Ch. 7: Aggregate Demand and
Aggregate Supply
Del Mar College
John Daly
©2003 South-Western Publishing, A Division of Thomson Learning
Aggregate Demand
• Aggregate Demand
refers to the quantity
demanded of goods and
services, or the quantity
demanded of the Real
GDP, at various price
levels.
Aggregate Demand Curve
• Notice the curve is downward
sloping, indicating an inverse
relationship between the price
level and the quantity demanded
of Real GDP: as the price level
rises, the quantity demanded of
Real GDP falls, and as the price
level falls, the quantity of GDP
demanded of Real GDP rises.
Why Does the Aggregate
Demand Curve Slope
Downwards??
• The Real Balance effect states that the inverse
relationship between the price level and the
quantity demanded of Real GDP is established
through changes in the value of monetary wealth.
• A fall in the price level causes purchasing power
to rise, which increases a person’s Monetary
Wealth. As people become wealthier, the quantity
demanded from the GDP rises.
• A rise in the price level causes Purchasing Power
to fall which decreases a person’s monetary
wealth.
Why Does the Aggregate
Demand Curve Slope
Downwards??
• The Interest Rate Effect states that the inverse
relationship between the price level and the quantity
demanded of Real GDP is established through changes in
household and business spending that is sensitive to
changes in interest rates.
• The International Trade Effect states that the inverse
relationship between the price level and the quantity
demanded of Real GDP is established through foreign
sector spending, which includes US spending on foreign
goods and foreign spending on US goods.
A Change in the Quantity
Demanded of Real GDP versus a
Change in Aggregate Demand
• A Change in the quantity demanded of Real GDP
is brought about by a change in the price level.
This would cause a shift down the Aggregate
Demand Curve, but would not move the curve.
• A Change in Aggregate Demand is a shift in the
Aggregate Demand Curve. An increase is a right
shift of the curve, while a decrease in Aggregate
Demand would cause a left shift to the curve.
A Shift in the Aggregate Demand
Curve
Changes in Aggregate Demand
• If at a given price level, Consumption,
Investment, Government Purchases, or Net
Exports INCREASE, then Aggregate
Demand will INCREASE as well.
• If at a given price level, Consumption,
Investment , Government Purchases, or Net
Exports DECREASE, the Aggregate
Demand will DECREASE as well.
How Spending Components
Affect Aggregate Demand
• Components of
Spending:
–
–
–
–
Consumption
Investment
Government Purchases
Net Exports
• A change in some or
all of these
components can affect
aggregate demand.
What Causes Consumption to
Increase?
• Wealth
• Expectations about
Future Prices and
Income
• Interest Rate
• Income Taxes
What Causes Investment to
Increase?
• The Interest Rate
• Expectations about
Future Sales
• Business Taxes
What Would Increase Net
Exports?
• Foreign Real National
Income: As exports rise,
net exports rise, and so
does the Real GDP.
• Exchange Rate: whether
or how far a different
monetary unit has
appreciated or depreciated
when compared to your
own monetary units.
Q&A
• Explain the Real Balance effect.
• Explain what happens to the Aggregate
Demand curve if the dollar appreciates
relative to other currencies.
• Explain what happens to the Aggregate
Demand curve if personal income taxes
decline.
Short Run Aggregate Supply
• The quantity supplied
of all goods and
services at different
price levels.
• The Short Run
Aggregate Supply
Curve is upward
sloping.
Short-Run Aggregate
Supply Curve
Short-Run Aggregate Supply
Curve: What is it, why is it
upward-sloping??
• “Sticky” Wages: Some economists believe
that wages are sticky or inflexible. Wages
may also become sticky because of certain
social conventions or perceived notion of
fairness.
• Most individuals are willing to work, and
current workers are willing to work more, at
higher than at lower real wages.
Short-Run Aggregate Supply
Curve: What is it, why is it
upward-sloping??
• Prices are also sometimes “sticky”: some prices
adjust quickly in an economy, others do not.
• Some prices are sticky because there are costs to
changing prices, called Menu Costs.
• If some prices are sticky, a decline in the price
level is linked with a decrease in output, which is
illustrative of an upward-sloping SRAS curve.
Short-Run Aggregate Supply
Curve: What is it, why is it
upward-sloping??
• Producer Misperceptions: Economists generally
agree that producers will produce more output as
their relative price of their good rises and produce
less output as the relative price of their good falls.
• If producers misperceive relative price changes,
then a higher price level will bring about an
increase in output, which is illustrative of an
upward-sloping SRAS curve.
