IIIE SECTION A ECONOMICS NOTES

1. Fundamentals of
Aggregate Demand
and Aggregate Supply

2. Session Outline
• Aggregate demand curve and its
properties
• Determinants of aggregate demand
• Aggregate supply curve and its properties
• Determinants of aggregate supply
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3. – The aggregate demand and supply model is
the basic macroeconomic model that studies
output and price level determination.
– The aggregate demand curve shows the
combinations price and output levels at which
the goods and the money markets are
simultaneously in equilibrium.
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4. Deriving aggregate demand curve
• This curve is derived from the IS-LM
framework.
• If the given price level is P0 and the
nominal stock of money is M, then the
real stock of money is (M/P0).
• The IS curve is denoted by IS.
• The economy is in equilibrium at point
E, and the output and interest rates
are denoted by Y0 and i0 respectively.
The initial price level is represented
by P0.
• When P is at P0 the goods and the
money market are in equilibrium at an
income level of Y0.
P
0
LM1
(M/P1)
E
1
i1
i0
Interest
Rate
Y
0
E
Income and
Output
LM
(M/P0)
IS
Y
1
A
D
E
E
1
P
1
Price
Level
Y
0
Output and
Spending
Y
1
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5. In the next figure, point E shows the income and price
combination (Y0, P0). If the price falls from P0 to P1, the
real stock of money in the economy Increases to M/P1
(for the same level of nominal stock of money M). This
increase in the real stock of money will lead to a shift of
LM curve downwards to LM1 (M/P1). The new
equilibrium is at point E1. Thus when the price level is
P1, the goods market and the money market are in
equilibrium at an income level of Y1. When the price
level falls form P0 to P1, the income level rises from Y0to
Y1 and vice versa. Therefore the aggregate demand
curve will be downward sloping.
P
0
LM1
(M/P1)
E
1
i1
i0
Interest
Rate
Y
0
E
Income and
Output
LM
(M/P0)
IS
Y1
AD
E
E
1
P
1
Price
Level
Y
0
Output and
Spending
Y
1
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6. Aggregate Demand Policies
Both the fiscal and monetary policy changes
influence and cause shift in the AD curve.
– Fiscal Policy
– Monetary Policy
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7. Effect of Fiscal policy on AD curve
In the upper panel of figure 1, the initial LM and IS
curves correspond to a given nominal quantity of money
and the price level P0. The economy is at equilibrium at
point E. The AD curve shifts to the right in case of fiscal
expansion and to the left in case of fiscal contraction. At
the initial price level there is a new equilibrium at point E1
with higher interest rates and higher level of income and
spending. Thus at initial level of prices P0, equilibrium
income and spending are higher. This is shown point E1
in the lower panel. E1 is the new equilibrium point on the
new AD curve. A similar exercise at other points on the
original demand curve would lead to a new aggregate
demand curve AD1.
IS1
E1
i1
i0
Interest
Rate
Y0
E
Income and Output
LM
IS
Y1
AD
E
E1
P0
Price
Level
Y0
Output and Spending
AD’
Y1
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8. Effect of monetary policy on AD curve
An increase in the nominal stock
of money results in higher real
money stock at each level of
prices and thus shifts the LM
curve to LM1. The equilibrium
level of income rises from Y0 to Y1
at the initial price level P0 and the
AD curve moves to the right in
case the equilibrium level of
income rises, which occurs due to
increase in the nominal stock of
money.
LM1
E1
E1
i1
i0
Interest
Rate
Y
0
E
Income and Output
LM
IS
Y1
AD
E
E1
P0
P’
Price
Level
Y
0
K
Output and Spending
AD
’
Y1
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9. Aggregate Supply in Short Run
and Long Run
Aggregate supply explains the production
and pricing side of the economy and also
explains the behavior of businesses as a
whole, which is contrary to the Keynesian
model where the price level is assumed to
be constant and output is determined by the
demand.
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10. Aggregate Supply in Short Run and Long Run
In the short run,
– the interaction between the AD and AS determines the level of output,
employment, capacity utilization and price levels. In the long run, AS is
the major factor behind economic development.
– the aggregate supply is upward sloping from right to left implying that
the quantity supplied at a point of time is limited.
– The discrepancies between actual and expected price level causes
changes in output and employment.
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11. Aggregate Supply in Short Run
and Long Run
Aggregate Supply in the Long Run
In the long run, other things being equal,
• the gap between expected and actual price level
narrows as the costs incurred by the firms rise as
economic agents react to higher prices.
• the natural rate of output is the equilibrium rate of
output for the economy.
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12. Aggregate Supply in the Short Run and
Long Run
ASL
ASS
P
Price
Level
Q
Output (Y)
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13. Short Run and Long Run Equilibrium
between Aggregate Demand and Aggregate
Supply
AD
ASL
ASS
P
Price
Level
Q
Output (Y)
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14. Factors Affecting Aggregate
Demand
• Change in Income
• Rate of Interest
• Government Policy
• Change in Exchange Rate
• Change in the Expected Rate of Inflation
• Change in Business Expectations
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15. Factors Affecting Aggregate Supply
• Change in Costs of Production
• Supply Shock or Supply Disturbances
• Investment Spending and Technological
Changes
• Availability of Raw Materials
• Supply of Labor
• Human Capital
• Incentives
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16. Aggregate supply, aggregate
demand and level of employment
The AD and AS curve determine the
equilibrium price level and output of an
economy. Based on this level of output,
there is some employment, which is given
by the production function for the
corresponding level of output. According
to JM Keynes this level of employment
may fall from the desirable level of
employment
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