LECTURE FIVE

AGGREGATE DEMAND AND AGGERGATE SUPPLY

5.1 Introduction
In this lecture we will introduce a new framework based on the concepts of aggregate demand
(AD) and aggregate supply (AS). Furthermore, we shall discuss the relationship between aggregate
demand, the price level and real GDP. We will also consider the relationship between aggregate
supply, the price level and real GDP. It is the interaction of aggregate demand and aggregate supply
that determines the dynamics of macroeconomic changes, with implications for output,
employment and inflation. We will discuss the concept of aggregate demand, changes in aggregate
demand, aggregate supply, changes in aggregate supply, short run and long run aggregate supply
and macroeconomic equilibrium

5.2 Expected Learning Outcomes

By the end of this lecture, the learner should be able to:

 Understand the nature of aggregate demand

 Understand the nature of aggregate supply
 Explain the changes in aggregate demand and supply in the economy
 Illustrate the relationship between short run and long run aggregate supply
 Understand the concept potential real GDP
 Identify how macroeconomic equilibrium depends upon the matching of aggregate demand
and aggregate supply.
5.3 Aggregate Demand
In the previous lecture we have seen that aggregate expenditure is composed of consumer spending
(C), investment spending (I), government spending (G) and spending on exports less imports (X −
M ). It is the spending plans under each of these demand headings that gives us aggregate planned
expenditure (AE) i.e

At any given point in time, aggregate demand will be equal to the actual output of the economy
(real GDP) and is given by:

AD = C + I + G + (X − M) = Real GDP
Assuming that the economy has sufficient productive capacity, the higher the level of aggregate
demand, the higher will be GDP, particularly because consumer spending is related directly to
income. We can therefore define an aggregate demand curve as a curve that shows the quantity
demanded of real GDP at different price levels, holding all other factors constant

Graphically is as shown below;

The AD Curve is downward sloping because of two effects:

Real Money Balance Effect: At lower price levels the real purchasing power of money balances
(currency and bank deposits) rises. This leads to a greater quantity of goods demanded and
therefore a higher real GDP. For example, if price levels fell by a half and money balances stayed
the same, the real purchasing power of the money balances would double.

Substitution Effect: Holding all other factors constant, a rise in the price level leads to a rise in
interest rates. This is because given higher prices households and firms have less real purchasing
power and therefore they will tend to lend less and will wish to borrow more. This decrease in the
supply of loanable funds alongside a rise in the demand to borrow will then tend to cause the
interest rate to rise.

5.4 Changes in Aggregate Demand

The aggregate demand shifts because of the following factors:

i. Government Macroeconomic policy

ii. Expectations of firms and households
iii. Global trends

i. Government Macroeconomic policy

Changes in government expenditure and taxation or fiscal policy will directly and indirectly impact
on aggregate demand. The undertaking of either more state spending or tax cuts will increase
aggregate demand. Government spending directly affects aggregate demand, while changes in
taxation indirectly stimulate consumer and investment spending through changes in disposable
income.

An expansionary fiscal policy, leads to aggregate demand (AD) curve to shift to the right from
AD1 to AD2. This leads to a higher aggregate demand resulting to an increase in real GDP. By
contrast, a reduction in government spending and higher taxes (a contractionary fiscal policy) will
shift the AD curve to the left leading to a lower real GDP; as illustrated by the movement from
AD1 to AD3. This is illustrated in the figure below;
Government might also use monetary policy to affect aggregate demand and therefore the level of
economic activity. The effects are similar to one for fiscal policy as shown above.

ii. The Role of Expectations

Expectations are important in determination of the stat o the economy this is because households
feel optimistic about future since they are likely to borrow in spending and investing in new plant
and machinery. When expectations are such that people and businesses feel pessimistic about the
future, they are likely to cut back on their consumption and investment plans. Expectations about
future income can affect spending today, as can expectations about, in particular, future price
levels, taxes, interest rates and exchange rates. If we expect something to cost more in the shops
in the future we are likely to buy it now.

In general, any positive change in expectations that boosts aggregate demand will shift the AD
curve to the right; any negative change in expectations will shift the AD curve to the left.

iii. Global Trends Impact

Aggregate demand at the national economy level is often affected by change in economy of the
world. For instance, a change in the current exchange rate will affect the demand for exports and
imports by altering their relative prices. Higher exports or less imports leads to a shift in the
aggregate demand curve to the right whereas, less exports and high imports leads to a shift in
aggregate demand curve to the left.

5.5 Aggregate Supply (AS)

It refers to the total value of goods and services produced in an economy at any given time. The
aggregate supply available depends upon the factors of production utilized.

5.5.1 Aggregate Supply in the Long run

It shows the relationship between the price level and real GDP in the long run. In a competitive
market economy, at any point in time in the long run, when all short-run frictions have worked
their way out, long-run aggregate supply (LRAS) should be at the level where actual real GDP
equals the economy’s potential real GDP given fully efficient use of all the avail-able inputs (i.e.
a state of full employment of resources).

The LRAS is unaffected by price changes. This is because an increase in the demand for goods
and services cannot increase the supply, which is fixed at the potential GDP. The expected result,
therefore, of a higher aggregate demand would be a higher price level. However, an increase in the
price level would reduce real wages (wages divided by the price level: W/P), to which, at full
employment, workers can be expected to respond by demanding a compensating money wage. The
curve is vertical as shown in the figure below;

The movement from LRAS1 to LRAS2 in the figure above illustrates an increase in long-run
aggregate supply from Yf1 to Yf2. A decline in long-run aggregate supply would be represented by
a movement in the opposite direction.

5.5.2 Short Run Aggregate Supply

In the short run, real GDP may be at or below the potential real GDP at full employment. A higher
aggregate demand at a time when aggregate supply is below its potential level can be expected to
lead to more output produced. The curve is upward sloping as shown in the figure below;
An increase in SRAS is illustrated in the figure above by the movement rightwards in the curve
from SRAS1 to SRAS2. A decrease in short-run aggregate supply would lead to a movement in the
opposite direction.

5.6 Macroeconomic Equilibrium

It occurs when aggregate demand is equal to the aggregate supply in the economy. The AD curve
shows the volume of real expenditure at every possible price level and the AS curve the volume
of real GDP supplied at every possible price level. The macroeconomic equilibrium occurs where
there is no excess aggregate demand in the economy i.e demand cannot meet the supply and vice
versa as shown below;
 The equilibrium occurs at point e giving a price level of P* and a real GDP of Y *. If, for
example, the price level was higher than P* then aggregate supply would exceed aggregate
demand (AS AD). As a result there would be unsold goods and services and, consequently,
output and prices would be cut. This would continue until the equilibrium, e, was restored.
Similarly, if the price level was below P* then aggregate demand would exceed aggregate
supply (AD AS). This would cause prices to rise and would encourage firms to produce more
until, again, the equilibrium position, e, was reached.

5.7 Lecture Activity

a) Illustrate the relationship between short run and long run aggregate supply curves

b) Explain three factors that lead to a shift in the demand curve