3.

2 Variations in economic activity – aggregate demand

and aggregate supply
Learning objectives
3.2 Variations in economic activity – aggregate demand Diagrams and
Depth
and aggregate supply calculations
Aggregate demand (AD) AO2 Diagram: AD curve
• Aggregate demand curve AO4

Components of AD: AO2

• Consumption (C)
• Investment (I)
• Government spending (G)
• Net exports (total exports [X] – total imports [M])
Learning objectives
3.2 Variations in economic activity – aggregate demand Diagrams and
Depth
and aggregate supply calculations

Determinants of AD components AO2

• C: consumer confidence, interest rates, wealth, income taxes,
level of household indebtedness, expectations of future price level
• I: interest rates, business confidence, technology, business taxes,
level of corporate indebtedness
• G: political and economic priorities
• X – M: income of trading partners, exchange rates, trade policies

Shifts of the AD curve caused by changes in determinants AO2 Diagram: shifts of the AD
AO4 curve
Learning objectives
3.2 Variations in economic activity – aggregate demand Diagrams and
Depth
and aggregate supply calculations
Short-run aggregate supply (SRAS) curve and determinants of the AO2 Diagram: SRAS curve
SRAS curve AO4
• costs of factors of production
• indirect taxes
Shifts of the SRAS curve AO2 Diagram: shifts of the SRAS
AO4 curve
Learning objectives
3.2 Variations in economic activity – aggregate demand Diagrams and
Depth
and aggregate supply calculations
Alternative views of aggregate supply (AS) AO2 Diagram: alternative views of
• Monetarist/new classical view of the long-run aggregate supply AO4 the AS curve
(LRAS) curve
• Keynesian view of the AS curve
• Inflationary and deflationary/recessionary gaps
Shifts of the AS curve over the long-run (monetarist/new classical AO2 Diagram: shifts of the LRAS
LRAS) or over the long term (Keynesian AS)
AO4 or Keynesian AS
• Changes in the quantity and/or quality of factors of production
• Improvements in technology
• Increases in efficiency
• Changes in institutions
Learning objectives
3.2 Variations in economic activity – aggregate demand Diagrams and
Depth
and aggregate supply calculations
Macroeconomic equilibrium AO2 Diagram: macroeconomic
Short-run equilibrium AO4 equilibrium in both the short
Equilibrium in the monetarist/new classical model run and long run
• Determination of long-run equilibrium at full employment level of
output (potential output)
• Automatic adjustment to full employment equilibrium
• Unemployment at full employment equilibrium is equal to the
natural rate of unemployment
Equilibrium in the Keynesian model
• Persistence of deflationary/recessionary gaps: equilibrium level
of output might not equal the full employment level of output
Learning objectives
3.2 Variations in economic activity – aggregate demand Diagrams and
Depth
and aggregate supply calculations
Assumptions and implications of the monetarist/new classical and AO3
Keynesian models
Introduction – aggregate demand
Aggregate demand (AD) refers to the total value of demand for all goods and services in an
economy by all stakeholders at different price levels over a time period. AD has four components:

Consumer Business Government Net exports

expenditure investment spending (exports – imports)
Components of aggregate demand
In microeconomics, demand depicts consumers’ willingness and ability to purchase goods and
services in a single market at different prices.

In macroeconomics, aggregate demand represents the sum of demand in an economy from

households, businesses, the government, and foreign stakeholders, and their willingness to
consume goods and services at different price levels.

As a result, aggregate demand is equal to:

AD = Consumption + Investment + Government spending + (Exports − Imports)

= C + I + G + (X − M) = C + I + G + Nx
Real world example
Video: Economy suffers record-breaking GDP fall due to COVID-19

Using the video and your own knowledge, explain how the COVID-19 pandemic may impact the
components of AD within an economy.
The aggregate demand curve
The AD curve shows the relationship between
the general price level and real GDP of an General price Aggregate demand
level
economy.

The general price level is the average price of

all goods and services in an economy.

Real GDP shows the total value of output of AD

final goods and services in an economy. Real GDP

The aggregate demand curve
Real GDP vs AD
General price Aggregate demand
You may have noticed the formulae for real level

GDP and AD are both given as

C + I +G + (X – M).

What is the difference between real GDP and

AD?

AD

Real GDP
The aggregate demand curve
Real GDP vs AD
General price Aggregate demand
Comparing real GDP and AD is akin to level

comparing quantity demanded with demand.

