iAggregate Demand and Aggregate Supply

In scope of the macroeconomy, aggregate demand and aggregate supply are the summations of individual demand for and ability to supply the breadth of goods the economy provides.

Aggregate Demand

Defined as "the total demand for goods and services in the economy", [1] aggregate demand is plotted as a sum of all of the individual demand curves, maintaining its inverse relationship between price level and real GDP:
-Aggregate demand slopes downward (McConnel and Brue)
-why the downward slope? explanation is centered on the income effect and substitution effect
(McConnel and Brue)
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Changes in the price level do not reflect an increase or decrease in one particular good - they reflect increases or decreases in the price level of all goods, hence the aggregate. The aggregate demand curve has three contributing factors to its downward-sloping
curve. The fact that the aggregate demand schedule is downsloping cannot be explained using the same arguments that explain why the demand schedule for a single product is downsloping. The downward slope of a demand schedule of a single product is explained through the income effect (as the price of a product decreases, the consumers' incomes, assumed to be fixed, will afford them more of that product) and the substitution effect (as the price of a product falls, consumers will buy more of that product since it is relatively less expensive than other products). These explanations do not make sense with regard to aggregate demand. Instead, the downward slope of the aggregate demand curve is explained with the real balances effect, the foreign trade (or foreign purchases) effect, and the interest rate effect. curve:

The Real Balances Effect

Price level increases, ceteris paribus, will decrease the value of individual currency holdings, such as cash or checkable deposits. Consumers will tend to buy less when price levels are high (and reduce real GDP since consumption contributes to real GDP) and tend to buy more when price levels are low (and increase real GDP since consumption contributes to it).
Assets with fixed money values, such as bonds, will decrease in real value.
In other words, a higher price level simply implies less consumption spending.

The Foreign Trade Effect

If the price level in Rycia (an open economy) increased, imports from other countries would become relatively less expensive. In turn, exports from Rycia would increase in price. In this case, consumers will tend to purchase more imported goods, and producers will export less goods due to the disparities in profit. Investors may even seek incentives to invest abroad and diminish their holdings in Rycia. The effects of all of these are a decrease in net exports (since imports exceed exports), a decrease in domestic consumption, and a decrease in domestic investment, leading to a decrease in real GDP when price levels are high. The opposite holds true when price levels are low.

The Interest Rate Effect

In drawing an aggregate demand curve, it is assumed that the economy's money supply is fixed. When the price level increases, the purchasing power of money decreases. Consumers will need more money to maintain their current consumption, and businesses will need more money to pay their workers and buy resources due to the increase in price levels. Demand for money goes up. The consumers and businesses will generally turn to loans. Since demand for money has gone up, the price paid to use money, i.e. the interest rate, will also rise. This is the interest-rate effect. Higher interest rates cut back investment spending and interest-sensitive consumer spending. The loanable funds market is shown, and reflects the relationship between the amount of loanable funds and the real interest rate:
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An increase in price level will increase the demand for loans and decrease the supply of loanable funds. Real interest rates will increase and decrease consumption. Real GDP will decrease in turn with price level increases, and the opposite holds true: decreases in price levels may decrease the real interest rate and spur consumption, increasing real GDP.

Determinants of Aggregate Demand (things that shift the demand curve)

It involves two main components:
1. A change in one of the determinants of demand that directly changes the amount of real GDP demanded.
2. A multiplier effect that produces a greater ultimate change in aggregate demand than the initiating change in spending.
  • Change in consumer spending
    • consumer wealth, consumer expectations, household indebtedness, and taxes
  • Change in investment spending
    • interest rates, expected returns (future business conditions, technology, degree of excess capacity, and business taxes)
  • Change in government spending
    • Government pumps money into the economy by spending more on goods and services, reducing taxes, or increasing transfer payments.
  • Change in net export spending
    • when we sell more goods to foreign consumers and buy fewer goods, this component of AD increases
    • when foreign consumers have more disposable income, this increases AD
    • consumer taste can also increase AD
    • imports decrease when the exchange ratebetween the US Dollar and other foreign currency falls
      • foreign goods become more expensive, so consumers buy fewer foreign produced items

Consumer Spending:

Domestic consumers can affect aggregate demand because if the decide to buy more output at each price level, the aggregate demand will shift to the left. However, the opposite holds true when consumers buy less output.
  • Consumer Wealth: This includes financial assets such as stocks and bonds and physical assets (house and land). An increase in the real value of consumer wealth (the stock market) will convince people to buy more products, and save less. This is known as the wealth effect (the effect being a shift to the right).
  • Consumer Expectations: If people expect their income to rise in the future, they will spend more of their current incomes, shifting the curve to the right.
    • Similarly, a widely held expectation of of surging inflation in the near future may increase aggregate demand today because consumers will want to buy products before their prices escalate
    • Conversely, the aggregate demand curve may shift to the left if the economy expects lower future income or prices
  • Household Indebtedness: People will spend and borrow, but if they spend past normal levels, consumers will cut spending, shifting the aggregate demand curve to the left.
  • Taxes: A reduction of taxes will raise "take-home income" and ultimately allow for more consumption. Tax cuts will shift the curve to the right.

