Chapter 9 Aggregate demand and aggregate supply

9.1. Aggregate demand (AD) and the aggregate demand curve

a. Explaining aggregate demand and the aggregate demand curve
Aggregate demand is the total amount of real output (real GDP) that consumers, firms, the
government and foreigners want to buy at each possible price level, over a particular time period.
The aggregate demand AD curve shows the relationship between the total amount of real
output demanded by the four components and the economy’s price level over a particular time
period. It is downward-sloping, indicating a negative relationship between the price level and
aggregate output demanded.

The reasons behind downward-sloping of the aggregate demand:

- The wealth effect: changes in the price  affect the real value of people’s wealth. If price
increases  real value of wealth falls  people feel worsen off and cut back on spending on
goods and services  less output demanded  an upward movement along the AD curve.
- The interest rate effect: changes in the price level affect rates of interest  in turn affect
aggregate demand. If price increases  need more money to carry out purchases and
transactions  increases more money  increases interest rate  cost of borrowing increases
 decreases in consumer purchases financed by borrowing or spending investment by firms
must borrow  increases the price  fall in quantity of output demanded or an upward
movement along AD curve.
- The international trade effect: if the domestic prices level increases while the price level in
other countries remain the same  exports become more expensive to foreign buyers and
imports become cheaper from foreign countries  net exports X-M fall  fall in quantity of
output demanded  an upward movement along the AD curve.
The difference of microeconomic concept of demand for a product and the macroeconomic
concept of aggregate demand:
Microeconomic Macroeconomic
Reflects the willingness and ability of Reflects the willingness and ability of all
consumers to buy a single product at different possible buyers to buy the economy’s
possible prices of that product over a aggregate output or total real GDP at
particular time period different possible price level over a time
period.
Downward-sloping indicates the diminishing Downward-sloping is due to the wealth effect,
marginal benefits that consumers derive as the interest rate effect and the international
they consume more and more of a product. trade effect.
As marginal benefits fall with increasing
purchases, consumers will be induced to buy
an extra unit of a product only if its price fall
Horizontal axis measure quantity of a single Horizontal axis represents the total income of
good an economy

The determinants of aggregate demand (shifts in the AD curve)

