Chapter 10: Aggregate Demand and Aggregate Supply

To relate National output to the price level and show how equilibrium price level and GDP are determined, by using the concepts of aggregate demand (AD) and aggregate supply (AS).

Aggregate demand (AD) is the sum of all planned expenditures for the entire economy

Or AD curve is a curve that shows the amount of real output that households, business sector, government and foreigners are desired to purchase at each possible price level.

What happens when the price level increases?

Aggregate demand curve downward sloping because of the following reasons:

  1. The real balance effect or wealth effect (direct effect): an increase in the price level leads to a decrease the purchasing power of the currency. This will decrease the desired consumption and therefore aggregate demand.
  2. Interest rate effect ( indirect effect):
  3. As the price level rises the purchasing power of your money ill decline, so people will carry more money to buy the same thing. Therefore, people will demand more money, then interest rate will increase and both businesses and households will spend less. Hence, Aggregate demand will decrease.

  4. The open economy effect (or international trade effect): when the price of domestic goods increases in relation to the price of foreign goods, net exports fall, causing aggregate expenditure to fall.

What happens when the price level falls? The vice verse of the above three cases will happen.

Shifts in the aggregate demand curve:

Factors that affect aggregate demand (AD)

  1. A decline in the foreign exchange rate of the dollar
  2. Increased security about jobs and future income
  3. Improvements in economic conditions in other countries
  4. A decrease in real interest rate not because of price level changes
  5. Tax decreases
  6. Money supply increase

In fact, aggregate expenditure is the sum of expenditures of each sector of the economy. That is household consumption, business sector (investment), government, and the rest of the world (net exports).

Therefore, each sector in the economy has different reason for spending. For example, household spending depends on household income while business spending depends on the profits they expect to earn.

So aggregate spending depends on all of these reasons.

Factors affecting investment are:

  1. Real interest rate changes that are not due to price changes.
  2. technology change: new technology stimulates investment as firms are forced to buy it to stay competitive
  3. Cost of capital goods: If the cost of capital goods is expensive then firms will spend less.
  4. Capacity utilization: if there is excess capacity (unused capital goods), then the firms do not need to buy new capital good, therefore, investment will decline.
  5. The expected profitability.

Net exports; exports are determined by conditions in the rest of the world, such as foreign income, tastes, exchange rates and government policies.

Aggregate Supply (AS) curve: the amount of goods and services (real GD) that businesses offer for sale. Or the total quantity of final goods and services produced in an economy during a given period.

Long-run aggregate supply curve (LRASC): is a vertical line at the potential level of real GDP or output.

The potential level of real GDP or output is the income level that is produced in the absence of any cyclical unemployment or when natural rate of unemployment exist. In the long run, wages and other resource costs fully adjust to price changes.

There are some assumptions to be held to derive vertical (long-run aggregate supply curve):

  1. technology is fixed
  2. Productive resources are not changing
  3. Labor productivity is constant
  4. Population is not changing

And in the long run, wages and other resource costs are fully adjusting to price changes. That is the price level has not effect on real GDP. If the price level for real output (real GDP) increases, there will proportional increases in input prices. Therefore, investors have no incentive to increase output. As a result, aggregate demand has no effect on long-run aggregate supply curve.

Actually, imagine the production possibilities curve in chapter 2, the vertical aggregate supply curve is the mirror of that.

If you relax those assumptions above, then long-run aggregate supply curve can shift out or inward.

The difference between short run aggregate supply curve and long-run aggregate supply curve is that short-run aggregate supply curve slopes upward because we assume that the costs of production (wages) do not change to offset changes in prices. In the short-run, higher prices increase producers’ profits and stimulate production without changing wages. However, in the long run, because the costs of production adjust completely to changes in prices, therefore, neither profit nor output will increase.

Why output can be expanded production in the short run is that firms can use labor and capital more intensively and the economy is producing below potential output (full capacity is not reached).

However when capacity is reached then the curve will become vertical. Short run aggregate supply curve can shift to the left because of the input price increase (the price of energy in the early 1970s and 80s).

Factors that can shift aggregate supply outward

  1. Discoveries of new raw materials
  2. Labor supply increase
  3. A decrease in tax rates
  4. A decrease in input costs
  5. A decrease in international trade barriers

The vice verse is true for those factors that shift aggregate supply curve inward.

A decrease in aggregate demand while aggregate supply holding constant will lead a short run equilibrium output. There will be a contractionary gap, which is the amount of which actual output is less than the economy’s potential output. Potential output is the maximum sustainable output level that can be produced in the economy by suing the all the available resources( see the graph).

An increase in aggregate demand without changing aggregate supply curve, will lead to short run equilibrium in out put. There will be expansionary gap in the economy. Expansionary gap is the amount of which actual output is greater than the economy’s potential output.