upward and the aggregate
demand curve to the right.

WHY DOES THE AD – AS MODEL HAVE A DOWNWARD SLOPE?

►REAL-BALANCES EFFECT – a change in the price level
►INTEREST-RATE EFFECT – an increase in money demand will drive up the price paid for
its use and that price is the interest rate
►FOREIGN PURCHASES EFFECT – as price levels rise, so do foreign price levels

CHANGES IN AGGREGATE DEMAND

Changes in aggregate demand involve two components:
(a) a change in one of the determinants of aggregate demand
(b) a multiplier effect that produces a greater ultimate change in aggregate demand
than the initiating change in spending
 DETERMINANTS OF AGGREGATE DEMAND
(1) CONSUMER SPENDING
(2) INVESTMENT SPENDING
If consumers decide to buy more output at each price
level, the aggregate demand curve will shift to the
right.
►CONSUMER WEALTH – an increase in consumer
wealth prompts people to save less and buy more
which will shift the aggregate demand curve to the
right.
►CONSUMER EXPECTATIONS – when people expect
their future real income to rise, they tend to spend
more of their current incomes which will shift the
aggregate demand curve to the right. Similarly, if
consumers expect inflation, they will want to buy
products before their prices escalate.
►HOUSEHOLD DEBT – increased household debt
enables consumers to increase their consumption
spending which shifts the aggregate demand curve to
the right. Alternatively, when consumers reduce their
household debt, both consumption spending and
aggregate demand decreases.
►PERSONAL TAXES – tax reductions shift the
aggregate curve to the right
A decline in investment spending at each price level
will shift the aggregate curve to the left and an
increase in investment spending will shift the
aggregate curve to the right.
►REAL INTEREST RATES – an increase in real interest
rates will lower investment spending and reduce
aggregate demand. A decrease in the money supply
raises the interest rate, reducing investment and
decreasing aggregate demand.
►EXPECTED RETURNS – higher expected returns on
investment projects will increase the demand for
capital goods and shift the aggregate demand curve
to the right.
Expected returns are influenced by the following
factors:
(a) Expectations about future business conditions – if
firms are optimistic about future business conditions
then they are more likely to forecast high rates of
return on current investment and invest more today.
(b) Technology – new and improved technologies
enhance expected returns on investment and thus
increase aggregate demand.
(c) Degree of excess capacity – a rise in unused
capital will reduce the expected return on new
investment and decrease aggregate demand
(d) Business taxes – an increase in business taxes will
reduce after-tax profits from capital investment and
lower expected returns, decreasing aggregate
demand.
(3) GOVERNMENT SPENDING
(4) NET EXPORT SPENDING
AGGREGATE SUPPLY
is a schedule or curve showing the level of real domestic output that firms will produce at
each price level.
An increase in government purchases will shift the
aggregate demand curve to the right.
A rise in net exports (higher exports relative to imports)
shifts the aggregate demand curve to the right.
►National income abroad – rising national income
abroad encourages foreigners to buy more products
which increase net exports and cause the aggregate
demand curve to shift to the right.
►Exchange rates – rand depreciation increases net
exports (imports go down and exports go up) and
increases aggregate demand.
AGGREGATE SUPPLY IN THE LONG
RUN
the long-run aggregate supply
curve is a vertical line at the full-
employment level of real GDP
because wages and other input
prices rise and fall to match
changes in the price level. So,
price-level changes do not affect
a firms’ profits and they create no
incentive for firms to later their
output.
AGGREGATE SUPPLY IN THE SHORT
RUN
the short-run aggregate supply
curve is an up-sloping curve
which indicates a positive/direct
relationship between the price
level and the amount of real
output that firms will offer for sale.
Per-unit production costs
underline the aggregate supply
curve.
Per-unit production cost =
𝒕𝒐𝒕𝒂𝒍 𝒊𝒏𝒑𝒖𝒕 𝒄𝒐𝒔𝒕
𝒖𝒏𝒊𝒕𝒔 𝒐𝒇 𝒐𝒖𝒕𝒑𝒖𝒕
CHANGES IN AGGREGATE SUPPLY
►Right shift – indicates an increase in aggregate supply which means that firms are willing
to produce and sell more real output at each price level.
►Left shift – indicates a decrease in aggregate supply which means that firms produce les
output than before

