Aggregate Demand and
Aggregate Supply
◦ Learning Outcomes
◦ define aggregate demand and explain the effects that cause this curve to
slope downward and discuss shifters of the AD curve,
◦ distinguish between the short-run and the long-run as these terms are used
in macroeconomics,
◦ draw a hypothetical long-run aggregate supply curve and explain what it
shows about the natural levels of employment,
◦ draw a hypothetical short-run aggregate supply curve and explain why it
may shift, and
◦ explain what is meant by equilibrium in the short-run, and how change in
AD and AS can change the equilibrium, and potential equilibrium output.
◦ Learning Outcomes
◦ What causes business cycles?
The fluctuating
line is the
ACTUAL GDP
This trend line is
actually the
POTENTIAL GDP
Economics
as a
Circular
Flow
GDP fluctuations can arise from either
the demand or supply side of the
economy…
GDP and Aggregate Demand (AD)
All goods and services purchased by
Households (C) This is also the
total amount of
goods and
Firms (I) services
GDP= demanded in an
C+I+G+NX economy, or AD
Government (G)
AD=
C+I+G+NX
Rest of World (NX)
Aggregate Demand
u Aggregate demand is the relationship between the
total quantity of goods and services demanded (from
all the four sources of demand) and the price level, all
other determinants of spending unchanged.
u The aggregate demand curve is a graphical
representation of aggregate demand.
On the vertical
axis, we plot the
average price
level of all goods
in the economy
On the horizontal axis, we plot the total amount of
goods and services demand, or real GDP
Aggregate quantity demanded
In general, a change in the
price level, with all other
determinants of aggregate
demand unchanged,
causes a movement along
the aggregate demand
curve.
Movements vs. Shifts
An increase in consumption, investment, government
purchases, or net exports shifts the aggregate demand curve
A change in C, I, G and NX shifts the AD curve
What are the factors that can cause
consumption (C) to change?
1. Consumer Confidence
2. Taxes
3. Transfer payments (government benefits)
What are the factors that can cause
investment (I) to change?
1. Business Expectations
2. Interest Rates (on loans)
3. Business Taxes
More projects by the
government can increase
government spending (G)
What are the factors that can cause
net exports to change?
1. Foreign Incomes
2. Trade Policies
3. Exchange Rates
§ Explain the effect of each of the
following on the aggregate demand
curve for Canada
A. A decrease in consumer optimism
B. An increase in real GDP in the countries
Class Exercise: that buy Canadian exports
C. An increase in the price level
D. An increase in government spending on
highways
Solutions
A. Agg. Demand falls – Demand Curve Shifts Left
B. Agg. Demand rises – Demand Curve Shifts Right
C. As price changes, just a movement along the AD curve
D. Agg. Demand rises – Demand Curve Shifts Right
◦ Learning Outcomes
§What does the supply side of the economy look
like?
Aggregate
SUPPLY CURVE
THE AGGREGATE SUPPLY (SAS)
CURVE SHOWS HOW FIRMS
INCREASE PRODUCTION WHEN
PRICE GOES UP
As prices rise,
firms increase
their production
P2
P1
Shifts in Supply Curve
For example, assume average wage
in economy is FIXED at $15/hr
Each AS curve is drawn
for a PARTICULAR LEVEL
OF COST OF INPUTS
that prevails in the
economy
Shifts in Supply Curve
(Wage=20) (Wage=15)
(Wage=10)
Any changes in the cost
of production causes
the supply curve to shift
There’s another supply curve in the model that shows
the potential GDP of the country…
i.e. GDP produced at full employment
We call this the Long Run Aggregate Supply Curve
To distinguish it from the regular supply curve, we often
call that upward sloping one the Short Run AS Curve
Long Run
Aggregate
Supply (LRAS)
THE LRAS IS A STRAIGHT
LINE DEPICTING THE LEVEL
OF POTENTIAL GDP OF THE
ECONOMY
Long Run Reminder: at
Aggregate Potential GDP,
unemployment is
Supply (LRAS) all NATURAL
THE LRAS IS A STRAIGHT
LINE DEPICTING THE LEVEL
OF POTENTIAL GDP OF THE
ECONOMY
Potential GDP increases if…
The LRAS < Labour stock increases
Changes with < Thequantity of capital
Changes in increases
potential GDP < Anadvance in technology
occurs
Change in potential GDP
• When resources
increase and/or
technology improves,
potential GDP
increases
• Both the LRAS and
SRAS supple curves
will shift
◦ Learning Outcomes
§What determines the level of actual GDP in the
economy?
