ECO 102Macroeconomics

Chapter 3Aggregate Demand and Aggregate Supply

Prof. Dr. Magdy El-Shourbagui

Head of the Department of Economics

College of Business & Economics

Misr University for Science & Technology

www.magdyel-shourbagui.com

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Learning Objectives Define the following terms: aggregate demand,

aggregate supply, economy’s potential real GDP, and macroeconomic equilibrium.

Distinguish between the aggregate demand curve and the aggregate supply curve.

Identify and describe the reasons for downward slope of the aggregate demand curve.

Identify and describe the factors that shift the aggregate demand curve.

Explain and illustrate graphically the macroeconomic equilibrium in the short run

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The Meaning of Aggregate Demand

Aggregate Demand, AD is the quantity demanded of all final goods and services (Real GDP) at different price levels. AD can be calculated by the following equation:

Real GDP = Y = AD = C + I + G + NX

= C + I + G + (X -M)

Where: C = personal consumption spending,I = gross private domestic spending,G = government spending,NX = net exports of goods and services,X = exports of goods and services, andM = imports of goods and services.

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The Aggregate Demand CurveThe Aggregate demand, AD curve is downward-sloping, specifying a negative relationship between the price level as independent variable and the quantity of real GDP demanded as dependent variable.

P

Y0

AD

P2

P1

Y1

E

F

Y2

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Reasons for Downward slope of the Aggregate Demand Curve

1. The price level and consumption (The Real wealth effect or the real money balance effect),

2. The price level and investment (The interest rate effect), and

3. The price level and net exports (The international trade effect).

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1. The price level and consumption (The Real wealth effect or the real money balance effect),

Real Wealth is the value of money in bank, bonds, stocks, and non-monetary assets people own measured in terms of what they will buy.

The price level

the real purchasing power of money balances (currency and bank deposits) and the real, monetary wealth

real wealth.

consumers feel wealthier encourages them to spend more

quantity of goods and services demanded

quantity demanded of Real GDP

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2. The Price Level and Investment (The Interest Rate Effect)

the purchasing power of money

money needed to buy fixed bundle of goods and services

the domestic saving

supply of credit the interest rate

the banks will provide more loans

spending on investment goods by households and

businesses

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3. The Price Level and Net Exports (The International Trade Effect)

the domestic goods will be cheaper relative to

foreign goods

Exports (X) and Imports (M) Net Exports (NX)

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A Change in the Quantity Demanded of the Real GDP: A Movement along the Aggregate Demand Curve

A change in the quantity demanded of real GDP caused by a change in the price level. It is shown by a movement along the aggregate demand curve

AD

P2

P1

Y2

Y1

Y

P

A

B

P

Y

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A Change in Aggregate Demand: Shifts in the Aggregate Demand Curve

A Change in aggregate demand is the change in the quantity demanded of real GDP as the change in the following factors: Consumption, investment, government spending, and net exports. These factors will affect the quantity demanded of real GDP at any given price level.

The aggregate demand curve shifts, when one of the factors above changes.

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An Increase in Aggregate Demand

An increase in aggregate demand is represented by an outward shift of the entire aggregate demand curve. If aggregate demand increases, greater quantities of real GDP are demanded at each possible price level for the year.

AD1

P1

Y2 Y

P

Y1

AD0

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A Decrease in Aggregate DemandA decrease in aggregate demand is represented by an inward shift of the entire aggregate demand curve. When aggregate demand decreases, a less quantity of real GDP is demanded at each possible price level for the year.

AD0

P1

Y1 Y

P

Y2

AD2

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Factors that shift the Aggregate Demand CurveThe aggregate demand curve will shift as a result of changes in the following:

1. Consumption Spending (C);2. Investment Spending (I);3. Government Spending (G); and4. Net Exports (NX).

The AD curve shifts to the right side when aggregate demand increases. However, the AD curve shifts to the left side when aggregate demand decreases.

