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AGGREGATE SUPPLY AND
AGGREGATE DEMAND
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• Economists analyze short-run economic fluctuations using the
aggregate demand and aggregate supply model. According to this
model, the output of goods and services and the overall level of
prices adjust to balance aggregate demand and aggregate supply.
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The Model of Aggregate Demand and Aggregate
Supply
• Two variables:
• Economy’s output of goods and services - measured by real
GDP
• Average level of prices – measured by CPI
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The Model of Aggregate Demand and Aggregate
Supply
• The aggregate-demand curve (AD) shows the quantity of goods and
services that households, firms, and the government want to buy at each
price level.
• The aggregate-supply curve (AS) shows the quantity of goods and services
that firms are willing to produce and sell at each price level.
• According to this model, the price level and the quantity of output adjust
to bring aggregate demand and aggregate supply into balance equilibrium.
• Different from the model of market demand and market supply  the
quantity of this model – real GDP – measures the total quantity of goods
and services produced in all markets.
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Aggregate Demand and Aggregate Supply
Price
Level
Aggregate
supply
Equilibrium
price level
Aggregate
demand
0
Equilibrium
output
Quantity of
Output
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THE AGGREGATE-DEMAND CURVE
• The aggregate-demand curve tells us the quantity of all goods and
services demanded in the economy at any given price level.
• Downward sloping (refer next slide) -- other things equal
• a decrease in the economy’s overall level of prices (from P1 to P2)
raises the quantity of goods and services demanded (from Y1 to
Y2).
• Conversely, an increase in the price level reduces the quantity of
goods and services demanded.
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The Aggregate-Demand Curve...
Price
Level
P
P2
1. A decrease
in the price
level . . .
0
Aggregate
demand
Y
Y2
Quantity of
Output
2. . . . increases the quantity of
goods and services demanded.
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THE AGGREGATE-DEMAND CURVE
• Why a negative relationship?
• Recall the four components of GDP (Y) contribute to the aggregate
demand for goods and services.
Y = C + I + G + (X-M)
Assumption: government spending is fixed by policy, ie,
holding the amount of money in the economy constant.
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Why the Aggregate-Demand Curve Is Downward
Sloping
• To understand the downward slope of the aggregate-demand curve,
we examine how the price level affects the quantity of goods and
services demanded for consumption, investment, and net exports.
1. The Price Level and Consumption:
• The Wealth Effect
2. The Price Level and Investment:
• The Interest Rate / Substitution Effect
3. The Price Level and Net Exports:
• The Exchange-Rate / International Substitution Effect
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Why the Aggregate-Demand Curve Is Downward
Sloping
• The Price Level and Consumption:
The Wealth Effect
• A lower price level raises the real value of money and makes
consumers wealthier, which encourages them to spend
more.
• This increase in consumer spending means larger quantities
of goods and services demanded.
• Example: 1 roti canai for RM1 or RM0.50
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Why the Aggregate-Demand Curve Is Downward
Sloping
• The Price Level and Investment:
The Interest Rate Effect
• The lower the price level, the less money households need to hold to buy
goods and services they want. Therefore, when price level falls,
households try to reduce their holdings of money by lending some of it
out  drive down interest rates.
• Interest rates, in turn, affect spending on goods and services firms
borrow more to invest in new plants and equipment, households borrow
more to invest in new housing.
• In short, a lower price level reduces the interest rate and makes borrowing
less expensive, which encourages greater spending on investment goods.
• This increase in investment spending means a larger quantity of goods
and services demanded.
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Why the Aggregate-Demand Curve Is Downward
Sloping
• The Price Level and Net Exports:
The Exchange-Rate Effect
• A lower price level lowers interest rates in Malaysia  investors will seek higher
returns by investing abroad  conversion of ringgit to foreign currency increases
the supply of ringgit in the market  ringgit depreciates.
