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Aggregate Demand and Aggregate Supply
Lesson 19


Aggregate Demand

1. Aggregate Demand - a schedule that shows how much goods and services people want to buy and the price level

  • Focus on the consumers' side
    • Total goods and services is GDP
    • Price level - index of all prices for final goods and services
  • AD Function has a negative slope
    • Not a demand function!
    • Why the negative slope?
      1. Real balance effect - the value of people's money, savings and investment after adjusting for inflation
        • A high price level results from inflation
          • Inflation - price level is increasing
        • Inflation reduces the value of money, savings, and investments like stocks and bonds
          • Reduces GDP
          • People feel poor
        • Wealth Effect - At a lower price level, people have a higher real balance effect and spend more on goods and services
      2. Interest rate effect - more complicated
        • Money in economy is fixed until central bank increases it
        • At higher price levels, people reduce their savings in financial institutions
          • Interest rates must be high to attract funds
          • i.e. Fisher Equation
        • At higher interest rates, businesses and people invest less in structures, machines, and equipment
          • Lower GDP
          • Note - Inflation causes greater interest rates
      3. Foreign purchases effect - how one country's price level compares to another country
        • The U.S. price level increases relative to another country
        • Exchange rates do not change, so the price level impacts exports and imports directly
        • Americans increase imports, because they are cheaper
        • Foreigners decrease exports, because they are more expensive
  • Aggregate Demand is shown below

The Aggregate Demand Function

2. Shifts in Aggregate Demand

  • Remember AE = C + G + Ig + X - M
  • Consumers
    1. Consumer spending - consumers decide to save less income and consume more, thus increasing the aggregate demand function, shifting it rightward
    2. Real Wealth - if consumers wealth increases, consumers spend more and aggregate demand shifts right
      • Stock prices dropped significantly during 2008
      • People lost wealth because pension plans and investments have lost value
      • Aggregate demand shifts left
    3. Consumer expectations
      • If consumers are optimistic about the future, they spend more now, boosting aggregate demand
      • If consumers are pessimistic about the future, they reduce their spending
        • If a worker expects layoffs, a tough job market, he or she likely reduces spending and increase savings
    4. Household debt -
      • If households have low debt, they can increase their spending by borrowing more, shifting aggregate demand rightward
      • If households have high debt, they reduce their spending in order to pay it back, decreasing aggregate demand
    5. Taxes
      • Government increase taxes which reduces disposable income, so households consume and save less, and AD shifts leftward
      • Government decreases taxes, disposable income increase, so households can consume and save more, thus, AD shifts right
  • Investment
    1. Real interest rates
      • Households - invest in more new houses, new cars, and appliances, when real interest rates are low
        • Not caused by a change in price level, otherwise we have a movement along an AD curve
      • Businesses - invest in more structures, machines, and equipment
        • AD increases and shifts right
    2. Expected Returns or Profits - businesses invests more if they expect future profits
      1. Businesses are optimistic about the future business climate
        • Economy is growing along with consumers' demands
      2. Businesses adopt new technologies
        • Technology lowers production costs, increases workers' productivity, or increases quality
      3. Businesses are using their capital at full capacity
        • Businesses invest in capital to boost the capacity level
      4. Taxes - if government decreases taxes, then businesses may invest more
  • Government - government is a large sector of economy
    • If government increases spending, then AD increases and shifts right
    • If government decreases spending, then AD decreases and shifts left
  • International sector
    • Not caused by a change of the price level
    • If net exports increase
      • Either exports increase and/or imports decrease
      • More products and services are produced here and exported, shifting the AD rightward
    • Foreign income - if a foreign country becomes richer, they import more
      • Our exports increase, shifting AD rightward
    • Exchange rates
      • If U.S. dollar appreciates or becomes stronger, then
        • Exports decrease
        • Imports increase
        • AD shifts left

The Aggregate Demand shifts


Aggregate Supply

1. Aggregate Supply - a schedule that shows the amount of goods and services producers manufacture at each price level

  • Focus on the production side
  • Short run - prices for some resources do not change immediately to changes in the price level
  • Long run - prices for all resources change immediately to price level changes
  • Short-run aggregate supply has positive slope
    • If the price level increases but wages do not change, companies can expand production
    • Firms receive greater revenue as inflation makes prices for goods and services greater
      • Firms pay lower costs if real wages fall, or real wages = nominal wages / price level
      • The total value of goods and services are higher, because the price level is higher
      • Sticky wages - wages are stuck at the same level, so firms earn profits when expanding output
      • Companies enter into contracts with workers
      • Companies rarely lower wages
  • Another explanation for positive slope - firm can fool its workers
    • Workers do not know inflation has lowered their real wages as employers work them more
    • Instructor - employers may exploit workers because many jobs, employees cannot demand greater wages
  • Short-run aggregate supply is shown below

