Chapter Eight: Module Summary -- Aggregate Demand and Aggregate Supply
- The Circular Flow Diagram is a graphical way to illustrate
how the different pieces of the economy fit together. Consumers
receive disposable income, and either consume it or save it. Consumption
goes directly into Aggregate Demand. The saving leaks out to the
financial system, to be injected back into the system as Investment.
The Government and Net Exports contribute to demand for goods
and services. The production of goods and services makes up GDP
which, after making some minor adjustments, is equal
to national income. The national income is used to pay taxes to
finance government expenditures, and it generates the disposable
income that people use for consumption and saving.
- Aggregate Demand (AD) is the total amount that
all consumers, firms, government, and foreigners wish to spend
on final goods and services produced in the U.S. borders, given
the price level.
AD = C + I + G + NX.
- Consumption (C) is the total amount spent by
consumers on newly produced goods and services. Consumption is for current
- Investment ( I ) is the total amount spent by
firms on factories, machinery, plant and equipment, plus the expenditures
of households on new homes. Investment must expand the production
capacity of the economy.
- Government Expenditures (G) are the total amount
of government purchases of newly produced goods and services.
- Net Exports (NX) are exports minus imports.
- In economics, the terms saving and investment are very distinct;
they are not interchangeable. Saving (S) is
disposable income not consumed. It is not a component of Aggregate
Demand. Investment expands the productive capacity of the economy.
- The Aggregate Demand curve plots the level of Aggregate
Demand at various price levels.
- The AD curve has a downward slope, reflecting the negative
relationship between the price level (P) and Aggregate Demand.
- The AD curve slopes downward due to the wealth effect and
the international trade effect.
- A change in the level of Aggregate Demand that is caused by
a change in price level is referred to as a movement along
the Aggregate Demand curve or a change in Aggregate quantity
demanded. A change in any factor that changes the level of Aggregate
Demand other than a change in the price level results in a shift
of the Aggregate Demand curve.
- Any increase in an autonomous (non-income) component of Aggregate
Demand shifts the AD curve to the right. This includes an autonomous
increase in consumption, investment, government expenditures,
or net exports.
- The Aggregate Supply curve is the total amount of output
(Y) produced at various price levels.
- The short-run Aggregate Supply curve is upward-sloping
because the costs of production are held constant.
- The long-run Aggregate Supply curve is a vertical line
at the potential level of output. In the long-run there is no
relationship between the price level and real output.
- A change in the level of Aggregate Supply that is caused by
a change in the price level is referred to as a movement along
the Aggregate Supply curve. A change in any factor that changes
the level of Aggregate Supply other than a change in the price
level results in a shift in the Aggregate Supply curve.
- A decrease in resource costs, an increase in technology, and
a decrease in inflation expectations shift the Aggregate Supply
curve to the right.
- The short-run equilibrium occurs where the AD curve
crosses the short-run AS curve. The intersection of AD and AS
gives both the price level the level of GDP in the economy.
- The long-run equilibrium can only occur where the AD
curve crosses the long-run AS curve. In long-run, equilibrium
output must equal potential output.
- Disequilibrium results when either Aggregate Demand exceeds
Aggregate Supply, or when Aggregate Demand falls short of Aggregate
Supply. In the first case, firms see inventories declining more
than they desire, and respond by increasing output and prices
until equilibrium is reached. In the second case, firms see unwanted
inventories increasing and respond by decreasing production and
prices. Again, the economy tends towards equilibrium.
- A demand-driven business cycle results from a shift in the
Aggregate Demand curve. When the AD curve shifts, prices and output
move in the same direction. This is the case in a "normal"
- A supply-driven business cycle is driven by shifts
in the Aggregate Supply curve. Prices and output move in opposite
- A shift in the AS curve to the left produces stagflation,
a period of economic stagnation coupled with high inflation.
- The Paradox of Thrift states that an increase in the desire of the economy as a whole to save more may lead to a decrease in output and employment, thus thwarting the attempt to save more.
- Whether an economy should consume or save depends upon the response of investment to saving and the time horizon. If investment increases as saving rises, then the paradox of thrift will not hold. Also, the longer the time period, the more likely it is that increased saving will lead to higher rates of investment and hence, higher rates of growth.