Real GDP is specific point on the AD curve at

a particular price level.

AD shows the real GDP of an economy across AD

Real GDP
different price levels.
Shifts in aggregate demand

General price Shifts in aggregate demand

level
consumption
The components of AD include _____________,
government spending and
investment ____________________,
_____________,
net exports
_____________.

An increase in any component of AD will lead to

an outward shift in AD, ceteris paribus. ADଵ ADଶ

Real GDP
Shifts in aggregate demand

General price Shifts in aggregate demand

level
consumption
The components of AD include _____________,
government spending and
investment ____________________,
_____________,
net exports
_____________.

Conversely, a fall in any component of AD will

lead to an inward shift in AD. ADଶ ADଵ

Real GDP
Determinants of AD components
There are many factors that affect the level of consumption, investment, government spending,
and net exports in an economy. These determinants will shift the AD curve inwards or outwards.

Consumption Investment Gov’t spending Net exports

Confidence (in the economy) Political priorities Incomes of trading partners
Interest rates Economic priorities Exchange rates
The level of indebtedness Trade policies
Taxation
Wealth
Expectations
Determinants of Consumption and Investment – confidence
Confidence refers to the degree of optimism and certainty
surrounding the level of future economic activity.

In periods of low confidence, consumers are concerned

about potential unemployment, therefore consumption
tends to decrease, and savings tend to increase. During
such times, businesses refrain from expansion and thus
investment tends to fall.

Meanwhile, the opposite occurs during periods of high

consumer and business confidence in the economy.
Determinants of Consumption and Investment – interest rates
Interest rates refers to the cost of borrowing and the
reward for saving expressed as a percentage.

When interest rates increase, there is a greater cost for

borrowing and a greater reward for saving. This
discourages consumption and investment, resulting in an
inward shift in AD. The opposite occurs when interest
rates are lowered.
Determinants of Consumption and Investment – indebtedness
Debt refers to borrowed money.

A higher level of indebtedness will reduce households’

propensity to consume and firms’ propensity to invest.

With high indebtedness, households will engage in less

discretionary expenditure and firms may delay projects.
Determinants of Consumption and Investment – taxation
Direct tax refers to taxes that households and firms pay to
the government via income and profits.

An increase in income (personal) taxes will reduce

households’ disposable income, leading to a fall in the level
of consumption.

Similarly, an increase in corporate taxes will reduce retained

profits for businesses, thereby leading to a fall in the level of
investment. Furthermore, low taxation rates may attract
inward investment from foreign businesses.
Determinants of Consumption – wealth

Wealth refers to the total value of valuable assets,

e.g., property, owned by households.

As households become wealthier, they tend to

consume more goods and services and vice versa.

Furthermore, wealthier households may consume

goods and services of a higher value that make a
greater contribution to real national output.
Determinants of Consumption – expectations
Expectations refer to the anticipated future prices of goods
and services. Speculation about the future price level will
affect current household consumption.

If households expect the price levels to increase in the future,

they may increase their current consumption to enjoy lower
prices.

Conversely, if households expect the price levels to fall in the

future, they may delay current consumption to enjoy lower
prices in the future.
Determinants of Government Spending – priorities

Government spending will vary depending on the

priorities of a government.

Governments may increase public sector spending on

education and healthcare for political reasons.

On the other hand, governments may impose austerity

measures to improve economic prudence by reducing
public sector spending.
Determinants of Net Exports – incomes of trading partners

Due to globalization and interdependence, when a

large economy suffers from an economic downturn,
there are negative impacts on its trading partners.

A fall in the income of trading partners leads to fewer

export sales and therefore a fall in net exports.

A rise in the income of trading partners leads to greater

export sales and therefore a rise in net exports.
Determinants of Net Exports – exchange rates

When the currency of an economy depreciates, its exports

are relatively cheaper for foreign consumers. This
improves a country’s international competitiveness and
hence increases net exports.

Conversely, when the currency of an economy

appreciates, its exports are relatively more expensive for
foreign consumers. This worsens a country’s international
competitiveness and hence decreases net exports.
Determinants of Net Exports – trade policies

Imposing trade barriers, such as tariffs and quotas, will

cause the price of imports to rise, reducing demand for
imports.

As such, restrictive trade policies will increase net exports.

