Aggregate demand (AD) refers to the total amount that different sectors in the

economy
willingly spend in a given period. This is because it is measured by the total
expenditure
of the economy’s community on goods and services. More specifically, AD is defined
as:
the total amount of money which all sections (households, firms, and governments)
are
ready to spend on the purchase of goods and services produced in an economy during
a
given period.
Alternatively, AD is the sum of spending by consumers, businesses, and governments
which depends on the level of prices as well as on monetary policy, fiscal policy and
other
factors. In other words, it is the total spending by all the entities in the economy.
Moreover,
we may say aggregate demand is the total expenditure on consumption and
investment. 2.1 Aggregate Demand
27
UNIT 2: AGGREGATE DEMAND AND AGGREGATE SUPPLY ANALYSIS
There are four major components of AD. household consumption demand (C)
 private investment demand(I)
 government demand for goods and services (G)
 net export demand (X-M)
So that,
(–)
AD C I G X M
  
A. Consumption (C) is primarily determined by disposable income, which is
personal income less taxes, household wealth, longer term trends in income, and
the aggregate price level.
B. Investment (I) spending includes private purchases of structures, equipment’s and
accumulation of inventories. The major determinants of investment are the level of
output, the cost of capital and expectation about the future.
C. Government Purchases (G) of goods and services - This component of AD is
determined directly by the government spending decisions.
D. Net Exports (X-M) is the value of exports minus the value of imports. Net exports
are determined by domestic and foreign incomes, relative prices and exchange
rates.
2.1.2 The Aggregate Demand Curve
The aggregate demand (AD) curve is a schedule that shows the amount of real output
that
buyers collectively desire to purchase at each price level ceteris paribus. The
relationship
between the price level and real GDP demanded is inverse or negative.2.1 Aggregate
Demand
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Grade 12 Economics Student Textbook
In general, it is observed that with other factors held constant, aggregate demand rises
with
a fall in the general price level. The inverse is also true. Thus, the AD curve is a
downward
sloping curve. It indicates the output (goods and services) which will be demanded in
the
economy at various general price levels.
Figure 2.1 shows that when the general price level falls
10
P to P
, the aggregate quantity
demanded of the output increases Q toQ 1 0 . Consequently, there is an inverse
relationship
between the general price level and aggregate demand. Remember here what you
learnt
in Grade 9 about the relationship between the price of an individual commodity and its
demand (law of demand).
Why Does the Aggregate Demand Curve Slope Downward?
Asking why the AD curve slopes downward is the same as asking why there is an
inverse
relationship between the price level and the quantity demanded of real GDP. This
inverse
relationship, and the resulting downward slope of the AD curve, is explained by the
real
balance effect, the interest rate, and the international trade effect.
Real Balance Effect
The real balance effect states that the inverse relationship between the price level and
the
quantity demanded of real GDP is established through changes in the value of monetary
wealth, or money holdings. A rise in the price level causes purchasing power to fall,
which
decreases a person’s monetary wealth. For example, as people become less wealthy,
the
quantity demanded of real GDP falls.
Interest Rate Effect
This is also called a “money supply effect”. A rise in price with a fixed money supply,
other
things being equal, leads to tight money and produces a decline in total real spending.
The inverse relationship between the price level and the quantity demanded of real
GDP
is established through changes in household and business spending that is sensitive to
changes in interest rates. A higher price level increases the demand for money. So,
given
a fixed supply of money, an increase in money demand will drive up the price paid for
its use. That price is the interest rate. Higher interest rates curtail investment spending
and interest-sensitive consumption spending. Firms that expect a 6% rate of return on
a
potential purchase of capital will find that investment is potentially profitable when
the 2.1 Aggregate Demand
29
UNIT 2: AGGREGATE DEMAND AND AGGREGATE SUPPLY ANALYSIS
interest rate is, say, 5%. But the investment will be unprofitable and will not be made
when the interest rate has risen to 7%. Similarly, consumers may decide not to
purchase a
new house or new automobile when the interest rate on loans goes up. So, by
increasing
the demand for money and consequently the interest rate, a higher price level reduces
the
amount of real output demanded.