- A rightward shift from AD1 to AD2 means that aggregate demand increases: for any price
level, a larger amount of real GDP is demanded.
- A leftward shift from AD1 to AD3 means that aggregate demand decreases: for any price level,
a smaller amount of real GDP is demanded.
Causes of changes in consumption spending
- changes in consumer confidence: consumer confidence is a measure of how optimistic
consumers are about their future income and the future of the economy. If they expect their
income increase  spend more on buying goods and services  AD curve shifts to the right.
- changes in interest rates: some consumer spending is financed by borrowing  exchange
rates influence: if exchange rates increase  borrowing more expensive  lower consumer
spending  leftward shift in the AD curve.
- changes in wealth: consumer wealth increase  people feel wealthier  spend more and the
AD curve shifts to the right.
- changes in personal income taxes: government increases personal income taxes  consumer
disposable income  income left over after personal income taxes fall  spending drops  AD
curve shifts to the left
- changes in the level of household indebtedness: indebtedness refers to how much money
people own from taking out loans in the past. If consumers have high level of debt  under
pressure to make high monthly payments  cut back on present expenditures  lower spending
 AD shifts to the left.
Causes of changes in investment spending
- changes in business confidence: business confidence refers to how optimistic firms are about
their future sales and economic activity. If business is optimistic  spend more on investment 
AD shifts to the right.
- changes in interest rates: increases in interest rates  raise cost of borrowing  business
reduce investment spending financed by borrowing  AD shifts to the left.
- changes in technology (improvement): improvement in technology = spending investment
increases  increases in aggregate demand  AD shifts to the right.
- changes in business taxes: if government increases taxes on profits  after-tax profits fall 
investment spending decreases  AD curve shifts to the left.
- the level of corporate indebtedness: if business have high level of debt  less inclined to
make investment  AD curve shifts to the left.
- legal/institutional changes: the legal and institutional environment in which business operate
has an important impact on investment spending. Many developing and transaction economies
where laws and institutions do not favor small business because of not having access to credit 
not borrow easily finance investments  low investment  AD curve shifts to the left.
Cause of changes in government spending
- Changes in political priorities: governments have many expenditures, arising from provision
of merit goods and public goods, spending on subsidies and pensions, payments of wages and
salaries to its employees, purchases of goods for its own use  increase/ decrease expenditures
 changes in priorities  AD shifts to the right/ to the left.
- Changes in economic priorities: deliberate efforts to influence aggregate demand. The
government can use its own spending as part of a deliberate attempt to influence aggregate
demand.
Cause of changes in export spending minus export spending
- Changes in national income abroad: consider aggregate demand in country A which has trade
links with country B. if country B’s national income increases  import more goods and
services from country A = country A’s exports increase  AD curve of country A shifts to the
right
- Changes in exchange rates: an exchange rate is the price of one country’s currency in terms of
another country’s currency. Consider country A, assume that the price of its currency increases =
more expensive relative to the currency of country B  country A’s output more expensive and
imports less from country A  country A’s exports fall  AD curve of country A shifts to the
left. At the same time, country A find country B’s output cheaper  increases imports from
country B  increase in price of country A’s currency has 2 effects: a fall in its exports and an
increase in imports  net exports X-M fall  AD curve shifts to the left.
- Changes in the level of trade protection: suppose country A trade freely with country B.
However, country B’s government decides to impose restrictions on imports from country A.
Country A’s exports fall  AD curve of country A shifts to the left.
Shifts in the AD curve and national income
Income is not included among the factors that can shift the AD curve. Changes in national
income cannot initiate any AD curve shifts. The real GDP measured on the horizontal axis
represents national income.
A clarification
- Changes in the real value of wealth that has resulted from a change in the price level.
- Changes in real wealth that have come about without any change in the price level 
changes in interest rate.
9.2. Short-run aggregate supply and short-run equilibrium in the AD-AS model
a. Short-run aggregate supply
The short-run and long run in macroeconomics
- The short-run in macroeconomics is the period of time when prices of resources are roughly
constant or inflexible. Ex: wages, the price of labor
- The long run in macroeconomics is the period of time when prices of all resources, including
the price of labor (wages) are flexible and change along with changes in the price level.
- The price of labor (wages) is often rigid (unchanging) because:
● Labor contracts fix wage rate for certain periods of time, perhaps a year or two or more
● Minimum wage legislation fixes the lowest legally permissible wage
● Workers and labor unions resist wage cuts
● Wage cuts have negative effects on worker morale, causing firms to avoid them.
Defining aggregate supply and the short-run aggregate supply curve
Aggregate supply is the total quantity of goods and services produced in an economy (real
GDP) over a particular time period at different price level.
The short-run aggregate supply curve (SRAS) shows the relationship between the price and
the quantity of real output (real GDP) produced by firms when resource prices (especially wages)
do not change.
Why the SRAS curve is upward-sloping
The positive relationship between the price level and real output (real GDP) is based on firm
profitability: price increases  output prices increase; but with unchanging resource prices
(since the economy is in the short run), firm’s profits increases  increase the quantity of output
produced.
Changes in short-run aggregate supply (shifts in the SRAS curve)
A rightward shift from SRAS1 to SRAS2 means that short-run aggregate supply increases: for
any particular price level, firms produce a larger quantity of real GDP.
A leftward shift from SRAS1 to SRAS3 means that aggregate supply decreases: for any
particular price level, firms produces a smaller quantity of real GDP.
Important factors cause SRAS curve shift:
- Changes in wages: wages can change for a number of reasons (such as changes in minimum
wage legislation, or changes brought about by labour union bargaining with employers). If wages
increase with the price level constant  firms’ costs of production rise  SRAS curve shifts to
the left.
- Changes in non-labor resource prices: changes in the price of non-labor resources such as the
price of oil, equipment, capital goods, land inputs  SRAS curve changes in the same way. An
increase in the price of a resource shifts the SRAS curve to the left and contrast.
- Changes in business taxes: business taxes are taxes on firm’s profits and treated by firms like
costs of production. Higher taxes on profits increases in production costs  SRAS shifts to the
left.
- Changes in subsidies offered to business: subsidies have the opposite effect to taxes as they
involve money transferred from the government to firms. If they increase  SRAS curve shift to
the right.
- Supply shocks: supply shocks are events that have a sudden and strong impact on short-run
aggregate supply. Example: a war or violent conflict  destruction of physical capital and
disruption of the economy  lower output produce  SRAS curve shifts to the left.
 Over short periods of time, the SRAS curve shifts to the left or to the right mainly as a result
of factors that influence firms’ costs of production (such as changes in wages, changes in non-
labor resource prices and changes in business taxes or subsidies) as well as supply shocks.
b. Short-run equilibrium in the AD-AS model
Illustrating short-run equilibrium
In the AS-AD model, the equilibrium level of output (or real GDP) occurs where aggregate
demand intersects aggregate supply. In the short run, equilibrium is given by the point of
intersection of the AD and SRAS curves, and determines the price level, the level of real GDP
and the level of employment.

