Aggregate Demand

Aggregate Demand
The aggregate demand (AD) curve shows the real output
(real GDP) that people are willing and able to buy at
different price levels, ceteris paribus.

The AD curve shows an inverse relationship between

price level and domestic output (real GDP in billions).
The explanation of the inverse relationship is not the
same as for demand of a single product, which centered
on substitution and income effect. The explanations are:

1. Wealth and real balances effect: when price level falls, purchasing power of existing financial assets rises, which can
increase spending. People fell wealthier when price level falls and will be encouraged to buy more goods and services.

2. Interest-rate effect: when price level increases, businesses and households may have to borrow additional funds to
complete their planned purchases. As borrowing demand increases, the interest rate rises, reducing actual borrowing
amount and curtail planned consumption and investment. A decline in price level means lower interest rates which can
increase certain spending.

3. Foreign purchases effect: when price level falls, other things being equal, Bangladesh prices will fall relative to foreign
prices, which will tend to increase spending on Bangladesh exports and also decrease import spending in favor of
Bangladesh products that compete with imports.

A change in the quantity demanded of Real GDP occurs because of a change in the price level. This causes a movement
along the AD curve, but not a shift of the AD curve. A change in an economic variable other than price would be required
to shift the AD curve. The economy consists of four sectors: Household, Business, Government, and foreign sector. Every
sector buys a portion of GDP.

The sum of their demand is called total expenditure (TE) or aggregate expenditure (AE). AE = C + I + G + Xn
 Aggregate Demand
Factors that change C, I, G, and Xn will change AE and AD. These factors are listed
below:

1. Consumption: Wealth, interest rate, income taxes, and expectations about future
prices and incomes will change C and shift AD curve.

2. Investment: Interest rate, business taxes, and expectation about future sales will
change I and shift AD curve.

3. Foreign Sector: Foreign real national income and exchange rate will change export
and import, causing AD curve to shift.

4. Money Supply: The money supply affects interest rates. An increase in money supply
will lower interest rate, causing the AD curve to shift to the right.
 Aggregate Supply
Aggregate Supply (AS) curve below
shows level of real domestic output (real
GDP in billions) available at each possible
price level, ceteris paribus. The upward
slope of the curve indicates that producers
are willing and able to sell more units of
their goods as prices increase, and that
their willingness to sell decreases as prices
falls.
The reasons listed below explaining the
AS's upward sloping shape in the short
run:
1. Rigid Wages: Economists believe that wages tend to be fixed by contracts or other
agreements. When prices rise, but higher wages do not accompany them, producers' profits
will rise temporarily, and the firm will produce more.
2. Sticky Prices: Prices are costly to change in some industries (menu costs). Where this is
true, decreases in the general price level will negatively affect sales, profits, and output,
causing producers to produce less.

These two reasons given for the upward sloping AS are likely to be true only for short periods
of time, and thus the AS curve described above is often called short run AS (SRAS) curve.
 Aggregate Supply
A change in the general price level will change the quantity supplied of the domestic output,
this is a change along the AS curve. Other economic variables will change the SRAS curve
and shift the curve to a new position. Some of these factors are listed below:

1. The Wage Rate: Higher wage rates means higher labor cost. Given constant prices,
higher production costs reduce the profit per unit and lowering the number of goods
produced. Therefore, higher wage rate shifts the SRAS curve to the left.
2. Prices of Non-labor inputs: Energy, land, capital and other non-labor inputs also have a
significant impact on SRAS. An increase in the price of these inputs shifts the SRAS curve
to the left.
3. Productivity: This is the output produced per unit of input used over a period of time.
Higher productivity of labor or any other inputs will shift the SRAS to the right.
4. Supply Shock: Major natural or institutional changes will affect AS. Shocks like the Iraq
War and 9/11 both impacted the AS.