International Trade Effect
The international trade effect states the inverse relationship between the price level
and
the quantity demanded of real GDP, which is established through foreign sector
spending.
Suppose that the price level in Ethiopia rises. As this happens, Ethiopian goods
become
relatively more expensive than foreign goods. As a result, both Ethiopians and
foreigners
buy fewer Ethiopian goods. Due to this, the quantity demanded of Ethiopia’s real
GDP
falls.
Change in Quantity Demanded Vs Change in Aggregate Demand
A change in the quantity demanded of real GDP is brought about by a change in the
price
level. For example, as the price level falls, the quantity demanded of real GDP rises,
ceteris
paribus. A change in the quantity demanded of real GDP is represented as a
movement
from one point to another along the same demand curve.
A change in aggregate demand is a shift in the aggregate demand curve from AD1 to
AD2 (see Figure 2.2). Try to notice also that when the aggregate demand curve shifts,
the
quantity demanded of real GDP changes even though the price level remains constant.
General Price level remaining constant, any positive change in any of these factors
causes
a rightward shift in the AD curve, and a negative change shifts the AD curve leftward.
These factors include:
 general level of income of the people,
 real interest rate,
 level of economic activity in other countries (it determines the level of exports),
 availability of credit,
 the level of economic activity in the economy itself.2.1 Aggregate Demand
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Grade 12 Economics Student Textbook
2.1.3 Shifts in the Aggregate Demand Curve
What are the kinds of variables that lead to shift in aggregate demand? In other words,
what
can cause aggregate demand to rise and what can cause it to fall? The simple answer
to
these questions is that aggregate demand changes when the spending on Ethiopian
goods
and services changes. For example, if spending increases at a given price level,
aggregate
demand rises; if spending decreases at a given price level, aggregate demand falls.
When individuals, firms, and governments want to buy more Ethiopian goods and
services
even though the prices of these goods have not changed, then we say that aggregate
demand
has increased. As a result, the AD curve shifts to the right. Of course, when individuals,
firms, and governments want to buy fewer Ethiopian goods and services at a given
price
level, then we say that aggregate demand has decreased. As a result, the AD curve
shifts to
the left. In short, a rise in consumption, investment, government purchases, or net
exports
will increase spending on Ethiopian goods and services. Similarly, a fall in
consumption,
investment, government purchases, or net exports will lower spending on Ethiopian
goods
and services.
Since we now know what causes total expenditure on Ethiopian goods and services to
change, we can relate the components of spending to (Ethiopian) aggregate demand.
If,
at given price level, consumption, investment, government purchases, or net exports rise,
aggregate demand will rise and the AD curve will shift to the right. On the other hand,
If, at a given price level, consumption, investment, government purchases, or net exports
fall, aggregate demand will fall and the AD curve will shift to the left. We can write
these
relationships as:2.1 Aggregate Demand
31
UNIT 2: AGGREGATE DEMAND AND AGGREGATE SUPPLY ANALYSIS
There are two categories of AD determinants. Namely, policy variables under
government
control, e.g. monetary and fiscal policy variables, and exogenous variables which are
determined outside the AD-AS framework, e.g. Foreign economic activity,
technological
change.
In this section, we will look at some of the factors that can change consumption,
investment,
government spending and net exports.
Factors Affecting Consumption
Four factors that can affect consumption are wealth, expectations about future prices
and
income, the interest rate, and income taxes.
1. Wealth. Individuals consume not only the basis of their present income but also on
the
basis of their wealth. Greater wealth makes individuals feel financially more secure
and thus, more willing to spend. Increases in wealth lead to increases in consumption.
For example, if consumption increases, then aggregate demand rises and the AD curve
shifts to the right. What will happen if wealth decreases? Decreases in wealth lead to a
fall in consumption, which in its turn leads to a fall in aggregate demand,
consequently,
the AD curve shifts to the left.