Three short-run equilibrium positions: Recessionary (deflationary) gaps, inflationary gaps and
short-run full employment equilibrium
- Recessionary (deflationary) and inflationary gaps represent short-run equilibrium
positions of the economy.
- A recessionary (deflationary) gap is a situation where real GDP is less than potential
GDP (and unemployment is greater than the natural rate of unemployment) due to
insufficient aggregate demand.
- A inflationary gap is a situation where real GDP is greater than potential GDP (and
unemployment is smaller than the nature rate of unemployment) due to excess aggregate
demand.
- When the economy is at its full employment equilibrium level of GDP, the AD curve
intersects the SRAS curve at the level of potential GDP, and there is no deflationary or
inflationary gap. This economy’s full employment level of output.
Impacts of changes in short-run equilibrium
The AD curve shifts from AD1 to AD2: an increase in price level from Pl1 to Pl2, and an
increase in real GDP from Y1 to Y2  fall in unemployment.
The rightward SRAS shifts from SRAS1 to SRAS2: (example: a technology improvement or
lower business taxes) result in a lower price level Pl2, a higher level of real GDP Y2 and lower
unemployment.
Shifts in AD or SRAS as possible causes of the business cycle
Part (a): a fall in aggregate demand, shifting the AD curve leftward from AD1 to AD2 causes a
recessionary gap. If the economy experiences an increase in aggregate demand, appearing as a
rightward shift in the AD cure from AD1 to AD3 inflationary gap.
Part (b): starting from full employment equilibrium, a fall in SRAS, shifting SRAS1 to SRAS2,
 economic contraction with real GDP falling to Y2 and unemployment increasing  an
increase in the price level along with a decrease in real GDP. Stagflation (combining ‘stagnation’
with ‘inflation’) involves the appearance of two problems: recession (with unemployment) and a
rising price level.
9.3. Long-run aggregate supply and long-run equilibrium in the monetarist/new classical
model
a. The monetarist/ new classical model
Defining the long-run aggregate supply curve and long-run macroeconomic equilibrium
According to the monetarists/new classical perspective, the long-run aggregate supply (LRAS)
curve is vertical at the full employment level of output, or potential GDP, indicating that in the
long run the economy produces potential GDP, which is independent of the price level.
Why the LRAS curve is vertical
Since wages are now changing to match output price changes, firms’ costs of production remain
constant even as the price level changes. As the price level increases/ decreases, with constant
real costs, firms’ profits are constant, and firms no longer have any incentive to increase or
decrease their output levels.
Why the LRAS curve is situated at the level of potential GDP (or why inflation and deflation
gaps cannot persist in the long run)
Recessionary and inflationary gaps are two possible short-run equilibrium positions of the
economy where the equilibrium level of real GDP differs from potential GDP. If the LRAS curve
is vertical at potential GDP, recessionary and inflationary gaps are only short-run phenomena
that cannot persist in the long run. As soon as the economy moves into the long run, the
recessionary and inflationary gaps disappear and the economy achieves full employment
equilibrium.
The assumption of wage and price flexibility in the long run has allowed the economy to
automatically come back to its long-run equilibrium level of output.

In the monetarist/new classical perspective, recessionary (deflationary) and inflationary gaps are
eliminated in the long run. This ensures that in the long run the LRAS curve is vertical at the
level of potential GDP. The economy has a built-in tendency towards full employment
equilibrium.
Impacts of changes in long-run equilibrium (or why in the long run aggregate demand
influences only the price level)

