ECON 212: ELEMENTS OF ECONOMICS II

Univ. Of Ghana, LegonLecture 8:

Aggregate Demand Aggregate Supply

Dr. Priscilla T. Baffour

Sections

1. Relaxing a Temporal Assumption

Price Level is no longer fixed. More realistically Prices vary.

2. Aggregate Demand

Shifts in AE: The Role of Price changes

Aggregate Demand Curve: derivation, slope, points off and shifts in AD

3. Aggregate Supply : slope and shifts in AS

4. Macroeconomic Equilibrium

5. Changes in GDP and the Price Level

Aggregate Demand Shocks

Aggregate Supply Shocks

Learning Outcomes

Aggregate demand is the level of desired real domestic spending at each price level.

The aggregate demand curve plots the negative relationship between GDP and the price level.

An exogenous change in autonomous spending (a demand shock) shifts the aggregate demand curve horizontally by the multiplier times the initial change in spending.

Learning Outcomes

The aggregate supply curve reflects a positive relationship between output and the price level, for given input prices.

An exogenous change in input prices or technology (a supply shock) shifts the short-run aggregate supply curve.

The equilibrium level of GDP and the price level are determined where aggregate demand and supply are equal.

Changes in the price level affects the AE curve and therefore causes it to

shift and equilibrium GDP to change.

We can therefore derive a relationship between the price level and the

GDP

Why and How does changes in the Price level affect AE?

When the price level changes it affects

the level of desired consumption spending

through its impact on the wealth of asset (money denominated) holders

net exports

Through its impact on export demand

Through its effect on relative prices and import demand

Aggregate Spending and the Price Level

Level of Desired Consumption spending

When prices change it affects the level of desired consumption spending by;

affecting the wealth of holders of assets denominated in money terms

↑P → ↓ Real value of outside assets denominated in monetary units → ↓in the

real value of private sector wealth → ↑in savings to restore real wealth → ↓

desired private consumption spending (C) → downward shift of AE curve → ↓Real

GDP or national output.

Aggregate Spending and the Price Level

Level of Net Exports

When prices change it affects the level of net export spending;

An increase in price level means domestically produced goods are relatively

more expensive than imports, thereby encouraging imports

An increase in the price level implies that the price of exports to foreign sector

consumers is relatively higher, thereby discouraging export demand

In both cases net exports spending declines thereby shifting the AE curve

downwards and leading to a decline in real GDP or national output

Aggregate Spending and the Price Level

Aggregate Spending and the Price Level

Money supply effect Recall aggregate demand in the relationship between the price leve and the

aggregate demand all things held constant.

One of such factors held constant in the nominal money supply.

How the can the nominal Ms be used to explain the downward sloping AD

Increase in Price level with a given MS leads to decease in the reals Ms leading to a reduction in

purchasing power hence a reduction in AD.

Changes in the price level cause the AE curve to shift and equilibrium GDP

to change.

The initial AE curve is AE0 and GDP is at Y1.

An increase in the price level reduces desired expenditure and thus causes

the AE curve to shift down to AE1.

As a result GDP falls to Y1.The reverse happens for a fall in the price level.

Aggregate Spending and the Price Level

AE1

Real National Income [GDP] 0

45o

Y1 Y0

E1

E0

AE0AE = Y

Des

ired

Ex

pen

dit

ure

Aggregate Spending and the Price Level

The AD Curve and the AE Curve

AE1

Des

ired

Ex

pen

dit

ure

0

45o

AE0

Y2 Y1

E2

E1

E0

AE2

Y0

AE = Y

Real National Income [GDP]

[i]. Aggregate expenditure

The AD curve and the AE curve

Equilibrium GDP is determined by the AE curve for each given price level.

The level of GDP and its associated price level are then plotted to yield a point

on the AD curve.

When the price level is P0 the AE curve is AE0 and GDP is Y0. Plotting Y0 against

P0 yields the point E0 on the AD curve.

An increase in the price level to P1 shifts the AE curve down to AE1, producing

GDP of Y1 and this is represented by point E1 on the AD curve.

A further increase in the price level to P2 shifts the AE curve down to AE2,

producing GDP of Y2 and this is represented by point E2 on the AD curve.