DETERMINANTS OF AGGREGATE SUPPLY

(1) INPUT PRICES Input or resource prices can either be domestic or
imported.
►DOMESTIC RESOURCE PRICES – decreases in wages
reduce the per-unit production costs and cause the
aggregate supply curve to shift to the right. Another
example is when the prices of machinery and
equipment fall it causes a decline in per-unit
production costs which causes the aggregate supply
curve to shift to the right.
►PRICES OF IMPORTED RESOURCES – if the ran
appreciates, it costs firms less to import resources
which will lower the per-unit production and cause the
aggregate supply curve to shift to the right.
►MARKET POWER – a change in the degree of market
power – the ability to set prices above competitive
levels which causes per-unit production costs to
increase and causes a left-shift of the aggregate
supply curve.
(2) PRODUCTIVITY Productivity is a measure of the relationship between a
nation’s level of real output and the amount of
resources used to produce that output.

𝒕𝒐𝒕𝒂𝒍 𝒐𝒖𝒕𝒑𝒖𝒕
Productivity =
𝒕𝒐𝒕𝒂𝒍 𝒊𝒏𝒑𝒖𝒕
 Example: If the real output is 10 units and 5 units of
input are needed to produce that quantity and the
price of each input is R2, then:

10
Productivity = =2
5
𝑅2 𝑥 5
Per-unit production cost = = R1
10

(3) LEGAL-INSTITUTIONAL ►CHANGES IN BUSINESS TAXES AND SUBSIDES – higher

ENVIRONMENT taxes increase per-unit production costs and will shift
the aggregate supply curve to the left. A business
subsidy will lower production costs and cause the
aggregate supply curve to shift to the right.
►CHANGES IN GOVERNMENT REGULATIONS – it is
usually costly for businesses to comply with
government regulations and so the more regulations
that they need to follow, the higher the per-unit
production costs which will cause the aggregate
supply curve to shift to the left.

EQUILIBRIUM AND CHANGES IN EQUILIBRIUM

The intersection of the aggregate demand and aggregate supply curves establishes the
economy’s equilibrium price level and equilibrium real output.

Real Output DEMANDED Price Level Real Output SUPPLIED

506 108 513
508 104 512
510 100 510
512 96 507
514 92 502

510 is the equilibrium real output and R100 is the equilibrium price level for this economy.
CHANGES IN AD-AS CURVES
INCREASE IN AD
Demand-pull inflation – the increase in
aggregate demand beyond the full-
employment level of output causes
inflation.
INCREASE IN AS
Full employment with price-level stability
DECREASE IN AD
Deflation – a decrease in the price level.
Recession – a decrease in real output.
Cyclical unemployment – fewer workers
needed to produce lower outputs.
Disinflation – the price level did not decline
DECREASE IN AS
Cost-push inflation – increase in price level.
 QUESTIONS
(1) The AD curve slopes downward because:
decreases in the price level give rise to real-balances effects, interest-rate effects and
foreign purchases effects that increase the amounts of real GDP demanded
(2) The AS curve slopes upward because:
per-unit production costs rise as real GDP expands toward and beyond its full-
unemployment level
(3) Illustrate the effects of the following variable changes on AD and/or AS and
subsequent to that indicate the impact of the change in general price levels (inflation)
and GDP (unemployment).
a. Government decides to increase government spending
b. Poor performances by the world economy lead to domestic job losses, which impact
negatively on private consumption in general
c. An increase in the oil prices led to an increase in domestic fuel costs, which impacted
on the production capabilities of manufacturing firms
d. An increase in investment spending was spurred by higher productivity. Illustrate the
effect f both variable changes on one graph.