As mentioned earlier, factors created the upward sloping SRAS are not present in the long
run. In the long run, the economy will always produce the full employment real GDP called
potential GDP (GDPp) or natural real GDP ( Qn). The long run AS (LRAS) curve will be
vertical at this real GDP level. Change in potential GDP will shift the LRAS curve to the
right.
 Equilibrium
Short Run Equilibrium
Putting AD and SRAS together, two curves will
intercept at a point. This point is the short run
equilibrium. This price level is the equilibrium
price level, Pe; this quantity is the equilibrium
quantity, Qe. At any other price level, the
economy is either in surplus or in shortage.

Long Run Equilibrium

The interception point of AD and SRAS may
be on the LRAS, creating a long run
equilibrium where real GDP is equal to
potential real GDP. If the potential GDP is at
600, then the following graph shows that the
SR equilibrium is on the LRAS curve, creating
a LR equilibrium.
However, short-run equilibrium (real GDP)
may occur on a level above or below the
potential GDP, creating a disequilibrium in the
economy.
Consider the following economy.
(1) Y = Z Output equals aggregate demand, an equilibrium condition
(2) Z≡C +I +G Definition of aggregate demand
(3) C = co + c1 YD Consumption function,
(4) YD ≡ Y – T Definition of disposable income
(5) T = t0 + t1Y Tax function;
(6) I =b0 Investment function,
(7) G = GO0 Government spending,
Q. Express, in algebraic symbols, the equilibrium level of income (Y0) in this
economy.
Soln:
Y = AD = C + I + G;
substitute in for C, I, G
Y = c0 + c1YD + b0 + GO0 ;
substitute in for YD
Y = c0 + c1(Y - T) + b0 + GO0 ;
substitute in for tax, transfers functions
Y = c0 + c1(Y - t0 - t1Y) + b0 + GO0;
bring the "Y" terms to left hand side.
Y – c1(Y – t1Y) = Y(1- c1(1-t1)) = c0 - c1t0 +b0 + GO0
divide both sides by (1- c1(1-t1)),
Recessionary gap
GDP Gaps
If real GDP < Potential real GDP (full employment GDP),
then a recessionary gap exist. At the same time:
Unemployment rate > natural rate of unemployment.

Since more job seekers are in the market, they tend to settle
with a lower wage. Lower wage will increase the AS curve,
causing the price to decrease. Lower price will increase
consumption. This process will continue until the economy
reaches the long run equilibrium (potential real GDP).

If the potential GDP is at 700, graph on the right presented a

recessionary gap between SR equilibrium and the LRAS
curve.
Inflationary gap
If real GDP > Potential real GDP (full employment GDP), then
an inflationary gap exist. At the same time: Unemployment rate
< natural rate of unemployment.

Since job seekers are less than job openings in the market,
employers are forced to raise the wage to attract new workers.
High wage will decrease the AS, and raise the price. Higher
price will lower consumption. This process will repeat until the
long run equilibrium is reached.

If the potential GDP is at 500, left graph presented an

inflationary gap between SR equilibrium and the LRAS curve.
Demand-Pull Inflation

 Demand-pull inflation is inflation that results from an initial

increase in aggregate demand.
 A demand pull inflation can result from any influence that
increases aggregate demand.

 In a demand-pull inflation, initially

 aggregate demand increases
 real GDP increases above potential GDP and the price
level rises
 money wages rise
 the price level rises further and real GDP decreases
toward potential GDP.
 A one-time increase in aggregate demand
raises the price level but does not always
start a demand-pull inflation.
 For demand pull inflation to occur,
aggregate demand must persistently
increase.
 The money supply must persistently grow
at a rate that exceeds the growth rate of
potential GDP.
Cost-Push Inflation
 Cost-push inflation is an inflation that results from an
initial increase in costs.
 The two main sources of cost-push inflation are:
 an increase in the money wage rate
 an increase in the money prices of raw materials

 In a cost-push inflation, initially

 short-run aggregate supply decreases
 real GDP decreases below potential GDP and the price level rises
 the economy could become stuck in this stagflation situation for some
time.

 A one-time decrease in aggregate supply raises the price level but

does not always start a cost-push inflation.
 For cost-push inflation to occur, aggregate demand must increase
in response to the cost push.