CHAPTER 14a

Aggregate Demand
& Aggregate Supply

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 CHAPTER OBJECTIVES
 Explain why the aggregate demand (AD) curve
INTHISLECTU
REslopes downward.
 Identify the factors that can change aggregate
demand (AD).
 Distinguish between a change in aggregate demand
(AD) & a change in quantity demanded of Real GDP.
 Explain why the short-run aggregate supply (SRAS)
curve slopes upward.
 Identify the factors that can change short-run
aggregate supply(SRAS).

CH 8 • 2
  Explain how short-run equilibrium in the economy
INTHISLECTU
REis established.
 Identify the factors that can change the price level,
Real GDP, and the unemployment rate.
 Explain the difference between the short-run
aggregate supply (SRAS) curve and the long-run
aggregate supply (LRAS) curve

CH 8 • 3
 AGGREGATE DEMAND

 The quantity demanded of all

goods & services (Real GDP) at
different price levels, ceteris
paribus.
 The aggregated demand curve
is downward-sloping,
specifying an inverse
relationship between the price
level & the quantity demanded
of Real GDP.

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 Why Does The Aggregate Demand Curve
Slope Downward?

 Real Balance Effect

 Interest Rate Effect
 International Trade Effect

CH 8 • 5
Exhibit 2 Why the Aggregate Demand Curve is Downward-
Sloping

6
Exhibit 2 Why the Aggregate Demand Curve is Downward-
Sloping (Continued)

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Exhibit 2 Why the Aggregate Demand Curve is Downward-
Sloping (Continued)

8
 1. Explain the real balance effect.

 Real balance effect: a rise (fall) in the price level

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causes purchasing power to fall (rise), which
decreases (increases) a person’s monetary wealth.
 As people become less (more) wealthy, the quantity
demanded of Real GDP falls (rises).

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Exhibit 3 A Change in the Quantity Demanded of Real GDP
versus a Change in Aggregate Demand

 A change in the quantity demanded of

Real GDP is a movement along AD
curve as a result of a change in the
price level (Example: from point A to
point B in Exhibit 3a)

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Exhibit 3 A Change in the Quantity Demanded of Real GDP
versus a Change in Aggregate Demand

 A change in aggregate demand (AD) is

a shift in AD curve (Example: from
AD1 to AD2).

 A change in consumption (C),

investment (I), government
purchases (G) & net export (X-M) will
shift the AD curve (refer Exhibit 4).

11
Exhibit 3 A Change in the Quantity Demanded of Real GDP
versus a Change in Aggregate Demand

12
Exhibit 4 Changes in Aggregate Demand

13
Exhibit 5 Factors That Change Aggregate Demand

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 Consumption(C)
(i) Wealth (W)
W   C  AD 
W   C  AD 

(ii) Expectations about future prices (P) & Income (Y)

Expect higher future P & Y  C  AD 
Expect lower future P & Y  C  AD 

(iii) Interest rate (r)

r   monthly payment  C  AD 
r   monthly payment  C  AD 

(iv) Income tax (IT)

IT   C  AD
IT   C  AD 
15
 Investment (I)
(i) Interest rate (r)
r   project implementation costs  I  AD 
r   project implementation costs  I  AD 

(ii) Expectations about future sales

Businesses become optimistic about future sales  I  AD 
Businesses become pessimistic about future sales  I  AD 

(iii) Business tax (BT)

BT   I  AD 
BT   I  AD 

16
 Net Exports (X-M)
(i) Foreign Real National Income (FRNI)
FRNI   Malaysian exports  Malaysian net exports  AD 
FRNI   Malaysian exports  Malaysian net exports  AD 

(ii) Exchange Rate

The price of one currency in terms of another currency.

 Appreciation  An  in the value of one currency relative

to other currencies
RM appreciates  Malaysian exports  Malaysian imports
 Malaysian net exports  AD .

 Depreciation  A  in the value of one currency relative

to other currencies.
RM Depreciates Malaysian exports  Malaysian imports
 Malaysian net exports  AD  17
 2. Explain what happens to the AD curve if the
dollar appreciates relative to other currencies.
 If the dollar appreciates, it takes more foreign currency
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to buy a dollar & fewer dollars to buy foreign currency.
 This makes U.S. goods (denominated in dollars) more
expensive for foreigners & foreign goods cheaper for
Americans.
 In turn, foreigners buy fewer U.S. exports, & Americans
buy more foreign imports. As exports fall & imports
rise, net exports fall.
 If net exports fall, total expenditures fall, ceteris
paribus. (the AD curve shifts to the left).

