AGGREGATE DEMAND AND

AGGREGATE SUPPLY
• Exhibit 1: An Economy
There are two sides to an economy: a buying side and a producing side. There are two time periods that relate to the
producing side: production in the short run and production in the long run. Buying side = Aggregate demand (AD);
Production in the short run = Short-run aggregate supply (SRAS); Production in the long run = Long-run aggregate
supply (LRAS).

8-2
• Exhibit 2: The Aggregate Demand Curve
The aggregate demand curve is downward sloping, specifying an inverse relationship between the price level and the
quantity demanded of Real GDP.

8-3
• Exhibit 3: Why the Aggregate Demand Curve Is Downward Sloping
This exhibit outlines the three effects that explain why the AD curve is downward sloping. Each effect relates
to a change in the price level (P) leading to a change in the quantity demanded of Real GDP (Q).

(continued…)

8-4
8-5
1) Import will reduce and export will increase (X > M) = NX increases

2) Export will reduce and import will increase (X < M) = NX reduce

 The Aggregate Demand Curve and the Income-Expenditure Model
Planned 45-degree line
Aggregate
Spending E2 AEPlanned2

(a) Change in AEPlanned1

Income-Expenditure
Equilibrium
E1

Real GDP
Aggregate
Price Level

P1
(b) Aggregate
Demand
P2

AD

Y1 Y2 Real GDP
• Exhibit 4: A Change in the Quantity Demanded of Real GDP Versus a Change in
Aggregate Demand
(a) A change in the quantity demanded of Real GDP is graphically represented as a movement from one point, A, on
AD1 to another point, B, on AD1. A change in the quantity demanded of Real GDP is the result of a change in the price
level. (b) A change in aggregate demand is graphically represented as a shift in the aggregate demand curve from AD1
to AD2.

8-8
 Shifts of the Aggregate Demand Curve

• The aggregate demand curve shifts because

of:
– changes in expectations
– wealth
– the stock of physical capital
– government policies
• fiscal policy
• monetary policy
 Shifts of the Aggregate Demand Curve
Changes in expectations
• If consumers and firms become more optimistic, aggregate demand
increases.
• If consumers and firms become more pessimistic, aggregate demand
decreases.

Changes in wealth
• If the real value of household assets rises, aggregate demand
increases.
• If the real value of household assets falls, aggregate demand
decreases.
Size of the existing stock of physical capital
• If the existing stock of physical capital is relatively small, aggregate
demand increases.
• If the existing stock of physical capital is relatively large, aggregate
demand decreases.
Continue…….
Fiscal policy (2 tools – tax (T) & government own spending (G)
• If the government increases spending or cuts taxes, aggregate
demand increases.
• If the government reduces spending or raises taxes, aggregate
demand decreases.

Monetary policy
• If the central bank increases the quantity of money, aggregate
demand increases.
• If the central bank reduces the quantity of money, aggregate
demand decreases
• Fiscal policy- Tax (T) and Government expenditure (G)
o Economic condition – economic inflation (too fast) & unemployment (too
slow)
a) Inflation
- Sustained increases in price level of the goods and services
- WHY price level increase – Ag. Demand increasing
Demand Pull Inflation
- Continuous increase in demand (from households, govt. & foreign
countries)
(a) Households- more currencies (holding more money) – increases in
demand – C increase
(b) Government- overspending – government development project – AD
increase – G increase
(c) (X) export increase and (M) import will reduce – NX increase – when
prices of Malaysian goods and services cheaper than foreign goods

*CONTINUATION NEXT SLIDE*

• AD= C + I + G + NX
• AD2= C1 + I + G1 + NX1

• Tax – Income Tax

• Yd= Y –NT(Income Tax), so net income or disposable income will change
based on the tax

• Economic too fast (inflation) Yd= C + S → When government increase the

tax ---- Yd reduce, consumption will reduce
• Economic too slow (deflation or unemployment)– government reduces
the tax – Yd will increase – consumption increase
(a) Expansionary (expanding) fiscal policy – applicable when economic very
slow
Government – will reduce the tax – Yd increase – C will increase
- G – will increase – AD= C+I+G+NX ----→ AD Increase

(b) Contractionary fiscal policy – Applicable when economy is too fast

(inflation)
- Increase the tax – Yd reduce – consumption reduce
- Grown spending also reduce
Monetary policy
• To control the money supply

a) Increase in money supply – when economic too slow

(deflation) – AD move rightward
b) Decrease the money supply when economic too fast
(inflation) – AD will move leftward

Changes in Money supply will influence AD -→ increase or

decrease
• Exhibit 5: Changes in Aggregate Demand
The flow charts show how aggregate demand changes given changes in various spending components.
C = consumption, I = investment, G = government purchases, NX = net exports, EX = exports, IM = imports. Keep in
mind that NX = EX – IM.