2. Expectations about future prices and income. If individuals expect higher prices in
the future, they increase current consumption expenditures to buy goods at the lower
current prices. This increase in consumption leads to an increase in aggregate demand.
If individuals expect lower prices in the future, they decrease current consumption
expenditures. This reduction in consumption leads to a decrease in aggregate demand.
Similarly, expectation of a higher future income increases consumption, which leads
to an increase in aggregate demand. In contrast to this, expectation of a lower future
income decreases consumption, which leads to a decrease in aggregate demand.2.1
Aggregate Demand
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Grade 12 Economics Student Textbook
3. Interest rate. Current empirical work shows that spending on consumer durables is
sensitive to the interest rate. Many of these items are financed by borrowing. So, an
increase in the interest rate increases the monthly payment amounts which are linked
to
their purchase and thereby reduces their consumption. This reduction in consumption
leads to a decline in aggregate demand. Alternatively, a decrease in the interest rate
reduces monthly payment amounts which is linked to the purchase of durable goods
and thereby increases their consumption. This increase in consumption leads to an
increase in aggregate demand.
4. Income taxes. As income taxes rise, disposable income decreases and when people
have less take-home pay to spend, consumption falls. Consequently, aggregate
demand
decreases. Reduction in taxes has the opposite effect; it raises disposable income. In
other words, when people have more take-home pay to spend, consumption rises and
aggregate demand will increase.2.1 Aggregate Demand
33
UNIT 2: AGGREGATE DEMAND AND AGGREGATE SUPPLY ANALYSIS
Factors Affecting Investment
Three factors that can change investment are the interest rate, expectations about
future
sales, and business taxes.
1. Interest rate. changes in interest rates affect business decisions. For example, as the
interest rate rises, the cost of a given investment project rises and businesses invest
less. As investment decreases, aggregate demand also decreases. On the other hand, as
the interest rate falls, the cost of a given investment project falls and businesses invest
more. Consequently, aggregate demand increases.
2. Expectations about future sales: businesses invest because they expect to sell the
goods they produce. If businesses become optimistic about future sales, investment
spending grows and aggregate demand increases. On the other hand, if businesses
become pessimistic about future sales, investment spending contracts and aggregate
demand decreases.
3. Business taxes: Businesses naturally consider expected after-tax profits when making
their investment decisions. For example, an increase in business taxes lowers
expected
profitability. With less profit expected, businesses invest less. As investment spending
declines, aggregate demand declines. A decrease in business taxes, on the other hand,
rises expected profitability and investment spending. This in its turn increases
aggregate
demand.2.1 Aggregate Demand
34
Grade 12 Economics Student Textbook
Factors Affecting Government Spending
An increase in government purchases (for example, on military equipment) will shift
the
aggregate demand curve to the right as long as tax collections and interest rates do not
change as a result. In contrast, a reduction in government spending (for example,
fewer
transportation projects) will shift the curve to the left.
Factors Affecting Net Exports
The main determinants of net export are domestic and foreign incomes, relative price,
exchange rate, domestic and foreign trade policies, and preferences and technology.
For
instance, a change in national income affects net exports. Just as Ethiopians earn a
national
income, so do people in other countries. For example, as foreign real national income
rises, foreigners buy more Ethiopian goods and services. Thus, Ethiopia’s exports (EX)
rise and as exports rise, net exports rise, ceteris paribus. As net exports rise,
aggregate
demand increases. This process works in reverse, too. This means that as foreign real
national income falls, foreigners buy fewer Ethiopian goods and exports fall. This in
its
turn lowers net exports, which reduces aggregate demand.
