2.2: Aggregate demand & supply, Macroeconomic equilibrium



  1. Aggregate demand is the total spending on goods and services in an economy, consisting of consumption, investment, government expenditure and net exports.
  2. Consumption is spending by individuals and households on domestic goods and services in a period of time.
  3. Investment is spending by firms on the addition stock to the economy in the form of factories, offices, machinery and equipment which is used to produce domestic goods and services
  4. Demand side/demand management policy is any government policy, fiscal or monetary, designed to influence the level of aggregate demand in an economy, thus affecting the average price levels and the real output.
  5. Fiscal policy is a demand side policy using changes in government spending and taxation to achieve economic objectives, often relating to inflation and unemployment.
  6. Monetary policy is a demand side policy using changes in money supply and interest rates to achieve economic objectives, often relating to inflation and unemployment.
  7. Exports are domestic goods and services that are brought by foreigners, resulting in an inflow of export revenue (injection) to the country.
  8. Imports are domestic goods and services that are brought from foreigners, resulting in an outflow of import expenditure (leakage) to the country.
  9. Aggregate supply is the total amount of goods and services, including both consumer and capital goods, supplied by all industries in an economy at any given price level.
  10. Short run aggregate supply (SRAS) varies with the level of demand for goods and services in an economy and that is shifted by changes in factors of production.
  11. Long run aggregate supply (LRAS) is dependent upon the resources in an economy and that can only be increased by improvements in the quality and/or an increase in the quantity of factors of production.
  12. Inflationary gap is present when the economy is at equilibrium level of output that is greater than the full employment level of output, thus causing inflation.
  13. Deflationary gap is present when the economy is at equilibrium level of output that is less than the full employment level of output, thus causing unemployment.
  14. Supply side policies is designed to shift the long run aggregate supply curve to the right, thus increasing the potential output in an economy, by bringing about an increase in the quantity and/or improving the quality of factors of production..
  15. Privatization is the sale of government-owned firms to the private sector, in the hope that privately-owned, profit maximizing firms will be more efficient, thus increasing the potential output in an economy.
  16. Multiplier is the ratio of change in the level of national income to an initial change in one or more of the injections, i.e. investment, government spending or export revenue, into the circular flow of income. The final increase in aggregate demand will be greater than initial injection.


Aggregate Demand

  • AD = C + I + G + (X – M)
  • Aggregate Demand = Consumption + Investment + Government Spending + Net Exports
  • Formula is the same as expenditure method for calculating GDP!


1. Consumption

  • Total spending by consumers on domestic goods and services.
  • Two types of goods:
  • Durable goods
  • Goods that are used for long period of time.
  • Examples include vehicles, computers, phones etc.
  • Non-durable goods
  • Goods that are used for short period of time.
  • Examples include toilet paper, pencils, food etc.


2. Investment

  • Addition of capital stock to the economy.
  • Two types of investment:
  • Replacement investment
  • Occurs when firms spend on capital to maintain productivity of existing capital stock.
  • Induced investment
  • Occurs when firms spend on capital to increase their output to reach higher demand of products in the economy.
  • Leakage from the circular flow of income.
  • Includes all goods made by people to be used for other goods and services, such as offices, factories etc.


3. Government Spending

  • The government spend on a variety of products, mainly merit products, such as education, healthcare, transportation, social security etc. depending on their policies.


4. Net Exports

  • Exports
  • Products brought by foreigners.
  • When firms sell exports to foreigners, it results in an inflow to the country.
  • Imports
  • Products brought from foreign producers.
  • When firms buy imports, it results in an outflow to the country.
  • Net Exports = Export Revenues (X) – Import Expenditure (M)
  • Export Revenues > Import Expenditure = Positive net exports
  • Import Expenditure > Export Revenues = Negative net exports


What affects the consumption of the economy?


1. Changes in income

  • Rise in income → People spend more on goods and services → Consumption increases.
  • Increase in national income → Consumption increases → Aggregate demand increases.


