Chapter 4 – The macroeconomy

4.3 Aggregate demand and aggregate supply analysis

4.3.1 Definition of Aggregate demand (AD)
4.3.2 Components of AD and their meaning: AD = C + I + G + (X-M)
4.3.3 Determination of AD (detailed knowledge of the components of AD is not required)
4.3.4 Shape of AD curve (downward sloping)
4.3.5 Causes of a shift in the AD curve
4.3.6 Definition of Aggregate supply (AS)
4.3.7 Determinants of AS
4.3.8 Shape of the AS curve in the short run (SRAS, upward sloping line or sweeping curve) and
the long run (LRAS, either a vertical line or in three sections – highly elastic, upward
sloping, vertical)
4.3.9 Causes of a shift in the AS curve in the short run (SRAS) and in the long run (LRAS)
4.3.10 Distinction between movement along and a shift in AD and AS
4.3.11 Establishment of equilibrium in the AD/AS model and the determination of the level of
real output, the price level and employment
4.3.12 effects of shifts in the AD curve and the AS curve on the level of real output, the price level
and employment.
Recap
1. Define the economic problem
2. Define scarcity
3. What do economists assume individuals, firms and government aim
to maximise?
4. Define 3 fundamental economic questions

• Last question
Recap answer
1. The economic problem is the situation of scarcity due to infinite
wants
2. Scarcity is a condition where there are never enough resources to
satisfy everyone’s wants.
3. Individuals aim to maximise utility, firms aim maximise profit,
governments aim maximise benefits
4. A need is a good or service that is essential for living, and a want is a
good or service which is not essential for living but people would like
to have for better quality of life
5. What to produce, how to produce, for whom to produce
4.3.1 Definition of Aggregate demand (AD)
Aggregate Demand is the total spending on an economy’s output at a given price
level in a given time period
• AD = C + I + G + (X - M)

4.3.2 Components of AD and their meaning: AD = C + I + G + (X-M)

• C = Consumer expenditure – spending by households on goods and services
• I = Investment – spending by private firms on capital goods
• G = government spending – government spending on goods and services
(including government investment)
• (X – M) = Net exports (NX) – the difference between the value of exports of
goods and services and the value of imports of goods and services
[NB: Assume no Government exports and imports]
• Discuss: What are the determinants of consumption?
4.3.3 Determination of AD: Consumption
1. Disposable Income (the main determinant) • NB You are just expected to know
2. Wealth a few determinates to give as
3. Expected Inflation (there are 2 opposing effects): examples for essay. Pick 1 more.
a) Inflation on prices: • Note similar list to demand curve
• Inflation↑ → C↑ (Expect prices to rise, spend more now)
• Inflation↓ → C↓ (e.g., Japan)
b) Inflation on wealth: Inflation↑ → C↓ (since you are poorer)
NB: Wealth effect is usually greater than price effect so Inflation↑ → C↓
4. Rate of interest, and availability of credit
5. Change in structure of population - older tend to save more
6. Expected future income • Discuss what are the
7. Consumer confidence determinants of
8. Taste and attitudes investment?
9. Age of durables - after a recession, people would have a higher level of replacement
consumption since they held off spending on durables for a long time. e.g., Covid
10. Income distribution – rich have a lower MPC than the poor i.e., spend less proportionately
11. Population
4.3.3 Determination of AD: Investment
1.Rate of interest (main determinant)
2.Changes in consumer demand
3. Expectations of changes in National Income/consumer confidence
4.Technological change – a new invention may cause an injection of
investment e.g., mobile phone
5. Availability of finance – it will be difficult to get finance in a
recession, and also why many firms want to raise money on
American stock market
6. Government policy - e.g. subsidy to invest in car plants or change in
taxes on company profits

• Discuss: What are the determinants of government expenditure?

4.3.3 Determination of AD: Government expenditure
1. Government revenue - in the L.R., but not S.R.
2. Ability to borrow money (developing countries)
3. The needs of the country would affect government expenditure. e.g.
provision of public goods if the country lacks infrastructure in public goods, a
country with high income inequality might need to spend on benefits to
reduce income inequality.
4. The country’s macroeconomic objectives - maintain low inflation or full
employment and economic growth?
5. Political reasons – (usually to get more votes) governments found it easy to
increase expenditure but politically difficult to reduce it – Why?

• Discuss: What are the determinants of import and export?