8-16
• Exhibit 7: The Short-Run Aggregate Supply Curve
The short-run aggregate supply curve is upward sloping, specifying a direct relationship between the price level and
the quantity supplied of Real GDP.

8-17
 The Supply Curve
• A factor of production is any resource that is used by firms to
produce goods and services, items that are consumed by
households.

• Factors of production are bought and sold in factor markets,

and the prices in factor markets are known as factor prices.

• The firms uses Factors of productions as inputs to create

output. Factors of production are bought and sold in factor
markets, and the prices in factor markets are known as factor
prices. These prices and the price of output are important to
make decisions about HOW MUCH to produce at each price
over a period of time and derive the SUPPLY CURVE
 Why SRAS is upward sloping?
• depends on whether the price the producer receives for a unit of output is greater or
less than the cost of producing that unit of output

• at any given point in time, many of the costs producers face are fixed per unit of
output and can’t be changed for an extended period of time

• largest source of inflexible production cost is the wages paid to workers

• Wages here refers to all forms of worker compensation (paid health care and
retirement benefits)

• Nominal wage - the dollar amount of any given wage paid

 Why SRAS is upward sloping?
- Economist believe that wages are sticky or inflexible.
- Real wage (purchasing power) = Nominal Wage / Price
- If price index falls – real wages will increase.
So, Real wage ↑ = Quantity supplied of labor ↑
Real wage ↓ = Quantity supplied of labor ↓
AND
Real wage ↑ = Quantity demanded of labor ↓
Real wage ↓ = Quantity demanded of labor ↑
 4 models to explain the reason why AS
upward sloping

• STICKY-WAGE MODEL
• WORKER-MISPERCEPTION MODEL
• IMPERFECT-INFORMATION MODEL
• STICKY-PRICE MODEL
 Sticky-Wage Model

• Labor markets
• In Short run – wages fixed for permanent workers (btw. Union
and management)
• Wages sticky – not changing according economical changes
• When P increases – outputs will increase
• Wages remains (nominal wage) – real wages decline
• Lower real wages – labors become cheaper
• (initial)Amount of outputs produced remains – in order to
response to the higher prices – firms will hire more workers –
leads to output increases
• Exhibit 8: Wage Rates and a Shift in the Short-Run Aggregate Supply Curve

A rise in wage rates shifts the short-run aggregate supply curve leftward. A fall in wage rates
shifts the short-run aggregate supply curve rightward.

nominal

nominal

8-23
 Shifts of the Short-Run Aggregate Supply Curve

Changes in
– commodity prices (non labor inputs (oil))
– nominal wages
– productivity
lead to changes in producers’ profits and shift
the short-run aggregate supply curve.
 Factors that Shift Short-Run Aggregate Supply
• Changes in commodity prices
• If commodity prices fall, short-run aggregate supply increases.
• If commodity prices rise, short-run aggregate supply decreases.

• Changes in nominal wages

• If nominal wages fall, short-run aggregate supply increases.
• If nominal wages rise, short-run aggregate supply decreases.

• Changes in productivity
• If workers become more productive/ efficient, short-run aggregate supply
increases.
• Supply Shocks
Major institutional changes that affect aggregate supply.
TWO varieties:-
a) Adverse supply shock- e.g. bad weather
b) Beneficial supply shocks – e.g. major oil discovery and good weather
• Exhibit 9: Changes in Short-Run Aggregate Supply
The flow charts show how short-run aggregate supply changes given changes in several factors.

8-26
 Long-Run Aggregate Supply Curve

• The long-run aggregate supply curve shows

the relationship between the aggregate price
level and the quantity of aggregate output
supplied that would exist if all prices,
including nominal wages, were fully flexible.
 Long-Run Aggregate Supply Curve
Aggregate price
level Long-run aggregate
(GDP deflator, supply curve, LRAS
2005 = 100)
15.0
…leaves the quantity
A fall in the of aggregate output
aggregate supplied unchanged
price level… in the long run.

