Title:

AGGREGATE DEMAND AND AGGREGATE SUPPLY

MODEL

Submitted To:
Sir. Syed Tahir

Submitted by:
Muhammad Tasleem Shahzad
Program:

Reg No. 3546

MBA 19-B

International Islamic University Islamabad

AGGREGATE DEMAND AND AGGREGATE SUPPLY MODEL

We are very familiar with demand and supply curves for individual markets. It we take all the
markets in a domestic economy and combine them into an aggregate is called aggregate
demand and aggregate supply.
AGGREGATE DEMAND
The aggregate demand curve accounts for the purchases of all consumers, businesses, the
government, and foreign trade in an entire domestic economy.

The aggregate demand curve is a graphical representation of GDP or demand at the national
level. Remember that GDP is the sum of consumption, investment, government spending and
net exports. As the curve shifts to the right, the total level of output and GDP increases. The
aggregate demand curve shows the relationship between the price level and output. As the
curve shows, there is an inverse relationship between prices and output.
The label of Price Level represents changes in prices or the inflation rate. As we move up
along the axis, prices are moving upward. Another way of saying this is that inflation is
rising.
This axis measures output at the national level. As we move to the right along the axis, the
national output of goods and services increases. The common measure of output is total GDP.

Why AD down-sloping:

Economists have three explanations of why the AD curve is downward sloping from left to
right. They are:
1. the wealth effect or The Price Level and Consumption
2. the interest-rate effect or The Price Level and Investment
3. the foreign purchases effect or The Price Level and Net Exports
Price Level

Amount of output demanded The wealth effect:

1. The wealth effect:

When the price level in the economy increases what happens to the real value, or the
purchasing power, of financial assets (of money you have saved)
Price Level

real value of financial wealth

Amount of output demanded

because they now have less real wealth.

2. The interest-rate effect:
Price Level

interest rates

Amount of output demanded

because people will buy less of those things for which they have to borrow money.
3. The foreign purchases effect :
The third reason is the foreign purchases effect. When the price level in the US economy
increases what happens to the relative prices of foreign products and why are fewer American
products purchased ?
US Price Level

relative price of foreign products

Amount of US output demanded

because people will now buy more of the now relatively cheaper foreign products.
Shift in AD
Just like with supply and demand in the individual product market, there are determinants
that will shift the AS and AD curves. These determinants are the REAL WORLD EVENTS
that cause the graphs to shift.

Increase in AD
(shifts to the right)

Decrease in AD
(shifts to the left)

Just like with demand in the individual product market, there are determinants of AD that, if
they change, will shift the AD curve. They are:

Shifts arising from Consumption

C
AD
Shifts arising from Investment

I
AD
Shifts arising from Government Purchases

G
AD
Shifts arising from Net Exports
Xn

AD

AGGREGATE SUPPLY
Aggregate Supply is the supply of all products in an economy - OR the relationship between
the Price Level and the level of aggregate output (real GDP) supplied.

The aggregate supply curve shows the total output by producers of all goods and services in
our economy.
In long run, the aggregate-supply curve is vertical.
In short run, the aggregate-supply curve is upward sloping.

The Long-Run Aggregate Supply Curve

In the long-run, an economys production of goods and services depends on its supplies of
labor, capital, and natural resources and on the available technology used to turn these factors
of production into goods and services.
The price level does not affect these variables in the long run.
The long-run aggregate supply curve is vertical at the natural rate of output.
This level of production is also referred to as potential output or full-employment output.

Shift in AS
Increase and decrease in AS
Increase in AS
(shifts to the right)

Decrease in AS
(shifts to the left)

Determinants of AS
Just like with supply in the individual product market, there are determinants of AS that, if
they change, will shift the AS curve. They are:
a. change in input prices
price of resources

AS

1) Labor
2) land
3) Capital
4) Entrepreneurial ability
b. changes in the productivity of resource
productivity

AS

c. legal-institutional environment
business taxes and gov't Reg
1) Business taxes and subsidies
2) Government regulation

AS

Macroeconomic Equilibrium
Equilibrium
We can use the AS-AD graph to find the equilibrium price level and the equilibrium level of
output:

In this economy the level of real domestic output (real GDP) will move toward Yn and the
price level will move toward P*.
Changes in AD/AS
Shifts in AD will result in a new short-run equilibrium However, if the new equilibrium is not
at Yn, the economy will eventually return to its long run equilibrium. For example, suppose
we are at a long-run equilibrium and an increase in the money supply shifts AD right:

Initially both price level and output rise. However, now output is above its natural level. The
shortage of labor pushes up wages and the AS shifts left:

So in the long-run, the increase in AD only results in a higher price level, with no change in
output.
We know the AS will shift due to changes in the labor market, but other factors shift AS as
well

Expected price level. Workers expecting higher prices will demand higher wages,
shifting the AS curve left.
Wage push. Union demands for higher wages could also shift the AS curve left.
However, since less than 15% of the labor force is unionized this is unlikely.
Changes in other production costs. Higher prices for important inputs like energy
will shift the AS curve left. Also improvements in technology that reduce costs will
shift the AS curve right.

As with shifts in AD, shifts in AS will affect the short-run equilibrium, but output will return
to Yn in the long-run.
Over time, we would expect improvements in technology and productivity and economic
growth to increase Yn, shifting the long-run aggregate supply curve to the right.