AGGREGATE SUPPLY
AND AGGREGATE
DEMAND
The quantity of real GDP demanded (Y ) is the sum of real
consumption expenditure (C), investment (I ), government
expenditure (G), and exports (X ) minus imports (M). That is,
Y = C + I + G + X + M.
The quantity of real GDP demanded is the total amount of final
goods and services produced in a country that people,
businesses, governments, and foreigners plan to buy.
These buying plans depend on many factors.
Some of the main ones are
• The price level
• Expectations
• Fiscal policy and monetary policy
• The world economy
We first focus on the relationship between the quantity of real
GDP demanded and the price level. To study this relationship,
we keep all other influences on buying plans the same and
ask: How does the quantity of real GDP demanded vary as the
price level varies?
The Aggregate Demand Curve
Other things remaining the same, the higher the price level, the smaller
is the quantity of real GDP demanded. This relationship between the
quantity of real GDP demanded and the price level is called aggregate
demand.
The Aggregate Demand Curve
The aggregate demand curve slopes downward for
two reasons:
• Wealth effect
• Substitution effects
Changes in Aggregate Demand
A change in any factor that influences buying plans
other than the price level brings a change in aggregate
demand. The main factors are
Expectations
Fiscal policy and monetary policy
The world economy
Aggregate Supply
The quantity of real GDP supplied is the total quantity of
goods and services, valued in constant base year, that firms
plan to produce during a given period. This quantity depends
on the quantity of labor employed, the quantity of physical
and human capital, and the state of technology.
Aggregate Supply
Aggregate supply is the relationship between the quantity of real GDP
supplied and the price level. This relationship is different in the long run
than in the short run and to study aggregate supply, we distinguish
between two time frames:
• Long-run aggregate supply
• Short-run aggregate supply
Long-run aggregate supply
Long-run aggregate supply is the relationship between the quantity of
real GDP supplied and the price level when the money wage rate
changes in step with the price level to maintain full employment. The
quantity of real GDP supplied at full employment equals potential GDP
and this quantity is the same regardless of the price level.
Short-Run Aggregate Supply
Short-run aggregate supply is the relationship between the quantity of
real GDP supplied and the price level when the money wage rate, the
prices of other resources, and potential GDP remain constant.
Short-Run Aggregate Supply
Changes in Aggregate Supply
A change in the price level changes the quantity of real GDP
supplied, which is illustrated by a movement along the short-
run aggregate supply curve. It does not change aggregate
supply. Aggregate supply changes when an influence on
production plans other than the price level changes. These
other influences include changes in potential GDP and
changes in the money wage rate.
• Changes in Potential GDP
• Potential GDP can increase for any of three reasons:
An increase in the full-employment quantity of labor
An increase in the quantity of capital
An advance in technology
• Changes in Potential GDP
• Changes in the Money Wage Rate
• When the money wage rate (or the money price of any other
factor of production such as oil) changes, short-run
aggregate supply changes but long-run aggregate supply
does not change.
• Changes in the Money Wage Rate