In the monetarist/new classical perspective, changes in aggregate demand can influence real
GDP only in the short run; in the long run, the only impact of a change in aggregate demand is to
change the economy’s price level. Increases in aggregate demand in the long run are therefore
inflationary (cause inflation).
9.4. Aggregate supply and equilibrium in the Keynesian models
This section presents the theoretical model of Keynesian economics - base on the work of John
Maynard Keynes, one of the most famous economists of the 20th century, whose work in the
first half of the century came to form the basis of modern macroeconomics.
a. Getting stuck in the short run:
Wage and price downward inflexibility
The LRAS curve in the monetarist/new classical model depends on the idea that all resource
prices and product prices are fully flexible and respond to the forces of supply and demand.
Keynesian economists argue that: there is an asymmetry between wage changes in the upward
and downward directions.
● Economic expansion and strong aggregate demand  rightward shifts in the AD curve
causing inflationary gap  unemployment lower than the natural rate and a rising level
 wages quickly begin to move upward.
● In recessionary gapaggregate demand is weak  unemployment greater than the
natural rate  wages do not fall easily, even over long periods of time because of variety
of factors such as contracts, minimum wage legislation, worker and union resistance to
wage cuts.
Keynesian economists argue that: product prices do not fall easily, even if an economy is in a
recessionary gap. Because:
● If wages will not go down, firms will avoid lowering their prices because of reducing
their profits.
● Large oligopolistic (doc tai) firms may fear price wars, if one firm lowers its price, then
others may lower theirs more aggressively in an effort to capture market shares  all the
firms will be worse off.
The inability of the economy to move into the long run
If wages and product prices do not fall easily, this means the economy may get stuck in the short
run and cannot move into the long run.
In the Keynesian model, inflexible wages and prices mean that the economy cannot move into
the long run. Inflexible wages and prices are shown graphically by a horizontal section of the
Keynesian aggregate supply (AS) curve.
Keynesians would not suggest that wages and prices can never fall. They would agree that if a
recession or depression continues for a long enough time, wages and prices would begin to fall
 a long-lasting recession would be very costly in term of unemployment, low incomes and lost
output.
 Government intervene with active policies to help the economy out of the recession.
b. The shape of the Keynesian aggregate supply curve

The Keynesian aggregate supply curve has three sections.

- Section I: real GDP is low, the price level remains constant as real GDP increases  a lot of
unemployment of resources and spare capacity. Spare capacity refers to physical capital
(machines, equipment, etc) that firms have available but do not use. Firms can easily increase
their output by employing the unemployed capital and other unemployed resources without
having to bid up (tang gia) wages and other resource prices.
- Section II: real GDP increases are accompanied by increases in the price level. The reason is
that as output increases, so does employment of resources and bottlenecks in resource supplies
begin to appear as there is no longer spare capacity in the economy. Wages and other resource
prices begin to rise which means that costs of production increase.  firms will be induced to
increase their output is if they can sell it at higher prices  growing output leads to an increasing
price level.
At output level Yp, the economy has reached its full employment level of real GDP = potential
output level and unemployment has fallen to the point where equal to the natural rate of
unemployment.
- In section III: the AS curve becomes vertical at Ymax indicating that real GDP reaches a level
beyond which it cannot increase anymore; at this point, the price level rises very rapidly. Real
GDP can no longer increase because firms are using the maximum amount of labor and all other
resources in the economy.
c. The three equilibrium states of the economy in the Keynesian model

Macroeconomic equilibrium in the Keynesian model is determined by the point where the AD
curve intersects the Keynesian AS curve  occur at any level of real GDP.
(a) shows the AD curve intersecting the AS curve in its horizontal section determining Ye
less than Yp  recessionary (deflationary) gap with unemployment greater than the
natural rate. Aggregate demand is too weak to induce firms to produce Yp.
(b) the economy is producing at Ye greater than Yp and is experiencing an inflationary
gapstrong aggregate demand, unemployment has fallen below its natural rate and as the
economy approaches its maximum capacity, the price level has increased.
(c) shows the case where the economy has achieved full employment equilibrium or
potential output at Yp.
d. Some key feature of the Keynesian model
d1. Recession gaps can persist over long period of time
In the Keynesian model, an economy can remain for long periods of time in an equilibrium
where there is less than full employment (i.e. a recessionary/deflationary gap), caused by
insufficient aggregate demand.
d2. Increases in aggregate demand need not cause increases in the price level

Monetarist/new classical model Keynesian model

Increases in aggregate demand  price-level When the economy is in the horizontal part of
increases the AS curve, increases in aggregate demand
lead to increases in real GDP without
In short run, as AD shifts to the right causing
affecting the price level.
a movement along an upward-sloping SRAS
curve, an increase in real GDP and an The Keynesian AS curve begins to slope
increase in the price level result. upward, when it is close to the full
employment level of output, that further
In the long run, increases in aggregate
increases in aggregate demand begin to result
demand give rise to increases in the price
in changes in the price level as well.
level, leaving real GDP unaffected