In the case of change in exchange rate affecting net exports, when a currency appreciates
in value if more of a foreign currency is needed to buy it. A currency is said to
depreciate
if more of it is needed to buy a foreign currency. For example, a change in the
exchange
rate from $1 = 32 Birr to $32= 1 Birr means that more dollars are needed to buy 1 Birr,
and
Birr appreciates. This is because more dollars are needed to buy 1 Birr, when the
dollar
depreciates. Depreciation of a nation’s currency makes foreign goods more expensive.
Consider an Ethiopia leather jacket that is priced at 1500 Birr when the exchange rate
is
1Birr = 2 Indian Rupee. This would mean a person in India would have to pay 3000
Rupee.
Now, suppose that the Indian Rupee depreciates to 3 Rupee = 1 Birr. People in India
now
have to pay 4500 Rupee for the jacket. This process is symmetrical, so an appreciation
in
a nation’s currency makes foreign goods cheaper.
The depreciation and appreciation of the Ethiopian Birr affect net exports. For
example,
as Birr the depreciates, foreign goods become more expensive. Hence, Ethiopians cut
2.2 Aggregate Supply
35
UNIT 2: AGGREGATE DEMAND AND AGGREGATE SUPPLY ANALYSIS
back on imported goods, and foreigners (whose currency has appreciated) increase
their
purchases on Ethiopian exported goods. If exports rise and imports fall, net exports
increase and aggregate demand increases. As the Birr appreciates, foreign goods
become
cheaper; Ethiopians increase their purchases of imported goods, and foreigners
(whose
currency has depreciated) cut back on their purchases of Ethiopia’s exported goods.
So,
if exports fall and imports rise, net exports decrease, and thus, lower aggregate
demand.
Activity 2.1
1. Why do aggregate demand curves shift?
2. Explain why the aggregate demand curve slopes downward.
2.2 Aggregate Supply
At the end of this section, you will be able to:
 define concept of aggregate supply.
 construct and interpret the supply curve.
 describe the basic determinants of aggregate supply.
Start-up Activity
What important idea comes to your mind when you think of
aggregate supply in an economy?
2.2.1 Concept of Aggregate Supply
The aggregate demand and aggregate supply model is the basic macroeconomic
model 2.2 Aggregate Supply
36
Grade 12 Economics Student Textbook
for studying output and price level determination. Aggregate demand is one side of
the
economy; and aggregate supply is the other side.
Aggregate supply refers to the quantity supplied of all goods and services (real GDP)
at
various price levels, ceteris paribus. There is a direct or positive relationship between
the price level and the amount of real output that firms offer for sale. Aggregate
supply
includes both short-run aggregate supply (SRAS) and long-run aggregate supply
(LRAS).
The short-run aggregate supply and long-run aggregate supply are discussed in the
following section.
The Keynesian supply curve is horizontal. Firms will supply whatever amount of
good is
demanded at the existing price level since there is unemployment. Firms can obtain
much
labour as they want at the current wage. Average costs of production are assumed not
to
change as their output level changes.
The classical aggregate supply curve is vertical, indicating that the same amount of
goods
will be supplied whatever the price level based on the assumption that the labour
market
is always in equilibrium with full employment of the labour force (Dorrnbushpp,
2011).
2.2.2 The Upward Sloping Aggregate Supply Curve: The Short Run (SRAS)
The short run is a time horizon during which at least one of the firm’s inputs cannot
be
varied, whereas, the long run, is a time horizon that is long enough for a firm to vary
all
of its inputs.
The amount of output firms are willing to supply depends on the prices they receive
for their
goods and the amount which they have to pay for labour and other factors of
production.
Accordingly, the aggregate supply curve reflects conditions in the factor markets as
well
as the goods markets.
The short-run aggregate supply (SRAS) curve shows the quantity supplied of all
goods
and services (real GDP or output) at different price levels, ceteris paribus. Notice also
that
the SRAS curve is upward sloping: as the price level rises, firms increase the quantity
supplied of goods and services; as the price level drops, firms decrease the quantity
supplied of goods and services.
