10 Aggregate Demand & Aggregate Supply - HKEP · 2011-03-31 · 26 Chapter 10 Aggregate Demand & Aggregate Supply II. Other factors which cause changes in aggregate demand 1 Shifts

24 Chapter 10 Aggregate Demand & Aggregate Supply

10

A. Basicconcepts

AS-AD model

Aggregate supply• Long-run aggregate

supply (LAS)• Short-run aggregate

supply (SAS)

Equilibrium output & price level

Aggregate demandAD = C + I + G + NX

Aggregate Demand & Aggregate Supply

25New Horizon Economics – 5B　Essential Revision Handbook

I. Reasons why the aggregate demand curve is downward sloping

Quantity of goods & services

demanded ➞

1 Wealth effect

Price level ↓ Wealth ↑ Consumption ↑


demanded ➞

Price level ↓

Real money supply ↑

Consumption & investment ↑

Real interest rate ↓

Price level ↓ Real exchange rate ↓ Net exports ↑

B

A

2 Interest rate effect

3 Exchange rate effect


demanded ➞


II. Other factors which cause changes in aggregate demand

1 Shifts of the aggregate demand curve caused by consumption

Income tax ↓Welfare

allowances ↑

National income ↑

Disposable income ↑

Interest rate ↓

Saving rate ↓

Aggregate demand ↑Consumption ↑

2 Shifts of the aggregate demand curve caused by investment

Business prospects ↑

Interest rate ↓

Aggregate demand ↑Investment ↑

Profits tax rate ↓

3 Shifts of the aggregate demand curve caused by government expenditure

Aggregate demand ↑

Government expenditure ↑

4 Shifts of the aggregate demand curve caused by net exports

Exchange rate ↓

Aggregate demand ↑

Net exports ↑

Income of foreign countries ↑


B. Aggregatesupply

Long-run aggregate supply curve

Short-run aggregate supply curve

Features• LAS is vertical at the potential output.• LAS shifts only when the potential

output changes as a result of a significant change in long-term economic growth, resources or technology.

Why it is vertical• Prices & wages are fully flexible.• There is no misperception about the

price level.• The potential output is determined by

resources & technology.

Aggregate supply curve Shows aggregate output at different

price levels

Features• SAS slopes upward.• SAS shifts when the factor prices or

the expected price level changes.• When LAS shifts, SAS will shift

accordingly.

Why it slopes upward• Sticky-price theory• Sticky-wage theory• Misperceptions theory


C. Short-run&long-runeconomicadjustments

1. Suppose the long-run aggregate supply curve remains constant, the long-run and short-run effects of a change in aggregate demand are listed as follows:

Short-run effects Long-run effects

Price level Aggregate output Price level Aggregate

output

Aggregate demand falls

↓ ↓ ↓ Remains constant

Aggregate demand rises

↑ ↑ ↑ Remains constant

2. Suppose aggregate demand and the long-run aggregate supply curve remain constant, the short-run and long-run effects of a change in short-run aggregate supply are listed as follows:

Short-run effects Long-run effects

Price level Aggregate output Price level Aggregate

output

Short-run aggregate supply falls

↑ ↓ Remains constant

Remains constant

Short-run aggregate supply rises

↓ ↑ Remains constant

Remains constant


1.

Aggregate demand: The quantity of goods and services demanded at different price levels, which includes the planned expenditure on local output by all economic decision-makers.

2.

Aggregate demand (AD) = Private consumption expenditure (C) + Investment expenditure (I) + Government expenditure (G) + Net exports (NX)

3. The aggregate demand curve shows aggregate demand at different price levels.

4. Below lists the main factors affecting aggregate demand:

Factors

Components which affect aggregate demand

Diagram

Price level

• Private consumption

• Firms’ investment

• Net exports

Movements along the aggregate demand curve

Quantity of goods & services demanded falls

Quantity of goods & services demanded rises


Other Factors

Components which affect aggregate demand

Diagram

National income, income tax, welfare allowances, interest rates & savings habits

Private consumption

Shifts of the aggregate demand curve

Interest rates, business prospects & profits tax rates

Firms’ investment

Government revenue, expenditure on infrastructure & the public’s demand for public services

Government expenditure

Overseas economic conditions & exchange rates

Net exports

5.

Aggregate supply: The aggregate output or real national income at different price levels.

6. Aggregate supply is classified into long run and short run. In macroeconomics, long run and short run refer to the difference in time.


7. The differences between short run and long run are listed below:

Short run Long run

PricePrices may not be able to fluctuate freely to clear the market.

Prices can adjust freely.

Misperceptions about the price level

Yes No

Production resources & technology Constant Constant

8. The aggregate output in the long run equals the potential output.

Potential output: The output of an economy at full employment.

9. The potential output is affected by the following factors:‧ Labour

‧ Capital

‧ Natural resources

‧ Technology

10. An increase in resources or technological level will push up the potential output.

11. In both the long-run and short-run AS–AD models, the potential output is generally assumed to be constant, that is, the long-run aggregate supply curve is a fixed vertical line.

12. The long-run aggregate supply curve will shift only in case of a change in the potential output due to long-term economic growth, or significant changes in resources or technology.


13. The short-run aggregate supply curve slopes upward for the following reasons:‧ Sticky-price theory:

When the price level falls, some firms will choose to cut production instead of price, leading to lower aggregate output.

‧ Sticky-wage theory:

When the price level falls, wages are not fully flexible. This results in higher real wages, and some firms will produce less, leading to lower aggregate output.

‧ Misperceptions theory:

When the price level falls, firms mistakenly believe it as a fall in the relative prices of its goods and therefore produce less. Workers will also mistakenly believe real wages have fallen and supply less labour. These lead to lower aggregate output.

14. Reasons for a rise (fall) in the short-run aggregate supply:‧ Factor prices ↓ (↑)

‧ Expected price level ↓ (↑)

15. When the long-run aggregate supply curve shifts, the short-run aggregate supply curve will also shift accordingly.

16.

Short-run equilibrium: The when the quantity of goods and services demanded equals aggregate output.

17. In the AS–AD model, the equilibrium conditions are as follows:

Long-run equilibrium condition:

Aggregate output = Quantity of goods and services demanded = Potential output

Short-run equilibrium condition


18. When aggregate demand falls:‧ In the short run, due to sticky price, sticky wage and misperceptions about

the price level, the economy adjusts along the short-run aggregate supply curve when the price level falls, leading to lower aggregate output.

‧ In the long run, as price and wages are fully flexible, and misperceptions about the price level are corrected, aggregate output will return to the potential output.

19. When the price of resources or expected price level changes, the short-run aggregate supply curve will shift. In the long run, aggregate output will return to the potential output.

Aggregate demand 總需求Aggregate demand curve 總需求曲線Aggregate supply 總供應Potential output 潛在產量Long-run aggregate supply curve 長期總供應曲線Short-run aggregate supply curve 短期總供應曲線Stagflation 滯脹

Education Bureau, HKSAR – Economics references and resources

http://www.edb.gov.hk/index.aspx?nodeid=3226&langno=1

EconExperiments

http://iface.econ.cuhk.edu.hk/

Hong Kong Education City

http://www.hkedcity.net/

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10 Aggregate Demand & Aggregate Supply - HKEP · 2011-03-31 · 26 Chapter 10 Aggregate Demand & Aggregate Supply II. Other factors which cause changes in aggregate demand 1 Shifts