Lecture 7

The Aggregate
demand-supply
model

Reading:
Sloman and Garratt,
Chapter 10

Prepared by:
Dr. Bawani
Lelchumanan &
ECN1014 Dr. Chong Poh Ling
INTRODUCTORY (DEF, SBS)
ECONOMICS
 Reading:
AGGREGATE Sloman and
Garratt,
DEMAND Chapter 10
AGGREGATE
DEMAND DEFINED
Aggregate demand (AD) curve shows how much
national output (GDP) will be demanded at each
aggregate price level.
Aggregate demand is a collective demand which
should be contrasted to the demand for particular
goods and services.
WHAT IS AGGREGATE
DEMAND?
A curve that shows the various amounts of output that
buyers (domestic consumers, businesses, governments,
foreign buyers) desire to purchase at each possible price
level.

Inverse relationship: price level and output.

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 Aggregate Demand Curve
Price level

P2

P1

AD

O Y2 Y1 National output
Aggregate demand is composed of:

 Consumption (C)
 Private investment (I)
 Government expenditure (G)
 Net exports (NX)

Y = AD = C + I + G + NX
SHAPE OF AGGREGATE
DEMAND CURVE
Other things being equal, a rise in the aggregate price
level will reduce quantity of national output demanded,
as represented by a movement along a fixed AD curve.
The AD curve is downward-sloping can be explained
by:
 Income effects
 Substitution effects
 Trade-balance effect
 Real-balance effect
 Interest rate effect
 INCOME
EFFECTS
If wages remain fixed as aggregate price level increases, real
income would fall and consumption would also fall.
Rising prices may raise firms’ profits, which may in turn prompt
them to raise investment expenditures.
However, as consumers reduce spending, firms are unlikely to
increase investment expenditures.
As such, AD falls as aggregate price level increases.

P, real incomes, wealth (investment), C , AD

SUBSTITUTION
EFFECTS
Trade-balance effects/Foreign Purchases Effect
 A rising aggregate price level of domestic goods makes
imported goods relatively cheaper.
 Domestic residents turn to imported goods as
substitutes.
 Foreign residents also turn away from domestic goods
 A combination of higher imports and lower exports
reduces net exports, which in turn reduces aggregate
demand.

P, M, X, NX, AD

SUBSTITUTION
EFFECTS
Real-balance effects
A higher price level reduces the real value of savings
and wealth, thus prompting them to spend less.
 Lower consumer expenditures reduce aggregate
demand.

P, real value of savings, wealth, C, AD

SUBSTITUTION
EFFECTS
Interest-rate effects
A higher price level raises money demand, as consumers pay
more for goods and firms pay higher wages.
 With a fixed amount of money supply, higher money demand
would raise the rate of interest, and thus the cost of
borrowing.
 A higher cost of borrowing would tend to reduce investment
(or consumption), and therefore aggregate demand.

P, r, cost of borrowing, I (or C), AD

SHIFTS IN AGGREGATE
DEMAND CURVE
Apart from changes in the aggregate price level, a change
in any components of aggregate demand will lead to a
shift in the AD curve.
 Consumption
 Investment
 Government spending
 Net exports
 SHIFTS IN AGGREGATE
DEMAND CURVE
The rightward shift from
AD to AD2 represents an
increase in aggregate
demand.

The leftward shift from AD

to AD1 shows a decrease in
aggregate demand.

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 A Shift in Aggregate Demand Curve
Price level

AD2

AD1
O Y1 Y2 National output
DETERMINANTS OF
AGGREGATE DEMAND
Factors that can shift/change the AD curve.
(Remember! Price level does NOT cause a shift).

1. Changes in consumer spending (Consumption)

• If consumers spend more, AD shifts to the right.
• If consumers spend less, AD shifts to the left.

2. Changes in investment spending. Eg. Spending on capital

goods.
• If increase in investment spending, AD shifts to the right.
• If decrease in investment spending, AD shifts to the left.

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DETERMINANTS OF
AGGREGATE DEMAND
3. Changes in government spending.
•If government spending increases, AD increases. Right.
•If government spending decreases, AD decreases. Left.

4. Changes in net export spending.

•If net export spending rises, AD rises. Right.
•If net export spending declines, AD declines. Left.

