Chapter 3

Aggregate Demand (AD) and Aggregate Supply (AS)

Summary
 AD
o Definition:
 Quantity of real GDP demanded
 Total amount of final goods and services produced in the
economy that people (consumers), businesses, governments,
and foreigners plan to buy for, given the price level.
 Total demand for final goods and services in an economy
 Aggregate = total and demand = expenditure / spending.
 Hence AD = Total expenditure or Aggregate expenditure (AE)
 Since AE = C + I + G + (X – M), then AD = C + I + G + (X –
M)

o Factors that can influence AD

 Price level
 Affects change in quantity of real GDP demanded
 Will NOT cause a shift in AD curve, will only cause a
movement along the AD curve
 Govt policies
 Affects change in AD
 Will cause a shift in the AD curve to the left or right
 Expectations on the economy in the future
 Affects change in AD
 Will cause a shift in the AD curve to the left or right
 Change in variables from foreign countries (eg. Change in foreign
countries’ GDP, change in foreign countries’ price level etc)
 Affects change in AD
 Will cause a shift in the AD curve to the left or right
o AD Curve
 A curve showing the inverse / negative relationship between price and
quantity of real GDP demanded
 
 When price level increases → quantity of real GDP demanded
reduces (upward movement along the AD curve)
 AD curve = downward sloping.
o Why?
1. Wealth effect
 When price level increases while other
things remain the same, ceteris paribus
→ real wealth ↓ → the economy
demand less goods and services →
quantity of real GDP ↓
2. Substitution effect
 price level increases while other things
remain the same → interest rate ↑ →
saving ↑ → quantity of real GDP ↓
 price level increases while other things
remain the same → domestic goods =
relatively more expensive than foreign
goods → imports ↑ → quantity of real
GDP ↓
o Shift in AD curve
 Caused by factors other than change in price level
 If AD increases → AD curve shifts to right
 If AD decreases → AD curve shifts to left

 Factors that can shift AD:
 Govt policies
o Fiscal Policy (The only govt policy to influence the
economy using tax (T) and government spending (G))
1. Tax (T)
 T ↓ → disposable income ↑ → C and I ↑
→ AD ↑ → AD curve shifts to right
 T ↑ → disposable income ↓ → C and I ↓
→ AD ↓ → AD curve shifts to left
2. Government spending (G)
 G ↑ → AD ↑ → AD curve shifts to right
 G ↓ → AD ↓ → AD curve shifts to left
o Monetary policy (central bank’s policy to influence the
economy using money supply (Ms) and interest rate (r))
1. Ms ↑ → r ↓ → C and I ↑ → AD ↑ → AD curve
shifts to right
2. Ms ↓ → r ↑ → C and I ↓ → AD ↓ → AD curve
shifts to left
 Expectations
o If consumers and firms expect the economy to be better
in the future → C and I ↑ → AD ↑ → AD curve shifts
to right
o If consumers and firms expect the inflation rate will be
higher in the future → current C and I ↑ → AD ↑ → AD
curve shifts to right
 Change in variables from foreign countries
o If domestic currency depreciates / decrease in value in
exchange rate → domestic goods = cheaper in foreign
markets while foreign goods = more expensive in
domestic market → X ↑ and M ↓ → AD ↑ → AD curve
shifts to right
o If foreign countries’ GDP ↑ → Foreign countries buy
more domestic goods → X ↑ → AD ↑ → AD curve
shifts to right
 AS
o Definition
 The quantity of real GDP supplied
 The total quantity (output) that firms plan to produce during a
given period, given the price level.
o Can be separated into:
 Short run AS (SAS)
 In the SR, some resources will not be utilized (inefficiency).
Hence current real GDP ≠ potential real GDP
 Wage rate and prices of resources = remain constant
 SRAS curve = upward sloping
 Price ↑ → firms ↑ productions → quantity of real GDP
supplied ↑ → upward movement along the SRAS curve
 Long run AS (LAS)
 In the LR, all resources will be fully utilized. Hence real GDP
= potential GDP
 LRAS curve = vertical
 Potential GDP will not be influenced by price level
o Factors that can influence AS
 Price level
 Price ↑ → firms ↑ productions → quantity of real GDP
supplied ↑ → upward movement along the SRAS curve
 Change in the prices of factors
 Only cause a change in SRAS (only SRAS curve shifts)
 Prices of factors ↑ → cost of production ↑ → firms reduce
productions → SRAS ↓ → SRAS curve shifts to left
 Actual GDP Δ but no change in potential GDP

 Change in the quantity and quality of factors

 Cause a change in both SRAS and LRAS
 When quantity or quality of factors ↑ → firms can produce
more outputs → SRAS and LRAS ↑ → Both SRAS and LRAS
curves shift to right
 Both actual GDP and potential GDP Δ
 
 Long Run equilibrium
o Occurs when AD = SRAS = LRAS
o Actual GDP = potential GDP = full employment GDP

o
o If Actual GDP > potential GDP = Inflationary gap
o If Actual GDP < potential GDP = deflationary gap