Topic 2: Aggregate Demand

Aggregate Supply Model

Lecturer: Duong Thi Tuyen

Faculty of Economics and Development Studies,
Hue university of economics

1
 1. Aggregate Demand (AD)
• Aggregate demand is planned expenditure, in
real terms, on domestically produced output.
AD = C+I+G+(X-M)
AD curve is downward sloping .
It implies that there is an inverse
relationship between price level (vertical
axis) and quantity demanded by real
GNP (real GNP-horizontal axis)

2
 Why is the AD curve downward
sloping?
1. International substitution effect (the international-
trade effect): how a change in price level affects net
exports (X-M)?

2. Real balance effect (the wealth effect): how a change

in price level affects consumption (C) ?

3. Intertemporal substitution effect (the interest effect):

how a change in price level effects investment (I)?

3
 Movement vs Shift
PL

PL0 A B

AD0 AD1
GNP0 GNP1 Real GNP

A movement a long AD The shift in AD curve are

curve is caused by the
change in price level.
Eg, A movement from A to
B along AD curve is
caused by a decrease in
the price level (PL0 to PL1).
caused by the change in one
of components of AD (C, I, G,
X-M).
Eg, an increase in government
spending (G) shift the AD
curve to the right (AD0 to AD1).
4
 2. Aggregate Supply (AS)
• Aggregate supply is the planned supply of
domestically produced output in real terms.
PL AS curve is upward sloping. It
AS
implies that there is a positive
PL1 relationship between price
B
level (vertical axis) and
PL0
quantity of real GNP supplied
A
(horizontal axis).
GNP0 GNP1 Real GNP
𝜋 = 𝑇𝑅 − 𝑇𝐶
𝜋 = profit
𝑇𝑅 (total revenue) = PQ x Q: price of output x quantity of output
TC (total cost) = Pz x Z: price of inputs x quantity of inputs
Assume: price of inputs is constant (fixed) or ∆Pz=0 5
 Movement vs Shift
AS1
PL PL
AS
PL1
PL1 B
B AS0

PL0
PL0 A
A

GNP0 GNP1 Real GNP GNP0 Real GNP

A movement a long AS curve is The shift in AD curve are caused

caused by the change in price
level.
Eg, A movement from A to B
along AS curve is caused by an
increase in the price level (PL0 to
PL1).
by the change in cost of production
(inputs price, wages)
Eg, an increase in price of inputs
shift the AS curve to the left (real
GNP is unchanged but PL has
changed from PL0 to PL1).
6
 3. Equilibrium in AD-AS model
• Equilibrium will occur where AD & AS curves intersect.
• Firms will have desire level of stock (inventories)
• Changes in stock levels act as a signal to firms as to
whether production should be increased, decreased or
left unchanged.
c
Price
At A (equilibrium), we can
Level Excess Supply determine:
AS0

B • Equilibrium price (PL0)
C
PL1
• Equilibrium output (GNP0)
A
PL0 • Actual stock level =
PL2
E D planned stock level (no
excess supply or demand,

Excess Demand no unplanned changes in
AD0 stocks).
0 GNP1D GNP0 GNP1S Real GNP
GNP2S GNP2D 7
 4. Potential GNP (GNP*)
• Potential GNP (GNP*): is the level of output that could be
produced in the economy given the current state of technology,
size of the labour force & without accelerating inflation.
• If the economy is operating at this level:
- Firms are operating at full capacity
- There is full employment (unemployment rate = natural
unemployment)

Factors influencing Potential GNP growth (shift LRAS curve)

=
A change in factor of production
1. Growth of labour force
2. Growth of capital stock & technological progress
3. Supply of raw material
4. International trade
8