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Economics

TOPIC 4: AGGREGATE DEMAND (AD)/ AGGREGATE SUPPLY (AS) MODEL

Learning Objectives

• Understand AD and AD curve • Discuss factors shifting AD curve • Understand AS and AS curve • Discuss factors shifting AS curve • Understand Macroeconomic equilibrium

LO1

Aggregate Demand (AD)

• AD refers to the real GDP demanded • • •
at each price level. Y = AD = C + I + G + (X – M) There is an inverse relationship between real GDP demanded and the price level. AD curve is downward sloping.

LO1

Aggregate Demand

Price level

AD

0
LO1

Real domestic output, GDP

Movement along AD curve
• Changes in price will cause a movement along the AD curve.

Reasons for AD to be downward sloping
• Real balances effect - when price rises, purchasing power fall; C falls as a result. AD and real GDP fall. • Interest rate effect - when price rises, demand for money increases. Interest rate increases as a result. When interest rate increases, I and C falls. AD and real GDP fall. • Foreign purchases effect – when local items become more expensive, foreigners demand less of local goods. X falls and M increases. AD and real GDP fall.

Factors shifting AD curve
• Given that AD = C + I + G + (X-M), any factors •
affecting each component will affect AD. Factors affecting C:

• Factors affecting I: • Factors affecting G: • Factors affecting X: • Factors affecting M: LO1

Shifts of AD curve

Price level

AD2 AD3
0

AD1

Real domestic output, GDP
LO1

Aggregate Supply

• AS refers to the total real output • • •
produced at each price level. Price and real GDP supplied are positively related. The AS curve is upward sloping. Movement along the AS curve is caused by changes in the price level.

LO2

AS curve: Short Run

AS

Price level

Aggregate supply (short run)

0

Real domestic output, GDP

LO2

Factors that shift AS curve
1. Resource/Input prices: • Labor – Wages • Land – Rent • Price of raw materials (i.e. Price of oil) - Increase in the price of resources raises the cost of production and reduces profit. - AS falls and the AS curve shifts to the left. 2. Natural Disasters (i.e. flood, drought, earthquake) Earthquake destroys office buildings and factory and production will fall. Hence, AS falls. LO2

Shifts of AS curve
AS3 AS1 AS2
Price level
0

Real domestic output, GDP
LO2

Macroeconomic Equilibrium
Macroeconomic Equilibrium exists when AD = AS
AS
Price level (index numbers)
Real Output Demanded (Billions) Real Output Supplied (Billions)

Price Level (Index Number)

$506 508
100 e0

108 104 100 96 92

$513 512 510 507 502

510 512 AD 514

0

510

Real domestic output, GDP (billions of dollars)
LO3

AD Increases

AS

Price level

P2 P1

AD2 AD1 0
LO4

Q1

Q2

Real domestic output, GDP

Decreases in AD

AS

Price level

P1 P2
b

a

AD1 AD2 0
LO4

Q2

Q1

Real domestic output, GDP

Decreases in AS
AS2

AS1

Price level

b P2 P1 a

AD 0
LO4

Q2 Q1
Real domestic output, GDP

Increases in AS: Full-Employment
AS1 AS2

Price level

P1 P2

a b

AD1 0
LO4

Q1

Q2

Real domestic output, GDP

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