AGGREGATE DEMAND AND AGGREGATE SUPPLY

Aggregate Demand is the sum total of all planned expenditures in an Economy (in a year).
Aggregate Supply is the sum total of all planned production in an Economy (in a year).
Movement:
Change in Price Level leads to a change in REAL National Income
Shift (SHOCK): A movement of the entire curve left or right
Aggregate Demand Curve is downward-sloping.
Variables: The PRICE LEVEL of the economy over time and REAL NATIONAL INCOME
AD

PRICE
LEVEL

AD
0

REAL NATIONAL INCOME PER YEAR

Reasons for downward-sloping curve:

1. Interest Rate Effect: A rise in the Price Level leads to a rise in Nominal Interest Rates.
This leads to a fall in the Quantity Demanded (fall in sales). Thus
Total Consumption falls leading to an overall fall in Real National
Income.
2. Wealth Effect:

A rise in the Price Level leads to a fall in the value of moneydenominated forms of wealth (e.g. fixed rate bonds and savings). As
total wealth / assets diminishes consumers will spend less and thus
Total Consumption falls leading to a fall in Real National Income.

3. Substitution of Foreign Goods Effect: A rise in the Price Level leads to imported goods
becoming relatively less expensive than their domestically produced
equivalent. Expenditure on imported goods increases while
expenditure on domestic goods falls. Thus Total Consumption falls
(as does Net Exports) leading to a fall in Real National Income.
Aggregate Demand is represented the same in both the short-run and long-run

AGGREGATE SUPPLY
Two different Curves long-run and short-run
(In addition, there are significant differences between various schools of economic thought as to
the actual shape of the Aggregate Supply Curves)
Long-run Curve:

AS
Full Capacity
No Excess Capacity

PRICE
LEVEL

AS
Excess Capacity

Intermediate
(Some Excess Capacity)

Some bottlenecks
REAL NATIONAL INCOME

YF (Full Capacity)

FULL CAPACITY Absolute physical limit on how much an economy can produce with a
specific, finite amount of Factors of Production.
Bottlenecks: Supply constraints within an economy as they become increasingly scarce.

AS
Price
Level

AS
Price
Level

Real National Income (per year)

Extreme Keynesian Conception

Real National Income (per year)

Extreme Monetarist Conception

SHORT-RUN AGREGATE DEMAND

(Notable for Aggregate Demand and Aggregate Supply analysis)
SRAS
Price
Level

SRAS

Real National Income

Shifts in Aggregate Demand (Aggregate Demand Shock):

Increase in AD: Price level rises / Real National Income rises
Decrease in AD: Price level falls / Real National Income falls
This leads to an inverse relationship of Inflation and Unemployment.
Shifts in Aggregate Supply (Aggregate Supply Shock)
Increase in AS: Price level falls / Real National Income rises
Decrease in AS: Price level rises / Real National Income falls (STAGFLATION)
SUPPLY-SIDE ECONOMICS
This is a school of economic thought that came to prominence in the late 1970s.
They believe that certain policies lead to positive AS shocks that are followed by AD shocks that
produce non-inflationary economic growth.
Supply creates its own demand. This one-time economic orthodoxy claims that prolonged
over-production and deficient demand are not possible in an economy, for equilibrium will
always return to a high level of demand.
Policies:

1.
2.
3.
4.
5.
6.
7.

Lower the marginal tax rates

Reduce role of government in the economy
Reduce or eliminate budget deficits
Maintain low, constant interest rates (shared with monetarists)
Create a flexible labour market (weaken labour laws & union power)
Weaken environmental laws
Maintain low rates of inflation
AD

AD
AS

AS

Price
Level
P

Y1

Y2

Real National Income (per year)