AS economics : AD & AS 1

Topic 11 : Aggregate Demand and Aggregate

Supply
Aggregate demand (AD)
Total spending on an economy's goods and services at a given price level in a given time period.
Aggregate demand means total demand

AD = C + I + G + (X - M)

Components of AD

1. Consumption(C)
consists of spending by households on goods and services to satisfy current wants.
Consumption increases if:
● Disposable income increases
● Wealth increases
● Income tax decreases - disposable income increases
● If income becomes more equally distributed, rich people lose income they are unlikely to cut
back on their spending significantly, while people on low incomes who gain more income will
spend most of the extra.
● When people become more optimistic that their future jobs are secure and that their incomes will
rise, they are likely to increase their spending.
● Range of goods is more
● Interest rate is low : return from savings will be reduced, buying goods on credit will be cheaper
and households that have borrowed before to buy a house, for example, will have more money to
spend. If it becomes easier to obtain loans, total spending is likely to increase.
● Availability of credit increases

2. Investment
spending by private sector firms on capital goods. Investment increases if :
● Interest rate is low
● Consumer demand rises - firm will buy more capital to expand their capacity
 AS economics : AD & AS 2

● Advances in technology will raise productivity of capital goods so investment will increase
● Cost of capital decreases
● Increase in subsidies , Increase in profits, Political stability
● Business expectation is high
● Cut in corporation tax (tax on firm’s profits)

3. Government spending
covers government spending on goods and services. Government spending is high if:
● There is a spending on merit goods eg education, healthcare and public goods eg defence
● Social objectives: to reduce poverty
● Govt spending is high in Recession and low in boom
● Before elections
● Higher tax revenue
● Pressure to spend more on elderly eg healthcare

4. Net Exports (X-M)

Net expo = Exports - imports. Net exports increases:
● Increase in foreign income (exports rise)
● Domestic income falls (imports fall)
● Quality of exports improves , Tariffs on exports fall, tariff on imports rises
● Exchange rate: currency depreciation, imports expensive and exports cheaper which will increase
exports

AD = Consumption +Investment +Government spending + Net exports

Shape of the AD curve (downward sloping)

 AS economics : AD & AS 3

● Rise in the price level will cause a

contraction in aggregate demand

● Fall in the price level will result in an

extension in aggregate demand.

Reasons why AD curve is downward sloping:

1. The wealth effect

Rise in the price level will reduce the amount of goods and services that people's wealth can buy.

2. The international effect

Rise in the price level will reduce demand for net exports as exports will become less price competitive
while imports will become more price competitive.

3. The interest rate effect

A rise in the price level will increase demand for money to pay the higher prices. This will increase the
interest rate. A higher interest rate will reduce consumption and investment.

Causes of a shift in the AD curve

If any component of AD changes, AD will shift. Increase in aggregate demand include:
● consumer expenditure - a rise in consumer confidence, a cut in income tax, an increase in
wealth, a rise in the money supply, an increase in population
● investment - a rise in business confidence, a cut in corporate tax, advances in technology
● government spending - a desire to stimulate economic activity, a desire to win political support
● net exports - a fall in the exchange rate, a rise in the quality of domestically produced products,
an increase in incomes abroad.
 AS economics : AD & AS 4

Aggregate supply (AS)

Total output (real GDP) that producers in an economy are willing and able to supply at a given price level
in a given time period.

Short-run aggregate supply (SRAS)

Total output of an economy that will be supplied when there has not been enough time for the prices of
factors of production to change.

SRAS is an upward sloping curve

As the price rises, producers are willing and able to supply more goods and services.
 AS economics : AD & AS 5

Reasons upward sloping supply curve

1. The profit effect

As the price level increases (assuming price of factors of production do not change). Profit increases
so supply increases.

2. The cost effect

Average costs rise as output increases. To cover extra costs involved in producing a higher output,
producers increase prices.

