Welcome to unit 2’s final meeting! This session examines the connection between aggregate demand, the price level, and real GDP. We will also examine the relationship between total supply, price level, and real GDP.

The interaction between aggregate demand and aggregate supply determines the dynamics of macroeconomic changes, with implications for output, employment, and inflation.

In the same way that there are two sides to every market, there are two sides to every economy: the demand side and the supply side. Aggregate demand corresponds to the demand side, while aggregate supply corresponds to the supply side. Join me as we explore these ideas in greater depth.

Objectives Following this session’s reading, students should be able to:

Now Read On…


  • understand the nature of aggregate demand and appreciate why aggregate demand changes
  • recognise the importance of aggregate supply in the macroeconomy
  • understand the meaning of the aggregate production function
  • grasp the distinction between short-run and long-run aggregate supply
  • understand the meaning of an economy’s potential real GDP
  • identify how macroeconomic equilibrium depends upon the matching of aggregate demand and aggregate supply
  • understand the IS and LM curves
  • determine IS-LM equilibrium
  • understand the IS-LM and aggregate demand curve determination

Now read on… 


6.1 Aggregate Demand

As we have seen in prior lessons, total expenditure consists of consumer spending (C), investment spending (I), government spending (G), and spending on exports minus imports (X M).

The aggregate planned expenditure (AE) is derived from the spending plans under each of these demand headings.

Together, the AE schedule and the Keynesian 45° diagram allow us to analyze the potential for inflationary and deflationary gaps to develop in an economy.

Let’s now introduce the aggregate demand curve so that we can simultaneously examine the relationship between price, demand, and real GDP.

The aggregate demand of an economy is the total demand for products and services. This is the total of consumption spending (C), investment spending (I), government spending (G), and net export spending (X M). This is graphically depicted by the aggregate demand curve.

6.1 Aggregate Demand

The aggregate demand curve illustrates the quantity of real GDP demanded at various price levels, with all other factors held constant. Assuming that the economy has adequate productive capacity, the GDP will increase proportionally to the level of aggregate demand.

This is due to the fact that consumer expenditure is directly proportional to income. To construct the AD curve, we retain constant all other influences on real GDP levels besides the price level; thus, a change in any factor other than the price level results in a new AD curve.

Aggregate Demand

The aggregate demand curve is downward sloping as a result of two separate effects. These are;            

  1. real money balance effect and
  2. Substitution effects.

6.2.1 Real Money Balance Effect

Real money balance effects refer to the situation in which, at reduced price levels, the real purchasing power of money balances (currency and bank deposits) increases. This increases the quantity of products demanded and, consequently, the real GDP.

For instance, if prices declined by half while money balances remained unchanged, the real purchasing power of money balances would double.

In other words, a decrease in the price level of the economy enhances the real purchasing power of money and causes the AD curve to move downward.

6.2.2 Substitution Effects

A rise in the price level will typically result in an increase in interest rates, all else being equal.

This is because, as a result of higher prices, households and businesses have less real purchasing power and will therefore incline to lend less and borrow more.

This decrease in the supply of loanable funds coupled with an increase in the demand to borrow will likely result in an increase in the interest rate.

In turn, a higher interest rate will tend to reduce firms’ investment spending and households’ purchases of durable goods, such as automobiles, that are typically acquired on credit.

Additionally, the larger interest rate makes saving more appealing than current spending. In addition, the higher domestic price level is likely to reduce export demand and increase imports.

The end result is a decline in real GDP. Higher interest rates typically result in the substitution of prospective consumption for current consumption (an intertemporal effect) and the substitution of imports for domestic goods (an international substitution effect associated with a decline in exports).

6.3  Changes in Aggregate Demand

In practice, the AD curve is likely to shift over time. Major influences on aggregate demand include:

  • government macroeconomic policy;
  • expectations of firms and households;
  • global trends

6.3.1 Government Macroeconomic Policy

Changes in government expenditure and taxation or fiscal policy will impact aggregate demand both directly and indirectly. Either increasing government spending or reducing taxes will increase aggregate demand.

