• Social Scientist

Changes in AD and AS

Theme 5: Introduction of Macroeconomics

Topic: Changes in Aggregate Demand and Aggregate Supply

Relevance: H1 and H2 Economics

Introduction:

The equilibrium level of national income occurs when the Aggregate Demand equals the Aggregate Supply (AD=AS) in an economy at P0 and Y0 as shown in Figure 1, as there is no tendency for the either real national income or general price level to change.

Changes in aggregate demand and aggregate supply can cause both real national income or general price level to change in the economy.


Aggregate demand is defined as the total spending on goods and services produced within the economy at various general price level, over a given time period, ceteris paribus. AD=C+I+G+(X-M).

Changes in aggregate demand is caused by any changes in any of its component; consumer expenditure (C), investment (I), government expenditure (G) and net exports (X-M), This will cause the aggregate demand curve to shift.


Aggregate supply on the other hand is the total output of goods and services produced within the economy at various general price level, over a given time period, ceteris paribus.

Changes in aggregate supply is caused by any changes in unit cost of production, quality of resources available, quantity of resources available and technological level. This will cause the aggregate supply curve to shift.

Increase in Aggregate Demand

Increase in aggregate demand can be caused by an increase in any of its component; consumer expenditure (C), investment (I), government expenditure (G) and net exports (X-M).

For example:

  • Increase in consumer expenditure (C) caused by improvement in household optimism

  • Increase in investment (I) caused by a decrease in interest rate

  • Increase in government expenditure (G) caused by new expansionary fiscal policy

  • Increase in net exports (X-M) caused by depreciation in exchange rate

These changes will cause an increase in the total spending on goods and services produced within the economy at various general price level, over a given time period, leading to an increase in aggregate demand and the aggregate demand curve to shift right from ADOriginal to ADNew in Figure 1.

Figure 1: Increase in Aggregate Demand

When aggregate demand increases, there will be excess demand in the short run at original price level P0 as aggregate demand is more than aggregate supply. This will lead to unplanned inventory depletion and hence a decrease in stocks. The unplanned inventory depletion or shortage will induce firms to increase their output level in the next period leading to an increase in the real national income from YO to YN and inflation as general price level increases from P0 to PN.

Decrease in Aggregate Demand

Decrease in aggregate demand can be caused by a decrease in any of its component; consumer expenditure (C), investment (I), government expenditure (G) and net exports (X-M).

For example:

  • Decrease in consumer expenditure (C) caused by increase income tax

  • Decrease in investment (I) caused by worsening of business confidence

  • Decrease in government expenditure (G) caused by new contractionary fiscal policy

  • Decrease in net exports (X-M) caused by appreciation in exchange rate

These changes will cause a decrease in the total spending on goods and services produced within the economy at various general price level, over a given time period, leading to a decrease in aggregate demand and the aggregate demand curve to shift left from ADOriginal to ADNew in Figure 2.


Figure 2: Decrease in Aggregate Demand

When aggregate demand decreases, there will be excess supply of output, or goods and services produced in the economy at original price level P0 as aggregate demand is less than aggregate supply. This will lead to unplanned inventory accumulation or unplanned surplus. The build-up in stocks (inventories) will sends a signal to producers to cut prices so as to stimulate demand and to reduce output so as to reduce the build-up of excess stocks in the next period leading to a decrease in the real national income from YO to YN and deflation as general price level decreases from P0 to PN.

Increase in Aggregate Supply

Increase in short run aggregate supply (SRAS) can be caused a decrease in unit cost of production

Increase in long run aggregate supply (LRAS) can be caused one of the following changes:

  • Increase in quality of resources available

  • Increase in quantity of resources available

  • Improvement in technological level

These changes will cause an increase in the total output of goods and services produced within the economy at various general price level, over a given time period, leading to an increase in aggregate supply and the aggregate supply curve to shift right from ASOriginal to ASNew in Figure 3 and Figure 4.

Figure 3: Increase in Short Run Aggregate Supply

Figure 4: Increase in Long Run Aggregate Supply

The difference between an increase in SRAS and LRAS is that increase in LRAS would also lead to an increase in full employment output from YF to YFN but increase in SRAS does not.

When aggregate supply increases, there will be excess demand in the short run at original price level P0 as aggregate demand is more than aggregate supply. This will lead to unplanned inventory accumulation or unplanned surplus. The build-up in stocks (inventories) will sends a signal to producers to cut prices so as to stimulate demand and to reduce output so as to reduce the build-up of excess stocks in the next period leading to an increase in the real national income from YO to YN and deflation as general price level decreases from P0 to PN.

Decrease in Aggregate Supply

Decrease in short run aggregate supply (SRAS) can be caused an increase in unit cost of production

Decrease in long run aggregate supply (LRAS) can be caused one of the following changes:

  • Decrease in quality of resources available

  • Decrease in quantity of resources available

  • Reduction in technology available

These changes will cause a decrease in the total output of goods and services produced within the economy at various general price level, over a given time period, leading to a decrease in aggregate supply and the aggregate supply curve to shift left from ASOriginal to ASNew in Figure 5 and Figure 6.

Figure 5: Decrease in Short Run Aggregate Supply

Figure 6: Decrease in Long Run Aggregate Supply

The difference between an decrease in SRAS and LRAS is that decrease in LRAS would also lead to an decrease in full employment output from YF to YFN but decrease in SRAS does not.

When aggregate supply decreases, there will be excess demand in the short run at original price level P0 as aggregate demand is more than aggregate supply. This will lead to unplanned inventory depletion and hence a decrease in stocks. The unplanned inventory depletion or shortage will induce firms to increase their output level in the next period leading to a decrease in the real national income from YO to YN and inflation as general price level increases from P0 to PN.

Want to learn more? Let us know what do you want to learn next.

Don’t forget to share, like and comment on this post!

Subscribe to our mailing list to get the latest update from the Social Scientist Academy.

188 views0 comments

​© 2020 Social Scientist Academy 

Block 265 Serangoon Central Drive #02-271 Singapore 550265

ALL RIGHTS RESERVED