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Aggregate Demand and

Supply
Copyright 2005 Biz/ed
http://www.bized.ac.uk
Aggregate Demand and Supply
Aggregate Demand (AD)
Aggregate Demand
The sum of all expenditure in the economy over a
period of time
Macro concept WHOLE economy

Formula:
AD = C+I+G+(X-M)
C= Consumption Spending
I = Investment Spending
G = Government Spending
(X-M) = difference between spending on
imports and receipts from exports (Balance of
Payments)
Aggregate Demand Curve

Shows the overall level of spending at
different price levels
Note Inflation used for the vertical
axis follows from new thinking on the
derivation of AD curves from the likes of
David Romer @ University of California
Assumes Central Banks do not target
the money supply but short term
interest rates

Why does it slope down from left to right?
Assume Bank of England sets short term interest
rates
Assume a rise in the price level will be met by a
rise in interest rates
Any increase in interest rates will raise the cost of
borrowing:
Consumption spending will fall
Investment will fall
International competitiveness will decrease exports fall,
imports rise
Therefore a rise in the price level leads to lower

levels of aggregate demand

The AD diagram:
Inflation on the vertical axis
assume an initial target rate of
2.0% (as measured by the HICP or
CPI)
Real GDP or Real National Income
or Real Output on the vertical axis
(shown by the initial Y)

Inflation
Thea lower
This
At
higher
level of
level
rate
output
of
of
At an
level
will
inflation
National
be inflation
associated
(3.0%)
Income
of 2%,
the
ADrates
with
rising
requires
ainterest
particular
fewer
units
curve
gives
level
mean
of
labour
ofthat
C,aIlevel
and
of output
of Y1 rises
(X-M)
unemployment
all have
which
negative
to
7% we
shown
effects
will call
by on
UU=
= 5%
AD
7%
NY falls to Y2
3.0%
2.0%
AD
Y2
U = 7%
Y1
U = 5%
Real National Income

Shifts in the Aggregate Demand

This
cause
Shiftswould
in AD will
be a
Curve
Any
exogenous
Inflation
caused
changes in
rise in by
national
factor
causing
factors
C,C,
I,
incomeaffecting
(economic
andG(X-M)
IG
or
toand
rise,
or
growth)
lead
(exogenous
factors)
a
surplus
to trade
a fall in
e.g. increasing
unemployment
causes
a rates
shift (U
to
income tax
=
2%)
(and
the
right
in vice
AD
affect
consumption
versa)
2.0%
AD2
AD
Y1
U = 5%
Y2
U = 2%

Consumption Expenditure
Exogenous factors affecting consumption:
Tax rates
Incomes short term and expected income over
lifetime
Wage increases
Credit
Interest rates
Wealth
Property
Shares
Savings
Bonds
Investment Expenditure
Spending on:
Machinery
Equipment
Buildings
Infrastructure
Influenced by:
Expected rates of return

Interest rates
Expectations of future sales
Expectations of future inflation rates
Government Spending
Defence
Health
Social Welfare
Education
Foreign Aid
Regions
Industry
Law and Order
Import Spending (negative)

Goods and services bought from abroad
represents an outflow of funds from the UK
(reduces AD)
Export Earnings (Positive)

Goods and services sold abroad represents a
flow of funds into the UK (raises AD)
Key Variables
Macroeconomic Policy
Fiscal Policy
Government Income (taxes and borrowing)
Government Spending
Monetary Policy
Interest Rates (Bank of England)
Aggregate Supply (AS)
Capacity of the Economy
Costs of Production
Technology
Education and Training
Incentives
Tax regime
Capital stock
Productivity
Labour Market
Aggregate Supply
Inflation
AS
Economy starts to overheat
Y1
Yf
Between Y1 and Yf,

The
shape
the
AS
Yf
Anrepresents
output
level
Full
of
Y1
increases
in of
capacity
are
This
shape
curve
important
Employment
wouldissuggest
thein
possible
but
theOutput
nearer
reflects
the
economy
to Yf,
determining
the
at
economy
this
point
isagets
working
the
morefull
problems
are to
outcome
in
the
economy
below
iscapacity
working
Keynesian
view
experienced
with
economy
full
andcapacity
there would
and be
of
the
AS
curve.
acquiring
resources
to
cannot
widespread
produce
any
boost production
more.
unemployment.
(production
bottlenecks)
especially labour skills
shortages.