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 SHORT-RUN AGGREGATE SUPPLY (SRAS)

 SRAS - shows the quantity

supplied of all goods & services
(Real GDP) at different price
levels, ceteris paribus.
 SRAS curve is upward sloping:
 as the price level , firms 
the quantity supplied of
goods & services
 as the price level , firms 
the quantity supplied of
goods & services

CH 8 • 19
 Why SRAS Curve is Upward Sloping
 The upward slope of the curve indicates that producers are
willing and able to sell more units of their goods as prices 
& that their willingness (and, perhaps, ability) to sell  as
prices .
 There are four reasons economists give for why the SRAS
curve is upward sloping:
i. Sticky Wages
ii. Sticky Prices
iii. Worker Misperceptions

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(i) Sticky Wages
 Some economists believe that wages are sticky or
inflexible.
 This may be because wages are “locked in” for a few
years due to labour contracts entered into by
workers & management.
 For example, management & labour may agree to
lock in wages for the next one to three years.
 The quantity supplied of labour is directly related to
the real wage:
 Real wage  quantity supplied of labour 

Real wage = nominal wage/price level

CH 9 • 21
For example:
 Nominal wage = RM30, Price index = 1.50
 Real wage = 30/1.50
= RM20
 If Nominal wage = RM30, Price index  to 1.25
 Real wage = 30/1.25
= RM24

Conclusion
 If nominal wages are sticky, then
 P  real wage  labour costs  output (Real GDP) 
 P  real wage  labour costs  output (Real GDP) 

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(ii) Sticky Prices
 Economists reason that some prices are sticky
because there are costs to changing prices called
menu costs.
 Menu costs usually include such things as the cost of
printing a new catalog with new prices (for a catalog
company), the cost of printing a new menu (for a
restaurant) & the costs of changing the price tags
(for many firms).
 For example: Suppose firms have set their prices
based on the price level in the economy remaining
constant & then the demand for goods in the
economy .

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 Some firms reduce their prices accordingly, but many
may not because of
 menu costs
 not sure whether the decline in demand in the
economy is temporary or permanent.
 Firms which have not lowered prices in the face of
falling demand will not be able to sell the same level of
output they did at the higher demand. Their sales will
 which will cause them to  the output they produce.

Conclusion
 If some prices are sticky: P  output (Real GDP) 

CH 9 • 24
(iii) Worker Misperceptions

 If workers misperceive real wage changes, then a 

in the price level will bring about a  in output,
ceteris paribus, which is illustrative of an upward-
sloping SRAS curve.
 In response to (the misperceived) falling real wage,
workers may  the quantity of labor they are willing
to supply.
 With fewer workers (resources), firms will end up
producing less (Real GDP ).

CH 8 • 25
 3. Discuss the details of the worker misperceptions
explanation for the upward-sloping SRAS curve.
 Workers initially misperceive the change in their real wage
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due to a change in the price level.
 For example, suppose the nominal wage is $30 & the price
level is 1.50; it follows that the real wage is $20.
 Now suppose the nominal wage  to $25 & the price level
 to 1.10. The real wage is now $22.72.
 But suppose workers misperceive the decline in the price
level and mistakenly believe it has  to 1.40. They will now
perceive their real wage as $17.85 ($25/1.40).
(continued)

CH 8 • 26
  In other words, they will misperceive their real
wage as falling when it has actually increased.
 How will workers react if they believe their real
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wage has fallen?
 They will cut back on the quantity supplied of labor,
which will end up reducing output (or Real GDP).
 This process is consistent with an upward-sloping
SRAS curve: A decline in the price level leads to a
reduction in output.

CH 8 • 27
 A Change in the Quantity Supply of Real
GDP VS a Change in SRAS

 A change in the quantity supply of Real GDP is a

movement along SRAS curve as a result of a change in
the price level.
 A change in short-run aggregate supply (SRAS) is a shift in
SRAS curve.
 There are four factors that can shift the SRAS curve:
i. Wage rates
ii. Price of nonlabour inputs
iii. Productivity
iv. Supply-shocks
(refer Exhibit 7)
CH 8 • 28
 Changes in SRAS (Shifts in the SRAS Curve)

 Wage rates
W  production costs  profit  SRAS  (assumption: P constant)
W  production costs  profit  SRAS  (assumption: P constant)
(Refer Exhibit 7)

 Price of nonlabour inputs (PNI)

PNI (example: oil)  production costs  profit  SRAS 
PNI (example: oil)  production costs  profit  SRAS 

CH 8 • 29
Exhibit 7 Wage Rates and a Shift in the Short-Run
Aggregate Supply Curve

30
 Changes in SRAS (Shifts in the SRAS Curve)

Productivity
 is the output produced per unit of input employed over some
period of time. Although various inputs can become more
productive, let’s consider the labor input.
 An  in labor productivity means businesses will produce more
output with the same amount of labor(SRAS curve shift rightward)
A  in labor productivity means businesses will produce less
output with the same amount of labor (SRAS curve shift leftward).

