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AD and AS
Tragakes 2012, chapter 9
Aggregate Demand

Aggregate Demand (AD): The total
quantity of aggregate output, or real GDP,
that all buyers in an economy want to buy
at different possible price levels, ceteris
paribus.


The price level is measured using the GDP
deflator.
The quantity of real GDP demanded is
composed of C+I+G+(X-M).

The AD curve shows the relationship between
real GDP demanded and the economy’s price
level, ceteris paribus.


The AD curve is NOT the same as a
market demand curve.
A market demand curve illustrates the
total demand of all consumers for ONE
particular product. The AD curve illustrates
the total demand of all agents in the
economy for all goods and services in the
economy.
Negative slope of the AD curve
1. Wealth Effect. Changes in the price level
affect the real value of people’s wealth. Wealth
is the value of assets that people own (ex:
houses, stocks, juwellery, art…).
 If price level ↑, real value of wealth ↓. People
then feel worse off and decrease their
consumption of g&s. So the quantity of output
demanded falls (upward movement ALONG the
AD curve).

If price level ↓, real wealth ↑. People feel
better off and increase their spending on g&s.
So the quantity of real GDP demanded rises
(downward movement ALONG the AD curve).
2. Interest rate effect

An ↑ in the PL means consumers and firms
need more money for C and I, respectively.
People then increase their borrowing.

The increase in borrowing (because of an
increase in money demand) pushes up the
price of money...which is the interest rate.

As the interest gets higher it becomes too
costly to borrow and people tend to decrease
their expenditures financed by borrowing (ex:
houses, cars, luxury vacations, renovations)
and firms decrease their I. As a result, the
quantity of real GDP demanded falls.



A ↓ in the PL means consumers and firms need
less money for C and I, respectively. People then
decrease their borrowing.
The decrease in borrowing (because of a
decrease in money demand) pushes down the
price of money...which is the interest rate.
As the interest gets lower it becomes cheaper to
borrow and people tend to increase their
expenditures financed by borrowing (ex: houses,
cars, luxury vacations, renovations) and firms
increase their I. As a result, the quantity of real
GDP demanded rises.



NOTE: The interest rate effect can be
tricky!
If changes in the price level are CAUSING
the change in the interest rate then the
change in the interest rate is linked to a
movement along the AD curve.
BUT the government can change the level
of the interest rate completely separately
from any changes in the price level. In this
case the change in the interest rate will
cause a SHIFT of the AD curve.
3. International trade effect.

An ↑ in the PL means the price of
domestic goods is changing relative to
the prices of foreign goods…foreign
goods could be more attractive due to
this change in relative prices. Thus M ↑
and X (which are relatively more
expensive to the foreigners buying them)
↓. Domestic goods are substituted by
foreign goods.

A ↓ in the PL means the price of domestic
goods is changing relative to the prices of
foreign goods…foreign goods could be less
attractive due to this change in relative
prices. Thus M ↓ and X (which are
relatively cheaper to the foreigners buying
them) ↑. Foreign made goods are
substituted by domestic goods (by both
domestic and foreign consumers).
Shifts in the AD curve



Rightward shift of AD means that for any
particular PL, a larger amount of real GDP
is demanded.
Leftward shift of AD means that for any
particular PL, a smaller amount of real GDP
is demanded.
Since AD = C + I + G + (X-M), anything
that causes a change in any of the
components of AD, will cause AD to shift.
Shifts in the AD curve
Price
level
AD1
AD
AD2
Real GDP
Factors causing a change in C



Changes in Wealth. An ↑ in wealth (ex: value of
homes) makes people feel wealthier, so they increase C
expenditures.
Changes in consumer confidence Consumer
confidence is a measure of how optimistic consumers are
about their future income and the economy.
Expectations of increasing incomes in the future or
optimistic expectations about the economy will increase
spending by consumers because they know they will
have more money.
Changes in Interest rates. Some consumer spending
is financed by borrowing and thus sensitive to interest
rate changes. If i ↓, borrowing becomes less expensive
and C increases.