2. Changes in interest rates

  • Spending on non-durable goods can be carried out by incomes, but spending on durable goods might require people to borrow money from the bank.
  • Increase in borrowing money → Increased interest rates → Less borrowing as it is more expensive to borrow → Consumption decreases → Aggregate demand decreases.
  • Fall in interest rates → Consumption increases → More people will be willing to spend money on durable goods and services but it will be less appealing to save money in the bank when the interest earned is too low.


3. Changes in wealth

  • Amount of consumption depends on amount of wealth people have.
  • Wealth is made up of stuff people own, such as houses, jewellery, shares in firms etc.
  • Two main factors that change the level of wealth.
  • Change in house prices
  • Increase in house prices → Consumers feel more wealthy → Confident enough to increase their consumption by saving less or borrowing more.
  • Change in value of stocks and shares
  • Increase in shares → People will feel more wealthy → Encourage spending
  • People might sell shares and use earnings from the shares to increase consumption.



4. Changes in expectations/consumer confidence

  • If people have high expectations about the economy → Consumption increases.
  • Higher consumer confidence → Increased consumption.
  • If people have low expectations about the economy → Consumption decreases in order to save in the future.
  • Increase in consumer confidence index → Increase in consumer confidence →

Increase in consumer spending.


5. Household indebtedness

  • If borrowing money is easy and the interest rates are low → Households take on more debt by getting loans or using their credit cards → Consumption increases.
  • If interest rates rise → Households will have to spend more to repay loans and mortgages → Consumers have less money to spend on products.


What affects the investment of the economy?


1. Changes in interest rates

  • Firms use their retained profits or borrow money to invest in their company.
  • Increase in cost of borrowing → Fall in investment.
  • If interest rates are high, firms would rather use their retained profits to earn higher returns as savings than invest them.
  • Decrease in interest rates → Decrease the incentive to save → Decrease the cost of borrowing → Increase in borrowing → Increase in level of investment.


2. Changes in level of national income

  • As national income rises → Increase in consumption → Encourage firms to invest in new outlet and equipment to meet the increase in demand.


3. Changes in technology

  • Technology change → Firms have to invest more to keep up with the latest technology!


4. Changes in expectations/business confidence

  • Businesses make decisions about their investment choices depending on the economic future of the country.
  • Fall in consumer demand → Investment on certain products decreases.
  • If businesses are confident about the future and expect the consumer demand to rise → Investing on products to increase potential output and productivity to meet the increases in consumer demand.


What affects the government spending?


1. Fiscal policy

  • Policies based on spending and taxation rates.
  • Two types of fiscal policies
  • Expansionary fiscal policy
  • Increases aggregate demand by decreasing tax rates or increasing spending.
  • If government wants to encourage spending → Lower income taxes →

Increase disposable income → Increases aggregate demand.

  • If government wants to encourage investment → Lower corporate taxes → Firms enjoy after-tax profits that can be used for investment → Increases aggregate demand.
  • Governments may increase their spending to improve/increase public services, which leads to an increase in aggregate demand.
  • Contractionary/Deflationary fiscal policy
  • Decreases aggregate demand by increasing tax rates or reducing spending.
  • Opposite of all effects in expansionary fiscal policy!


2. Monetary policy

  • Policies based on money supply and interest rates.
  • Changes in central bank’s base interest rate affects borrowing and lending in the economy significantly and they also consider their activities as a part of government policies.
  • Lowering base rate → Reduces the cost of borrowing → Increased consumption and investment → Increases aggregate demand.
  • Two types of monetary policies
  • Loose monetary policy
  • Increases aggregate demand by reducing interest rates or increasing money supply.
  • Tight monetary policy
  • Decreases aggregate demand by increasing interest rates or decreasing money supply.


Shifts in Short Run Aggregate Supply


1. Change in wage rates

  • Increase in wages → Increase in costs of production to firms → Fall in SRAS.




2. Change in the costs of raw materials

  • Change in price for products such as rubber, pencils would affect industries that would produce them, but it wouldn’t affect SRAS significantly.
  • Change in price for products such as oil, food would affect all industries as they are important in the production process and productivity, thus it affects SRAS significantly.