However, these policies may lead to retaliation from other
countries, who may impose their own trade barriers.
Test your knowledge on this unit: Kahoot!
Aggregate supply
Aggregate supply refers to the total value of goods and services produced in an economy at
different price levels, over a time period.
Aggregate supply
While there is consensus on the nature of the AD curve, there are different schools of thoughts on
the nature of the AS curve. The two main schools of thought are:

• The New Classical / Monetarist Model

• The Keynesian Model

Monetarist Model
The Monetarist model separates aggregate supply into short run aggregate supply (SRAS)
and long run aggregate supply (LRAS).

The key assumption of the monetarist model is that resource prices are flexible in the long run and
eventually adjusts according to changes in the general price level.
Monetarist Model – short run aggregate supply

Short run aggregate supply (SRAS) General Price Aggregate supply

Level
shows the relationship between real GDP SRASଵ

and the price level in the short run.

As price levels rise, in the short run (while

resource costs are fixed), there is a greater
profit margin and incentive for producers to
increase output. Hence, the SRAS curve is
upward sloping. Real GDP
Monetarist Model – shifts of the SRAS curve

The determinants of SRAS include General Price Aggregate supply

Level

• factors of production costs SRASଶ SRASଵ

• indirect taxation

An increase in the costs of production or a rise

in indirect taxes will reduce the willingness and
ability of firms to produce goods and services.

As such, the SRAS curve will shift inwards. Real GDP

Monetarist Model – shifts of the SRAS curve

The determinants of SRAS include General Price Aggregate supply

Level

• factors of production costs SRASଵ

SRASଶ
• indirect taxation

A fall in the costs of production or a fall in

indirect taxes will increase the willingness and
ability of firms to produce goods and services.

As such, the SRAS curve will shift outwards. Real GDP

Over to you…

Hoang, Wray, & Chakraborty (2020)

Economics for the IB Diploma Programme

• Page 251-252

• Paper 2 and 3 Exam Practice Question 17.1+17.2

• [4 marks] + [4 marks]
Monetarist Model – long run aggregate supply
Long run aggregate supply (LRAS)
shows the relationship between real GDP General Price Aggregate supply
Level
and the price level in the long run. LRAS

In the long run, resource prices change to

match the general price level changes of
goods and services. Therefore, there is no
incentive to increase or decrease
production with price level changes as
Y୮ Real GDP
profit margins remain constant.
Keynesian Model
The Keynesian model holds a different set of assumptions on resource cost and price flexibility.

Keynesians believe that resource prices, especially wages, do not fall in the long run due to:

• labour contracts
• minimum wage legislation
• worker and union resistance to wage cuts
• some firms may prefer to cut workers rather than wages

If wages are “sticky downwards”, firms will avoid lowering prices beyond a certain point.
Keynesian Model – aggregate supply
In the Keynesian AS model, there is no distinction
between the short run and long run. General Price Keynesian Aggregate Supply
Level

AS
Keynes famously stated, “In the long run,
we are all dead!”

The Keynesian AS is split into three sections.

Y୮ Y୫ୟ୶ Real GDP

Keynesian Model – aggregate supply

In the perfectly elastic portion of AS, price General Price Keynesian Aggregate Supply
Level
levels do not fall beyond a certain point due to
AS
labour contracts, minimum wage legislation,
and labour union resistance to wage cuts.

Increases in AD will not increase price levels

due to spare capacity; firms can increase
their output without needing to purchase
additional resources. Real GDP
Keynesian Model – aggregate supply

As spare capacity diminishes, firms need General Price Keynesian Aggregate Supply
Level
more resources to increase production e.g.,
AS
hiring more workers and purchasing more raw
materials.

Hence, the AS curve is upward sloping and

relatively price elastic, with the general price
level increasing due to the increase in real
GDP. Real GDP
Keynesian Model – aggregate supply

In the perfectly inelastic portion of the AS General Price Keynesian Aggregate Supply
Level
curve, the economy is fully utilizing all
AS
available resources, with no spare capacity.

Any increases in AD will only lead to a higher

general price level without any increase in
real GDP.

Real GDP
 Shifts in Aggregate Supply
LRAS or Keynesian AS may shift outwards due to improvements in the quantity and/or quality of the
factors of production, improvements in technology, increases in efficiency, or changes in institutions.