The AD Curve and the AE Curve

0 Y2 Y1 Y0

P2

P1

P0

AD

E0

E1

E2

Real National Income (GDP)

[ii]. Aggregate Demand

The AD Curve and the AE Curve

AE1

Des

ired

Exp

end

itu

re

0

45o

AE0

Y2 Y1

E2

E1

E0

AE2

Y0

AE = Y

Real National Income [GDP]

[i]. Aggregate expenditure

E2

E1E0

AD

P2

P1

P0

[ii]. Aggregate Demand

Real National Income [GDP]

Slope and Properties of AD Curve

The AD is negatively sloped just like the individual demand curve under

microeconomics

As general price level increases AE declines because private consumption

declines as households or the private sector saves more to restore real value of

wealth

As general price level decreases AE increase because private consumption

increase as households or the private sector benefits from an increase in the real

value of wealth

However note that the properties of the AD curve are different from the individual

demand curve

AD Curve vs. Individual Demand Curve

AD Curve

1. movement along the AD curve is

caused by changes in general price

level.

2. The negative slope of the AD curve

is due to changes in AE resulting

from changes in desired

consumption and net exports as

general price level changes

3. Reflects total demand for aggregate

output of goods and services

Individual Demand Curve

1. movement along the individual

demand curve is caused by

changes in price of the commodity.

2. The negative slope of the

individual demand curve is due to

the substitution and income effect

of a own price change (assuming

all other prices and income is

fixed)

3. Reflects individual demand for a

particular goods or service

Points Off AD: Relationship between AE and AD curves

Real GDP

Real GDP

Des

ired

sp

end

ing

Pri

ce l

evel

45o

AE

AE=Y

E0

e2

e0

e1

Y1 Y0 Y2

AE

Y1 Y0 Y2

P0

0

0

XE0 Z

ADDesired spending

less than output

Desired spending

equal output

Desired spending

exceeds output

Shifts in AD

A change in autonomous consumption

A change in investment

A change in Government Spending and/or Taxes

A change in Net exports

Rightward Shift of AD

Increase in autonomous consumption and/or Investment Spending and/or

Government Spending and/or net exports, but a decrease in net taxes

Leftward Shift of AD

decrease in autonomous consumption and/or Investment Spending and/or

Government Spending and/or net exports, but a increase in net taxes

The simple multiplier and shifts in the AD curve

A change in autonomous expenditure changes equilibrium GDP for any given

price level, and the simple multiplier measures the resulting horizontal shift in

the aggregate demand curve.

The original AE curve is at AE0 with equilibrium at E0, GDP=Y0 and Price

level=P0; the yield point E0 on AD0.

AE0 shifts to AE1 because of an autonomous expenditure increase A, and

GDP increases to Y1.

With given price level P0, the AD curve shifts rightward to E1.

AE = Y

The Simple Multiplier and Shifts in the AD Curve

Real GDP

[i]. Aggregate Expenditure

Des

ired

Ex

pen

dit

ure

0

45o

AE0

Y1

E0

Y0

AE1

A

E1

Y1

The Simple Multiplier and Shifts in the AD Curve

0 Y1Y0

P0

AD0

E0 E1

AD1Y

Real GDP

[i]. Aggregate Demand

Aggregate Supply

This is the aggregate output of goods and services that are produced by

all firms assuming that all will be sold at the going general price level.

The AS curve relates the aggregate output of goods and services

supplied to the price level

There are two main types of AS curves, namely

Short Run Aggregate Supply (SRAS) :shows the aggregate output of goods and

services that all firms would like to produce and sell at each general price level

assuming the prices of all inputs remain fixed.

Long Run Aggregate Supply (LRAS) :shows the aggregate output of goods and

services that all firms would like to produce and sell after the general price level

and input prices have fully adjusted to any exogenous shift of AD.

Y

SRAS

A Short-run Aggregate Supply Curve

Real GDP

Y0

P0

SRAS

Real GDP

A Short-run Aggregate Supply Curve

Y0 Y1

P0

P1

SRAS

Real GDP

A Short-run Aggregate Supply Curve

The short-run aggregate supply curve

The SRAS curve is positively sloped.

The positive slope shows that with prices of labour and other inputs given,

total desired output and the price level will be positively associated.