The Aggregate Supply Curve

  • Long-Run Aggregate Supply - all resource prices increase with the price level
    • Workers wages rise with the cost of inflation
    • Long-run aggregate supply is a vertical line
    • Country produces at that level of GDP regardless of the price level
      • Is this correct? Remember hyperinflation?
      • Hyperinflation can destroy an economy
    • Long-run aggregate supply is shown below

The long-run Aggregate Supply function

2. Shifts in Aggregate Supply

  • Input Prices
    1. Labor - largest expense for businesses
      • Immigration - if many new workers enter the market, wages tend to fall
        • Labor costs are cheaper and AS shifts right
      • Some workers retires, supply of workers decreases and wages may increase
        • Labor becomes more expensive and AS shifts left
    2. Capital like machines, equipment, and structures
      • Price of capital decreases, businesses invest more, causing AS to increase
      • If capital from foreign countries becomes cheaper, businesses import and invest more
    3. Materials
      • If resources used for inputs become cheaper, then firms expand production, causing AS to increase
      • More petroleum or mineral deposits are discovered, then prices for these products tend to fall
      • If resources from foreign countries becomes cheaper, firms use more and import more
    4. Market Power - an industry with market power can impact whole economy
      • OPEC sets production quotas on petroleum, boosting petroleum price
      • Petroleum is used in many products and transportation, raising prices for everything in the economy
        • AS decreases and shifts and left
  • Productivity - firms produce a level of output given that it uses labor to make the output
    • Increases in productivity is firms produce more output given the same level of labor
      • Adopt new technology
      • Workers become more productive over time
        • Productivity increases approximately 2% per year in U.S.
        • AS increases and shifts right
  • Legal environment - government impacts businesses greatly
    • If government changes legal structure that lowers businesses' production costs
      • Government lowers business taxes
      • Improved property rights
      • Government reduces regulations and bureaucratic red tape
      • Government increases subsidies
        • AS increases and shift right

The Aggregate Supply shifts

Changes in Equilibrium

1. Equilibrium - state of rest; nothing changes

  • Price level and level of GDP do not change
  • At P', businesses and producers produce at Q1 while consumers want to buy Q2
    • Consumers bid up prices until the price level is at P*
    • Business inventories are falling
    • Businesses boost production to accumulate inventories

The Aggregate Supply and Demand

  • At P" businesses and producers produce at Q2 but consumers want to buy Q1
    • Inventories are increasing
    • Businesses reduce prices to sell inventories and cut back on production
      • Price level falls until it equals P*

The Aggregate Supply and Demand

2. AD increases and shifts right

  • Businesses increase investment
  • Government increases spending or lowers income taxes
  • If the economy was at full employment (FE) and AD increases
    • GDP increases
    • Price level increases
  • Creates Demand Pull Inflation

The Aggregate Demand increases

3. AD decreases and shifts left

  • Business investment decreases
  • Government decreases spending (not typical)
  • Government increases taxes on incomes
  • Note - prices in an economy tend not to decrease
    • If prices could fall (deflation), then economy is in a recession at Q1
    • If prices do not fall, then economy is in a recession at Q2
      • The recession is worse

The Aggregate Demand decreases

  • Why prices do not fall?
    • Companies do not want to start a price war
      • Price wars destroy profits, as companies keep trying to under cut each other
    • Menu costs - changing prices imposes additional costs on companies
      • If firms believe recession will be short live, they may not lower their prices
      • Menu costs
        • Cost of printing new catalogs, menus, etc.
        • Cost to re-price merchandise that is in inventory
        • Cost to communicate prices to consumers
          • Consumers get angry if prices change suddenly or unexpectedly
    • Labor is a major cost and firms may not be able to lower workers' wages
      • Wage contracts - companies and workers agreed to wages specified in a contract
      • Efficiency wages - some employers may pay greater wages than the market
        • Attracts the best workers
        • Workers boost their productivity
        • Wages reflect productivity
      • Reducing wages may decrease workers' morale and work habits
        • Workers reduce their productivity
        • Workers could steal from employer
        • Workers can sell trade secrets, software, etc.
        • Best workers flee and work for rival firms
      • Minimum wage laws - firms cannot lower wages below the minimum wage

4. AS decreases and shifts left

  • War
  • Natural disaster
  • Energy price shock
    • Example is OPEC
  • Leads to lower output and a higher price level
    • Cost Push inflation
    • Stagflation

The Aggregate Supply decreases

5. AS increases and shifts right

  • Producers adopt new technology
  • Increased immigration, which lowers wages
  • Output increases
    • If prices could fall, then economy grows to Q1
    • If prices are rigid, then economy grows larger to Q2
      • Prices may not fall because prices and wages are sticky

The Aggregate Supply increases


Blue arrow If an economy has rigid prices, where prices cannot fall, then changes can have a much larger impact on the economy.


  • aggregate demand
  • real-balance effect
  • interest-rate effect
  • foreign purchases effect
  • determinants of aggregate demand
  • aggregate supply
  • short run
  • short-run aggregate supply curve
  • long run
  • long-run aggregate supply curve
  • determinants of aggregate supply
  • productivity
  • equilibrium
  • menu costs
  • efficiency wages

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