Changes in personal income taxes. If the gov
increases personal income taxes (taxes paid by
households on their incomes), then their disposable
income (income left over after personal income taxes
have been paid) falls and C spending drops.
Changes in the level of household indebtedness.
Indebtedness is how much money people owe from
taking out loans in the past (ex: mortgages, credit
cards). If cons are able to lower their debt payments
more money can be spent on C and AD will rise and shift
right.
Factors causing a change in I



Changes in business confidence. Business
confidence refers to how optimistic firms are about their
future sales and economic activity. Optimism about the
future leads to higher I and thus ↑ AD, which will shift
right. Pessimism will lower I and thus ↓ AD, which will
then shift left.
Changes in business taxes. If the gov ↓ taxes on
profits of businesses (fiscal policy), firms’ after-tax
profits increase, which ↑ I, as firms have more money to
spend. An ↑ in taxes will ↓ I, as firms will have less
money to spend.
Legal/institutional changes. Sometimes the legal
and institutional environment in which firms operate has
an impact on I spending. Ex: access to credit, property
rights.



Changes in interest rates. An ↑ in interest rates
makes borrowing more expensive and I tends to fall. A ↓
in interest rates makes borrowing less expensive, so
firms tends to increase their I.
Changes in technology. Improvements in technology
stimulate investment spending, so AD ↑ and shifts right.
Level of corporate indebtedness. If firms have high
levels of debt, they will be less inclined to make
investments and AD curve will shift left.
Factors causing a change in G


Changes in political priorities. The gov may decide
to ↑ or ↓ its expenditures (provision of merit and public
goods, subsidies and pensions, salaries to gov
employees) in response to changes in its priorities. ↑G:
AD shifts right.
Deliberate efforts to influence AD . The gov can use
G as part of a deliberate attempt to influence AD. Same
effects as above.
Factors causing a change in X-M


Changes in national income abroad. If national
income in foreign countries is rising they will buy more
goods and services from us, so our AD will ↑ and shift
right. If national income in foreign countries is falling
they will buy less goods from us, so our AD will ↓ and
shift left.
Changes in exchange rates.


If the exchange rate (the price you pay using your own currency
to buy another currency) goes up then it takes more of your
currency to buy foreign goods, M will ↓ but X ↑ as it is easier for
foreigners to buy our currency. So (X-M)↑, and AD shifts right.
If the exchange rate (price of foreign currency) goes down it
takes less domestic currency to buy foreign goods. M↑ and X↓ as
it costs more in terms of foreign currency to buy our goods. (XM)↓ and AD shifts left.
Shifts in the AD and national income
Income is not included among the factors that can shift
the AD curve, as changes in national income cannot
initiate any AD curve shifts. Remember that national
income is measured on the horizontal axis, and it is not
possible for any variable measured on either of the two
axes to cause a shift of a curve.
Important: do not confuse



The wealth effect resulting from a change in the price level
(causing a movement along AD) with changes in wealth, that
cause shifts in the AD curve.
The interest rate effect that results from a change in the price
level (producing a movement along the AD curve) and changes
in interest rates that occur without any change in the price level,
causing shifts of the AD curve.
Aggregate Supply (AS)
Short run and long run in macroeconomics.



