Aggregate Demand & Aggregate Supply

Aggregate Demand

Definition: “The total level of expenditure on all domestic goods and services”.

In an economy, expenditure (spending) will come from one of four groups of individuals: consumers, firms, the
government, or from foreign countries. Therefore, when thinking of aggregate demand, you should think of the
following equation:

Aggregate Demand = Consumption + Investment + Government Spending + Exports – Imports

AD = C + I + G + X – M

This equation shows the sources of all demand for goods and services in the UK (note how imports are taken
away from the equation, as this is in effect ‘lost demand’ for the UK, as money is being spent on foreign
goods/services which could have been spent domestically).

The aggregate demand curve is downwards sloping, as there is an inverse relationship between the price level
and real output (GDP) – this is to be expected, as when the price of goods in the UK economy falls, you would
expect there to be more demand for those goods.

P
L
P
2
P
1
A
Y Y DR
2 1 O
A change in the price level will simply cause a movement along the AD curve (i.e. an expansion/contraction).
However, anything else that causes a change in demand will cause a shift in the entire curve. As AD = C + I +
G + X – M, the AD curve will shift when there is an increase or decrease in any one of these components (for a
reason other than the price level changing). For AD to shift to the right, there must be an increase in C, I, G or
X, or a decrease in M. This could happen for various reasons:

1. Rise in consumption due to:

a. Rising consumer confidence
b. Rising incomes
c. Falling interest rates
d. Falling income tax
e. Rising wealth (wealth effect)

2. Rise in investment due to:

a. Increased business confidence
b. Increased profitability
 c. Falling interest rates
d. Falling corporation tax

3. Rise in government spending (this could be due to any change in the government’s policy, or a new
government)

4. A rise in net exports (i.e. a rise in exports and/or a fall in imports) due to:
a. A rise in the UK’s price competitiveness due to:
i. Fall in sterling exchange rate (remember: SPICED)
ii. Fall in interest rates (which will cause a fall in sterling exchange rate)
b. A rise in the UK’s non price competitiveness due to:
i. Better quality goods/services
ii. Better innovation etc

AD will shift left for the reverse reasons.

Aggregate Supply

Note: This is a more simplistic version of the analysis to the Keynesian/Classical analysis considered in
class.

Definition: “The total level of real output of all domestic goods and services”.

Unlike with AD, there is no equation for the AS curve; it is simply total supply in the economy. The AS curve
is upwards sloping; as the price level increases, firms have more incentive to expand output as they will become
more profitable, and so there is a positive relationship between the price level and real output. However, the AS
curve is not linear. Recall from Unit 1: The four factors of production (land, labour, capital and enterprise) are
scarce resources – there are limited amounts of these in the economy. Therefore, there must be a limit as to how
much we can supply – once we reach this level, we cannot increase aggregate supply any more, given the
factors of production we have in their current state. This level is called the full capacity (or full employment
level) of the economy; once supply reaches this point, it becomes vertical, as no more can be supplied. Note,
this is not saying that every person in the economy is working, or every patch of land is being used. There are
some people who are inactive – people who are not looking for work, if they choose not to work, or maybe are
unable to work if for example they are prevented by disability. Similarly, not every patch of land in the UK is
available to be used for production – there is, for example, greenbelt land which we cannot build on. Thus, the
full employment level shows the maximum that can be produced using all the factors of production that are
available.

PL AS

YFE RO
Again, a change in the price level will simply cause a movement along this curve (expansion/contraction).
However, the aggregate supply curve can be shifted, if something other than the price level changes how much
we can supply. Think back to the explanation for the shape of the AS curve – it becomes vertical, as we have
reached the full capacity (or full employment) of the economy – all factors of production that are available to be
used are being used, and the economy can produce no more. But this full capacity can increase, if we get more
factors of production (e.g. foreign workers), or the ones we have become more productive (e.g. UK workers
become more skilled/educated).

Thus, the AS curve will shift right (i.e. the full capacity of the economy increases) if:

1. There is an increase in the quantity of factors of production.

a. From abroad e.g. immigration of workers, or foreign investment into the UK
b. Domestically e.g. tax cuts means people who previously did not want a job are now looking for
work, or the government making greenbelt land available to be built on.

2. There is an increase in the productivity of factors of production.

a. For example due to better skilled workers, due to new technology which means machines
produce goods quicker etc.