• A lower price level in Malaysia causes Malaysia’s interest rates fall and the real
exchange rate to depreciate, which stimulates Malaysia’s net exports.
• The increase in net export spending means a larger quantity of goods and
services demanded.
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Summary
When price level falls..
When price level rises..
1. Consumers are wealthier,
which stimulates demand
for consumption goods.
2. Interest rates fall, which
stimulates demand for
investment goods.
3. Currency depreciates,
which stimulates demand
for net exports.
1. Decreased wealth
depresses consumer
spending.
2. Higher interest rates
depress investment
spending.
3. Currency appreciation
depresses net exports.
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A thought of experiment
• One day you wake up
and notice that for
some mysterious
reason, the prices of all
goods and services
have fallen by half..
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Why the Aggregate-Demand Curve Might Shift
• The downward slope of the aggregate-demand curve shows that a fall
in the price level raises the overall quantity of goods and services
demanded.
• Many other factors, however, affect the quantity of goods and
services demanded at any given price level.
• When one of these other factors changes, the aggregate demand
curve shifts.
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Why the Aggregate-Demand Curve Might Shift
Changes in Aggregate Demand
A change in any influence on buying plans other than the price level changes
aggregate demand.
The main influences on aggregate demand are
 Expectations
 Fiscal policy and monetary policy
 The world economy
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Why the Aggregate-Demand Curve Might Shift
Expectations
• Expectations about future income, future inflation, and future profits change
aggregate demand.
• Increases in expected future income increase people’s consumption today and
increases aggregate demand.
• A rise in the expected inflation rate makes buying goods cheaper today and
increases aggregate demand.
• An increase in expected future profits boosts firms’ investment, which increases
aggregate demand.
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Why the Aggregate-Demand Curve Might Shift
Fiscal Policy and Monetary Policy
• Fiscal policy is the government’s attempt to influence the economy by setting
and changing taxes, and purchasing goods and services.
• A tax cut increases households’ disposable income.
• An increase in disposable income increases consumption expenditure and increases
aggregate demand.
• The most direct way policymakers shift the AD curve is through government
purchases. Eg. Government starts building more highways (increase in government
expenditure)  greater quantity of goods and services demanded at any price level
 AD curve shifts to the right.
• What happen if government decides to reduce purchases of new medical equipment?
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Why the Aggregate-Demand Curve Might Shift
• The central bank’s attempt to influence the economy by changing the interest
rate and adjusting the quantity of money is called monetary policy.
• An increase in the quantity of money increases buying power and increases
aggregate demand.
• A cut in interest rates increases expenditure and increases aggregate demand.
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Why the Aggregate-Demand Curve Might Shift
The World Economy
The world economy influences aggregate demand in two ways:
• A fall in the foreign exchange rate lowers the price of domestic goods and
services relative to foreign goods and services, which increases exports, decreases
imports, and increases aggregate demand.
• A decrease in foreign income decreases the demand for local exports and
decreases aggregate demand. Eg. Japan experiences a recession – buy fewer
goods from Malaysia – reduces local net exports at every price level and shift AD
curve to the left.
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Changes in Aggregate Demand
Changes in aggregate demand
Aggregate demand increases if
• Expected future income,
inflation, or profits increase.
• Fiscal policy or monetary policy
actions increase planned
expenditure.
• The exchange rate falls or
foreign income increases.
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THE AGGREGATE-SUPPLY CURVE
• Aggregate supply is the relationship between the quantity of real GDP
supplied and the price level.
• We distinguish two time frames associated with different states of the
labor market:
• Long-run aggregate supply (LAS)
• Short-run aggregate supply (SAS)
• In the long run, the aggregate-supply curve is vertical because the price
level does not affect long run determinants of real GDP.
• In the short run, the aggregate-supply curve is upward sloping.
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THE AGGREGATE-SUPPLY CURVE
• In the long run, an economy’s production of goods and services
depends on its supplies of labor, capital, and natural resources and on
the available technology used to turn these factors of production into
goods and services.