4.3.3 Determination of AD: Imports and exports
1. Exchange rates
2. National Income - Imports
3. Incomes of other countries - Exports
4. Price competitiveness - depends on a number of supply factors including
costs and inflation
5. Non-price factors - such as quality of goods e.g., Belgium Chocolate, Cuban
cigars, French wine
NB A common mistake students make is to think when a country is richer, they produce more
and so they export more. When a country produce more, they can simply consume all the
additional extra products rather than exports them. Exports are solely determined by the
incomes of other countries.
4.3.5 Causes of a shift in the AD curve
A change in any one of C, I, G, NX, will lead to a shift in AD curve.
1av1 – ADAS 5.32m
4.3.4 Shape of AD curve (downward sloping)
The shape of the AD curve is negative
• A rise in the price level will cause a
contraction of AD and a fall in the price
level will cause an extension in AD.
• The relationship between AD and the price
level might seem similar to the relationship
in demand curve for individual goods.
There is a significant difference. For
individual demand curve, the price of the
product is changing but it assumes that the
prices of other products have not changed.
More of the product is purchased when
price falls in part due to the substitution
effect. For the AD curve, the prices of
• Aggregate expenditure, AE, is a point on the
products are changing in the same
aggregate demand curve, AD
direction as there is no substitution effect.
Similar to Quantity demanded and Demand
In microeconomics, the demand curve slopes downwards because of income and
substitution effects

Income effect is the effect of a price change on real income and this change in
real income would cause a change in the quantity demanded.

For example, a fall in the price of a good or service causes the consumer’s real
income to rise, that is, with the same amount of income, the customer is able to
buy more products. This change in real income will cause the quantity demanded
for the good or service to increase. v.v.

This explains is one ‘proof’ of why the relationship between price and quantity
demanded is inverse and why the demand curve is downward sloping.
Substitution effect is the effect of a price increase will encourage consumers to
switch to a cheaper alternative and so the quantity demanded for the good or
services will decrease. v.v.

This also explains why the relationship between price and quantity demanded is
inverse and why the demand curve is downward sloping.

There is no substitution effect in macroeconomics because the change in price

level are looking at average price level of all goods in the economy
Reasons for the Shape of AD curve
There are three reasons for the inverse relationship between price level and AD:
Money supply
1. Pigou’s wealth effect* (where Pigou defines wealth as ) or the real balance
Prices
effect (income and wealth) – a rise in the price level will reduce people’s wealth and
income, assuming money supply is held constant* (This is often tested in exam MCQs).
Therefore, the purchasing power of wealth and income falls and C↓. Hence, AE ↓.
2. The interest rate effect – a rise in the price level will increase the demand for money from
consumers (as you need to carry more money since prices have risen). Thus higher nominal
interest rates will be required to attract savings and a higher interest rate will usually reduce
consumption (rather put money in bank) and investment (more expensive to borrow
money) and so C↓ and I↓. Hence, AE↓.
3. The international effect – a rise in price level will reduce the demand for net exports
because Exports become less competitive and imports will become more competitive and
so (X – M)↓. Hence, AE↓.
• *Confusing part is that income and wealth effects are separate effects but in his days, Pigou
defined ‘wealth’ as both. Therefore many economists misinterpret it as only wealth effect
as they did not realise Pigou’s definition.
What happens if there is an increase in
money supply?
Trade balance is the difference between the value of exports and the
value of imports
• 1av2 - AD – 3.21m

• 4.3ae1s – AD: and introduction

worksheet
• 4.3ae2s - Shift in AD worksheet
• A.3ae3s - AD consolidation
worksheet

Recap
• What are the determinants of C, I, G,
NX?
Recap answers
1. C: Disposable Income (the main determinant), Wealth, Expected Inflation,
Rate of interest, and availability of credit, Change in structure of population,
Expected future income, Consumer confidence, Taste and attitudes, Age of
durables, Income
2. I: Rate of interest (main determinant),Changes in consumer demand,
Expectations of changes in National Income, Cost of capital goods &
technological changes, Availability of finance, Government policy
3. G: Government Expenditure is limited by the country’s National Income in the
L.R., but not S.R, The needs of the country, macroeconomic objectives,
Political factors, Ability to borrow money
4. NX: Exchange rates, National Income – Imports, Incomes of other countries –
Exports, Price competitiveness - depends on a number of supply factors
including costs and inflation, Non-price factors