The AS curve will shift left for the opposite reasons.

PL AS1 AS2

Y1FE Y2FE RO

However, there is a third factor that shifts the AS curve. If goods become more expensive to produce (i.e.
there is a rise in the cost of production), then the AS curve will be affected – at each and every level of output,
the price level in the economy will now be higher. However, this doesn’t affect the maximum that the economy
can produce. The fact that goods are more expensive to produce has no effect on the maximum that can be
produced in the economy if all factors of production are being employed. Thus, the full employment level on
the diagram should not change. All that changes is that, at each level of output before that point, goods are now
more expensive to produce, and so the price level will increase.

Thus, the AS curve shifts up if:

1. There is a rise in the cost of production for firms.

(Opposite for a fall in the cost of production).

 PL

AS2

AS1

YFE R
O

Macroeconomic Equilibrium

In order to determine the price level and the level of real output (GDP) in the economy, we need to find the
point at which AS equals AD. This will be where the two curves intersect.

PL AS

PL1

AD
Y1
R
O
In this diagram, the overall price level in the economy is given by PL1, whilst the level of output (GDP) is Y1.
This will not change, unless there is a shift in one/both curves. Imagine now that income tax falls. This will
increase the level of disposable income for individuals, and so the level of consumption increases. This is a
component of AD, and so AD will shift right. However, cutting income tax will also mean that people who
previously did not want a job in the UK now decide to start looking for one (as working is now more rewarding
compared to claiming benefits). Thus there is also a higher quantity of one of the factors of production (labour);
AS therefore also shifts right. Thus, the overall effect on the economy is as follows:
 PL AS1 AS2

PL1
AD1 AD2

Y1 Y2 RO

Looking at where the curves originally intersected and where they intersect now, this cut in income tax has
increased the level of output from Y1 to Y2, whilst the price level has stayed the same (note: price level has only
stayed the same as both curves have been drawn to shift by the same amount. You should be able to see that if
AD shifted more, price level would rise, whereas if AS shifted more, price level would fall. You can show any
of these things happening in an exam).

This is all equilibrium is: drawing the two curves together, and finding the point of intersection. If something in
the economy changes (e.g. taxes fall), think carefully how it affects each of the two curves (it may affect just
one or both), then simply find the new intersection point and read from the axis.

Interpreting Macroeconomic Equilibrium

The most important thing about AS/AD analysis is being able to use it to describe what has happened to the
government’s four macroeconomic objectives: high and sustainable economic growth, low and stable inflation,
full employment, and a balance of payments equilibrium. It is important that, once you have shown a change in
the macroeconomic equilibrium, you know what this means for the government meeting its objectives.
Consider the following change to macroeconomic equilibrium following an increase in AD:

PL AS

PL2

PL1
AD2
AD1
Y1 Y2
RO
Following the AD shift, price level has increased along with real output. Is this good for the four objectives?
Let’s look at each in turn:

1. Economic growth. This is defined as a rise in the level of real output produced in an economy. As this
has occurred (Y1 to Y2), this has led to economic growth.

Whenever equilibrium moves rightwards along the real output (RO) axis, this is good for the
economic growth objective. If it moves leftwards along this axis, this objective is not met.

2. Low inflation. Here, there has been a rise in the price level – this means that there is high inflation.

Whenever equilibrium moves upwards along the price level (PL) axis, this is generally bad for the
price stability objective. When equilibrium moves down the PL axis, the price stability objective is
usually met (as there is now less upward pressure on inflation. Note, however, that too big a
movement downwards could show deflation, which is also bad for the economy).

3. Full employment. Here, the real output of the economy has increased from Y1 to Y2. More workers will
therefore be needed to make this output (as labour is a derived demand); there is more employment in
the economy.

Whenever equilibrium moves rightwards along the real output (RO) axis, this is good for the full
employment objective. If it moves leftwards along this axis, fewer people will be employed, so the
objective is not met.

4. Balance of Payments Equilibrium. The output of the economy has increased from Y1 to Y2; more
workers are needed to make this output, so employment rose. This means average income is higher, and
more will be spent on imports. Thus, the economy sees a larger BoP deficit.

Generally, whenever equilibrium moves rightwards along the real output (RO) axis, the BoP
deficit worsens as more is spent on imports and so the objective is not met. When equilibrium
moves leftwards on this axis, the BoP deficit improves and so the objective is closer to being met.