• The price level does not affect these variables in the long run.
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The Long-Run Aggregate-Supply
Curve
Price
Level
Long-run
aggregate
supply
P
P2
2. . . . does not affect
the quantity of goods
and services supplied
in the long run.
1. A change
in the price
level . . .
0
Natural rate
of output
Quantity of
Output
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THE AGGREGATE-SUPPLY CURVE
• The long-run aggregate-supply curve is vertical at the natural rate of
output, which is the production of goods and services that an
economy achieves in the long run when unemployment is at its
normal rate.
• This level of production is also referred to as potential output or fullemployment output.
• The natural rate of output is level of output towards which the economy
gravitates in the long run.
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Short-Run Aggregate-Supply Curve
• SAS tells us the quantity of goods and services supplied in the short run for
any given level of prices.
• Similar to LAS but is upward sloping rather than vertical.
• What shift SAS are variables that shift the LAS plus a new variable –
expected price level.
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Why the Aggregate-Supply Curve Slopes Upward
in the Short Run
• LAS is vertical because, in the long run, the overall level of prices does
not affect the economy’s ability to produce goods and services.
• In the short run, the price level does affect the economy’s output.
That is, over a period of a year or two, an increase in the overall level
of prices in the economy tends to raise the quantity of goods and
services supplied, and a decrease in prices tend to reduce the
quantity of goods and services supplied
• As a result, the short-run aggregate-supply curve is upward sloping.
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Why the Aggregate-Supply Curve Slopes Upward
in the Short Run
• Three Theories:
• The Sticky-Wage Theory
• The Sticky-Price Theory
• The Misperceptions Theory (not explained here)
Why the Aggregate-Supply Curve Slopes Upward
in the Short Run
The Sticky-Wage Theory
• Nominal wages are slow to adjust to changing economic conditions, or are
“sticky” in the short run
• Nominal wages do not adjust immediately to a fall in the price level. A lower
price level makes employment and production less profitable.
• This induces firms to reduce the quantity of goods and services supplied.
• On the other hand, when prices rises and wages are sticky, firms hire more
workers to increase revenues and profits. When firms hire more workers,
output increases.
Why the Aggregate-Supply Curve Slopes Upward
in the Short Run
The Sticky-Price Theory
• Prices of some goods and services adjust sluggishly in response to changing
economic conditions.
• An unexpected fall in the price level leaves some firms with higher-thandesired prices. For a variety of reasons, they may not want to or be able to
change prices immediately.
• This depresses sales, which induces firms to reduce the quantity of goods and
services they produce.
The Short-Run Aggregate-Supply Curve
Price
Level
Short-run
aggregate
supply
P
P2
2. . . . reduces the quantity
of goods and services
supplied in the short run.
1. A decrease
in the price
level . . .
0
Y2
Y
Quantity of
Output
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Why the Short-Run Aggregate-Supply Curve
Might Shift
• From the positive slope of the AS curve, we can see that price is one
of the determinants of the AS curve.
• However, change in prices will only bring about changes along the AS
curve, i.e, changes in the production quantity supplied.
• Besides the price factor, other factors that cause the AS curve to shift
either to the left or right are:
•
•
•
•
Input price
Productivity
Government policy
environment
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Why the Short-Run Aggregate-Supply Curve
Might Shift
• Input price
• This resource includes land, labor, capital and entrepreneurs. Innovation in
this resource can reduce the price of the resource  production cost per unit
drops  firms increase production  SAS curve move to the right. Eg.
increased women participation in the labor cost.
• On the other hand, rise in input price (a cost shock) SAS curve shifts to the
left.
• Productivity
• An increase in productivity causes AS curve to shift to the right.
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Why the Short-Run Aggregate-Supply Curve
Might Shift
• Government policy
• Increase in business tax will increase production cost  AS curve shifts
to the left.
• If the government provides subsidies, AS curve shifts to the right.