7.5

0 $800
Potential Real GDP
output, YP (billions of 2005 dollars)
 From the Short Run to the Long Run
(a) Leftward Shift of the Short-Run (b) Rightward Shift of the Short-Run
Aggregate Supply Curve Aggregate Supply Curve

Aggregate price Aggregate price

level level

LRAS LRAS SRAS1

SRAS2

SRAS2
SRAS1

A1 A1 A fall in nominal
P1 P
1
wages shifts SRAS
rightward.
A rise in nominal
wages shifts SRAS
leftward.

YP Y1 Y1 YP
Real GDP Real GDP
 The AS–AD Model
• The AS–AD model uses the aggregate supply
curve and the aggregate demand curve
together to analyze economic fluctuations.
 Short-Run Macroeconomic Equilibrium
• The economy is in short-run macroeconomic equilibrium
when the quantity of aggregate output supplied is equal to
the quantity demanded.

• The short-run equilibrium aggregate price level is the

aggregate price level in the short-run macroeconomic
equilibrium.

• Short-run equilibrium aggregate output is the quantity of

aggregate output produced in the short-run macroeconomic
equilibrium.
Exhibit 10: Short-Run Equilibrium
At P1, the quantity supplied of Real GDP is
greater than the quantity demanded. As a
result, the price level falls and firms LRAS
decrease output. At P2, the quantity
demanded of Real GDP is greater than the
quantity supplied. As a result, the price
level rises and firms increase output.

Short run equilibrium occurs at point E,

where the quantity demanded of Real GDP
equals the (short-run) quantity supplied.
This is at the intersection of the aggregate
demand (AD) curve and the short-run
aggregate supply (SRAS) curve.

(Note: Although real world AD and SRAS

curves can, and likely do, have some
curvature to them, we have drawn both as
straight lines, This does not affect the
analysis. Whenever the analysis is not
disturbed, we follow suit throughout this
text.) 8-32
 2 situation of LRAS

Actual output Potential output

Qa lower than Qe
Resources are not fully utilised
• 1st diagram
- Deflationary gap- actual output < potential
output (the economy not fully utilizing the
resources own) [underutilization]

• 2nd diagram
- Inflationary gap – Actual output > potential
output (the economy over utilize the
resources)
Shifts of Aggregate Demand: Short-Run Effects
AD = C+I+G+NX

(a) A Negative Demand Shock (b) A Positive Demand Shock

Aggregate Aggregate
price level price level
A negative demand A positive demand
shock... shock...

SRAS SRAS

...leads to a higher
P1 E1 P2 E
2 aggregate price
...leads to a lower level and higher
P2 P
E2 aggregate price level E1 aggregate output.
1
and lower aggregate
AD1 AD2
output.
AD2 AD1
Y2 Y Y Y2
1 1 Real GDP
Real GDP
Shifts of the SRAS Curve

(a) A Negative Supply Shock (b) A Positive Supply Shock

Aggregate Aggregate price

price level level

A negative supply A positive supply

shock... shock...

SRAS SRAS
2 SRAS 1 SRAS
E2 1 2
E
1
P P
2 1
...leads to a higher
...leads to a lower
E1 aggregate output P E2 aggregate output
P
1 2 and lower aggregate
and a higher
price level.
AD aggregate price AD
level.

Y Y1 Real GDP Y Y2 Real GDP

2 1
 Long-Run Macroeconomic Equilibrium

• The economy is in long-run macroeconomic

equilibrium when the point of short-run
macroeconomic equilibrium is on the long-
run aggregate supply curve.
 Long-Run Macroeconomic Equilibrium
Aggregate price
level
L R AS

S R AS

P Long-run macroeconomic
E E
LR equilibrium (actual =
potential)

AD

Y Real GDP
P
Potential output
 Short-Run versus Long-Run Effects of a Negative Demand Shock
2. …reduces the aggregate price level
Aggregate and aggregate output and leads to
price level higher unemployment in the short
run…

LRAS
SRAS
1

SRAS
2

P E
1 1
1. An initial 3. …until an eventual
P2 negative fall in nominal wages
demand shock… E in the long run increases
2
short-run aggregate supply
P3 E and moves the economy
3 AD
1 back to potential output.
AD
2

