2.4 Aggregate Demand (AD) and Aggregate Supply (AS) Analysis
What is Aggregate Demand?
What is Aggregate Supply?
What is the difference between short-run and long-run?
It is recommended to complete this topic after 2.5 to 2.8.
2.4 What you need to know
 That changes in the price level are represented by
movements along the AD and AS curves
 Different factors that shift short-run AD and AS
curves
 The difference between factors that shift short-run
aggregate supply and long-run aggregate supply
 That economic growth is represented by an
outward shift in long-run aggregate supply
2.4 You should be able to:
 Demonstrate how changes in the price level are
represented on an AD/AS diagram
 Differentiate between the factors that might impact
short-run aggregate supply from long-run aggregate
supply
 Demonstrate economic growth in an economy using a
long-run aggregate supply curve
 Use AD/AS diagrams to explain and analyse different
macroeconomic problems and issues
Macroeconomic Equilibrium
 You should now have an understanding of aggregate demand (AD)
and aggregate supply (AS)
 We will now be putting these two concepts together to explain and
analyse the economy in more detail
 Using AD/AS analysis is an important skill and part of the
‘economists toolkit’ that will help you to identify, explain and analyse
economic problems
 To begin with, it is important to note that macroeconomic
equilibrium occurs where
AD = AS
Short-Run Equilibrium
Price
Level
SRAS
Building diagrams:
 Axis?
 AD Curve?
 SRAS Curve?
P
AD
Y
Real National Output
Shifts in AD and SRAS
Recap
 You should have an understanding of the factors
that shift AD and SRAS
Aggregate Demand
 Any change in the components of AD
 Recall the AD formula: C + I + G + (X-M)
Short-run Aggregate Supply
 Any change in the costs of production
Which components of
AD are aiding or
hindering economic
recovery?
1) Begin with the
equilibrium position.
Price
Level
Short-Run Shifts Example (1)
2) What will happen if
there is an increase in
consumption?
3) AD will shift to the right.
4) There will be an
expansion along
the SRAS curve
resulting in a new
equilibrium price
level of P1 and
output of Y1.
SRAS
P1
P
AD1
AD
Y
Y1
Real National Output
1) Begin with the
equilibrium position.
Short-Run Shifts Example (2)
2) What will happen if there is an
increase in the cost of raw materials
used in the production process?
Price
Level
SRAS1
3) SRAS will shift to the left.
SRAS
4) There will be a
contraction along the AD
curve. There will be a new
equilibrium price level of
P1 and output of Y1.
P1
P
AD
Y1
Y
Real National Output
For each of the following examples, identify the impact on an AD/SRAS and
draw a new diagram to show the new equilibrium position.
Scenario
1
The Government increase the rate of income tax
2
There is a rise in the national minimum wage
3
The Government injects £2bn into a new house building programme
4
The price of oil falls on global markets
5
There is a fall in the exchange rate
Classical Long-Run Equilibrium
Price
Level
Building diagrams:
 Axis?
 AD Curve?
 Classical LRAS Curve?
LRAS
P
AD
Y
Real National Output
Shifts in AD and Classical LRAS
Recap
 You should have an understanding of the factors
that shift AD and SRAS
Aggregate Demand
 Any change in the components of AD
 Recall the AD formula: C + I + G + (X-M)
Long-run Aggregate Supply
 Any change in the quantity, quality or productivity
of factors of production
1) Begin with the
equilibrium position.
Price
Level
Long-Run Shifts Example (1)
2) What will happen if
there is an increase in
exports?
LRAS
P1
P
AD1
AD
Y
3) AD will shift to the right.
4) There will be an expansion
along the LRAS curve
resulting in a new
equilibrium price level of P1.
Crucially, real national
output will remain at Y,
because all factor resources
have been employed and
remain unchanged. Therefore,
any increase in AD will only
cause inflation.
Real National Output
1) Begin with the
equilibrium position.
Price
Level
Long-Run Shifts Example (2)
2) What will happen if
there is a discovery of
new primary raw
materials?
LRAS
LRAS1
P
P1
AD
Y
Y1
3) LRAS will shift to the right.
4) There will be an expansion
along the AD curve resulting in
a new equilibrium price level
of P1. This time, real national
output increases to Y1
because there has been an
increase in the quantity of
factor resources. Therefore, the
economy now benefits from a
higher level of real national
output and lower price level.
Real National Output
For each of the following examples, identify the impact on an AD/Classical
LRAS and draw a new diagram to show the new equilibrium position.
Scenario
1
Tax breaks are given to firms who invest profits in research and development
2
There is an increase in imports
3
New laws are passed that block the construction of new oil pipelines
4
There is an increase in consumer confidence
5
The government injects £5bn into widening training course availability for
the unemployed
Macroeconomic Policy Implications
 Classical economists would advocate and support
economic policies that improve long-run aggregate
supply
 That is not to say aggregate demand is unimportant,
but if AD increases with no attention given to improving
the quality and quantity of factor resources, then
inflation (rising price levels) will occur and damage
economic growth
Keynesian Long-Run Equilibrium
Building diagrams:
 Axis?