Government expenditures have a direct impact on aggregate demand, whereas changes in taxation indirectly stimulate consumer and investment spending via changes in disposable income.

Therefore, an expansionary fiscal policy increases aggregate demand. Depending on the productive capacity of the economy, the expected consequence will be a rise in real GDP, as well as some impact on the price level.

A reduction in government expenditure and an increase in taxes, also known as a contractionary fiscal policy, will shift the AD curve to the left, resulting in a lower real GDP.

The government can also use monetary policy to influence aggregate demand and, by extension, the level of economic activity. The objective of monetary policy is to expand or contract aggregate demand by adjusting the money supply and interest rates.

The greater the real amount of money, the greater the tendency for aggregate demand to increase, and vice versa.

Similarly, with lower real interest rates, increased borrowing is anticipated to finance higher investment expenditures and consumer durables spending. The AD curve shifts to the right due to an increase in money supply and a decrease in interest rates, and vice versa.

6.3.2 The Role of Expectations

In determining the state of the macroeconomy, expectations are crucially essential. When households and businesses are optimistic about the future, they are more likely to borrow money for spending and investing in new equipment.

When individuals and businesses have pessimistic expectations for the future, they are likely to reduce their consumption and investment plans.

Expectations regarding future income can impact current expenditures, as can expectations regarding future prices, taxes, interest rates, and exchange rates. In general, any change in expectations that increases aggregate demand will shift the AD curve to the right; any change in expectations that decreases aggregate demand will shift the AD curve to the left.

6.3.3 The Impact of Global Trends

Changes in the global economy are likely to have an effect on national aggregate demand. By altering the relative prices of exports and imports, for instance, a change in the current exchange rate will impact demand. Additionally, changes in foreign incomes and the expectations of foreign customers and investors will influence the demand for national exports. More exports or fewer imports cause a shift to the right in the aggregate demand curve; conversely, fewer exports and more imports cause a shift to the left. This relationship should make it clear why expansions and contractions in the world’s main economies tend to move in tandem.

6.4 Aggregate Supply

Aggregate supply (AS) is the sum of all commodities and services produced at any given time in an economy. The available aggregate supply will hinge on the production factors utilized.

These production determinants are labor (N), capital (K), land (L), and technological development (T).

The aggregate supply relationship can be represented by an aggregate production function that relates output (Y) to inputs (N, K, L, and T).

Aggregate production function

Y  f (N, K, L, T)

According to the aggregate production function, the larger the volume of factor inputs, the greater the output of the economy.

Obviously, focusing solely on the quantity of inputs could be risky, as the utilization and quality of these inputs are crucial; unemployed labor and idle plant and apparatus contribute nothing to output.

The aggregate supply can be examined in two dimensions. The following are,

  1. Aggregate supply in the long run
  2. Aggregate supply in the short run

6.5 Aggregate Supply in the Long Run A long-run

The long-run aggregate supply curve depicts the relationship between the price level and real GDP. In a competitive market economy, long-run aggregate supply (LRAS) should be at a level where actual real GDP equals the economy’s potential real GDP, given entirely efficient use of all inputs (i.e. full employment of resources). At the economy’s full employment real GDP, Yf1, the LRAS curve is vertical and unaffected by price fluctuations.

This is due to the fact that an increase in demand for products and services cannot increase supply, which is fixed at the potential GDP.

The anticipated result of an increase in aggregate demand would be a higher price level.

However, an increase in the price level would reduce real wages (W/P), prompting employees at full employment to demand a monetary wage increase to compensate.

If real wages are not restored to their previous level, fewer workers will seek employment, resulting in a decline in labor inputs and output.

Employers are therefore anticipated to respond by providing a compensating wage increase. At a higher price level, the real wage (W/P) is brought back to its previous level. Real GDP remains unchanged.

