- It shows the relation between the price level and the aggregate output demanded in an economy, other factors being constant.
- Aggregate output demanded is the real output demanded by an economy at a particular price level over a specific period. It can be measured in terms of real GDP or real national income.
- Aggregate ouput demanded = C + I + G + NX
Movement along the AD Curve
Shifting of the AD curve
Changes in price level
Any non-price factors which would affect aggregate output demanded
Reasons for the downward sloping aggregate demand curve
- Wealth effect:
As many assets in the economy are dominated in nominal values., the higher the price level, the lower the purchasing power of money. This reduces the wealth of the economy (in real terms). As a result, household and firms reduce their purchase of all goods and services and the real output drops.
- Interest rate effect:
As the price level rises, households and firms demand more money to finance their transactions. Given the fixed supply of money, the interest rate would rise. An increase in interest rate would cause decline in investment and consumption and also the real output.
- Net exports effect:
As the domestic price level rises, foreign-made goods become relatively cheaper so the quantity demanded of imports increases. However, the rise in domestic price level also means that domestic-made goods are relatively more expensive to foreign buyers so the quantity demanded of exports decreases. When the volumes of exports decreases and of import increases, net exports will decrease, so as the real output.
Non-price-level factors which would shift the AD curve
Factors affecting private consumption expenditure
Desire to save
Desire to save↑Proportion of disposable income↓→C↑→AD↓
Interest rates↑→Cost of consumption↑→C↓→AD↓
Wealth→Ability to consume↓→C↓→AD↓
Factors affecting gross investment expenditure
Interest rates↑→Cost of investment↑→I↓→AD↓
Profit taxes↑→Less willing and able to invest →I↓→AD↓
Less optimistic business →Less profitable to invest →I↓→AD↓
Factor affecting government consumption expenditure
If the government raises government consumption expenditure, aggregate demand will increase, and vice versa.
Factors affecting exports and imports
Exchange value of trading partners
Value of domestic currency relative to a foreign currency↑→Our imports become less expansive to our residents while our exports become more expansive to foreign residents →Volume of imports↑ and volume of exports↓→Net exports↓→AD↓
Price level of trading partners
Foreign price level↓→Volume of imports↑and volume of exports↓→Net exports↓→AD↓
National income of trading partners
National income of trading partners↓→ volume of exports↓→Net exports↓→AD↓
Trade policies that can restrict our imports and promote our exports→Volume of imports↓and volume of exports↑→Net exports↑→AD↑
- It shows the relation between the price level and the aggregate output supplied in an economy, other factors being constant.
- Aggregate output supplied () is the real output supplied by an economy at a particular price level over a specific period. It can be measured in terms of real GDP or real national income.
Movement along the AS Curve
Shifting of the AS curve
Changes in price level
Any non-price factors which would affect
Reasons for the upward sloping short run aggregate supply curve
- The imperfect adjustment of input prices
When the price level increases, the adjustment of input prices is imperfect/incomplete (e.g. due to the long term contracts of factors of production), so the real cost of production — i.e. nominal cost divided by the general price level – will fall. Firms would thus use more factor inputs to produce larger output. Therefore, the SRAS curve is upward-sloping, i.e. a higher price level would result in a higher output level.
- Sticky-cost (wage) effect:
The input prices are usually fixed during a short period under long term contracts. When P↑, output price rises more than input prices, so it is more profitable for firms to produce more, output level would thus rise..
Non-price-level factors which would shift the SRAS ONLY
These factors would not cause any change to the full employment output level/potential output level since the quantity of factor endowment, quality of factor endowment, production technology, production efficiency and infrastructures remain unchanged.
*Factor endowment refers to factors of production owned by an economy that can be used in production.
Negative supply shock →SRAS↓
Expectation of price level
Expected price level↑→Firms retain more of their present supply for future sale→SRAS↓
Government policies with only short run effects on aggregate output supplied
Production subsidies↑→Production costs↓→SRAS↑
Long run supply curve
- The LRAS curve is a vertical line and is positioned at the gull employment output level (YfS), meaning that all available resources are used efficiently.
Reasons for a LRAS curve positioned at Yf
- Fully adjusted input and output prices:
In the long run, input prices are full flexible.
When price level increases, input suppliers renew long term contracts at increased prices, the nominal cost of production increases.
This offsets the rise in the price level.
Ultimately, the real cost of production returns to its original level.
Firms would restore their original production plans.
Therefore, in the long run, any change in the price level would have no effect on the aggregate output supplied.
As all output prices are fully flexible, all factor markets attain full employment.
Thus, the economy would always produce at the full employment output level in the long run.
- Capacity constraint:
The full employment output level of an economy is determined by its quantity and quality of resources, as well as the technology available, which are independent of the price level. is thus a constant at all price levels.
Non-price-level factors which would shift the LRAS curve and affect Yf
*These factors would usually also affect SRAS.
1. Quantity of factor endowment↑
2. Quality of factor endowment↑
Production technology and production efficiency
Technology advances, innovation, growth of international trade globalization and construction of infrastructure→Productivity and efficiency↑→Yf↑→LRAS↑
Government policies which affect
Government policies which increase factor quantity, improve factor quality or raise production technology and efficiency →Yf↑→LRAS↑
Determination of short run and long run equilibrium
- Short run equilibrium is determined by the intersection of the AD and SRAS curve.
- Long run equilibrium is determined by the intersection of the AD and LRAS curve.
Inflationary (output) gap / overheating
- When the short run output level is greater than the full employment output level, the difference is called an inflationary gap. Under this situation, the economy experiences overheating.
Automatic market adjustment of the SRAS curve under an inflationary gap
- When the economy is facing an inflationary (output) gap. There would be an excess demand in the factor market, creating pressure for factor prices to adjust upward. As the cost of production would rise, short run aggregate supply would fall over time, thus restoring the output level to full employment output level in the long run.
Deflationary (output) gap / unemployment
- When the short run output level is smaller than the full employment output level, the difference is called a deflationary gap. Under this situation, the economy experiences unemployment.
Automatic market adjustment of the SRAS curve under a deflationary gap
- When the economy is facing a deflationary (output) gap. There would be an excess supply in the factor market which would lower input prices. As the cost of production decreases, the short run aggregate supply would increase over time, thus restoring the output level to full employment output level in the long run.
DSE Econ 文章系列
- 經濟表現的量度 Measure of economic performance
- 國民收入決定及價格水平 National income determination and price level
- 貨幣與銀行 Money and Banking
- 宏觀經濟問題和政策 Macroeconomic Problems and policies
- 國際貿易和金融 International Trade and Finance