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AGGREGATE Reading:
Sloman and Garratt,
SUPPLY Chapter 10
AGGREGATE
SUPPLY DEFINED
Aggregate supply (AS) curve how much national
output (GDP) will be supplied at each aggregate
price level.
Aggregate supply is a collective supply which
should be contrasted to the supply of particular
goods and services.
SHAPE OF AGGREGATE
SUPPLY CURVE
Other things being equal, a rise in the aggregate
price level will increase quantity of national output
supplied, as represented by a movement along a
fixed AS curve.
SHAPE OF AGGREGATE
SUPPLY CURVE
Relationship depends on time horizon.
Immediate short run - both input prices (by contractual
agreements such as labor contracts) and output prices (issuance
of price lists that are in effect for a stated period of time) are
fixed.
Short run - input prices are fixed but output prices are variable.
Long run - input prices and output prices can vary.
Time Horizon Input prices Output prices
Immediate short run Fixed Fixed
Short run Fixed Variable
Long run Variable Variable
SHAPE OF AGGREGATE
SUPPLY CURVE
In the short-run, input prices are fixed but output prices
are flexible.
 It is easier for firms to change product prices than to
change the level of wages or salary paid to their
workers.
 As output prices rise against fixed input prices, profit
margin widens, thus prompting more national output
to be supplied.
 Aggregate Supply Curve in the Short-Run
Price level
At a lower price level of P1, all firms will
supply a lower level of total output at Y1.
At a higher price level of P2, all firms will AS
supply a higher level of total output at Y2.

P2

P1

O Y1 Y2 National output
 SHAPE OF AGGREGATE SUPPLY
CURVE: ELASTICITY
AS curve is relatively flat (i.e. elastic) when capacity is
underutilised.
With little cost pressure, production can be increased easily
without having to raise the price.
It becomes increasingly steeper (i.e. inelastic) as producers
approach full capacity and production cannot be increased
easily, as explained by:
 Diminishing returns (shortages of fixed inputs)
 Shortages of some variable inputs
DIMINISHING RETURNS:
SHORTAGES OF FIXED INPUTS
In the short-run firms may experience diminishing marginal
product as some production inputs (e.g. capital equipment) are
fixed in relation to other variable inputs (e.g. labour and raw
materials).
Productivity falls and marginal cost rises as more variable
inputs are added to fixed inputs.
 Firms must acquire more resources and use existing plant and
equipment more intensively.
 These exert additional strain on productive capacity, which in
turn raise the production costs (e.g. wear-and-tear, maintenance
and repair costs).
SHORTAGES OF SOME
VARIABLE INPUTS
As all firms raise their output further, some variable
inputs (e.g. skilled labour, raw materials) become
increasingly scarce and harder to obtain.
 Producers may need to pay overtime wages, raise base
wages, and pay premium prices to get needed inputs.
 Higher cost must be covered by raising the price.
 Aggregate Supply: As Production Approaches Full Capacity
Price level
When price rises from P1 to P2, total output can
be raised fairly easily from Y1 to Y2 since
productive capacity is underutilised.
AS
When price rises from P2 to P3, the increase in
total output becomes increasingly limited from
Y2 to Y3, since production approaches full
capacity.
P3

P2

P1

O Y1 Y2 Y3 National output
SHIFTS IN AGGREGATE
SUPPLY CURVE
Apart from the changes in the aggregate price level,
a change in “other things” will lead to a shift in the
AS curve.
 Input prices
 Productivity
 Business taxes and subsidies
 Government regulations
SHIFTS IN AGGREGATE
SUPPLY CURVE
Determinants of aggregate supply. Shift factors.

Changes that increase per-unit production costs: shift AS

left.

Changes that lower per-unit production costs: shift AS

right.

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INPUT PRICES
a) Domestic Resource Prices - Labor, Capital, Land.
– If cost of labour, capital, land reduce, production costs will reduce.
AS will increase and shifts right.
– If cost of labour, capital, land increase, production costs will
increase. AS will decrease and shifts left.

b) Prices Of Imported Resources

-Increase in the price of imported resources will increase per-unit

production costs which decreases aggregate supply.
-Decrease in the price of imported resources will decrease per-unit
production costs which increases aggregate supply.

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 PRODUCTIVITY

If productivity rises, unit production costs will fall.

This can shift aggregate supply to the right.
If productivity decreases, unit production costs will
increase. This can shift aggregate supply to the left.

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LEGAL INSTITUTION ENVIRONMENT
Taxes and subsidies
• Higher business taxes increase costs for businesses and reduce
short run aggregate supply.
• Subsidies lower production costs and increase short run aggregate
supply.