3. The misinterpretation effect

Producers may confuse changes in the price level with changes in relative [Link] may think that a
rise in the price indicates that their own product is becoming more popular so they will produce more.

Shifts in SRAS

1. A change in the price of factors of production

A rise in wage rates, not matched by an increase in labour productivity, and raw material costs will cause
a decrease in SRAS, shifting the curve to the left.

2. Change in taxes on firms

A reduction in corporation tax or indirect taxes will increase SRAS.

3. Change in factor productivity/quality of resources:

A rise in labour productivity and/or capital productivity will cause an increase in aggregate supply both in
the short and long run.

4. A change in the quantity of resources

In the short run the supply of inputs may be influenced by supply side shocks including natural
disasters that have a significant impact on productive potential in the long run.
Supply side shocks : large and unexpected changes in SRAS

SRAS will shift to the left if :

● Cost of production increases
● Taxes increases, Productivity decreases
 AS economics : AD & AS 6

● Quantity of resources decreases

Long-run aggregate supply (LRAS)

Total output of a country supplied in the period when prices of factors of production have fully adjusted
The LRAS curve shows the relationship between real GDP and changes in the price level.

The shape of the long-run aggregate supply curve

LRAS curve shows the relationship between real GDP and changes in the price level when there has
been time for input prices to adjust to changes in aggregate demand.

There are two types of long-run aggregative supply curves.

1. The Keynesian LRAS
2. The Classical LRAS

The Keynesian LRAS

Keynesians: economist John Maynard Keynes- believe that government intervention is needed to
achieve full employment.
 AS economics : AD & AS 7

Perfectly elastic (Excess capacity)

● From 0 to Y1: output can be raised without increasing the price level.
● When output and employment are low, firms can attract more resources without raising their
[Link] output can be produced without an increase in costs of production and the price
level, [Link] is time for input prices to change but, due to the low level of aggregate demand,
they do not. When unemployment is high, the offer of a job may be sufficient to attract new
workers.

Upward sloping (inelastic)

● As output rises from Y1 to Yf, there will be shortages of inputs so cost of production will increase
(wages, raw material prices and the price of capital equipment). Prices will increase

Perfectly inelastic (full employment)

● Yf: full employment output (potential output), the economy is producing maximum output it can
make with the existing resources.
● In the long run, an economy can operate at any level of output and not necessarily at full
capacity.

The Classical LRAS

New classical economists think that the economy will move towards full employment without
government intervention.
 AS economics : AD & AS 8

Shifts in the LRAS curve

increase/decrease in the quantity or quantity of
resources (factors of production )in the long run.

Causes of an increase in the quantity of resources in the long run:

● Net immigration: increases the size of the labour force if the immigrants are of working age.
● An increase in the retirement age: increases the size of the labour force. A number of countries
have raised the age at which people can receive a state pension and some of these countries
plan to raise it even further in the future as life expectancy increases.
● More women entering the labour force:
● Net investment: If gross investment (total investment) exceeds depreciation (capital goods that
have to be replaced because they have become worn out or out of date) there will be additions to
the capital stock.
● Discovery of new resources: The discovery of, for instance, new oil fields or gold mines can
increase a country's productive potential.
● Land reclamation (the creation of new land from the sea: For instance, in recent years, Dubai
has added considerably to its land area by reclaiming land on which it has built apartments,
hotels, marinas, theme parks and beaches
 AS economics : AD & AS 9

Causes of an increase in the quality of resources in the long run:

● improved education and training -increase the skills of workers and so raise labour productivity
● advances in technology - reduces costs of production and increase productive capacity.
● Productivity

Macroeconomic equilibrium
Macroeconomic equilibrium: the output and price level achieved where AD equals AS.

Increase in AD when economy is close to full capacity

 AS economics : AD & AS 10

There is a significant rise in the price level (demand pull inflation)

Increase in AD with spare capacity

increase in AD causes a bigger percentage increase in real GDP and a smaller increase in price level.