 AD Curve?
 Keynesian LRAS Curve?
LRAS
Price
Level
Recap.
Keynes believed the economy
could settle in equilibrium
below the full employment
level of output.
P
AD
Therefore, the distance Y-FE
represents spare capacity in the
economy.
It follows that there is likely to be
unemployment because of a
deficiency of AD.
Y
FE = Full Employment
FE
Real National Output
Shifts in AD and Keynesian LRAS
 This is the same as previously outlined
 However, of critical importance is the original
equilibrium position of the economy
1) Begin with the
equilibrium position. 2) What will happen if there
is an increase in
LRAS
consumption?
3) AD will shift to the right.
Price
Level
P1
P
AD1
4) There will be an
expansion along the LRAS
curve. The price level will
increase to P1 as the
economy gets closer to full
employment and resources
become more scarce. Real
national output increases
to Y1, but spare capacity of
Y1-FE remains.
AD
Y Y1
FE
Real National Output
Keynesian Long-Run Shifts Example (1)
5) If AD continues to increase....
Price
Level
6) ....without any increases in
LRAS
LRAS
7) At some point FE
equilibrium will be reached....
8) ...and any increases in AD
above AD2 will be purely
inflationary.
P2
P1
P
AD2
AD1
AD
Y Y1
FE
Real National Output
Keynesian Long-Run Shifts Example (1) Continued
9) If however AD is depressed at AD3....
10) ....and AD increases to AD4
LRAS
Price
Level
12) Therefore, any policies to
increase LRAS would simply
enhance spare capacity and
leave the equilibrium level of
employment unchanged.
P
AD3
Y3
Y4
11) the price level would be
unchanged because there
remains a significant amount of
spare capacity in the economy.
Increases in AD can be absorbed
without increases in the price
level.
AD4
FE
Real National Output
Keynesian Long-Run Shifts Example (1) Continued 2
1) Begin with the
equilibrium position.
Price
Level
2) What will happen if there is an
increase in capital efficiency?
LRAS
LRAS1
3) There will be an
expansion along the AD
curve. The price level will
decrease as available factor
resources are increased and
scarcity reduces. Real
national output increases
to Y1 and maximum
productive potential
increases to FE1, indicating
economic growth.
3) LRAS will shift to the
right
P
P1
AD
Y
FE Y1
FE1
Real National Output
Keynesian Long-Run Shifts Example (2)
Macroeconomic Policy Implications
 Keynesian economists would therefore advocate
and support economic policies that improve and
manage aggregate demand
 That is not to say long-run aggregate supply is
unimportant, but if the economy is operating
significantly below its full potential e.g. in a
recession, Keynesian economists would focus
attention on policies that stimulate the components
of aggregate demand (C, I, G, X, M)
Multiple Choice 1
Price
Level
 The shift in the aggregate demand curve
SRAS
AD1
AD
from AD to AD1 could have been caused
by an increase in
a) imports
b) labour productivity
c) household savings
d) the government budget deficit
Real National
Output
 Can you explain your answer?
Multiple Choice 2
Price
Level
SRAS
E
 The diagram shows the AD and SRAS curves
for an economy. Equilibrium is at point E.
Which one of the following would be likely to
lead to a new equilibrium position, with a fall
in the price level?
a) A fall in exports
b) An increase in government spending
AD
c) A fall in productivity
d) An increase in wage rates
Real National
Output
 Can you explain your answer?
Multiple Choice 3
 Which one of the following combination of
events, A, B, C or D is most likely to have
SRAS
bought about the change in equilibrium
output from 0Y to 0Y1?
SRAS1
Price
Level
P
P1
The level of investment
rises
Money wages in the
economy rise
B
The level of exports
decreases
Business taxes increase
C
The level of
consumption falls
The cost of oil and other
imported raw materials
decrease
D
Government spending
on welfare benefits falls
Average productivity
falls
AD
AD1
0
A
Y Y1
Real National
Output
 Can you explain your answer?
Multiple Choice 4
Price
Level
LRAS
 The diagram shows the AD curve and SRAS
SRAS
X
AD
and LRAS curves of an economy. The
economy is currently operating at point X.
At this point, the economy must be
experiencing
a) inflation caused by excess demand.
b) inflation caused by increasing costs.
c) unemployment of labour.
d) a low rate of economic growth.
Real National
Output
 Can you explain your answer?
2.4 You should be able to:
 Demonstrate how changes in the price level are
represented on an AD/AS diagram
 Differentiate between the factors that might impact
short-run aggregate supply from long-run aggregate
supply
 Demonstrate economic growth in an economy using a
long-run aggregate supply curve
 Use AD/AS diagrams to explain and analyse different
macroeconomic problems and issues