Aggregate Demand and Supply

Aggregate Demand and Supply

 Demand and Supply
 Aggregate Demand Curve
 Equilibrium Condition for Aggregate Demand
 Shift of Aggregate Demand Curve
 Aggregate Supply Curve
 Long run Supply Curve (Long rum
Equilibrium)
 Short run Supply Curve(Short run Equilibrium)
 Conclusion
Demand and Supply
 Fundamental Concepts and theory
 Foundation for many other elaborate economic
models and theories
 Economic model based on the price and
availability of a product in a market
 Valuable tool – workings of market economy
 Crucial Elements – Directly effect Resource
allocation
Definitions of Demand
General Definition:
Demand is the quantity of a good or resource that buyers (or
demanders) are willing and able to buy under a given set of
conditions over a given period of time.
Specific Definition:
Demand is a schedule or a curve showing the various amounts
of a good or a service consumers (buyers) are willing and able
to buy at various prices, ceteris paribus, over a specified period
of time. Other things unchanged, as price rises, the quantity
demanded decreases, and as price falls, the quantity demanded
increases; the relationship between price and the quantity
demanded is inverse.
Definitions of Supply
General Definition:
Supply is the quantity of a good or resource that
sellers (or suppliers) are willing and able to offer
to the market for sale under a given set of
conditions over a specific period of time.
Specific Definition:
Supply (or a supply curve) is a schedule or curve
showing the quantities of a product a firm (or
firms) is (are) willing and able to produce and offer
to the market for sale at a range of possible prices,
ceteris paribus, over a certain period of time.
Aggregate demand

 Introduced by John Maynard Keynes

 Heart of most macroeconomics theories – overall
level of employment and national income in a
country’s economy during a given year
 Aggregate demand is defined as the total demand for an
economy’s output (production of goods and services) over a given
period of time.
 The aggregate demand (AD) curve is a curve that shows the
relationship between the price level and the quantity of real GDP
demanded by households, firms, and the government.
Difference Between AD Curve and Microeconomics
demand curve

 No substitute effect, because you cannot

substitute all goods.
 No income effect, because a lower price level
actually means less nominal income for the
resource suppliers -- e.g. lower wages, rents,
interests, profits.
Components of Aggregate Demand
AD = C + I + G + (X - M)
Where
AD= Aggregate Demand
C = Consumer expenditure on goods and services.
I = Gross Capital Investment – i.e. investment spending on capital goods e.g. factories and machines
G = Government Spending e.g. spending on NHS, education. Note transfer payments in the form of pensions
and unemployment benefits are not included because they are not related to output produced.
X = Exports of goods and Services. Goods leave the country but money from abroad flows into the economy,
therefore this is an increase in AD (an injection in to the circular flow)
M = Imports of goods and Services, although goods enter the country money is leaving the economy to go to
other countries, therefore AD falls

We assume an inverse relationship between price and aggregate demand

Price
Level, P

○
A
P1

P2 B
●

0 AD
Y2 Y1
Aggregate output (Income), Y
Decrease in the Increase in the
Price Level Aggregate
Output
Reasons why AD is downward
sloping
 The consumption link: The decrease in
consumption brought about by an increase in
the interest rate contributes to the overall
decrease in output.
 The real wealth effect, or real balance, effect:
When the price level rises, there is a decrease
in consumption brought about by a change in
real wealth.
 Shifts in the Aggregate Demand Curve
Price Level

P1

AD2
AD

Y1 Y2 Real National Income

Increase in non-price Increase in the

level determinants: Aggregate Demand
C, I, G, (X-M) curve
Shifts of the Aggregate Demand Curve
 An increase in the
 An increase in
quantity of money government purchases
supplied at a given price or a decrease in net taxes
level shifts the aggregate shifts the aggregate
demand curve to the demand curve to the
right. right.
 Factors that Shifts the Aggregate Demand
Curve
 Income (+)  Foreign Demand (+)
 Wealth (+)  Investment (+)
 Population (+)  Expectations
 Interest Rates (–) • Inflationary (+)
 Credit Availability (+) • Income (+)
 Government Demand (+) • Wealth (+)
 Taxation (–) • Interest Rates (+)

(+): An increase in this factor causes the curve to shift right.

(–): An increase in this factor causes the curve to shift left.
 Aggregate Supply
Aggregate supply is defined as the total supply
of goods and services produced by a national
economy during a specific time period. It is the
total amount of goods and services in the economy
available at all possible price levels.
The aggregate supply (AS) curve is a graph that
shows the relationship between the aggregate
quantity of output supplied by all firms in an
economy and the overall price level.
 Aggregate Supply
Price Level, P AS
In the short run, the
aggregate supply curve
(the price/output
response curve) has a
positive slope.