General Price New Classical LRAS General Price Keynesian Aggregate Supply
Level Level
LRASଵ LRASଶ
ASଵ ASଶ

Real GDP Real GDP

Test your knowledge on this unit: Kahoot!
Macroeconomic equilibrium
Monetarist Model – short run equilibrium

General Price Short-run equilibrium

Level

SRAS
In the monetarist model, the short run
macroeconomic equilibrium occurs when
PLୣ
SRAS is equal to AD, resulting in the
equilibrium price level PLe and real GDP
Ye.
AD

Yୣ Real GDP
 Macroeconomic Equilibrium – New Classical Model
Shifts in AD and SRAS may result in a new short run macroeconomic equilibrium with changes in
the price level and real GDP.

Shifts in AD Shifts in SRAS

General Price General Price
Level Level

SRAS SRASଷ
SRASଵ
PLଶ PLଷ
SRASଶ

PLଵ PLଵ
ADଶ
PLଷ PLଶ

ADଵ
AD
ADଷ

Yଷ Yଵ Yଶ Real GDP Yଷ Yଵ Yଶ Real GDP

Monetarist Model – long run equilibrium

Long-run equilibrium
General Price
Level
LRAS
SRAS
Long run equilibrium occurs where
AD = SRAS = LRAS at the full employment
PLୣ
level of output (potential output) Y୮ at price
level PLୣ .

AD

Y୮ Real GDP
Full Employment and the Natural Rate of Unemployment
Full employment does not mean a complete absence of unemployment. Every economy will
experience a natural rate of unemployment (NRU) which comprises of:

• Frictional unemployment where people in between jobs.

• Seasonal unemployment where demand for a specific kind of work changes with the seasons.

• Structural unemployment where there is mismatch between skills available and required.

At full employment, there is an absence of cyclical unemployment which occurs due to downturns
in the business cycle i.e., unemployment due to insufficient levels of AD.
Keynesian Model – equilibrium

General Price Equilibrium

Level

AS
In the Keynesian model, the macroeconomic
equilibrium occurs when AS is equal to AD,
resulting in the equilibrium price level PLୣ and
real GDP Yୣ .
PLୣ
AD

Yୣ Real GDP
 Inflationary and deflationary gaps
An inflationary gap occurs when actual real GDP is greater than the potential level of GDP at full
employment level of output. Inflationary gaps are usually caused by excess levels of AD
Inflationary gap Inflationary gap
General Price General Price
LRAS
Level Level
AS

SRASଵ

PLଶ Pୣ

PLଵ
AD
ADଵ

Y୮ Yଶ Real GDP Y୮ Yୣ Real GDP

 Inflationary and deflationary gaps
A deflationary/recessionary gap occurs when actual real GDP is less than the potential level of
GDP at full employment level of output. Deflationary gaps are usually caused by insufficient AD.
Recessionary gap Recessionary gap
General Price General Price
LRAS
Level Level
AS
SRASଵ

Pଵ

AD
Pଶ

Pୣ
ADଵ
Yଶ Y୮ Real GDP Yୣ Y୮ Real GDP
Inflationary and deflationary gaps in the business cycle

Real National Fluctuations in the Business Cycle

Output

Actual GDP > Potential GDP Actual GDP

Employment > Full Employment

Potential GDP
(Full Employment)

Actual GDP < Potential GDP

Employment < Full Employment

Time
Over to you…

Hoang, Wray, & Chakraborty (2020)

Economics for the IB Diploma Programme

• Page 257

• Paper 3 Exam Practice Question 17.4

• [1 + 2 + 2 + 1 marks]
Real world example – Artificial Intelligence
The White House proposed government spending on artificial intelligence (AI) and quantum
information sciences research and development in its 2021 budget proposal.
Read the article and answer the following questions.
Real world example – Artificial Intelligence
Article: Trump administration to propose big jump in
funding for AI, Quantum R&D

1. What is meant by the term budget proposal (line 3)?

2. Explain the impact that the increased spending on AI

and Quantum Computing is likely to have on
economic growth.