A rise in the price level from P0 to P1 will be associated with a rise in output

supplied from Y0 to Y1.

The slope of the SRAS curve is fairly flat at low levels of output and very

steep at higher levels.

Slope of AS

The positive relation between total output supplied and price level

depends on;

How production costs are related to output

How goods prices and output are related

Costs and Output

Unit costs are positively related to output and as such as firms desire to supply

more aggregate output their units costs rise

Prices and Output

Price-taking firms produce more if prices rise because unit costs rise with output

Price-setting firms will increase prices when aggregate output is expanded into a

range where unit costs are rising.

Shifts in AS

This is caused by;

Changes in productivity

Changes in input prices (cost of production)

Productivity

An increase in productivity implies that firms can supply more output at the same

price and therefore the AS shifts down to the right.

The opposite is also true

Changes in Input Prices

If input prices rise, the cost of production increases and therefore the profit of firms

decline at the same price level. Firms will react by cutting down on production and

therefore produce less aggregate output. This will shift SRAS upward to the left

The opposite is also true.

Y0

P0

SRAS

Macroeconomic Equilibrium

AD

E0

0Real GDP

Macroeconomic Equilibrium

Macroeconomic equilibrium occurs at the intersection of the AD and SRAS

curves and determines the equilibrium values for GDP and the price level.

Equilibrium occurs at E0 with GDP equal to Y0 and the price level P0.

If the price level were P1, below P0, the desired output of firms would be Y1

but desired demand would be Y2, so desired spending would exceed

desired production.

Only at E0 are desired plans of producers and consumers consistent.

Y0

P0

SRAS

AD

E0

Y2Y1

P1

0 Real GDP

Macroeconomic Equilibrium

AE=Y

AE0

Des

ired

Ex

pen

dit

ure

[i]. Aggregate expenditure

45o

E0

Y0

SARS

AD0

Real GDP

Real GDP

[i]. Aggregate demand

P0

Y0

The AE Curve and the Multiplier When the Price Level Varies

The AE curve and the multiplier when the price level varies

An upward shift in AE is partly offset by the resulting rise in prices, so the

multiplier is smaller than when prices are constant.

There is an increase in autonomous expenditure A creating the initial shift 1.

But prices then rise so the AE curves shifts part of the way back down as

shown by 2.

The economy moves from point E0 to E1.

AE=Y

AE0

Des

ired

Ex

pen

dit

ure

[i]. Aggregate expenditure

45o

E0

Y0

SARS

AD0

Real GDP

Real GDP

[i]. Aggregate demand

P0

Y0

The AE Curve and the Multiplier When the Price Level Varies

AE’1

A

E’1

Y’1

E’1E0

Y’1

AE=Y

AE0

Des

ired

Ex

pen

dit

ure

[i]. Aggregate expenditure

45o

E0

Y0

SARS

AD0

Real GDP

Real GDP

[i]. Aggregate demand

P1

P0

Y0

The AE Curve and the Multiplier When the Price Level Varies

AE’1

A

E’1

Y’1

E’1E0

Y’1

AE1

E1

Y1

Y

E1

Y1

AD1

AD Shocks

AD shocks cause the price level and real GDP to change in the same

direction.

Real GDP and Price Level both rise with and increase in AD

Real GDP and Price Level both decline with and decrease in AD

The effect of a given shock to AD will be divided between a change in

real GDP and a change in the price level depending on the conditions of

the AS

The steeper the AS curve, the greater is the price effect and the smaller is the

output effect

AD Shocks : The Importance of the Shape of SRAS

Demand shocks when the SRAS curve is vertical

AS Shocks

AS shocks cause the price level and real GDP to change in opposite

directions

An increase in AS (downward shift of AS curve) will cause a fall in general price

level and an increase in real GDP or output

An decrease in AS (upward shift of AS curve) will cause a rise in general price

level and an decrease in real GDP or output

Examples of AS shocks

Oil Price Increases during 1973-74, 1979-80, during Gulf war in 1990, and during

the late 2000s (i.e. 2007/08)

Productivity gains from an upsurge of new technologies in late 1990s

In Ghana during the droughts in 1982/83, energy crises in early 1980s, mid 2000s

and 2011-2015.

Aggregate supply shocks