Why is the SRAS curve upward sloping? Economists have put forth a few
explanations,
from which we will discuss only two of them,. sticky wages and worker
misperceptions.2.2 Aggregate Supply
37
UNIT 2: AGGREGATE DEMAND AND AGGREGATE SUPPLY ANALYSIS
Sticky wages: some economists believe that wages are sticky, or inflexible. This is the
case
due to the fact that wages are “locked in” for a few years due to labour contract
agreements
entered into between workers and employers. For example, management and labour
may
agree to lock in wages for the next one to three years. Both labour and management
may
see this as in their best interest. Management has some idea of what its labour costs
will
be during the time of the contract, and workers may have a sense of security knowing
that their wages cannot be lowered. Alternatively, wages may be sticky because of
certain
social conventions or perceived notions of fairness. Whatever the specific reason for
sticky
wages, let’s see how they provide an explanation of an upward-sloping SRAS curve.
Firms pay nominal wages (e.g., $30 an hour), but they often decide how many
workers to
hire based on real wages. Real wages are nominal wages which are divided by the
price
level.
Real wage = Nominal wage
Price level
For example, suppose that the nominal wage is $30 an hour, and the price level as
measured
by a price index is 1.50. The real wage is therefore, $20.
Note that the quantity supplied of labour is directly related to the real wage: as the real
wage rises, the quantity supplied of labour rises; as the real wage falls, the quantity
supplied
of labour falls. However, the quantity demanded of labour is inversely related to the real
wage: as the real wage rises, the quantity demanded of labour falls; as the real wage
falls,
the quantity demanded of labour rises.
With this as background, suppose a firm has agreed to pay its workers $30 an hour for
the
next three years and it has hired 1,000 workers. When this nominal wage was agreed,
it
was thought that the price index would remain at 1.50 and the real wage would stay at
$20.
Now, suppose that the price index falls to 1.25. When the price level falls to an index
of 1.25, the real wage rises to $24 ($30/1.25). This is a higher real wage than the firm
expected when it agreed to lock in nominal wages at $30 an hour. If the firm had
known
that the real wage would turn out to be $24 (and not remain at $20), it would never
have
hired 1,000 workers. It would rather have hired, say, 800 workers instead.
So, what does the firm do? As we stated, there is an inverse relationship between the
real
wage and the quantity demanded of labour (the number of workers that firms want to
hire). 2.2 Aggregate Supply
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Grade 12 Economics Student Textbook
Now that the real wage has risen (i.e. from $20 to $24), the firm cuts back on its
labour
(say, from 1,000 to 800 workers). With fewer workers working, less output is
produced.
In conclusion, if wages are sticky, a decrease in the price level (which pushes real
wages up)
will result in a decrease in output. This is what an upward-sloping SRAS curve
represents:
as the price level falls, the quantity supplied of goods and services declines.
Worker misperceptions: another explanation for the upward-sloping SRAS curve holds
that workers may misperceive real wage changes. To illustrate, suppose that the
nominal
wage is $30 an hour and the price level as measured by a price index is 1.50. It
follows
that the real wage is $20. Now, suppose that the nominal wage falls to $25 and the
price
level falls to 1.25. The real wage is still $20 ($25/1.25 = $20), but workers may not
know
this. They will know their nominal wage has fallen (they know they are earning $25
an
hour instead of $30 an hour). They also may know that the price level is lower, but
they
may not know initially how much lower the price level is. For example, suppose that
they
mistakenly believe the price level has fallen from 1.50 to 1.39. They will then think
that
their real wage has actually fallen from $20 ($30/1.50) to $17.98 ($25/1.39).
In response to (the misperceived) falling real wage, workers may reduce the quantity
of
labour that they are willing to supply. With fewer workers (resources), firms will end
up
producing less. In conclusion, if workers misperceive real wage changes, then a fall in
the
price level will bring about a decline in output, which is illustrative of an upward-
sloping
SRAS curve.