Short run: the period of time when prices of resources,
in particular wages, are roughly constant or inflexible
(they do not change much in response to supply and
demand).
Long run: the period of time when the prices of all
resources, including wages, are flexible and change in
response to changes in the price level.
The price of labour is often rigid because:



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Labour contracts fix wages for a period of time
Minimum wage legislation
Resistance from workers and labour unions to wage cuts
Negative effects on worker morale, causing firms to avoid them



AS is the total quantity of G&S produced in an economy
(real GDP) over a particular time period at different price
levels.
The short run AS (SRAS) curve shows the relationship
between the price level and the quantity of real output
(real GDP) produced by firms when resource prices
(wages) do not change.
SRAS curve is upward sloping because of firm
profitability. As PL ↑, with resource prices constant, firms’
profits increase. As production becomes more profitable,
firms increase the quantity of output they produce. As PL
↓, firm profitability falls and output decreases.
Shifts in the SRAS curve




A number of factors other than the PL can cause shifts of
the SRAS curve.
A rightward shift of the SRAS curve means that for any
particular price level, firms produce a larger quantity of
real GDP.
A leftward shift of the SRAS curve means that for any
particular price level, firms produce a smaller quantity of
real GDP.
Factors include: changes in firms’ costs of production,
changes in taxes and subsidies and ‘supply shocks’.
Price
level
SRAS3
SRAS1
SRAS2
Real GDP
Factors that influence firms’ costs of
production


Changes in wages. Wages constitute a major portion of
firms’ costs of production. They can change as a result
of a change in minimum wage legislation or as a result
of labour union negotiations with employers. If wages ↑
(with PL constant), firms’ costs ↑ and SRAS shifts left. If
wages ↓ (with PL constant), firms’ costs ↓ and SRAS
shifts right.
Changes in non-labour resource prices. Ex: changes in
the price of oil, equipment, capital goods,... They have
the same impact on SRAS as a change in wages.



Changes in business taxes. These are taxes on firms’
profits and are treated by firms as a cost of production.
If taxes ↑ = production costs ↑ and SRAS shifts to the
left. If taxes ↓ = production costs ↓ and SRAS shifts to
the right.
Changes in subsidies offered to businesses. These are
money transferred from the gov to firms, so they have
the opposite effect to taxes.
Supply shocks. These are events that have a sudden and
strong impact on SRAS:


Negative supply shocks. A war can result in the destruction
of physical capital and disruption of the economy, which
reduces output produced and shifts the SRAS curve to the
left. Unfavourable weather conditions can decrease
agricultural output, shifting SRAS to the left. A sudden
increase in the price of a major input such as oil, increases
firms’ production costs, shifting SRAS curve to the left.
Positive supply shocks. Oil discovery or good weather
conditions lead to an increase in SRAS and a rightward
shift of the SRAS curve.
LRAS and long-run equilibrium in the
monetarist/new classical model

Monetarist/new classical perspective. Based on
the following principles:
1.
2.
3.


Importance of the price mechanism
Competitive market equilibrium
The economy as a system that tends towards FE
Disagreement among economists over their
relevance in the study of macroeconomics.
Difference between the monetarist/new
classical perspective and others: the shape of
AS curve.




Monetarist/new classical approach to AS relies on the
distinction between short and long-run. In the long-run,
all resource prices change so as to match changes in the
PL.
The relationship in the long-run between the price level
and aggregate output is referred to as LRAS.
The LRAS curve is vertical at potential GDP (YP).
In the long run, a change in the price level does not give
rise to any change in the amount of output produced.
The economy is in long-run equilibrium when the AD
curve and the SRAS curve intersect at any point on the
LRAS.
PL
LRAS
SRAS
AD
Yp
Real GDP
 In the long-run the
economy produces
potential GDP, Yp, which is
independent of the price
level.
 A movement along the
LRAS curve involves a
change in two sets of
prices:
 The price level
 The prices of resources
Why the LRAS curve is vertical


In the short-run, with wages being constant, as PL
increases, firms’ profits increase and they increase the
quantity of output produced.
In the long-run, when PL changes, wages and other
resource prices also change: as PL increases (decreases),
wages increase (decrease) by the same amount.
Therefore, firms’ profits are constant and firms have no
incentives to increase or decrease their output levels.
Why the LRAS curve is situated at the level
of Potential GDP