Government regulation
• Businesses need to comply to government regulation.
• More regulation increases per-unit production costs for businesses
and shifts the aggregate supply curve to the left.
• Deregulation will reduce per-unit production costs and shift the AS
rightward.

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 A Shift in Aggregate Supply Curve
Price level
AS1 AS2

O Y1 Y2 National output
 MACROECON
OMIC
EQUILIBRIUM Reading:
, INSTABILITY Sloman and Garratt,
Chapter 10
AND
BUSINESS
CYCLES
Aggregate demand and supply summarise the market
activity of the whole economy.
Macroeconomic equilibrium is the combination of
price level and real output compatible with AD and
AS.

 It is the only price-output level mutually

compatible with both buyers’ and sellers’ intentions.
 Total spending equals total production: everything
produced is sold.
 Macroeconomic Equilibrium
Price level
AS

At the macroeconomic
equilibrium, desired spending
(AD) equals total production (AS).
Pe

AD

O Ye National output
MACROECONOMIC
EQUILIBRIUM AND BUSINESS
CYCLES
Macroeconomic equilibrium is not permanent.
It can change in response to changes of buyers’ and sellers’
behaviour.
Economists use the model of aggregate demand and aggregate
supply to explain short-run fluctuations in economic activity
around its long-run trend.
Business cycles or short-run fluctuations result from:
 A shift in the AD curve
 A shift in the AS curve
 A shift in both the AD and AS curve
APPLICATION
AND ANALYSIS
Three steps for analysing economic fluctuations:
 Determine whether the event affects aggregate supply
or aggregate demand.
 Decide which direction the curve shifts.
 Use a diagram to compare the initial and the new
equilibrium.
o Impact on the aggregate price level (i.e. inflation)
o Impact on the national output level (i.e.
unemployment)
 An Increase in AD

AS

Price level
1.
B
P2
2. A
P1 AD2
AD1
O Y1 3. Y2 National output

1. An increase in AD will shift the AD curve rightward from AD1 to AD2…

2. …will lead to an increase in the aggregate price level from P1 to P2,

representing a positive change in the rate of inflation…
3. …and a rise in national output from Y1 to Y2, representing a fall in the level
of unemployment.
 A Decrease in AD

AS

Price level
1.
A
P1
2. B
P2 AD1
AD2
O Y2 3. Y1 National output
1. An decrease in AD will shift the AD curve leftward from AD1 to AD2…
2. …will lead to an decrease in the aggregate price level from P1 to P2,
representing a negative change in the rate of inflation…
3. …and a fall in national output from Y1 to Y2, representing a rise in the level
of unemployment.
 An Increase in AS

AS1

Price level
AS2

1.
A
P1
2. B
P2
AD1
O Y1 3. Y2 National output

1. An increase in AS will shift the AS curve rightward from AS1 to AS2…

2. …will lead to a decrease in the aggregate price level from P1 to P2,
representing a negative change in the rate of inflation…
3. …and a rise in national output from Y1 to Y2, representing a fall in the level
of unemployment.
 A Decrease in AS

AS2

Price level
AS1

1.
B
P2
2. A
P1
AD1
O Y2 3. Y1 National output

1. An fall in AS will shift the AS curve leftward from AS1 to AS2…

2. …will lead to an increase in the aggregate price level from P1 to P2,

representing a positive change in the rate of inflation…
3. …and a fall in national output from Y1 to Y2, representing a rise in the level
of unemployment.
 ECONOMIC
GROWTH AND Reading:
THE Sloman and Garratt,
Chapter 10
BUSINESS
CYCLE
 ACTUAL GDP GROWTH AND
POTENTIAL GDP GROWTH
The study of the business cycle requires distinguishing
between actual GDP growth and potential GDP growth.

Actual GDP Growth Potential GDP Growth

• Percentage annual change or • Percentage annual change or
increase in real GDP increase in the economy’s
productive capacity
 The Business Cycle
National output (GDP)
Potential
output

Full Employment

Actual
output

Potential GDP is the value of real GDP when all the

economy’s production factors are fully employed.
In the short-term, actual GDP fluctuates around
potential GDP.

O Time
EXPLANATIONS OF THE
BUSINESS CYCLE
Fluctuations in aggregate demand
 Instability of private household consumption (C) spending
 Instability of private investment spending (I)
 Fluctuations of stocks
 Instability of exchange rates (NX)
Fluctuations in aggregate supply
 Volatility of commodity or input prices (e.g. oil and minerals)
 Technological progress
Globalised trade and finance
 Interdependence and interconnectedness between different
economies in trade and finance