Aggregate Demand

• Aggregate demand is the total demand in an economy for all the goods and services produced.

• The aggregate demand schedule is a schedule relating the total demand for all the goods and services produced in an economy to the price level.

• The aggregate demand curve slopes down.

Aggregate Demand

AD

P

Y

P2

Y1 Y2

P1

Note that at P2, the higher price level,aggregate demand equals Y1, but at P1,the lower price level, aggregate demandequals Y2.

0

Aggregate Demand

• Aggregate demand slopes down because:– As the price level increases, the purchasing power

of real wealth decreases, resulting in less spending and lower Y.

– As the price level increases, the real money supply decreases, pushing up interest rates.

– As the domestic price level increases, foreigners buy less of our goods and services.

Aggregate Demand

AE2(P1)

AE1(P2)

AE

Y

Y

P1

P2

PY1 Y2

Y1 Y2

A

B

AS

AD

We begin at point A where incomeis Y1 and the price level is P2.

Y1 and P2 comprise one point onthe aggregate demand curve, AD.

We let the price level fall to P1. Atthe lower price level, purchasing power increases, causing aggregateexpenditures to shift up from AE1 toAE2.

At P1, equilibrium income is Y2.

Y2 and P1 comprise another point on aggregate demand curve, AD.

A

B

0

0

Changes in Aggregate Demand

• Aggregate demand increases when people want to buy more goods and services and decreases when people want to buy less.

• There are two types of aggregate demand change that can occur– A change in aggregate demand caused by a

change in the price level.– A changes in aggregate demand caused by events

not related to a change in the price level.

Moving along the AD Curve

• Changes in aggregate demand caused by a change in the price level are shown by a movement along the aggregate demand schedule.– Increases in the price level decrease aggregate demand– Decreases in the price level increase aggregate demand.

Moving along the AD Curve

AD

P

Y

P2

Y1 Y2

P1

Note that at P2, the higher price level,aggregate demand equals Y1, but as theprice level falls to P1, the lower price level, aggregate demand rises to Y2.

0

Shifting the AD Curve

• A change in any of the variables in the AE/AS model except the price level shifts AD.

• Examples:– An increase or decrease in investment– An increase or decrease in consumption– An increase or decrease in taxes– An increase or decrease in government spending.– An increase or decrease in the money supply

Shifting the AD Curve

Y

P

AD1

AD2

Y1 Y2

P1

Increases in AD are shown by shiftingthe AD curve from AD1 to AD2. Notethat at the price level P1, aggregatedemand on AD2 is greater than on AD1.

Decreases in AD are shown by shifting the AD curve from AD2 to AD1. Notethat at the price level P1, aggregatedemand on AD1 is less than on AD2.0

Shifting Aggregate Demand

AE2(P1)

AE1(P1)

AE

Y

Y

P1

PY1 Y2

Y1 Y2

AS

AD1

AD2

An increase in spending that is NOTcaused by a change in the price level causes the aggregate demandcurve to shift.

Increases in spending shift aggregateexpenditures from AE1 to AE2. Increases in spending shift aggregate demand from AD1 to AD2.

Decreases in spending shift aggregateexpenditures from AE2 to AE1. Decreases in spending shift aggregatedemand from AD2 to AD1.

A

A

B

B

0

0

Aggregate Demand and the Multiplier

AE2(P1)

AE1(P1)

AE

Y

Y

P1

PY1 Y2

Y1 Y2

A

B

AS

AD1

D

AD2

C

When aggregate expenditures rise,income increases by more than theincrease in expenditures.

A change in spending that is notcaused by a change in the price levelshifts the aggregate demand curve.

Note that the price level is P1 at bothY1 and Y2.

The distance Y1Y2 = CD reflects theimpact of the multiplier effect in the aggregate demand model.

0

0

Practice

• How does a lower price level change aggregate demand? Is this a shift in AD or a movement along the AD schedule?

• What will cause the AD schedule to shift up? List three real world examples of such an AD shift.

• What will cause the AD schedule to shift down? List three real world examples of such an AD shift.

Aggregate Supply

• Aggregate supply is the total quantity of goods and services produced in an economy.

• The aggregate supply schedule is a schedule relating the total supply of all the goods and services produced in an economy to the price level.

Short-Run Aggregate Supply Curve

• The short run aggregate supply curve shows how aggregate supply increases as the price level rises but factor costs do not change.– The short run is defined as that period of time over

which nominal factor costs do not change.• Nominal factor costs include wages, interest paid on

loans, and the cost of plant and equipment.