As the LRAS curve is vertical at the level of potential
GDP, this implies that in the long run output gaps (when
actual GDP produced differs from potential GDP)
disappear and the economy moves automatically
towards FE equilibrium. This represents the Neoclassical
view.
Show adjustment (see notes).
Changes in the long run equilibrium



A change in the long run equilibrium occurs when the
SRAS and AD curves intersect at a different point on the
LRAS curve.
For a given LRAS curve, a change in long run equilibrium
means that only the price level changes, as the level of
real GDP remains at YP.
Important principle of the monetarist/ new classical
view: Changes in AD can have an influence on real GDP
only in the short run; in the long run, they only result in
changing the price level, with no impact on real GDP.
The Keynesian model




Getting stuck in the short run
The shape of the Keynesian AS curve
The three equilibrium states of the
economy in the Keynesian model
Some key features of the Keynesian model
Shifts in the LRAS curve

PL
Over time the LRAS and KAS curves can shift to the
right or to the left in response to factors that change
potential output.
LRAS1
LRAS2
YP1
YP2
PL
RGDP
AS1
YP1
AS2
YP2
RGDP
Factors that change AS over the long term
1.
2.
3.
Increases in the quantities of the factors of production.
An increase in the quantity of labour, the quantity of
physical capital or the quantity of land means that the
economy is able to produce a larger quantity of real
GDP.
Improvements in the quality of factors of production.
For ex: greater levels of education, skills or health
contribute to a more productive workforce, increasing
the level of output produced.
Improvements in technology. Technological change
enables firms to produce more from any given amount
of factors of production.
4.
5.
6.
Increases in efficiency. An economy that increases its
efficiency in production, it makes better use of its
scarce resources and can produce a greater quantity of
output.
Institutional changes. Changes in institutions can
sometimes have important effects on how efficiently
scarce resources are used and therefore in the quantity
of output produced. For ex: degree of competition,
degree of private ownership of resources, the degree of
gov regulation of private sector activities, amount of
burocracy.
Reductions in the NRU. The NRU includes unemployed
people who are in between jobs, who are retraining and
others. It differs from country to country and it can
change over time. If it decreases, YP increases.
Long term growth versus short term economic
fluctuations


Long term growth in the business cycle diagram
(increase in YP) corresponds to rightward shifting LRAS
or Keynesian AS curves.
Short term economic growth occurs during expansions
(positive growth/increase in real GDP):


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Monetarist/new classical: increases in AD or increases in SRAS.
Keynesian model: only increases in AD
In the real world, it is very difficult to arrive at accurate
conclusions about what part of growth is due to shortterm fluctuations and what part to growth in potential
output. However, efforts are made to measure YP and its
growth, as this helps governments to formulate
appropriate economic policies.
PL
PL
LRAS1
LRAS2
AS1
SRAS1
SRAS2
AD1
Y1
AD2
AD1
Y2
Real GDP
AS2
Y1
Real GDP
Y2
AD2
Shifts in LRAS and SRAS in the monetarist/new
classical model


If the LRAS shifts, then the SRAS also shifts. This is
because at any moment in time the economy is always
producing on a SRAS curve. Any factor that shifts the
LRAS must, over the long run, also shift the SRAS curve.
However, a shift in the SRAS curve does not cause the
LRAS to shift.


Changes in input prices may only shift the SRAS without
affecting the LRAS. An increase in wages increases firms’
production costs, shifting SRAS to the left, but this does not
affect potential GDP. The same happens with an increase in the
price of oil.
Certain events have only a temporary impact on AS and these
can shift the SRAS for a short while, while leaving the LRAS
unchanged. Ex: adverse wheather conditions during one season
that cause a drop in agricultural output.

Important: As an economy grows, it is likely that AD
also increases. The reason is that many of the factors
that cause the LRAS (and SRAS) curves to shift also
cause the AD curve to shift. Example: increases in the
quantity of physical capital, affecting AS, result from
private and public investments, also shifting AD.