Aggregate Supply in the Long Run A long-run

Aggregate Supply in the Long Run A long-run

As a result of economic expansion, the LRAS curve is anticipated to migrate to the right over time or years.

For instance, an increase in the quantity of factor inputs or a change in their quality or productivity should cause the LRAS curve to shift to the right.

A movement in the opposite direction would indicate a decline in long-term aggregate supply.

6.6 Aggregate Supply in the Short Run

In the short term, real GDP may be at or below full employment’s potential real GDP. A higher aggregate demand at a time when the aggregate supply is below its potential level is likely to result in increased output.

This is illustrated by the short-run aggregate supply (SRAS) curve that slopes upward. When aggregate demand increases, the elasticity of the short-run aggregate supply curve reflects the extent to which real GDP rather than the price level rises.

For instance, if rising prices raise demand. It causes a fall in the real wage (W/P) the real cost of employing labor, and if workers do not respond by successfully demanding a compensating monetary wage (W) adjustment in the short term, there will be an incentive for employers to hire more employees who are now effectively cheaper.

The outcome is a larger labor force (N) and, all else being equal, a greater real GDP.

Therefore, the ‘flexibility’ of the labor force in terms of its response to changes in the price level and wage demands can have a substantial effect on the elasticity of the SRAS curve.

When immediate wage increases are attained, the SRAS will be vertical (similar to the LRAS curve). Changes in the availability of factor inputs influence the short-run aggregate supply curve, just as they do the long-run aggregate supply curve.

Moreover, changes in nominal wage rates (W) can influence the SRAS due to their effect on real wages (W/P) and, consequently, the willingness of employers to engage labor and increase output.

Capital inputs, along with land and technology, are more essential in determining changes in long-term aggregate supply than in determining changes in short-term aggregate supply due to the fact that current investments have only a marginal effect on the capital stock.

In contrast, expectations are likely to influence management decisions regarding production levels at any given time and are subject to rapid change. Thus, expectations can have a substantial impact on SRAS. An increase in SRAS causes the curve to shift to the right, and vice versa.

6.7 Macroeconomic Equilibrium

By plotting the aggregate demand and aggregate supply curves on the same graph, the macroeconomic equilibrium can be determined. When there is no aggregate demand in the economy that cannot be satisfied by supply, macroeconomic equilibrium exists.

Similarly, it occurs when there is no excess supply of production that is not currently in demand. When aggregate demand and aggregate supply are equal (AD = AS). This equilibrium is depicted in the figure that follows;

At the equilibrium point e, the price level is P* and the real GDP is Y*. In reality, fluctuations in aggregate demand and aggregate supply cause the economy to oscillate around its long-term development path.

For instance, an increase in aggregate demand may result in a price increase.

As discussed previously, the rise in prices causes a decline in the real wage rate (W/P), which leads to a temporary increase in employment until wage adjustments can be made to compensate.

Higher prices of other inputs, such as the increase in global oil prices, will raise firms’ production costs, causing a shift to the left in the SRAS curve, a decline in real GDP, and a new short-run macroeconomic equilibrium.

The shift to the left of the SRAS curve results in higher prices and, in this instance, a real GDP below the full employment potential real GDP. Inflation and economic stagnation are the results.

6.8 IS-LM Analysis

The equilibrium in macroeconomics has been discussed so far using the aggregate expenditure (45° line) diagram and aggregate demand (AD) and aggregate supply (AS) curves. We will now deal with an alternative approach called IS–LM analysis.

6.8.1 The IS Curve

Additionally referred to as the Investment – Savings curve, the IS curve is also known as the Investment – Savings curve. It acknowledges that fluctuations in interest rates affect the level of planned total expenditure.

Higher interest rates are likely to reduce firms’ borrowing and, consequently, their planned investments in plant and machinery, commercial buildings, etc.

Similarly, firms are likely to plan to invest more when there are reduced interest rates. The IS curve illustrates the combinations of real GDP and interest rate where aggregate planned expenditures equal actual national output and total injections equal total leakages. Specifically, equilibrium on the ‘goods’ market.