AD0

P1

Y1 Y

P

Y2

AD2

Y0

AD1

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1. Consumption Spending (C)The following factors can cause consumption spending to change:a) Consumer Wealth;b) Personal Income Taxes; andc) Expectations about Future Income, and Inflation.

Factors that shift the Aggregate Demand Curve

a) Consumer Wealth

Consumer Wealth consumers feel wealthier demand for goods and services

by consumers

aggregate demand

rightward shift of theaggregate demand

curve

Consumption Spending

( C )

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Factors that shift the Aggregate Demand Curve

b) Personal Income Taxes

personal income tax disposable income of households

Consumption Spending

( C )aggregate demand

rightward shift of theaggregate demand

curve

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Factors that shift the Aggregate Demand Curve

c) Expectations about Future Income, and Inflation

Consumption Spending

( C )

aggregate demand

rightward shift of theaggregate demand

curve

expected future income the amount of consumption goods that people plan to

buy today

A increase in expected inflation buying goods and services cheaper today

Consumption Spending

( C )aggregate demand

rightward shift of theaggregate demand

curve

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Factors that shift the Aggregate Demand Curve

2. Investment Spending (I)The following factors can cause investment spending to change:a) Interest Rates;b) Corporate Profits Taxes; andc) Expectations about Future Sales.

a) Interest Rates

The interest rates borrowing by investors

InvestmentSpending

( I )

aggregate demand

rightward shift of theaggregate demand

curve

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Factors that shift the Aggregate Demand Curve

b) Corporate Profits Taxes

Taxes on profits of firmsfirms after-tax profits

InvestmentSpending

( I )

aggregate demand

rightward shift of theaggregate demand

curve

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Factors that shift the Aggregate Demand Curve

c) Expectations about Future Sales

Expected future sales profits expectations

InvestmentSpending( I ) today

aggregate demand

rightward shift of theaggregate demand

curve

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Factors that shift the Aggregate Demand Curve

3. Government Spending (G)An increase in government purchases of goods and services increases aggregate demand. This shifts the aggregate demand curve to the right

4. Net Exports (NX)The following factors can cause net exports to change:a) Foreign Real Income; andb) Foreign Exchange Rate.

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Factors that shift the Aggregate Demand Curve

a) Foreign Real Income

Foreign real income (Real GDP of foreign countries)

The exports of the home country

aggregate demand

rightward shift of theaggregate demand

curve

AD = C + I + G + X - M

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b) Foreign Exchange Rate

Factors that shift the Aggregate Demand Curve

Foreign exchange rate (price of foreign currency )

The prices of domestic goods and services

relative to foreign goods and services

Exports and Imports Net exports

aggregate demand

rightward shift of theaggregate demand

curve

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The Meaning of Aggregate SupplyAggregate supply, AS is the quantity supplied of all final goods and services (Real GDP) at different price levels. ). This is represented by the aggregate production function:

Y = f (N, K, L, T)Where:Y = The aggregate supply (Real GDP);f = depends on;N = Labor;K = Capital;L = Land;T = The State of Technology.

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The short-Run Aggregate Supply CurveThe Short-Run Aggregate Supply, SRAS curve is upward-sloping, specifying a positive relationship between the price level as independent variable and the quantity supplied of real GDP as dependent variable.

P

Y

SRAS

Y10

P2

P1

Y2

FE

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3.2.2.2 The Long-Run Aggregate Supply Curve Page 75

till Figure 3.11: A Change in Aggregate Supply in the Short-Run: Shifts of the Short-Run

Aggregate Supply Curve page 81and

3.3.2 Long-Run Macroeconomic Equilibrium page 82

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1 Short-Run macroeconomic EquilibriumWhen the quantity demanded of real GDP equals the quantity supplied of real GDP, the Short-Run macroeconomic equilibrium occurs

The short-run equilibrium point (n) is the interaction of the AD curve and SRAS curve. This intersection determines the equilibrium price level (Pe) and the equilibrium real GDP (Ye).

P

Y

AD

SRAS

Pe

Ye

n1

0

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