Chapter 8

Aggregate Demand and

Aggregate Supply

Issues In Economics Today, 4e

Guell
McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights rese
 Chapter Outline

• Aggregate Demand
• Aggregate Supply
• Shifts in Aggregate Demand and
Aggregate Supply
• Causes of Inflation
• Supply-Side Economics
• How the Government can Influence (but
probably not control) the economy

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You Are Here

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 Aggregate Demand
• Aggregate Demand: the amounts of
real domestic output which domestic
consumers, businesses,
governments, and foreign buyers
collectively will desire to purchase at
each possible price level

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 Figure 1 Aggregate Demand

PI

AD

RGDP
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 Why Aggregate Demand
is Downward Sloping

• Real Balances Effect

– Because higher prices reduce real spending
power, prices and output are negatively related.
• Foreign Purchases Effect
– When domestic prices are high, we will export
less to foreign buyers and we will import more
from foreign producers. Therefore higher prices
leads to less domestic output.
• Interest Rate Effect
– higher prices lead to inflation which leads to less
borrowing and a lowering of RGDP

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 Aggregate Supply

• Aggregate Supply: the level of real

domestic output available at each
possible price level

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 Figure 2 The Aggregate Supply Curve
AS
PI
Classical
Range

Intermediate
Range

Keynesian Range

RGDP
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 The Ranges of AS

• Keynesian Range
– Large amounts of unemployment make it so that
increases in aggregate demand have no affect on
wages or prices.
• Classical Range
– Full employment makes it so that increases in
aggregate demand only increase wages or prices.
• Intermediate Range
– Some sectors of the economy reach full
employment more quickly than others.

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 Variables that Shift Aggregate Demand

• Taxes
• Interest Rates
• Confidence
• Strength of the Dollar
• Government Spending

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 Determinants of AD
Variable GDP Effect of an Effect of a
Component increase on AD decrease on AD
C,I,G,X
Taxes C,I Decrease so Increase so
AD <= AD =>
Interest Rates C,I Decrease so Increase so
AD <= AD =>
Confidence C,I Increase so Decrease so
AD => AD <=
Strength of the X (exports- Decrease so Increase so
Dollar imports) AD <= AD =>
Government G Increase so Decrease so
Spending AD => AD <=

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 Figure 3 AD Increases

PI AS

PI’

PI*

AD’

AD

RGDP* RGDP’ RGDP

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 Figure 4 AD Decreases

PI AS

PI*

PI’

AD

AD’

RGDP’ RGDP*
RGDP
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 Variables that Shift AS

• Input Prices
• Productivity
• Government Regulation

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 Determinants of AS

Variable Effect of an Effect of an

Increase on AS Decrease on AS

Input Prices Decrease so Increase so

AS AS
Productivity Increase so Decrease so
AS AS
Government Decrease so Increase so
Regulation AS AS

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 Figure 5 Increase in AS

PI
AS

AS’

PI*

PI’
AD

RGDP* RGDP’ RGDP

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 Figure 6 Decrease in AS

PI AS’

AS

PI’

PI*

AD

RGDP’ RGDP*
RGDP
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 Causes of Inflation

• Demand Pull Inflation: inflation caused

by an increase in aggregate demand
• Cost Push Inflation: inflation caused
by a decrease in aggregate supply

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 Government Influence:
Aggregate Demand

• Government can influence economic

activity with aggregate demand side
policies affecting:
– Taxes
– Government Spending
– Interest Rates

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 Government Influence:
Aggregate Supply

• Government can influence economic activity

with aggregate supply side policies affecting
– input costs (labor and wage)
– reducing regulation
– Increase incentives to
• Work
• Take Risks
• The actions are call Supply Side Economics

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 What You Need to Know

• Aggregate Supply
• Aggregate Demand
• Aggregate Supply Shifters
• Aggregate Demand Shifters
• Inflation

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