Random Fact

India was the 20th largest exporter in the world this past year. It was the 12th largest importer in the world (CIA World Fact Book).

Section 6: Aggregate Demand and Aggregate Supply PDF Print E-mail
Macroeconomics - Unit 5

The Aggregate Demand Curve

 

In Unit 2, we learned that a demand curve illustrates the relationship between quantity demanded and the price of one product. Aggregate demand represents the quantity demanded of all products in a certain country or area at different price levels.

 The aggregate demand curve is downward sloping, just like one product's demand curve. It slopes downward because of the substitution effect and because of the income effect. The substitution effect states that as the price of a product decreases, it becomes cheaper than competing products, ceteris paribus, and consumers will substitute the cheaper product for the more-expensive product, and vice versa. In the case of the aggregate demand curve, we consider all domestic products, so the substitution effect only applies to the substitution of domestic products for foreign products. In other words, when domestic products become cheaper, buyers purchase more of these products and they purchase fewer of the relatively more-expensive foreign products. If we were to consider a "world demand" curve, the substitution effect would not apply (until we start production on other planets!).

The income effect states that as the price of a product decreases, buyers will have more income available to purchase more products, and vice versa. In the case of the aggregate demand curve, if the average price level of all products decreases, buyers will have more discretionary income available. For example, if all buyers purchase 1 million products per week at an average price of $4, then the buyers' total expenditure equals $4 million. If the average price level falls to $3, the total expenditure if everyone buys the same number of products now equals $3 million. This means that buyers now have $1 million more to spend on other products. In essence, buyers' real incomes have increased.

Below is a graph of a typical aggregate demand curve.

A Shift in the Aggregate Demand Curve

 

 

The aggregate demand curve can shift for various reasons. A shift to the right illustrates an increase in aggregate demand (see adjacent graph). A shift to the left illustrates a decrease in aggregate demand. The components of aggregate demand include Consumption (C), Gross Private Domestic Investment (I), Government Spending (G) and Net Exports (X). Anything affecting these components will shift the curve.

Buyers' wealth, incomes, the level of taxes, and subsidies all affect Consumption. For example, an increase in wealth and incomes increases aggregate demand. This shifts the curve to the right.

Interest rates, expected interest rates and expected rates of return (profits) affect Gross Private Domestic Investment. For example, if interest rates decrease, the cost of borrowing decreases. This increases firms' incentives to borrow and invest. This increases aggregate demand.

Government spending is for the most part autonomous. This means that it is not dependent on a particular variable. The government can decide to increase spending on the military or domestic programs. This increases aggregate demand.

Net Exports is dependent on the relative prices of foreign versus domestic products and exchange rates. If domestic prices decrease, then the demand for our products increases. This increases aggregate demand.

The Aggregate Supply Curve

In Unit 2, we learned that a supply curve illustrates the relationship between quantity supplied and the price of one product. Aggregate supply represents the quantity supplied of all products in a certain country or area at different price levels.

 A typical aggregate supply curve is upward sloping, just like one product's supply curve. It slopes upward because of the substitution effect and because of the income effect.

The supplier's substitution effect states that as the market price of a product increases, other competing products, ceteris paribus, will become less attractive to produce, and suppliers will substitute the higher-priced product for the less-expensive product (and vice versa). In the case of the aggregate supply curve, we consider all domestic products, so the substitution effect only applies to the substitution of the production of domestic products in place of the production of foreign products. In other words, when domestic products can be sold at a higher real price, suppliers will have more incentive to produce domestic products versus foreign products (ceteris paribus). If we were to consider a world supply curve, the substitution effect would not apply.

The supplier's income effect states that as the real market price of a product increases, a supplier will earn more income (make a greater profit), so that the supplier has more incentive and greater means to increase production (and vice versa). For example, if all suppliers sell 1 million products per week at an average price of $7, then the suppliers' total revenue equals $7 million. If the average price level rises to $8, the total revenue for selling the same number of products now equals $8 million. Assuming no change in the cost of production, this increases suppliers' income and their incentives and abilities to produce.

Below is a graph of a typical aggregate supply curve.


A Shift in the Aggregate Supply Curve

 

The aggregate supply curve can shift for various reasons. A shift to the right illustrates an increase in aggregate supply (see adjacent graph). A shift to the left illustrates a decrease in aggregate supply.