 A host of factors lead to  labor productivity, including a more

educated labor force, a larger stock of capital goods &
technological advancements.

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Changes in SRAS (Shifts in the SRAS Curve)

Supply Shocks
 Major natural or institutional changes that affect
aggregate supply are referred to as supply shocks.
 Supply shocks are of two varieties: adverse &
beneficial supply shocks.
 Examples of adverse supply shocks are droughts,
wars& an oil embargo (shift the SRAS curve to the
left)
 Examples of beneficial supply shocks include a major
new energy discovery or exceptionally good weather.
(shift the SRAS curve to the right).

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Exhibit 8 Changes in Short-Run Aggregate Supply

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Exhibit 9 Short-Run Equilibrium

36
 Short-run Equilibrium

 At P1, Qs (Q2) > Qd (Q1)  price level  & firms  output.

 At P2, Qd (Q2) > Qs (Q1)  price level  & firms  output.
 Short-run equilibrium occurs at point E, (Qd = Qs).

 Exhibit 10 shows the effects of shifting the AD & SRAS

curves.

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Exhibit 10 Changes in Short-Run Equilibrium in the
Economy

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The Unemployment Rate in the Short-Run
 Real GDP & unemployment are inversely related:

 Real GDP  unemployment 

 because more workers are needed to produce the
additional output.
 Real GDP  unemployment 
 because fewer workers are needed to produce
the less output.

 Ceteris paribus is an important assumption here.

If the labor force participation rate  at the same
time that Real GDP was , the result could be an 
in unemployment.
CH 8 • 39
Price, Real GDP & Unemployment Rate in
the Short-Run
 Exhibit 11 pulls together the interaction of AD &
SRAS to determine the effect on the price level (P),
Real GDP (Q), and the unemployment rate (U).

 For example:
 An  in wealth will shift the AD curve to the right,
causing the price level (P) to  , Real GDP to  &
unemployment (U) to  .
 An adverse supply shock will shift the SRAS curve
left, causing the price level (P) to  , Real GDP to
 & unemployment (U) to .

CH 8 • 40
Exhibit 11
How a Factor
Affects the Price
Level, Real GDP,
and the
Unemployment
Rate in the Short
Run

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Exhibit 12 A Summary Exhibit of AD and SRAS

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LONG-RUN AGGREGATE SUPPLY (LRAS)

 The factors that created the upward slope to the

SRAS (sticky wages, sticky prices & worker
misperceptions) are not present in the long run.
 In the long run, the economy will always produce the
full employment Real GDP or Natural Real GDP (QN).
 The long-run aggregate supply curve (LRAS) will
therefore be vertical at this Natural Real GDP level
and the economy will produce QN, regardless of
aggregate demand (AD).

(See Exhibit 13).

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Exhibit 13 Long-Run Aggregate Supply (LRAS) Curve

44
 SHORT-RUN EQUILIBRIUM, LONG-RUN
EQUILIBRIUM & DISEQUILIBRIUM
 Short-run equilibrium
 Occurs where SRAS & AD cross.
 The quantity supplied of Real GDP (short-run) = the
quantity demand of Real GDP (at Q1)
 Long-run equilibrium
 occurs where LRAS & AD cross.
 The level of Real GDP that the economy produces in the
long-run equilibrium = Natural Real GDP (QN)
 Disequilibrium
 Situation where the economy is neither in short-run
equilibrium nor long-run equilibrium.
 Quantity supplied of Real GDP & quantity demanded of
Real GDP are not equal.
CH 8 • 45
Exhibit 14 Equilibrium States of the Economy

46
 1. What is the difference between short-run
equilibrium and long-run equilibrium?
 In long-run equilibrium, the economy is producing
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Natural Real GDP.
 In short-run equilibrium, the economy is not
producing Natural Real GDP, although the quantity
demanded of Real GDP equals the quantity supplied
of Real GDP.

CH 8 • 47
 2. Diagrammatically represent an economy
that is in neither short-run equilibrium nor
long-run equilibrium.
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 The diagram should show the price level in the

economy at P1 & Real GDP at Q1 but the intersection
of the AD curve & the SRAS curve at some point
other than (P1, Q 1).
 In addition, the LRAS curve should not be at Q 1 or at
the intersection of the AD and SRAS curves.

CH 8 • 48
Real GDP and Natural Real GDP:
Three Possibilities

 Recessionary Gap:
Real GDP < Natural Real GDP

 Inflationary Gap:
Real GDP > Natural Real GDP

 Long-Run Equilibrium:
Real GDP = Natural Real GDP