Inflation
Aggregate Supply
AS1
AS2
Increases in
capacity can
occur as a result
of a shift in AS
(akin to a shift
outwards of the
Production
Possibility
Frontier) (PPF)
Yf1
Yf2

Aggregate Supply
Inflation
SRAS 1
SRAS
SRAS 2
SRAS
assumes
Short run
costs
suchsupply
as
aggregate
(SRAS)
overall assumes
wage
firms
only able to
rate remain
increase
output at
fixed, changes
in
higher costs (e.g.
such costs cause
overtime
a
shift in the
payments)
SRAS
therebycurve
pushing
(exogenous
up price level
shocks input
costs)

Aggregate Supply
Inflation
LRAS
Yf
This is because they

Classical
believe that in the
economists
long run, there will be
no
unemployment
of
assume
the long
resources because
run aggregate
markets will clear,
supply
curve
thus whatever
the
rate of inflation,
firms
(LRAS)
is vertical
will
supply the
(perfectly
maximum capacity of
inelastic).
the economy.

Aggregate Supply
Inflation
AS
For our analysis,
we will assume
the AS curve
looks like this!

Putting AD and AS together

AS
Inflation
2.5%
2.0%
A shift in the AD
In
thisto
situation,
curve
AD1 as athe
economy
bein
result of awould
change
operating
at the
less
any or all of
than
capacity,
there
factors
affecting
AD
would
be
would increase
unemployment
growth, reduce and
the
economy might
unemployment
but at
be
growing
only
a cost of higher
slowly.
inflation (a trade-off)
AD 1
AD
Y1
Y2
Yf

Putting AD and AS together

AS
Inflation
3.5%
Further increases in
AD would lead to
successively
smaller increases in
growth and
employment at the
cost of ever higher
inflation.
AD2
2.5%
2.0%
AD1
AD
Y1
Y2
Yf
Y3

Sustained Growth
Inflation
AS
AS1
Sustained
growth (not to
be confused with
sustainable
economic
growth) occurs
when AS and AD
rise at similar
rates national
income can rise
without effects
on inflation
2.0%
AD2
AD
Y1
Y2


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http://www.bized.ac.

Aggregate Demand and

Copyright 2005 Biz/ed

Aggregate Demand and Supply

Copyright 2005 Biz/ed

Aggregate Demand (AD)

Copyright 2005 Biz/ed

Macro concept WHOLE economy

Copyright 2005 Biz/ed

Aggregate Demand Curve

Aggregate Demand Curve

Therefore a rise in the price level leads to lower

Copyright 2005 Biz/ed

Aggregate Demand Curve

Aggregate Demand Curve

Real National Income

Shifts in the Aggregate Demand

Real National Income

Expected rates of return

Copyright 2005 Biz/ed

Copyright 2005 Biz/ed

Import Spending (negative)

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Export Earnings (Positive)

Copyright 2005 Biz/ed

Copyright 2005 Biz/ed

Copyright 2005 Biz/ed

Copyright 2005 Biz/ed

Copyright 2005 Biz/ed

Aggregate Supply (AS)

Copyright 2005 Biz/ed

Capacity of the Economy

Economy starts to overheat

Between Y1 and Yf,

Real National Income

Real National Income

Real National Income

This is because they

Real National Income

Real National Income

Putting AD and AS together

Real National Income

Putting AD and AS together

Real National Income

Real National Income

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