Chapter 08

Aggregate
Demand and
Aggregate
Supply

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 Chapter Outline
• Aggregate Demand
• Aggregate Supply
• Shifts in Aggregate Demand and
Aggregate Supply
• Causes of Inflation
• Supply-Side Economics
• How the Government Can Influence
(but probably not control) the
Economy
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 Aggregate Demand

• Aggregate Demand: the amounts

of real domestic output which
domestic consumers, businesses,
governments, and foreign buyers
collectively will desire to purchase at
each possible price level

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 Figure 1 Aggregate Demand
PI

AD

RGDP
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 Why Aggregate Demand is
Downward Sloping
• Real Balances Effect
• Because higher prices reduce real spending power,
prices and output are negatively related.
• Foreign Purchases Effect
• When domestic prices are high, we will export less
to foreign buyers and we will import more from
foreign producers. Therefore higher prices leads to
less domestic output.
• Interest Rate Effect
• higher prices lead to inflation which leads to less
borrowing and a lowering of RGDP
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 Aggregate Supply

• Aggregate Supply: the level of real

domestic output available at each
possible price level

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Figure 2 The Aggregate Supply
Curve AS
PI
Classical
Range

Intermediate
Range

Keynesian Range

RGDP
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 The Ranges of AS
• Keynesian Range
• Large amounts of unemployment make it so
that increases in aggregate demand have no
affect on wages or prices.
• Classical Range
• Full employment makes it so that increases in
aggregate demand only increase wages or
prices.
• Intermediate Range
• Some sectors of the economy reach full
employment more quickly than others.

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 Variables that Shift Aggregate
Demand
• Taxes
• Interest Rates
• Confidence
• Strength of the Dollar
• Government Spending

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 Determinants of AD
Variable GDP Effect of an Effect of a
Component increase on AD decrease on
C,I,G,X AD
Taxes C,I Decrease so Increase so
AD <= AD =>
Interest Rates C,I Decrease so Increase so
AD <= AD =>
Confidence C,I Increase so Decrease so
AD => AD <=
Strength of the X (exports- Decrease so Increase so
Dollar imports) AD <= AD =>
Government G Increase so Decrease so
Spending AD => AD <=
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 Figure 3 AD Increases

PI AS

PI’

PI*

AD’

AD

RGDP* RGDP’ RGDP

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 Figure 4 AD Decreases

PI AS

PI*

PI’

AD

AD’

RGDP’ RGDP* RGDP

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 Variables that Shift AS

• Input Prices
• Productivity
• Government Regulation

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 Determinants of AS
Variable Effect of an Effect of an
Increase on AS Decrease on AS
Input Prices Decrease so Increase so
AS AS
Productivity Increase so Decrease so
AS AS
Government Decrease so Increase so
Regulation AS AS

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 Figure 5 Increase in AS
PI
AS

AS’

PI*

PI’
AD

RGDP* RGDP’ RGDP

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 Figure 6 Decrease in AS
PI AS’

AS

PI’

PI*

AD

RGDP’ RGDP*
RGDP
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 Causes of Inflation

• Demand Pull Inflation: inflation

caused by an increase in aggregate
demand
• Cost Push Inflation: inflation caused
by a decrease in aggregate supply

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 Government Influence:
Aggregate Demand
• Government can influence economic
activity with aggregate demand side
policies affecting:
• Taxes
• Government Spending
• Interest Rates

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 Government Influence:
Aggregate Supply
• Government can influence economic activity
with aggregate supply side policies affecting
• input costs (labor and wage)
• reducing regulation
• Increase incentives to
• Work
• Take Risks
• The actions are call Supply Side Economics

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