Aggregate Output (income), Y

Aggregate Supply
SHORT-RUN AGGREGATE LONG-RUN AGGREGATE SUPPLY
SUPPLY (SAS) (LAS)

Short-run Aggregate Supply Long-run Aggregate Supply

(SAS) shows the different (LAS) represents the most
quantities of real output in the output that an economy can
short-run that will be supplied sustain
at different prices
 Long Run Aggregate Supply

 In the long run, money is neutral

– Any changes in the money supply will be met by a proportionate change in prices
– Increasing the money supply will not affect the economy’s output in the long run.

 Long run output is determined entirely by an economy’s

productive capacity
- Production Function: YP = A*F(K,L,H,N)

 Only changes in real variables can affect potential output.

-Price does not have any effect on YP

 In the long run, all resources are being efficiently utilized such
that unemployment equals the natural rate
 Short Run Aggregate Supply

• In the short run, money is not neutral

– An increase in the money supply need not trigger an immediate
increase in price.
– Prices are sticky due to uncertainty, menu costs, and long-term
contracts.
• Suppose output prices across the economy rise.
– Wage and input contracts do not immediately adjust to higher output
prices.
– Profit per unit rise, leading to an increase in production.
– Eventually, these contracts will readjust to factor in the higher cost of
living, erasing the increased profits and returning output back to YP
 Aggregate Supply Curves
SHORT-RUN AGGREGATE SUPPLY LONG-RUN AGGREGATE SUPPLY
CURVE CURVE

SRAS LRAS

B
● Price Level, P B●
Price
Level, P
A○
A●
C●
Full
Full
employment
employment
● ●
Aggregate Output Aggregate Output
(Income) , Y (Income) , Y
 Factors that Shifts the Aggregate Supply Curve
 Costs (–)  Foreign Supply (–)
• Labour(Wages)  Expectations
• Resource • Profits (+)
 Investment (prior) (+)
• Inflationary (?)
 Productivity (+)
 Interest Rates (+) • Interest Rates (?)
 Credit Availability (+)  Taxation (–)

(+): An increase in this factor causes the curve to shift right.

(–): An increase in this factor causes the curve to shift left.
Determinants of Aggregate Supply and
Aggregate Demand
 Equilibrium in AD/AS

Price Level
The equilibrium is the point at which the
AS
aggregate demand and aggregate supply
curves intersect.

P0

AD

Y0
Real GDP Y
 Equilibrium in AD/AS

Price Level
P0 and Y0 correspond to equilibrium in
AS
the goods market and the money market
and a set of price/output decisions on the
part of all the firms in the economy.

P0

AD

Y0
Real GDP Y
Short- Term Equilibrium

Graph 1
Graph 2 Graph 3
The equilibrium in the short-run is shown by the intersection of
the Aggregate Demand (AD) curve and the
Short-Run Aggregate Supply (SAS) curve. When either AD or SAS
shifts, the equilibrium point is changed. For example, in Graph 1, a
shift to the right of the AD curve will cause the equilibrium output
as well as the price level to increase. And if the AD curve were to
shift to the left, as in Graph 2, the opposite would be true: output
and price level will decrease. A shift to the left in SAS, as shown in
Graph 3, will cause the price level to rise while equilibrium output
will decrease. And a shift to the right, as shown in Graph 4, will
decrease price level and increase output. 
Graph 4
Long-Run Equilibrium
The equilibrium in the long-run is shown by the
intersection of the AD curve, the SAS curve, and
the Long-Run Aggregate Supply (LAS) curve.
Since LAS represents potential output, a shift in the
AD curve will only result in a change in price
level: a shift to the right increasing price level and
a shift to the left decreasing price level. If an
economy is said to be in long-run equilibrium, then
Real GDP is at its potential output, the actual
unemployment rate will equal the natural rate of
unemployment (about 6%), and the actual price
level will equal the anticipated price level. 
Aggregate Demand and Supply – Mind Map
Conclusions
 Shift in aggregate demand affects output
only in the short run and has no effect in the long run
 Shifts in aggregate demand affects only price level
in the long run
 Shift in short run aggregate supply affects output and
price only in the short run and has no effect in the
long run
 The economy has a self-correcting mechanism
 The pace of self-correction may justify policy
intervention.