• Increased regulations of government forces firms to allocate some
money to carry out control activities  increased cost of operations 
AS shifts to the left.
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Why the Short-Run Aggregate-Supply Curve
Might Shift
• Environment
• Includes weather, natural disasters and wars.
• Eg. during the monsoon season, fishermen cannot go out to sea. This will
cause a reduction in seafood supply  AS shifts to the left.
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Explaining Macroeconomic Trends and
Fluctuations
•Aggregate supply and aggregate demand determine real GDP and the price
level.
•Macroeconomic equilibrium occurs when the quantity of real GDP demanded
equals the quantity of real GDP supplied.
•Macroeconomic equilibrium occurs at the point of intersection of the AD
curve and the AS curve.
•Short-run macroeconomic equilibrium occurs when the quantity of real GDP
demanded equals the quantity of real GDP supplied at the point of intersection
of the AD curve and the SAS curve.
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Long Run Equilibrium
• The long run equilibrium of the economy is found where the AD curve
crosses the LAS (point A) (refer next slide).
• When the economy reaches this long-run equilibrium, the expected
price level will have adjusted to equal the actual price level.
• As a result, the SAS curve crosses the point as well.
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Long Run Equilibrium
Price
Level
Long-run
aggregate
Supply (LAS)
Short-run
aggregate
Supply (SAS)
A
Equilibrium
price
Aggregate
Demand (AD)
0
Natural rate
of output
Quantity of
Output
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TWO CAUSES OF ECONOMIC FLUCTUATIONS
Four steps in the process of analyzing economic
fluctuations:
1. Determine whether the event affects aggregate
supply or aggregate demand.
2. Decide which direction the curve shifts.
3. Use a diagram to compare the initial and the new
equilibrium.
4. Keep track of the short and long run equilibrium,
and the transition between them.
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Effects of a Shift in a Aggregate Demand
• Scenario 1: Suppose that a wave of pessimism suddenly overtakes the
economy…
• People lose confidence in the future – cut back on spending and delay
major purchases, firms put off buying new equipment.
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Effects of a Shift in a Aggregate Demand
1. Because it affects spending plans, it affects the AD curve.
2. Because households and firms now want to buy a smaller quantity
of goods and services for any given price level, the event reduces
AD – AD curve shifts to the left from AD1 to AD2.
3. By comparing the initial and new equilibrium, we can see the
effects of the fall in AD.
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Effects of a Shift in a Aggregate Demand
3. In the short-run, the economy moves along the initial SAS, AS1, going
from point A to point B. As the economy moves between these two
points, output falls from Y1 to Y2, and the price level falls from P1 to
P2. The falling level of output indicates that the economy is in a
recession – firms respond to lower sales and production by reducing
employment. This is somewhat self-fulfilling: pessimism about the
future leads to falling incomes and rising unemployment.
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Effects of a Shift in a Aggregate Demand
4. Transition from SR equilibrium to LR equilibrium: because of the reduction in AD,
the price level initially falls from P1 to P2.
The price level is thus below the level that people have come to expect (P1)
before the sudden fall in AD. Although people are surprised in the SR, they will
not remain surprised. Over time, expectations catch up with this new reality,
and the expected price level falls as well.
The fall in the expected price level alters wages, prices, and perceptions, which
in turn influences the position of the SAS – sticky wage theory – workers and
firms come to expect a lower level of prices and start to strike bargains for lower
nominal wages. Reduction in labor costs expands production at any give level of
prices.
Thus, the fall in the expected price level shifts the SAS to the right from AS1 to
AS2.
Now economy moves to point C, where the new AD2 crosses the LAS.
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Effects of a Shift in a Aggregate Demand
• In the new LR equilibrium, point C, output is back to its natural rate.
The economy has corrected itself – the decline in output is reversed
in the LR, even without action by policymakers.
• In the LR, the shift in AD is reflected fully in the price level and not at
all in the output level.