Investment Spending:

A decline in investment spending at each price level will shift the aggregate demand curve to the right.
  • Real Interest Rates: An increase in interest rates would lower investment spending and reduce aggregate demand ("interest-rate effect"). Money supply affects interest rates. For example, if the money supply was to increase, this would lower interest rate, and increase investment and shift aggregate demand to the right. However, if the reverse is true, this would increase interest rate and discourage investment, shifting the curve to the left.
  • Expected Returns: If there are higher expected returns on investment projects, this would increase the demand for capital goods and shift the aggregate demand curve to the right.
    • Expectations about future business conditions: If businesses speculate high rates of return on current investment, they will invest more.
    • Technology: New technology would enhance expected returns on investment and increase aggregate demand.
    • Degree of excess capacity: Too much excess of unused capital will reduce the expected return on new investment and decrease aggregate demand.
    • Business taxes: An increase in taxes for businesses will reduce after-tax profits from capital investment and lower expected returns

Government Spending:

  • An increase in government spending will increase aggregate demand resulting in a shift to the right.
  • A decrease in government spending will decrease aggregate demand resulting in a shift to the left.

Aggregate Supply

Aggregate supply measures the total amount of goods and services that are produced in the economy.
  • The production responses of firms to changes in price level differ in the long run and the short run.
  • The long and short runs vary by degree of wage adjustment, not by a set length of time.
  • Long run: A period in which nominal wages match changes in the price level.

Long-Run Aggregate Supply

Theoretically, the long-run Aggregate Supply is not affected by the price level. The long-run aggregate supply curve is vertical, and it measures the potential GDP of the economy. This curve correlates with where an economy is on its production possibilities curve. So, if the productions possibilities curve shifts outward, the long-run aggregate supply, which represents the potential GDP will also shift to the right. Economists propose that the long-run aggregate supply curve is not affected by price levels, because in the long-run the wages and costs of inputs will adjust accordingly to the price level.
  • some economists propose that the economy never reaches the "long run" and therefore this idea is irrelevant to economical theory, while others propose that with a stable economy and proper decisions, the economy can reach this long run curve and remain on it, which would keep the economy running at "optimal" efficiency, or at full production
Source: http://www.econport.org/content/handbook/ADandS/LAS.html

Short-Run Aggregate Supply Curve

This curve is affected by changes in the price level, because wages and the costs of inputs do not change suddenly to represent the change in the price level. For simplicity, let's assume there is only one business in the economy. If the business produces and sells 1000 units of a toy for $1 each, it would make a total of $1000. Let's assume that the costs of input $900--including the money spent for wages and other supplies. The owner makes a profit of $100. Now if the price level triples, the total revenue would be $3000, and since in the short run costs of inputs would not be affected, the owner would now make a profit of $2100. The real profit would rise to $700, considering the price index of 1 (in hundredths) to be associated with $1. Since the price index now would by 3 (in hundredths) the real profit would be $700, which would be a $600 dollar increase from the previous real profit. The owner in this case would produce more of the toys and increase total output, so that he can benefit from this increase in profits. The opposite is also true. If the price-level were to decline, the owner would reduce total production, so that he is not hurt by the decreased price level and resulting reduced real profits. In the long-run it is assumed that the costs of the inputs would rise to balance out this increase in price levels. So, the in that case the costs of inputs would also triple, from $900 to $2700, which would mean a profit of $300 dollars. In terms of real profits, this would be $100. Therefore, the owner would reduce the the "excess" production, previously mentioned. This is representative of the long-run aggregate supply curve, on which changes in price level do not affect the potential GDP. [2]
Source: http://www.oocities.org/szulczyk/lessons/economics_lesson_19.html

Expected Returns

  • Technology: Improvements in technology can increase the expected return on investment resulting in an increase in aggregate demand (McConnell and Brue, 196).
  • Degree of excess capacity: Aggregate demand will decrease when there is unused capital. Firms will have a lower expected return of investment as a result (McConnell and Brue, 196).
  • Business Taxes: By increasing business taxes, after-tax profits from capital investment would be reduced as a result. This would lead to a decline in investment and aggregate demand (McConnell and Brue, 197).
  • Expectations about future business conditions.
    • o If firns are optimistic about future business conditions, they are more likely to forcast high rates of return on current investment, resulting in more investing today.
    • o If they think the economy will worsen in the future they will forcast low rates of return and might invest less today.

