- 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.
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.
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.
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.
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.
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