Short-Run Aggregate Supply
Curve: What is it, why is it
upward-sloping??
• Worker
Misperceptions: if
workers misperceive
Real wage changes,
then a fall in the price
level will bring about
a decline in output,
illustrative of the
upward-sloping curve.
Shifts in the Aggregate Supply
Curve
• Wage Rate: a rise
in equilibrium
wage rates leads
to a leftward shift
in the aggregate
supply curve.
• Price of Nonlabor
units: An increase
in the amount
nonlabor input
shifts the ASC
leftward.
• A decrease in the
amount nonlabor
input shifts the
ASC rightward,
Shifts in the Aggregate Supply
Curve
• Productivity: describes the
output produced per unit
of input employed over
some time.
• This causes the SRAS to
shift rightward. A
decrease in labor
productivity means
business will produce less
output with the same
amount of labor.
Shifts in the Aggregate Supply
Curve
• Supply Shocks: Major
natural or institutional
changes on the supply side
of the economy that affect
aggregate supply are
referred to as supply
shocks.
• A Supply shock might
include a drought in the
Midwest, or finding even
more oil in the middle
ease.
Q&A
• If wage rates decline, explain what happens
to the short-run aggregate supply curve?
• Give an example of an increase in labor
productivity.
How Short-Run Equilibrium In
The Economy Is Achieved
• Aggregate demand and short-run aggregate supply
determine the price level, Real GDP, and the
unemployment rate in the short run.
• In instances of both surplus and shortage,
economic forces are moving the economy toward
the short-run equilibrium point, where the quantity
demanded of Real GDP is equal to the short-run
quantity supplied of Real GDP.
• An increase in the short-run aggregate supply
lowers the equilibrium price level and raises Real
GDP.
The Unemployment Rate In The
Short Run
• All other things held constant, we expect a higher
Real GDP level to be associated with a lower
unemployment rate and a lower Real GDP level to
be associated with a higher unemployment rate.
• Since more workers are needed to produce more
output (more Real GDP), fewer people remain
unemployed and the unemployment rate drops.
• Since fewer workers are needed to produce less
output, more people are unemployed and the
employment rate rises.
Ceteris Paribus Makes All The
Difference in the Relationship between
Real GDP and the Unemployment Rate
• If some other things
change, it may appear as if
the inverse relationship
between the
unemployment rate and
Real GDP doesn’t hold.
• Economics is about
establishing a connection
or link between an effect
and a correct cause.
Q & A: Identify what will happen to
the price level and Real GDP when
each of the following occurs:
• Short-Run Aggregate
Supply rises
• Short-Run Aggregate
Supply falls
• Aggregate Demand
rises
• Aggregate Demand
falls
• Aggregate Demand
rises by more than the
Short-Run Aggregate
Supply rises
• Aggregate Demand
falls by less than the
Short-Run Aggregate
Supply falls
Long Run Aggregate Supply
• Short-Run equilibrium identifies the Real GDP the
economy produces when any of these conditions
are held: sticky wages, sticky prices, producers’
misperceptions, workers’ misperceptions.
• Wages and prices eventually become unstuck and
misperceptions will turn to accurate perceptions:
when this happens the economy is said to be in
The Long Run.
• An important question is: Will the Level of Real
GDP the economy produces in the long run be the
same as in the short-run?
Long-Run and Short-Run
When the economy is
neither in the ShortRun nor the LongRun, the economy is
in a state of
disequilibrium.
Questions Economists Ask
• What can cause the
economy to move
from one short-run
equilibrium position to
another short-run
equilibrium position?
Questions Economists Ask
• What happens to certain economic variables such
as the price level and Real GDP, as the economy
moves from one short-run equilibrium to another
short-run equilibrium?
• If the economy is in the short-run equilibrium,
what path does it travel to long-run equilibrium?
• How long does it take the economy to move from
short-run equilibrium to long-run equilibrium?
Questions Economists Ask
• If the economy is in longrun equilibrium, what
must happen to move it to
another long-run
equilibrium?
• How long does it take to
move from one long-run
equilibrium position to
another long-run
equilibrium postion?
Questions Economists Ask
• Are some of the states of
an economy better than
other states?
• If some states of the
economy are better than
others, is there anything
that government can do to
move the economy from
one state to another?
Q&A
• What is the difference
between short-run
equilibrium and longrun equilibrium?
• Diagrammatically
represent an economy
that is in neither short
run equilibrium nor
long run equilibrium.