Deriving the Aggregate Demand and Aggregate Supply Curves PDF

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Deriving the Aggregate Demand and Aggregate Supply Curves Deriving the Aggregate demand curve from the is/lm model We are originally in equilibrium at point A in the IS/LM diagram at interest rate r1 and real output level Y1. This corresponds to point A* and price level is P1 and output level Y1 If we now lower the assumed price level from P1 top P2, this has the effect of increasing the real money supply (M1/P1) becomes (M1/P2) this has the effect of increasing the real money supply so LM1 shifts to LM2. The excess real money balances result in a lower interest rate r2 and equilibrium in the is now at point B with interest rate r2 and real income Y2. The lower interest rate stimulate investment expenditure so increasing output to Y2. Hence the fall in the price level from P1 to P2 boosts aggregate demand from Y1 to Y2 giving a negatively sloped aggregate demand curve.

Factors shifting the Aggregate demand curve A shift to the right of the aggregate demand curve means that for a given price level e.g. P1 there is an higher level of aggregate demand eg it is now Y2 rather than Y1. Increases in aggregate demand can come about through an increase in consumption, investment, government expenditure or exports or a decrease in demand for imports. Increases in aggregate demand can be induced by improved business and consumer confidence, a fall in interest rates, increases in the money supply, increased government expenditure, a reduction in taxes, a depreciation of the domestic currency, increases in wealth from stock market and property prices etc

Changes in aggregate demand

Factors that change aggregate demand

Aggregate supply curve As the price level rises from P1 to P2 then “other things being equal” for example wages and other input costs being fixed then a rise in the price level by reducing real wages will increase firms profits and therefore encourage them to increase production and therefore raise output from Y1 to Y2. This might be true in the short run but may be less likely in the long run.

Factors shifting the Aggregate supply curve A shift to the right of the aggregate supply curve means that for a given price level e.g. P1 there is an higher level of aggregate supply eg it is now Y2 rather than Y1. Increases in aggregate supply can come about through anything that causes profits of firms to increase. Increases in aggregate supply might be induced by a fall in wages, a reduction in the price the costs of non labour inputs, a rise in productivity, an appreciation of the exchange rate etc

Changes in short-run aggregate supply

An extreme keynesian aggregate supply curve Under the extreme Keynesian case the price level is fixed at P1 and increases in aggregate demand lead to increases in output and not changes in the price level which remains at P1 only once the full employment level of income is reached YF will increases in aggregate demand lead to rises in the price level since further increases in output are not possible.

An extreme monetarist/new classical aggregate supply curve Under extreme Monetarist assumptions the economy is always at or close to the full employment level of output YF and hence increases in aggregate demand result in rises in the price level not changes in real income/ output. They claim the aggregate supply function is more or less vertical at the full employment level of income YF

the moderate view of the aggregate supply curve According to the moderate view the aggregate increases supply curve is positively sloped and relatively flat at low levels of output but becoming steeper as we increases output and approach the full employment level of output YF. In such circumstances increases in aggregate demand from AD1 to AD2 increase both the price level and real income/output in the short run. The effect on the price level is less significant at low levels of output but more significant at higher levels of output

the short run and long run aggregate supply curve In the short run the price and output level are given at point A by P1 and Y1. There is then an increase in aggregate demand and in the short run both price and output rise and initial equilibrium is given at point B with price P2 and output level Y2. In the long run, however, the price rises starts to impact on wages and the cost of production and hence the aggregate supply curve starts to shift to the left as profits begin to decline until we end up at point C with price level P3 and output level Y3. The longer run aggregate supply curve LRAS1 is steeper than the short run aggregate supply curves SRAS1 and SRAS2

effects of an increase in investment on the long run aggregate supply curve According to some economists increases in aggregate demand that are led by investment are more benign. Initially the economy moves from point A and price level P1 output level Y1 to point B and price level P2 and output level Y2. However, the increase in investment then improves productivity and lowers cost per unit of output resulting in improved profit margins and this encourages firms to further expand output so the SRAS1 curve shifts to the right to SRAS2 and we end up at point C with output level Y3 and price level P3 the long run aggregate supply curve LRAS1 is flatter than the short run SRAS1 and SRAS2...