Y Y Potential
2 1 Real GDP
output
Recessionary gap
 Short-Run versus Long-Run Effects of a Negative Demand Shock
Aggregate 3. … reducing both the
price level 1. Originally the
aggregate price level and
LRAS economy is at E1.
aggregate output and
leading to higher
unemployment in the SRAS1
short run.
SRAS2

P1 E1 4. Eventually in the long

run, the fall in nominal
wages increases the
P2 E2
SRAS curve and moves
the economy back to
P3 E3 potential output.
2. A negative demand
AD1
shock shifts the AD
curve to the left, … AD2

Y2 Y1 Potential Real GDP

output
Recessionary gap
 Short-Run versus Long-Run Effects of a Positive Demand Shock
3. …until an eventual rise in nominal
Aggregate wages in the long run reduces short-run
price level aggregate supply and moves the economy
1. An initial positive
back to potential output.
demand shock… LRAS
SRAS
2
SRAS
1
E
3
P
3

P E 2. …increases the
2 E1 2 aggregate price level
P and aggregate output
1 and reduces unemployment
AD
2 in the short run…
AD
1

Potential Y Y
1 2 Real GDP
output
Inflationary gap
E2 - Unemployment reduce (wage rate ↑) – overutilization of manpower – demand for
manpower will increase – WHY increase ?
All the producers wanted to produce more outputs due to the higher aggregate prive
level. So due to the strong demand for labours – wage rate will increase.
Other commodities – at E2 demand for other commodities also will increase – the prices
of commodities also will increase

Conclusion: at E2 cost to produce the goods and services will increase  SRAS1 moved
to SRAS2
Because of – small firms – shut down operations
Big firms – reduce the outputs
 Short-Run versus Long-Run Effects of a Positive Demand Shock
Aggregate 4. Eventually in the long run, the rise in
price level nominal wages decreases the SRAS curve
2. A positive demand LRAS and moves the economy back to
shock shifts the AD potential output.
curve to the right, … SRAS2

SRAS1

P3 E3 3. … raising both the

aggregate price level and
aggregate output and
P2 E2
leading to lower
unemployment in the
P1 E1 short run.
1. Originally the AD2
economy is at E1.
AD1

Potential Y1 Y2 Real GDP

output
Inflationary gap
 Gap Recap
• There is a recessionary gap when aggregate output is
below potential output.

• There is an inflationary gap when aggregate output is

above potential output.

• The output gap is the percentage difference between

actual aggregate output and potential output.
 Gap Recap

• The economy is self-correcting when shocks

to aggregate demand affect aggregate
output in the short run, but not the long run.
 Negative Supply Shocks
• Negative supply shocks pose a policy
dilemma: a policy that stabilizes aggregate
output by increasing aggregate demand will
lead to inflation, but a policy that stabilizes
prices by reducing aggregate demand will
deepen the output slump.
• Exhibit 13: A Summary Exhibit of AD and SRAS

8-47
END
 Group Discussion.
Choose ONE COUNTRY, identify consumption and investment,
pattern, in order to explain the real Factors that influence the

changes of the economies activities.

 Tutorial
a) Price can affect the aggregate supply curve (AS). Can you try to
identify factors other than the price that affect the AS curve?

b) What is shown by an aggregate demand curve that is sloping

negatively from left to right?

c) Explain FOUR factors that influence changes in the aggregate

supply curve either to the left or right.

d) Explain FOUR factors that influence changes in the aggregate

demand curve either to the left or right.
 Question
1) Assume that an economy experiences a shock on AD due to investors’
pessimistic views (bearish). Illustrate graphically the effects of this
shock.
2) Assume now that instead of bearish investors, the country experiences
a negative shock of immigration flows (fewer people entering the
country to work there) due to a tightening of their immigration
policies. Illustrate graphically the effects of this shock.
1. Determine the effect on short -run aggregate supply of
each of the following events. Explain whether it
represents a movement along the SRAS curve or a shift of
the SRAS curve.

a. A rise in the consumer price index (CPI) leads producers to

increase output.
b. A fall in the price of oil leads producers to increase output.
c. A rise in legally mandated retirement benefits paid to
workers leads producers to reduce output.