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A Contraction in Aggregate Demand
2. . . . causes output to fall in the short run . . .
Price
Level
Long-run
aggregate
supply
Short-run aggregate
supply, AS
AS2
3. . . . but over
time, the short-run
aggregate-supply
curve shifts . . .
A
P
B
P2
P3
1. A decrease in
aggregate demand . . .
C
Aggregate
demand, AD
AD2
0
Y2
Y
4. . . . and output returns
to its natural rate.
Quantity of
Output
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Effects of a Shift in a Aggregate Demand
• Opposite will be true when AD shifts to the right.
• When AD shifts to the right, price and output increases in short run.
• Real production level exceeds potential production. There will be
overtime for labor and capital.
• In longer run employees will bargain for higher wages and this
increases firms’ production costs.
• The increase in costs shifts the SAS curve to the left.
• At the new equilibrium, only the price increases but the production
remains the same. This equilibrium is for both short- and long-run.
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TWO CAUSES OF ECONOMIC FLUCTUATIONS
Conclusion - Effects of a Shift in a Aggregate Demand
Shifts in Aggregate Demand
• In the short run, shifts in aggregate demand cause fluctuations in the
economy’s output of goods and services.
• In the long run, shifts in aggregate demand affect the overall price
level but do not affect output.
• Policymakers who influence aggregate demand can potentially
mitigate the severity of economic fluctuations.
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TWO CAUSES OF ECONOMIC FLUCTUATIONS
Four steps in the process of analyzing economic fluctuations:
1. Determine whether the event affects aggregate supply or
aggregate demand.
2. Decide which direction the curve shifts.
3. Use a diagram to compare the initial and the new
equilibrium.
4. Keep track of the short and long run equilibrium, and the
transition between them.
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Effects of a Shift in a Aggregate Supply
• Scenario 2: Suppose that suddenly some firms experience an increase
in costs of production.
• Eg. Outbreak of war that interrupts the shipping of crude oil or bad
weather destroying some crops, driving up the cost of production…
What is the macroeconomic impact of such
scenario?
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Effects of a Shift in a Aggregate Supply
1. Because it affects production costs, it affects the AS curve.
2. Because higher production costs make selling goods and services
less profitable, firms now supply a smaller quantity of output for
any given level price – AS curve shifts to the left from AS1 to AS2.
3. By comparing the initial and new equilibrium, we can see the
effects of the fall in AS.
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Effects of a Shift in a Aggregate Supply
3. In the short-run, the economy moves from point A to point B,
moving along the existing AD curve. As the economy moves between
these two points, output falls from Y1 to Y2, and the price level rises
from P1 to P2. Because the economy is experiencing both stagnation
(falling output) and inflation (rising prices), such an event is
sometimes called stagflation.
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Effects of a Shift in a Aggregate Supply
4. Transition from SR equilibrium to LR equilibrium.
According to stick-wage theory, firms and workers may at first respond to
the higher level of prices by raising their expectations of the price level
and setting higher nominal wages – firms’ costs will rise again, and the
SAS will shift further to the left. Higher prices leads to higher wages, in
turn leads to even higher prices (wage-price spiral).
At some point, this will slow. The low level of output and employment will
put downward pressure on wages when unemployment is high. As
nominal wages fall, producing goods and services becomes more
profitable, and SAS shifts to the right. As it shifts back towards AS1, the
price level falls, and output approaches its natural rate.
In the long run, the economy returns to point A, when AD crosses LAS.
This assumes AD is held constant throughout the process.
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Figure 10 An Adverse Shift in Aggregate
Supply
1. An adverse shift in the shortrun aggregate-supply curve . . .
Price
Level
Long-run
aggregate
supply
AS2
Short-run
aggregate
supply, AS
B
P2
A
P
3. . . . and
the price
level to rise.
Aggregate demand
0
Y2
2. . . . causes output to fall . . .
Y
Quantity of
Output
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