When input prices (wages, prices of raw materials, interest payments, rent, etc.) decrease, or technology advances, or taxes decrease, or subsidies increase, or regulations loosen, then it becomes more attractive to produce, and aggregate supply increases (and vice versa). Unpredictable events, such as weather emergencies, war, and political instability decrease aggregate supply and shift the aggregate supply curve to the left.

Keynesian Economics and the Horizontal Part of the Aggregate Supply Curve

The economy is at equilibrium (no product shortages or surpluses) at the point where aggregate demand (AD) and aggregate supply (AS) intersect. For example, if the economy's aggregate demand schedule is AD1 and its aggregate supply schedule is AS, then the economy experiences an equilibrium GDP level equal to GDP1 (see graph below). In the graph below, this GDP is at a relatively low level, which means that there is a recessionary gap and unemployment. Note that for low levels of GDP, the aggregate supply curve in the Keynesian model is horizontal. In this case, the economy experiences a recessionary gap (GDP1) and if aggregate demand increases to AD2, then the equilibrium increases to GDP2, without an increase in the price level.

 


Keynesian Economics and the Vertical Part of the Aggregate Supply Curve

In the graph below, if the economy's aggregate demand schedule is AD1 and its aggregate supply schedule is AS, then the economy experiences an equilibrium level equal to GDP. This GDP is at a high level, which means that there is full employment. Note that for high levels of GDP, the aggregate supply curve in the Keynesian model is vertical. The economy experiences an inflationary gap (GDP1) if aggregate demand increases to AD2. The price level rises without an increase in real GDP.

 

Keynesian Economics and the Upward Sloping Portion of the Aggregate Supply Curve

In the graph below, if the economy's aggregate demand schedule is AD1 and its aggregate supply schedule is AS, then the economy experiences an equilibrium level equal to GDP1. The aggregate supply curve at this level of GDP is upward sloping. If aggregate demand increases to AD2, equilibrium GDP increases, as does the price level.

 

Keynesian Economics and the Phillips Curve

According to the Keynesian model, when the AD curve shifts in the upward sloping part of the AS curve (see graph above), we observe a growing economy and a rising price level. Typically, when the economy grows, unemployment decreases. Therefore, in the upward sloping part of the AS curve, we observe decreasing unemployment and increasing inflation. This inverse relationship between unemployment and inflation is illustrated by the so-called "Phillips curve." The Phillips curve (see graph below) is named after economist A.W.H. Phillips, who published a study in 1958, which observed the inverse relationship between wage inflation and unemployment in the United Kingdom from 1861 to 1957.

 

Classical Economics and the Key to Economic Growth

Classical economics and offsprings of this economic school, believe that the Keynesian model focuses too much on the short run and not enough on the long run. In the short run, classical economists acknowledge that an increase in aggregate demand increases equilibrium GDP. However, if the increase in aggregate demand is triggered by artificial increases in government spending via increases in the money supply or increases in the nation's national debt, then in the long run, inflation and interest rates increases. Higher inflation and higher interest rates lead to decreases in aggregate demand, particularly in the private sector. So while active fiscal and monetary policy may increase aggregate demand in the short run, they lead to decreases in aggregate demand in the long run.

 

The key to economic growth, according to classical economists, is aggregate supply growth. An offspring of the classical economic school, the Austrian school, believes that the economy can grow and increase its production capacities while keeping the money supply constant. In Unit 1, we learned that economic growth is caused by advances in technology and increases in resources. As the economy grows, aggregate supply increases. In the graph below, this is illustrated by shifts in the aggregate supply curves from AS1 to AS2, and AS2 to AS3. The equilibrium GDP moves from point X to Y and from Y to Z. The price level decreases, because the money supply is constant and production increases (see also Unit 7 for a more detailed explanation of this relationship). Nominal GDP and nominal incomes remain constant, because the money supply is constant. However, real GDP increases because production increases and buyers' purchasing power increases due to the falling prices. Because of the constant money supply, the aggregate demand curve does not shift. However, quantity demanded increases because of the falling price level and higher real incomes.

 

Video Explanation
For a video explanation of how to apply the Aggregate Demand and Aggregate Supply curves to the Keynesian and Classical Economics theories, please visit:

Last Updated on Saturday, 04 October 2014 16:14