Short Run Equilibrium
AD = SRAS
gives us the
actual GDP
Equilibrium in the Model
When AD = SRAS
we have the short
run equilibrium in
the model, i.e. the
level of actual GDP
Changes in Equilibrium: Demand
Side Driven
• If AD rises, we will
have price levels
and output levels
rising in the
economy
• Economy will move
to a new
equilibrium with
higher GDP
Changes in Equilibrium
A change in price
levels show how
inflation is
changing
A change in GDP
levels can
indicate how
output and
employment is
changing
Changes in Equilibrium: Supply
Side Driven
If AS rises, we will
have price levels
falling and
output levels
rising in the
economy
◦ Learning Outcomes
§How can we use the AS-AD model to explain
business cycles?
What causes fluctuations?
• In the model, fluctuations are caused by
shocks of AD and AS
• These shocks can be caused by anything…
e.g. Covid-19 which is a negative shock to
aggregate demand
What causes fluctuations?
u Whenthe shocks happen, the actual
GDP deviate from its potential GDP
u This creates OUTPUT GAPS
u This will cause the business cycles
Suppose we start
where the economy
is producing at
potential GDP
Then there is a “good”
demand shock to the
model, for e.g. the govt
has reduced taxes
which increases
consumption spending
Effect of demand shock
• Due to the demand
shock, there is an
increase in aggregate
demand
• This shifts the AD curve
rightward
Effect of positive demand shock
• As AD increases, prices rise
• Firms respond by changing
output in the short run
• Actual GDP rises over
potential GDP
• We get a positive
output/inflationary gap
Macro impacts of inflationary gap
Price Levels Increase
in the Economy
As Actual GDP >
Potential GDP,
unemployment falls
below NATURAL level
How is Actual GDP rising over potential?
• Because at full employment, it is not the case that
unemployment is zero
• We still have frictional and structural unemployment
• When AD increases, these people now find jobs more
easily
• Unemployment falls below natural rate
• Similarly, we can have
negative demand
shocks- e.g. as caused
by Covid-19
• Actual GDP falls below
potential GDP, creating
a recessionary output
gap
Price Levels fall
(inflation falls)
GDP falls,
unemployment rises
(over natural rate)
◦ Learning Outcomes
§How does the economy go back to its potential
GDP level (in the long run)?
Periods of
positive output
gaps (peaks,
booms)
Periods of
negative output
gaps
(recessions)
Natural adjustment
•When the economy adjusts
Two naturally and goes back to
potential GDP
adjustment
processes Stabilization using policy
•When the government uses
some policy action
• Suppose there is a
positive demand shock
A
B
• At the short-run
equilibrium, there is an
inflationary gap
• Inflation increases,
unemployment
decreases
• Due to high prices, cost of
C inputs will eventually rise
B • For example, workers will
A want higher wages
• Firms will comply, also due
to shortage of workers
• The SRAS shifts up
• As the SRAS shifts up, the
C inflationary gap is eliminated
B • Economy goes back to
A
potential GDP in long run
• Essentially, as the economy
was operating above full
capacity, the adjustment
happens
Natural adjustment
• When the economy adjusts
Two naturally and goes back to
potential GDP
adjustment
processes Stabilization thru policy
• When the government uses
some policy change
Government Intervention
u Sometimes the natural adjustment process can take time
u Or there might be situations where the natural adjustment might
not happen
u The government might not want to wait too long to restore the
economy to full employment, or to stabilize prices
Classical Economists…
• Believe market can solve problems
by themselves by adjusting prices
Keynesian Economists…
• Believe markets can get stuck at
bad equilibriums, so govt
intervention might be needed…
Thank you!