Changes in AD & AS

  • Increase in AD causes Demand Pull Inflation
    • An increase in aggregate demand will result in greater demand and therefore a shift to the right of the aggregate demand curve. This results in an increase in prices and therefore inflation that is caused by an increase in the demand of goods, hence the name
    • A great example is America during the 1960's in the Vietnam war. The U.S. increased military spending by 40% shifting the aggregate demand curve to the right, producing inflation.(Wilson)
  • Decreases in AD causes Recession & Cyclical Employment
    • A decrease in aggregate demand will result in contraction of the economy and therefore firms will not produce as much and employment will increase
  • Decreases in AS causes Cost-Push Inflation:
    • Aggregate supply shocks- Sudden, large increases in resource costs that move the an economy's short-run AS curve leftward(McConnell and Brue)
    • Decrease in aggregate supply due to a supply shock for example will drive prices up. This is due to the fact that less products will be available to the public and therefore demand for those products will increase further driving up the prices.
    • Aggregate supply shocks can cause both high rates of unemployment and high rates of inflation, called stagflation, as supported by the data one can find an the Phillips curve(McConnell and Brue)

Increases in AS: Full employment with Price-Level Stability

  • Between 1996 and 2000 the U.S. experienced a mixture of full employment, strong economic growth, and very little inflation.
  • The unemployment rate fell to 4 percent and real GDP grew nearly 4 persent annually.
  • Inflation remained very mild in the late 1990s.

Factors Affecting Aggregate Supply

Increase/Decrease in Resources:
  • If a natural disaster destroys significant amounts of resources, the aggregate supply curve will be shifted to he left.
  • if a country is dependent on others and those foreign countries reduce exports, AS will shift to the left for the importing country
    • example of this is when OPEC put an oil embargo on the US in 1973, which shifted the AD curve far left and caused a huge inflationary period.

Domestic Resource Prices

  • Decrease in wages reduce the per-unit production costs (McConnell and Brue)
  • Changes in the size of the labor force.
  • Changes in taxes and subsidies of producers.
    • Example: price of machinery and equipment fall due to cheaper resource prices, thus reducing per-cost production and shifting AS curve to right.
  • Changes in the productiveness of certain factories through technology/innovation.
  • Resources imported from abroad add to the U.S. aggregate supply just like foreign demand for U.S. goods contributes to U.S. aggregate demand.


Productivity is a measure of average real output, or real output per unit of input. (McConnell and Brue)

so the two formulas are

Productivity = total output / total inputs

Per unit production cost = total input costs / total output

Legal-Institutional Environment

  • Changes in the legal-institutional setting in which businesses operate may change the costs of output.
  • Two changes include:
  1. Changes in taxes and subsidies
    • Higher businesses taxes increase per-unit costs and therefore reduce short-run aggregate supply, shifting aggregate supply to the left.
    • Conversely, a business subsidy (a payment or tax break by government to producers) lowers the per-unit production cost, increasing short-run aggregate supply and shifting it to the left.
  2. Changes in extent of regulation

  • The intersection of AS and AD is the equilibrium price level and equilibrium real output.
  • This is the state of complete balance
  • Quantity demanded and quantity supplied are equal
  • Regulations may be put in place, (price ceilings or floors) to stop the market from reaching equilibrium

Increases in Demand-Pull Inflation
  • If the increase in demand causes the AD curve to shift to the right past full employment level then demand-pull inflation will occur due to an increase in price level
    • this happened in the late 1960's due to an increase in government spending which caused the economy's AD curve to shift to the right.

Decreases in AD

  • Recession: A period of declining real GDP, accompanied by lower real income and higher unemployment.
  • Cyclical Unemployment: A type of unemployment caused by insufficient total spending/aggregate demand.
  • Wage contracts
    • Wages are usually inflexible downward and this is due to contracts that make it so firms can't cut wages whenever they like. In collective bargaining agreements in major industries, these contracts usually run for 3 years.
  • Menu costs
    • When there is an update in prices due the economy status. The costs are estimating the magnitude and duration of the shift in demand to determine whether prices should be lowered. There's the repricinitems that are held in inventory.
    • When menu costs are present, firms may choose to avoid them by keeping current prices. They do this to see if the decline in aggregate demand is permanent
  • Morale, effort, and productivity
  • Minimum wage is the legal amount that is offered to least skilled workers.
  • efficiency wages-wages that elicit maximum work effort and thus minimize labor per cost per unit of output
    • if wages decrease a workers moral might decrease as well and production efficiency might also decrease.
  • Fear of price wars: Some businesses fear price wars because as competing businesses keep lowering their prices to match the other business, eventually all the businesses involved in the price war will end up with less profit. Businesses would rather reduce production and lay off workers than engage in a price war.

Decreases in AS: Cost-push inflation

  • Example: A major terrorist attack on oil facilities disrupts world oil supplies, which causes the rise in price level.

  1. ^ The Princeton Review, p.128
  2. ^ McConnell and Brue, Economics: Principles, Problems, and Policies Sixteenth Edition, pg. 198