3. With the use of a diagram, illustrate the effect that

this spending would have on the long-run
equilibrium level of real output and prices in the US
economy.
 Automatic adjustment to full employment equilibrium
In the short run, there may be inflationary or deflationary gaps in the New Classical Model, but
these are always temporary. Automatic adjustments of market forces will eventually restore the
economy back to the long run equilibrium at the level of potential output.
Inflationary gap Recessionary gap
General Price General Price
LRAS LRAS
Level SRASଶ Level SRASଵ
SRASଵ
SRASଶ
PLଷ

PLଶ PLଵ

PLଵ PLଶ

PLଷ
ADଵ ADଶ ADଶ ADଵ

Y୮ Yଶ Real GDP Yଶ Y୮ Real GDP

Automatic adjustment to full employment equilibrium

Restoring an inflationary gap Inflationary gap

General Price
LRAS
1. Assume an economy is in long run Level
SRASଵ

equilibrium where AD=SRAS=LRAS

resulting in PL1 and Yp.
PLଶ

2. Suppose there is an increase in AD from PLଵ

AD1 to AD2, resulting in an inflationary gap

where Y2 > Yp and price levels increase ADଵ
ADଶ

Y୮ Yଶ
from PL1 to PL2. Real GDP
Automatic adjustment to full employment equilibrium

Resource Market
Restoring an inflationary gap Price
($) Sଵ
3. At the Y2 level of real GDP, firms are
producing more goods and services compared
to Yp which requires more resources.
Pଶ

In the resource market, the demand for Pଵ

resources such as labour is increasing,

resulting in a higher price of resources. Dଵ
Dଶ

Qଵ Qଶ Quantity
Automatic adjustment to full employment equilibrium
Restoring an inflationary gap
General Price Inflationary gap
4. When the price of resources increase, this Level
LRAS
SRASଶ SRASଵ
negatively impacts SRAS resulting in a
shift to SRAS2. Real GDP returns to Yp PLଷ

and price levels increase further from PL2

PLଶ
to PL3.
PLଵ

5. The full employment level of output is

ADଵ ADଶ
restored at Yp and the economy returns to
Y୮ Yଶ Real GDP
its long run equilibrium.
Automatic adjustment to full employment equilibrium

Restoring a recessionary gap Recessionary gap

General Price
LRAS
1. Assume an economy is in long run Level
SRASଵ
equilibrium where AD=SRAS=LRAS
resulting in PL1 and Yp.
PLଵ

2. Suppose there is a decrease in AD from PLଶ

AD1 to AD2, resulting in a recessionary gap

where Y2 < Yp and price levels fall from ADଶ ADଵ

Yଶ Y୮
PL1 to PL2. Real GDP
Automatic adjustment to full employment equilibrium

Resource market
Restoring a recessionary gap Price
($) Sଵ
3. At the Y2 level of real GDP, firms are
producing less goods and services compared
to Yp which leads to unemployment.
Pଵ

In the resource market, the demand for Pଶ

resources such as labour is falling, resulting in

a lower price of resources. Dଶ Dଵ

Qଶ Qଵ Quantity
Automatic adjustment to full employment equilibrium
Restoring a recessionary gap
Recessionary gap
4. When the price of resources fall, this General Price
LRAS
Level
SRASଵ
increases SRAS resulting in a shift to
SRAS2. Real GDP returns to Yp and price SRASଶ

levels fall further from PL2 to PL3.

PLଵ

PLଶ
5. The full employment level of output is
restored at Yp and the economy returns to PLଷ
ADଶ ADଵ
its long run equilibrium.
Yଶ Y୮ Real GDP
Over to you…

Hoang, Wray, & Chakraborty (2020)

Economics for the IB Diploma Programme

• Page 261

• Paper 2 Exam Practice Question 17.5 + 17.6

• [4 marks] + [4 marks]
Keynesian Model – long-run output gaps
In the Keynesian model, an economy can
remain stuck in a recessionary gap. General Price Output gaps
Level
AS
This is due to the assumption that resource
prices are inflexible and therefore market
forces cannot automatically adjust AS back to Pଶ

full employment.
P୤ ADଶ
Keynesian economists believe that government Pଵ
ADଵ
intervention is necessary to eliminate an output
Yଵ Y୮ Yଶ Real GDP
gap with demand-side policies.
Keynesian vs New Classical Model
Monetarist Keynesian
Resource prices Flexible Sticky downwards
Nature of aggregate supply SRAS and LRAS Keynesian AS – 3 sections

Automatically adjusts to full May be stuck in a recessionary

Other assumptions
employment level of output gap

Role of government Demand side policies required

Laissez-faire
intervention to correct recessionary gap

Which types of economies are Monetarist

and Keynesian economics more useful for?
Test your knowledge on this unit: Kahoot!