Changes in Short-Run Aggregate Supply and Shifts in the SRAS Curve
A change in the quantity supplied of real GDP is brought about by a change in the
price
level. This is shown as a movement along the SRAS curve, but what are the factors that are
likely to shift the SRAS curve? 2.2 Aggregate Supply
39
UNIT 2: AGGREGATE DEMAND AND AGGREGATE SUPPLY ANALYSIS
Aggregate Supply is determined by a number of factors. Some of these factors are as
follows:
a) cost of input or change in input price
b) domestic Resource availability
 managerial ability, land, labour and capital
 price of imported resource
 market power
c) change in productivity
d) state of technology
e) tax policy of government (business taxes and subsidies)
f) weather (applies particularly to agricultural output)
Wage rates: labour is the major input that contributes for cost of production. Hence,
wage
rate can be taken up as an example of cost of input in the supply process. Changes in
wage rates have a major impact on the position of the SRAS curve because wage costs
are
usually a firm’s major cost item. The impact of a rise or fall in equilibrium wage rates
can
be understood in terms of the following equation:
Profit per unit = Price per unit - Cost per unit
Higher wage rates mean higher costs and, at constant prices, translate into lower
profits
and a reduction in the number of units (of a given good) managers of firms will want
to
produce. Lower wage rates mean lower costs and, at constant prices, translate into
higher
profits and an increase in the number of units (of a given good) managers will decide
to
produce.
The impact of higher and lower equilibrium wages is shown in Figure 2.4. At the given
price level, P1 on SRAS1 , the quantity supplied of real GDP is Q1 . When higher wage
rates
are introduced, a firm’s profits at a given price level decrease. Consequently, the firm
reduces production. This, this corresponds to moving from Q1 to Q2 , which at the given
price level is point B. Point B represents a point on a new aggregate supply curve
(SRAS2 ).
Thus, a rise in equilibrium wage rates leads to a leftward shift in the aggregate supply
curve. The steps are simply reversed for a fall in equilibrium wage rates.2.2 Aggregate
Supply
40
Grade 12 Economics Student Textbook
2.2.3 The Vertical Aggregate Supply Curve: The Long Run (LRAS)
In this section, we will discuss long-run aggregate supply and draw a long-run
aggregate
supply (LRAS) curve. We will also discuss long-run equilibrium and explain how it
differs
from short-run equilibrium. As explained above, economists give different reasons for
an
upward-sloping SRAS curve. Recall that those reasons have to do with: sticky wages
and
workers misperception. It follows, then, that short-run equilibrium identifies the real
GDP
where the economy produces when either of these two conditions hold. In time, wages
will become flexible and misperceptions will turn into accurate perceptions. When
this
happens, the economy is said to be in the long run. In other words, in the long run,
these
two conditions do not hold.
An important macroeconomic question is: Will the level of real GDP that the economy
produces in the long run be the same as in the short run? Most economists say that it
will
not. They argue that in the long run, the economy produces the full-employment real
GDP
or the natural real GDP (QN). The aggregate supply curve that identifies the output the
economy produces in the long run is the long-run aggregate supply (LRAS) curve. 2.3
Equilibrium of Aggregate Demand and Aggregate Supply
41
UNIT 2: AGGREGATE DEMAND AND AGGREGATE SUPPLY ANALYSIS
It follows that long-run equilibrium identifies the level of real GDP that the economy
produces when wages and prices have adjusted to their (final) equilibrium levels and
there
are no misperceptions on the part of workers. Furthermore, the level of real GDP that
the
economy produces in long-run equilibrium is natural real GDP (QN).
Activity 2.2
1. Why does the supply curve slope upward to the right?
2. Explain the meaning of the AS curve and why it shifts when technology
or factor prices change.
3. How are movements along the supply curve different from shifts of the
supply curve?
