Deriving the Aggregate

Demand and Supply

Curves

The Aggregate Demand Curve

Aggregate demand is the total spending which the

consumers, businessmen, government and foreigners
are willing to make on aggregate output of goods and
services produced in an economy at different price
levels during a given period.
The Aggregate demand curve is a downward sloping
curve that denotes that an increase in the price levels
will result in to decrease in the aggregate demand and
vice versa.

If price level goes up

If prices increase, the real value of money falls. People
feel more poor. They consume less of goods.
They will require more money to conduct their daily
transactions.
This increases the demand for loans and the interest
rates go up.
As interest rates increase, the investment tends to
decrease.
If prices in India increase, the exports decrease and
imports increase. This reduces the net exports.

If prices fall
If price decreases, the real value of money increases.
People feel more richer. They consume more of goods.
They will require less money to conduct their daily
transactions.
This will decrease the demand for loans and the interest
rates go down.
As interest rates fall, the investment tends to increase.
If prices in India decrease, the exports increase and
imports decrease. This raises the net exports.

Derivation of Aggregate Demand Curve

Y
Aggregate Expenditure

C + I + G + Xn (at initial price level P0 )

E0

C + I + G + Xn (at a higher price level P 1 )

E1

Price Level

C + I + G + Xn (at lower price level P2 )

E2

P1
P0
P2

Y1

Y0

Y2

E1
E0
E2
Y1
Y0
Y2
Aggregate Output

Shifts of the Aggregate Demand Curve

An increase in the
quantity of money
supplied at a given
price level shifts the
aggregate demand
curve to the right.

Shifts of the Aggregate Demand Curve

An increase in
government purchases
or a decrease in net
taxes shifts the
aggregate demand
curve to the right.

Shifts of the Aggregate Demand Curve

Factors That Shift the Aggregate Demand Curve
Expansionary monetary
Contractionary monetary
policy
policy
Ms
right

AD curve shifts to the

Expansionary fiscal policy

Ms
left

AD curve shifts to the

Contractionary fiscal policy

G
right

AD curve shifts to the

G
left

AD curve shifts to the

T
right

AD curve shifts to the

T
left

AD curve shifts to the

The Aggregate Supply Curve

Aggregate supply is the total supply of all

goods and services in the economy.
The aggregate supply (AS) curve is a
graph that shows the relationship between
the aggregate quantity of output supplied by
all firms in an economy and the overall price
level.

Aggregate Supply
Price Level

SRAS

Economy starts to overheat

Y1

Yf

Between Y1 and Yf,

The
shape
the
AS
Yf
Anrepresents
output
level
Full
of
Y1
increases
in of
capacity
are
This
shape
curve
important
Employment
wouldissuggest
thein
possible
but
theOutput
nearer
reflects
the
economy
to Yf,
determining
the
at
economy
this
point
isagets
working
the
morefull
problems
are to
outcome
in
the
economy
below
iscapacity
working
Keynesian
view
experienced
with
economy
full
andcapacity
there would
and be
of
the
AS
curve.
acquiring
resources
to
cannot
widespread
produce
any
boost production
more.
unemployment.
(production
bottlenecks)
especially labour skills
shortages.

Real National Income

Aggregate Supply
Price Level

AS
For our analysis,
we will assume
the AS curve
looks like this!

Real National Income

Aggregate Supply in the Short Run

At low levels of
aggregate output, the
curve is fairly flat. As
the economy
approaches capacity,
the curve becomes
nearly vertical. At
capacity, the curve is
vertical.

Aggregate Supply in the Short Run

Macroeconomists focus on whether
or not the economy as a whole is
operating at full capacity.
As the economy approaches
maximum capacity, firms respond to
further increases in demand only by
raising prices.

Shifts of the Short-Run

Aggregate Supply Curve
A cost shock, or supply shock, is a
change in costs that shifts the aggregate
supply (AS) curve.

Shifts of the Short-Run

Aggregate Supply Curve
Factors That Shift the Aggregate Supply Curve
Shifts to the Right

Shifts to the Left

Increases in Aggregate Supply

Decreases in Aggregate Supply

Lower costs
lower input prices
lower wage rates

Higher costs
higher input prices
higher wage rates

Economic growth
more capital
more labor
technological change

Stagnation
capital deterioration

Public policy
supply-side policies
tax cuts
deregulation

Public policy
waste and inefficiency
over-regulation

Good weather

Bad weather, natural

disasters, destruction
from wars

The Equilibrium Price Level

The equilibrium price
level is the point at
which the aggregate
demand and aggregate
supply curves intersect.

Aggregate Demand, Aggregate

Supply, and Monetary and Fiscal Policy
AD can shift to the right for
a number of reasons,
including an increase in the
money supply, a tax cut, or
an increase in government
spending.
Expansionary policy works
well when the economy is
on the flat portion of the AS
curve, causing little change
in P relative to the output
increase.

Aggregate Demand, Aggregate

Supply, and Monetary and Fiscal Policy
On the steep portion of the
AS curve, expansionary
policy does not work well.

When the economy is

operating near full capacity,
an increase in AD will result
in an increase in the price
level with little increase in
output.

The Simple Keynesian

Aggregate Supply Curve
The output of the economy
cannot exceed the maximum
output of YF.
The difference between
planned aggregate
expenditure and aggregate
output at full capacity is
sometimes referred to as an
inflationary gap.