• The short run aggregate supply curve may be flat or upward sloping.

Short Run Aggregate Supply Curve

Y

P AS

Aggregate supply is drawn as a horizontalline over the range of output that is farbelow the economy’s full capacity. Over this range, 0Y1, there is no shortage of inputs and the economy can expand without a price level increase.

As the economy approaches full capacity,Yfe, employers have difficulty finding skilled workers and must hire lessproductive employees. The price levelrises due to diminishing returns. This is reflected in an upward sloping AS curve.

At Yfe, we have full employment of all resources. Output is fixed.

Y1 Yfe0

Aggregate Supply and the Price Level

Y

P AS

Yfe0

A fall in the price level from P2 to P1

causes a decrease in profits, givenfixed resource costs.

Lower profits are an incentive for lowerlevels of production and output.

A rise in the price level from P1 to P2 results in an increase in profits, givenfixed resource costs.

Higher profits are an incentive forhigher levels of production and output.

P2

P1

Y1

Shifting the Aggregate Supply Curve

Y

PAS1

0

AS2

AS3

A shift in the aggregate supply curverepresents any change in aggregatesupply that is not caused by a changein the price level.

Shifts in aggregate supply are causedby events such as a change in theoverall level of resource productivityand changes in resource availability.Tax policy also can affect AS.

Increases in AS are shown by a shiftof the curve to the right.

Decreases in AS are shown by a shiftof the curve to the left.

Practice

• How does a lower price level change aggregate supply? Is this a shift in AS or a movement along the AS schedule?

• What will cause the AS schedule to shift up? List three real world examples of such an AS shift.

• What will cause the AS schedule to shift down? List three real world examples of such an AS shift.

Equilibrium in the AD/AS Model

• Equilibrium in the AD/AS model occurs where aggregate demand just equals aggregate supply.

• It is a stable equilibrium. – If AD>AS, the price level rises and Y falls– If AD<AS, the price level falls and Y rises.

Equilibrium in the AD/AS Model

Y

P AS

Y1 Yfe0

AD

P1 E

Equilibrium occurs at the point E where theprice level is P1 and output is Y1.

At this point, aggregate demand is justequal to aggregate supply. All the goodsand services produced are demanded bythe members of the economy.

The equilibrium is stable. If the economy isnot at equilibrium, there are forces that push AD and AS towards equilibrium.

Equilibrium in the AD/AS Model

Y

P AS

Ye 0

AD

Pe E

Equilibrium occurs at point E, where theprice level is Pe and output is Ye.

At price levels above Pe, AS >AD by theamount AB. Firms will not be able to sell all the goods they produce, resultingin an increase in inventories and a decline in both production and the price level.

At price levels below Pe, AD>AS by theamount CD. Firms will not be able to meet demand with current production levels, resulting in a decline in inventories and a risein both production and the price level.C

B

D

ADeflationary Gap

Inflationary Gap

Changes in Aggregate Demand

Y

P AS

Y1 Y2 0

AD1

P1

BA

AD2

P2

Increases in aggregate demand shift the AD curve to the right. Both income andthe price level rise.

Decreases in aggregate demand shift theAD curve to the left. Both income andthe price level fall.

Changes in Aggregate Supply

Y

P

AS2

Y1 Y20

AD

P1

P2

B

A

Increases in aggregate supply shift the AS curve to the right. Income rises andthe price level falls. We move frompoint A to point B.

Decreases in aggregate supply shift theAS curve to the left. Income fallsand the price level rises.. We move frompoint B to point A.

AS1

Practice

• Assume the economy is at full employment and increase AD. What happens to P and Y?

• Now assume the economy is at full employment and increase AS. What happens to P and Y?

• If you were in charge of increasing Y while avoiding inflation, which curve would you want to shift? How would you do it?

Practice• Explain and show graphically what will happen to

P and Y under the following circumstances: (Assume the economy is neither in a recession or at full employment)– Taxes on consumers fall– Taxes on businesses fall– Interest rates rise– Business optimism falls– Oil prices double– People begin to save more at every rate of interest

Practice

• In the Great Depression, the price level and GDP fell. What shift or combination of shifts in AD and AS would best describe the Great Depression?

• Currently, we are in an economic expansion. Is our expansion caused by changes in AD or AS? Explain your answer.