2.3 Equilibrium of Aggregate Demand and Aggregate Supply
At the end of this section, you will be able to:
 define market equilibrium.
 identify the concepts of short-run and long-run equilibrium.
 analyse how the market reaches equilibrium, and the possible factors that could
cause a change in equilibrium.
 differentiate between demand shock and supply shock.2.3 Equilibrium of Aggregate
Demand and Aggregate Supply
42
Grade 12 Economics Student Textbook
Start-up Activity
Discuss when an economy’s market reaches equilibrium level.
Let’s bring aggregate demand and supply together to see how the market price of a
product
is determined. In this section, we put aggregate demand and short-run aggregate
supply
together to achieve short-run equilibrium in the economy. Aggregate demand and
short-run
aggregate supply determine the price level and real GDP. Figure 2.6 shows an
aggregate
demand (AD) curve and a short-run aggregate supply (SRAS) curve. We consider the
quantity demanded of real GDP and the quantity supplied of real GDP at three
different
price levels: P1 , P2 , and PE.
At P1 , the quantity supplied of real GDP (Q2 ) is greater than that of the quantity
demanded
(Q1 ). There is a surplus of goods. As a result, the price level drops, firms decrease
output,
and consumers increase consumption. Why do consumers increase consumption as
the
price level drops? (Hint: Think of the real balance, the interest rate, and the
international
trade effects.)
At , the quantity supplied of real GDP (Q1 ) is less than that of the quantity demanded
(Q2 ). There is a shortage of goods. As a result, the price level rises, firms increase
output,
and consumers decrease consumption.2.3 Equilibrium of Aggregate Demand and Aggregate
Supply
43
UNIT 2: AGGREGATE DEMAND AND AGGREGATE SUPPLY ANALYSIS
In instances of both surplus and shortages, economic forces are moving the economy
towards E, where the quantity demanded of real GDP equals the (short-run) quantity
supplied of real GDP. This is the point of short-run equilibrium. PE is the short-run
equilibrium price level; QE is the short-run equilibrium real GDP.
Static Equilibrium
It is probably obvious that the short-run equilibrium of the economy occurs at the
intersection of the aggregate demand and short-run aggregate supply curves and that
the long-run equilibrium is where the aggregate demand curve intersects the long-run
aggregate supply curve. Figure 2.7 shows this state of long-run and short-run
equilibrium.
If the aggregate demand curve and aggregate supply curves were to remain unchanged,
the economy would continue to produce the natural rate of output and have an
equilibrium
price indefinitely.
2.3.1 Shocks to Aggregate Demand
However, as noted above, there are many reasons why the AD and AS curves could
shift.
A change in aggregate demand, short-run aggregate supply, or both will obviously
affect
the price level and/or real GDP. 2.3 Equilibrium of Aggregate Demand and Aggregate Supply
44
Grade 12 Economics Student Textbook
Consider first the effects of a one-time unexpected exogenous positive shock to
aggregate
demand. This could arise from an expansionary monetary-policy action, an
expansionary
fiscal-policy action, or an increase in desired expenditures from another source. An
increase in aggregate demand shifts the AD curve to the right; more output is
demanded
at each level of the aggregate price index. A demand shock can either be expansionary
or
contractionary. An expansionary demand shock shifts the AD curve to the right,
increasing
both P and Y. Notice that we use the word “expansionary” or “contractionary” to refer
to
the effect of the shock on the equilibrium level of output.
2.3.2 Shocks to Aggregate Supply
Aggregate supply shocks cause P and Y to change in opposite directions. For example,
an
improvement in production technology or an increase in the amount of labour or
capital
resources available would increase the aggregate amount produced and thus, shift the
short-run AS curves to the right. A storm that destroyed agricultural crops or a sudden
interruption in the availability of imported inputs such as oil might cause a reduction
shift
to the left in the AS curves. Consider the effects of a negative supply shock. An
example of
a negative supply shock is an increase in the price of oil. Beginning at point A, an
increase
in the price of oil causes a decrease in the supply of the product which results in a
leftward
shift of the aggregate supply curve from SRAS, results in a decrease in output from
Y1 to
Y2 and an increase in price from Y1 to Y2.