3. Change in price of imports

  • Increase in price of imports → Increase in costs of production to firms due to changes in the exchange rate of a country’s currency → Fall in SRAS


4. Change in government indirect taxes/subsidies

  • Increase in indirect taxes → Increase in costs of production to firms → Fall in SRAS.
  • Increase in subsidies → Decrease in costs of production to firms → Increase in SRAS.


Long-run aggregate supply


1. New classical LRAS

  • LRAS is inelastic or vertical at full employment level of output.
  • Full employment level of output represents potential output that economy could produce at their full capacity.
  • Full employment doesn’t mean zero employment.


2. Keynesian LRAS

  • LRAS is perfectly elastic or horizontal at low levels of economic activity.
  • Producers can raise their levels of output without increasing higher average costs because of high levels of unemployed labor and under-utilized capital.
  • As the economy reaches full employment level of output, the economy’s available factors of production become scarce, therefore increasing the higher average costs for producers.
  • When economy reaches full employment, all factors of production are fully used, so it is impossible to increase output, so therefore, LRAS becomes inelastic.








Shifts in the LRAS


1. Improvement in quantity

  • Land relocation
  • Increased access to supply of resources
  • Discovery of new resources
  • Increase in birth rate
  • Immigration
  • Decrease in natural rate of unemployment
  • Investment


2. Improvement in quality

  • Technological advancements that allow increased access to resources or discovery of new resources and contribute to more efficient capital
  • Fertilisers
  • Immigration
  • Education
  • Training
  • Re-training
  • Apprenticeship programmes
  • Research and develop


Supply-side policies


1. Interventionist supply-side policies

  • Government has an important role to play in actively encouraging growth.
  • Governments encourage growth by:

❖      Investment in human capital

  • In order to increase labor force, education and training should be available.
  • They are not only benefited by people who receive the training or education, but benefits the economy as a whole.
  • Governments responsible for providing education to many people as possible so that they have necessary skills to provide for the economy.
  • Governments should provide money for firms for training and apprenticeship programs so that they can provide necessary skills for jobs for new employees.



❖      Research and development

  • Important for an economy’s firms to be updated with latest technology → develop new production techniques and production methods.
  • Increase potential output but also spending on research and development.
  • Governments encourage R&D by giving tax incentives.

❖      Provision and maintenance of infrastructure

  • It is important to maintain infrastructure as most economic activity takes place in infrastructure such as buildings, schools, hospitals etc.

❖      Direct support for business/industrial policies

  • Governments have agencies that develop policies and encourage industry development.


2. Market-based supply-side policies

  • Governments have no role in influencing the market.
  • Allows market to operate more freely.
  • The economy grows by:

❖      Reduction in household income taxes

  • Higher income → Higher income taxes → Disincentive to work.
  • Reduction in income taxes → Incentive to work harder and be more productive → Increasing potential output of the economy.

❖      Reductions in corporate taxes

  • If firms are able to keep more of their profits, they will have more money for investment in machinery or equipment → Increase in factor of production.
  • Firms also use profits for R&D.
  • If firms know they are keeping most of the profits to themselves than giving it to the government, they will be more productively efficient.

❖      Labor market reforms

  • Reducing unemployment benefits → Increases incentives for people to get jobs.
  • Decrease or abolishment in minimum wages → Decrease in labor costs → Increases aggregate supply.
  • Reducing trade union power → Reduce ability for unions to negotiate higher wages → Lower production costs → Increase no. of workers a firm hires.

❖      Deregulation

  • Less regulations mean more potential output in an economy → Increases aggregate supply.

❖      Privitization

  • Sale of government-owned firms to private sector.
  • Private firms tend to be more efficient than nationalized firms → Increases potential output in an economy.

❖      Policies to increase competition

  • Encourages greater efficiency and productive potential of an economy.




Multiplier effect

  • Increase in aggregate demand → Increase in national income.
  • Happens when government decides to increase their spending to fill deflationary gap.