Aggregate Demand & Aggregate Supply

By: Professor Jermaine Whirl For students of East Georgia College

*Great Portions of this powerpoint are credited to 2002 Prentice Hall Publishing; Principles of Economics by Case & Fair*

The AD/AS Model

The AD/AS Model
Explains short-run fluctuations in real GDP and the Price level (inflation)

Aggregate Demand
Aggregate demand is the total demand for goods and services in the economy. 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.

Deriving the Aggregate Demand Curve

The AD curve is not a market demand curve, and it is not the sum of all market demand curves in the economy. It is a more complex concept. How are aggregate demand and aggregate expenditure related?
At every point along the aggregate demand curve, the aggregate quantity of output demanded is exactly equal to planned aggregate expenditure.

Aggregate Demand Curve

Aggregate demand falls when the price level increases because the higher price level causes the demand for money to rise, which causes the interest rate to rise. It is the higher interest rate that causes aggregate output to fall. At all points along the AD curve, both the goods market and the money market are in equilibrium.

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 AD
Changes in Governmental Policies Changes in Monetary Policy Changes in Expectations of Households and Firms

Aggregate Supply
Aggregate supply is the total supply of all goods and services in the economy. 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 Curve

The aggregate supply curve is not a market supply curve and it is not the simple sum of all the individual supply curves in the economy.
One reason is that firms do not simply respond to market-determined prices, but they actually set prices. Price-setting firms do not have individual supply curves because these firms are choosing both output and price at the same time. We can add something that does not exist!

Aggregate Supply Curve

Another reason is that when we draw a firms supply curve, we assume that input prices are constant. If the overall price level is rising, there will be an increase in at least some input prices.
The outputs of some firms are the inputs of other firms. As wage rates and other input prices rise, the firms individual supply curves are shifting, so we can not sum them to get an aggregate supply curve.

Aggregate Supply
Price Level AS

In the short run, the aggregate supply curve (the price/output response curve) has a positive slope. At low levels of aggregate output, the curve is fairly flat. As the economy approaches capacity, the curve becomes nearly vertical. At capacity, the curve is vertical.

Real GDP Y

Shifts in the Short-run AS Curve

A leftward shift of the AS curve could be caused by cost shocks. A decrease in costs, economic growth, or public policy, can cause a rightward shift of the AS curve.

Factors that shift the Aggregate Supply Curve

Factors That Shift the Aggregate Supply Curve Shifts to the Right
Increases in Aggregate Supply Lower costs lower input prices lower wage rates Economic growth more capital more labor technological change Public policy supply-side policies tax cuts deregulation Good weather

Shifts to the Left

Decreases in Aggregate Supply Higher costs higher input prices higher wage rates Stagnation Capital deterioration

Public policy waste and over-regulation inefficiency

Bad weather, natural disasters, destruction b/ wars

Equilibrium in AD/AS
Price Level

AS

P0

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

AD
Y0

Real GDP Y

Long-Run AS Curve
LRAS- is a curve that shows the relationship in the long-run between the price level and the quantity of real GDP supplied. Changes in the price level do not affect the level of aggregate supply in the long-run. Therefore it is vertical. Remember in the long run capital is not fixed. LRAS represents potential GDP (what the economy could be doing if all resources are being used efficiently, & the economy is experience full employment.

Graphical Presentation of LRAS

LRAS LRAS

Price Level

Decrease

Increase

Real GDP

The AS/AD Model Together

Shift in AD
Output can be pushed above potential GDP by higher aggregate demand. The aggregate price level also rises. Eventually, this pressure will ease, and we'll return back to potential.

Shifts in AS
When output is pushed above potential, there is upward pressure on costs. Rising costs push the shortrun AS curve to the left.

If costs ultimately increase by the same percentage as the price level, the quantity supplied will end up back at Y0.