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Chapter 8
Aggregate Demand and
Aggregate Supply
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p. 1
The Circular Flow Diagram
The circular
flow diagram
shows the
flows of
production
and aggregate
demand in the
economy.
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p. 2
Aggregate Demand
• Aggregate Demand (AD) is composed of the
sum of Consumption (C), Investment (I),
Government Expenditures (G) and net exports
(NX).
AD = C + I + G + NX
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Investment vs. Saving
• The terms “saving” and “investment” are often
used interchangeably in common usage, but
they have very different meanings in
economics.
• Saving (S) is disposable income not consumed.
It is not a component of Aggregate Demand. In
contrast, Investment (I) expands the productive
capacity of the economy.
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p. 4
The Aggregate Demand Curve and its Slope
• The AD curve
is downwardsloping
because of the
wealth effect
and the
international
trade effect.
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p. 5
The Wealth Effect
• The wealth effect is a situation in which a price
level increase reduces the purchasing power of
financial assets, which leads to a reduction in a
person’s wealth and, hence, consumption.
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p. 6
The International Trade Effect
• The international trade effect occurs when, for
a fixed nominal exchange rate, an increase in
the domestic price level leads to an
appreciation of the domestic currency, which
reduces net exports.
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Movements Along the Aggregate
Demand Curve
• Any factor that
changes the
price level
leads to a
movement
along the AD
curve.
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Shift of the Aggregate Demand Curve
• A change in any
factor other than a
change in the price
level that changes
the level of
Aggregate Demand
results in a shift of
the Aggregate
Demand curve.
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p. 9
Factors that Shift the AD Curve
• Factors that shift the AD curve include:
– A change in consumption (perhaps due to a change
in income taxes)
– A change in investment
– A change in government expenditures
– A change in net exports (perhaps induced by a
change in exchange rates or foreign incomes)
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p. 10
Aggregate Supply
The Aggregate
Supply curve graphs
the total amount of
output (Y) produced
at various price
levels. The curve
slopes upward in the
short run because
input costs are
assumed fixed.
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p. 11
Long-run Aggregate Supply
The long run is a
period of time in
which all prices and
costs are variable. An
increase in the price
level will have no
impact on long-run
Aggregate Supply
because all firms'
costs will rise
proportionately with
the price level.
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p. 12
Movements Along the Short-Run
Aggregate Supply curve
• When the price level
changes but resource
costs are held
constant, there is a
movement along the
Aggregate Supply
curve
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p. 13
Shifts of the Short-Run Aggregate
Supply curve
• A change in any
factor other than a
change in the price
level that changes the
level of Aggregate
Supply shifts the
Aggregate Supply
curve.
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p. 14
Factors that shift the AS Curve
• Three nonprice factors that shift the Aggregate
Supply curve are
– changes in resource costs: an increase (decrease) in
resource costs shifts the AS curve to the left (right).
– An advance in technology shifts the AS curve to
the right.
– An increase (decrease) in inflation expectations
shifts the AS curve to the left (right).
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p. 15
Short-Run Equilibrium
• A short-run
equilibrium
occurs where
the AD and
AS curves
intersect at
point E.
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p. 16
Long-Run Equilibrium
The long-run
equilibrium can only
occur where the
Aggregate Demand
curve crosses the
vertical Long Run
Aggregate Supply
curve because in the
long run, equilibrium
output must equal
potential output.
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p. 17
Disequilibrium: AD exceeds AS
• If AD > AS, firms’
inventories
unexpectedly
deplete, leading
firms to ramp up
prices and
production,
helping to restore
equilibrium.
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p. 18
Disequilibrium: AS exceeds AD
• If AS > AD, firms’
inventories
unexpectedly
accumulate,
leading firms to
reduce prices and
production,
helping to restore
equilibrium.
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p. 19
Aggregate Demand, Aggregate Supply,
and the Business Cycle
• “Typical"
business
cycles are
generated by
fluctuations in
Aggregate
Demand.
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Aggregate Demand, Aggregate Supply,
and the Business Cycle
• However,
business cycles
can also result
from fluctuations
in Aggregate
Supply (e.g. oil
shocks), which
may lead to
stagflation.
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p. 21
Paradox of Thrift
• The Paradox of Thrift states that an increase in the
desire of the economy as a whole to save more may
lead to a decrease in output and employment, thus
thwarting the attempt to save more.
• Is it good for the economy to save income or to
consume?
• The U.S. in the post-war era had much higher
consumption rates (and lower saving rates) than in
Japan, yet its economy grew more slowly. Why?
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p. 22
Paradox of Thrift
• The paradox of
thrift assumes
that investment
does not
increase with
the increased
saving, so AD
shifts to the left.
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