6.8.2 The LM Curve

The second component of IS–LM analysis is the LM (liquidity–money) curve. The LM curve represents financial market equilibrium. Firms and households require funds for transactional, precautionary, and speculative purposes.

The monetary supply is determined by the banking system and the actions of the central bank in particular. The money market is in equilibrium when the stock of real money demanded equals the stock of real money supplied.

The money market is in equilibrium when the stock of real money demanded equals the stock of real money supplied.

Real money is of concern because the quantity of money demanded is proportional to the price level; for instance, when inflation increases, households require more money to fund their spending.

6.9 IS-LM Equilibrium

Separate IS and LM curves have been derived in terms of real GDP and interest rates. They can now be brought together.

IS–LM equilibrium represents the specific combination of real GDP and interest rate at which the goods and money markets are concurrently in equilibrium.

At a 4% interest rate and a real GDP of level Ye, an IS–LM equilibrium occurs on this diagram. The IS curve demonstrates that the 4% interest rate is consistent with a real GDP of Ye and is the expenditure equilibrium point.

Given Ye’s real GDP, the 4% interest rate also leads to a money market equilibrium. For instance, if the interest rate were above 4%, aggregate planned expenditures and real GDP would require a lower real GDP than is required for the equilibrium of the demand and supply of real money.

In contrast, if the interest rate were less than 4%, there would be disequilibrium in terms of expenditure on goods and services, demand and supply of real money, or disequilibrium in both markets.

6.10 IS-LM and the Aggregate Demand Curve

If prices were to alter, the result would be a shift in the actual demand for and supply of money.

When prices increase, the real supply of money decreases and interest rates increase, resulting in a corresponding decrease in the demand for money.

When prices decline, the real supply of money rises, and interest rates fall, resulting in a proportional increase in the demand for money.

Changes in interest rates result in a distinct equilibrium in the goods market or in planned expenditures relative to real GDP in every instance. This is depicted in the diagram that follows;

6.11 IS-LM and Macroeconomic Policy

We can illustrate the effects of changes in fiscal and monetary policies using IS-LM analysis

6.11.1 Fiscal Policy

A fiscal policy that leads to an increase in government expenditure or a decrease in taxation will shift the IS curve to the right.

All else being equal, the result is a higher real GDP and a higher interest rate.

A contractionary (or deflationary) fiscal policy will adjust the IS curve to the left, resulting in a decrease in real GDP and a decrease in the interest rate.

It should be noted that the shift in the IS curve exceeds the change in real GDP in both instances.

6.11.2 Monetary Policy

Monetary policy involving an increase in the money supply will lead to a shift in the LM curve to the right. As a result, interest rates fall and real GDP rises.

The lower interest rate following the increase in the money supply stimulates investment and perhaps consumer expenditure, leading to a higher real GDP.

It is worth noting that if the LM curve is horizontal – the extreme Keynesian case – monetary policy would be ineffective in stimulating the economy.

We introduced the concepts of aggregate demand and aggregate supply in this session. Aggregate demand is the entire demand in the economy, whereas aggregate supply is the economic output.

We have emphasized the significance of supply in determining macroeconomic equilibrium by introducing the aggregate supply curve.

We also examined the IS–LM analysis, which examines the relationship between interest rates, real GDP, and market equilibrium for goods (IS) and money (LM). It offers a different perspective on the effects of fiscal and monetary policies on the macroeconomy than the AD–AS analysis.

Self-Assessment Questions

Exercise 2.6

  1. Explain the composition of aggregate demand.
  2. Explain under what circumstances the aggregate demand curve might shift a. to the right b.  to the left
  3. Distinguish between short-run and long-run aggregate supply and discuss the importance of this distinction for macroeconomic policy.
  4. Using appropriate AD–AS diagrams explain how
    1. a deflationary gap
    2. or an inflationary gap may occur.
  5. How might governments attempt to influence long-run aggregate supply and therefore potential GDP?





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