EC 111 Lecture Notes - Lecture 10: Unemployment, Market Power, Absenteeism
4 Jun 2018
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Chapter 11 – Aggregate Demand and Aggregate Supply
Introduction to AD-AS Model
• AD-AS model is a variable price model.The aggregate expenditures model in Chapters 9 and 10 assumed
constant price.
• AD-AS model provides insights on inflation, unemployment and economic growth.
Aggregate demand is a schedule that shows the various amounts of real domestic output that
domestic and foreign buyers will desire to purchase at each possible price level.
• The aggregate demand curve is shown in Figure 11-1.
• It shows an inverse relationship between price level and domestic output.
• The explanation of the inverse relationship is not the same as for demand for a single product, which centered
on substitution and income effects.
• Substitution effect doesn't apply in the aggregate case, since there is no substitute for "everything."
• Income effect also doesn't apply in the aggregate case, since income now varies with aggregate output.
• What is the explanation of inverse relationship between price level and real output in aggregate demand?
• Real balances effect: When price level falls, the purchasing power of existing financial balances rises, which
can increase spending.
• Interest-rate effect: A decline in price level means lower interest rates which can increase levels of certain
types of spending.
• Foreign purchases effect: When price level falls, other things being equal, U.S. prices will fall relative to
foreign prices, which will tend to increase spending on U.S. exports and also decrease import spending in
favor of U.S. products that compete with imports.
Deriving AD-curve from aggregate expenditures model.(See Figure 11-2)
• Both models measure real GDP on horizontal axis.
• Suppose initial price level is P1 and aggregate expenditures AE1 as shown in Figure 11-2a.Then equilibrium
GDP is GDP1.This is shown in Figure 11-2b.
• If price rises to P2, aggregate expenditures will fall to AE2 because purchasing power of wealth falls, interest
rates may rise, and net exports fall.(See Figure 11-2a)Then new equilibrium is at GDP2shown also in Figure
11-2b.
• If price rises to P3, real asset balance value falls, interest rates rise again, net exports fall and new equilibrium
is at GDP3.Again see Figures 11-2a and 11-2b.
• Determinants of aggregate demand:Determinants are the "other things" (besides price level) that can cause a
shift or change in demand (see Figure 11-3 in text).Effects of the following determinants are discussed in
more detail in the text.
• Changes in consumer spending, which can be caused by changes in several factors.
• Consumer wealth,
• Consumer expectations,
• Consumer indebtedness, and
• Taxes.
• Changes in investment spending, which can be caused by changes in several factors.
• Interest rates,
• Profit expectations,
• Business taxes,
• Technology, and
• Amount of excess capacity.
• A change in government spending is another determinant.
• Changes in net export spending unrelated to price level, which may be caused by changes in other factors
such as:
• Income abroad, and
• Exchange rates: Depreciation of the dollar encourages U.S. exports since U.S. products become less expensive
when foreign buyers can obtain more dollars for their currency. Conversely, dollar depreciation discourages
import buying in the U.S. because our dollars can't be exchanged for as much foreign currency.
• Aggregate demand shifts and the aggregate expenditures model:
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