9.5. Shifting aggregate supply curves over the long term

Changes in aggregate supply over the long term
a. Economic growth and aggregate supply curve shifts in AD- AS models
So far, the LRAS and Keynesian AS curve in fixed, unchanging positions.
Yet, over time, these curves can shift to the right or left.
Each of these two curves represents a particular level of potential output which is the total
quantity of goods and services produced by an economy when there is ‘full employment’.
b. Factors that change aggregate supply (shift AS curves) over the long term
- Increasing in quantities of the factors of production: quantity of factors of production
increases  LRAS curve and Keynesian AS curve shift to the right.
- Improvements in the quality of factors of production (resources): improvements in resource
quality shift the LRAS curve and AS curves to the right.
- Improvements in technology: improved technology of production  factors of production can
produce more output  AS curve shift to the right.
- Increases in efficiency: an economy increases efficiency in production  better use of its
scarce resources  produce a greater quantity of output  potential output increasesAS
curves shift to the right.
- Institutional changes: changes in institutions can have important effects on how efficiency
scarce resources are used  quantity of output produced.
- Reductions in the natural rate of unemployment: the nature rate of unemployment is the
unemployment that is ‘normal’ or ‘natural’ for an economy when it is producing its ‘full
employment’ level of output. The natural unemployment rate differs from country to country and
change over time. If it decreaseseconomy is making better use of its resources  produce a
larger quantity of outputpotential output increases and the AS curves shift to the right.
c. Long term growth versus short-term economic fluctuations
Long-term growth in the business cycle diagram, showing increases in potential output
corresponds to rightward shifting LRAS or Keynesian AS curve.
Note: Short-term economic growth does not involve an increase in potential output  no
rightward shift on the AS curve.
d. The relationship between the SRAS and LRAS curves in the monetarist/new classical model
If an economy is experiencing long-term economic growth, its LRAS curve will be shifting
rightward  increases in potential output. Over the long periods of time, SRAS curve will be
shifting rightward as well. Any factor that shifts the LRAS curve must, over the long term, shift
the SRAS curve.
9.6. Illustrating the monetarist/ new classical model and Keynesian models

The figure shows how the monetarist/new classical and Keynesian models relate to each other.
Point a in both parts determines full employment equilibrium output or potential GDP.
Point b in both parts represents a recessionary (deflationary) gap which occurs due to aggregate
demand given by AD2 in part (a) and (b).
Point c in both parts represents an inflationary gap, which arises due to strong aggregate demand,
given by AD3.
9.7. The Keynesian multiplier (so nhan Keynes)
a. The nature and importance of the multiplier
Introducing the multiplier
Keynesian multiplier defined as the change in real GDP divided by the initial change in
expenditure:
So that, initial change in expenditure x multiplier = change in real GDP
As a rule, the multiplier > 1 change in real GDP is likely to be greater than the initial change
in expenditure.
Understanding the multiplier in terms of leakages (withdrawals) and injections (rut va bom)
Initial change in expenditure produces a chain reaction of further expenditures, with the effect of
increasing of AD and real GDP to a value greater than the initial expenditure.
Marginal propensity to consume, abbreviated as MPC, defined as the fraction of additional
income that households spend on consumption of domestically produced goods and services.
Marginal propensity to save (MPS) or fraction of additional income saved
Marginal propensity to tax (MPT) = fraction of addition income taxed
Marginal propensity to import (MPM) = fraction of additional income spent on imported
goods and services
Note: MPC + MPS + MPT + MPM =1

The relationship between the multiplier and the MPC is:

 1 1
The value of the multiplier is given by , which is equivalent to
1−MPC MPS+ MPT + MPM
 if we know the value of the MPC, we can calculate the value of the multiplier. Alternatively,
if we know the value of the MPS, MPT and MPM, we can calculate the value of the multiplier.
The larger the MPC, the smaller value of the denominator of the first fraction, and so the greater
is the multiplier.
Calculating the multiplier and its effects on real GDP

b. The multiplier, aggregate demand and real GDP

The first part is the $8 million increase in investment spending  autonomous spending = it has
not been caused by a change in income
The second part is the effects on aggregate demand of the multiplier ($24 million of included
spending) = spending caused by changes in income
The total effect on aggregate demand is the sum of autonomous plus included spending. This is
equivalent to taking the initial change in autonomous investment spending and multiplying it by
the multiplier.
The multiplier effect can only be initiated by a change in spending that is not caused by a change
in income.
It is impossible for national income (or real GDP) to change unless something acts to upon it
from outside the system.
The effect of the multiplier in relation to the price level

The shift from AD1 to AD2 is in the horizontal part where the price level is constant, and the
increase in real GDP from Y1 to Y2 is exactly equal to the increase in aggregate demand  the
full multiplier effect.
The full effect of the multiplier can be experienced only when the price level is constant. If the
price level is increasing, the greater the price level increase, the smaller is the size of the
multiplier effect.
9.8. Understanding aggregate demand and the multiplier of the Keynesian cross model