Aggregate Demand & Supply I

Objectives
After working through this topic you should be able to:
· Understand the meaning and derivation of the aggregate demand
curve
· Explain the factors that can cause the AD curve to shift
· Identify the microeconomic foundations of the aggregate supply curve
· Explain the importance of price expectations as a determinant of the
supply of labour
· Distinguish between complete money illusion, imperfect foresight and
perfect foresight as three cases of price expectations

Key Concepts
real money supply money wage rate
aggregate demand curve real wage rate
aggregate supply curve expected price level
aggregate production function coefficient of adjustment
labour market complete money illusion
imperfect foresight perfect foresight

Introduction
In the IS/LM analysis it has been assumed that the general price level
is fixed up to the point of full employment, after which it can rise
without limit. Clearly this is an unacceptable assumption because
since 1950 an axiom of economic life in advanced economies has
been the existence of inflation during both booms and slumps.
Moreover inflation has persisted even though high levels of
unemployment have emerged since the mid 1970’s, i.e. stagflation.
Therefore the general price level has to be explicitly analysed, and
this is the purpose of the aggregate demand and supply framework.
The next two topics discuss in detail the construction and meaning of
the AD/AS model.

Aggregate Demand & Supply I 103

 In this first topic, we begin by showing how the aggregate demand
curve is derived and discuss the factors which can cause it to shift.
The microeconomic foundations of the aggregate supply curve are
then explained in detail focusing on the aggregate labour market,
worker’s expectations of the price level and the aggregate production
function. The actual derivation of the three different aggregate supply
curves is explored in following topic.

The Aggregate Demand Curve

The first step in constructing the AD/AS model is to look at the
meaning and derivation of the aggregate demand curve. As you will
see, the AD curve is easily derived form the basic IS/LM model for
either a closed or open economy. For ease of exposition, it will be
assumed that we are dealing with a closed economy
· The aggregate demand curve can be defined as the schedule which
shows the combinations of the general price level and total
output where the goods and money (assets) markets are in
equilibrium i.e. where the IS and LM curves intersect.

Derivation of the AD Curve

To derive an aggregate demand curve a number of variables are held
constant. These variables include:
1. the marginal propensity to consume
2. the position and slope of the investment demand function
3. the marginal rate of tax
4. the level of Government spending
5. the nominal money supply
6. the position and slope of the demand for money schedule
With these ceteris paribus assumptions in place, the general price
level is varied to chart the impact on the goods/money markets, and
hence the level of aggregate demand. Figure 9-1 below illustrates the
process.

104 Aggregate Demand & Supply I

 LM0
Interest LM1
rate

E
r0
E1
r1

IS0

Y0 Y1 Real GDP(Y)
Price
level
(P)

P0

P1

AD

Y0 Y1 Real GDP(Y)

Figure 9-1: Derivation of the AD Curve

In the top panel of the diagram there is an IS/LM framework with

interest rates (r) on the vertical axis, and income/output (Y) on the
horizontal axis. In the bottom panel an aggregate demand curve can
be derived with the general price level (P) on the vertical axis and
total output (Y) on the horizontal axis.
Initially the economy is in equilibrium where the curves IS 0 and LM0
intersect at point E. More specifically the LM curve is defined for a
given nominal money supply (MS0) and general price level (P0). Point
E also defines an equilibrium rate of interest (r 0) and level of output
(Y0). The price level (P0) and the level of output (Y 0) can then be
charted on the bottom diagram as a point where the goods and
money markets are in equilibrium.
Say the price level falls by 10% to P 1. With a given nominal money
supply, the real money supply will increase i.e. M0/P1 > M0/P0. In the
top panel the LM curve shifts to the right i.e. LM1. This causes the
rate of interest to fall (to r1) stimulating investment spending.

Aggregate Demand & Supply I 105

 Moreover larger real balances (i.e. wealth) will tend to increase the
propensity to consume. Consequently a new equilibrium will emerge
at point E1 with a higher level of output Y1.
P1 and Y1 can be charted on the bottom diagram and, when combined
with point P0/Y0, an aggregate demand curve is derived. The
aggregate demand curve is always downward sloping. The steepness
or flatness of the aggregate demand curve depends primarily on the
interest elasticity of both the money demand function and the
investment demand function. For further information on this issue see
Dornbusch and Fischer.

Activity 1
Use a diagram like Figure 9-1 to derive the AD curve for an open
economy. Explain carefully why the schedule would be downward
sloping. Would it have a flatter or steeper slope than the closed
economy AD curve in Figure 9-1?. (Hint; remember the effect of a
fall in the domestic price level, ceteris paribus, on the real
exchange rate.)

106 Aggregate Demand & Supply I

Shifting the Aggregate Demand Curve
If any of the ceteris paribus assumptions (see above) are relaxed then
the aggregate demand function will shift. However in this section it is
useful to show how changes in fiscal and/or monetary policy will
cause the curve to shift.

Fiscal Policy
First consider the impact of a fiscal expansion, assuming the general
price level is given - see Figure 9-2 below. The fiscal expansion can
be generated by increased government spending and/or cuts in the
marginal rate of taxation. In the top panel the economy starts with
price level P0 and curves IS0 and LM0, generating an equilibrium with
interest rate r0 and output Y0 at point E. In the bottom diagram it can
be shown that this is compatible with aggregate demand curve AD0.
Holding the price level constant consider the impact of a fiscal
expansion. This is represented in the top panel by a rightward shift in
the IS curve. The rate of interest rises to r 1 and output increases to Y1
- point E1. In other words at the original price level P0 a higher level
of output Y1 is consistent with equilibrium in the goods/money
markets. Charting this down to the bottom panel it is clear that the
aggregate demand curve has shifted to the right, consistent with AD1.
It follows that if there is a fiscal contraction the aggregate demand
curve shifts to the left.

Aggregate Demand & Supply I 107

 LM0
Interest
rate
E1
r1

E
r0
IS1

IS0

Y0 Y1 Real GDP(Y)
Price
level
(P)

P0

AD1

AD0

Y0 Y1 Real GDP(Y)

Figure 9-2: Effect of a Fiscal Expansion on the AD Curve

Thus, summarising these results, we can say:

· Fiscal Expansion shift the aggregate demand curve to the RIGHT
· Fiscal Contraction shifts the aggregate demand curve to the LEFT

Monetary Policy
Consider the effect of a monetary expansion assuming the price
level is constant - see Figure 9-3 below.
Once again the economy starts with price level P 0 and curves IS0
and LM0. The LM curve is defined by the real money supply (i.e.
the nominal money supply Ms0 deflated by the price level P0).
Interest rate r0 and output Y0 are consistent with equilibrium in the
goods/money markets shown by point E. Bringing this down to
the bottom panel it can be shown that point P 0,Y0 is consistent
with aggregate demand curve AD0.

108 Aggregate Demand & Supply I

 LM0
Interest LM1
rate

E
r0
r1
E1

IS0

Y0 Y1 Real GDP(Y)
Price
level
(P)

P0

AD1

AD0

Y0 Y1 Real GDP(Y)

Figure 9-3: Effect of a Monetary Expansion on the AD Curve

Suppose that the nominal money supply is increased by 10% to

Ms1, assuming the price level is constant at P 0. The real money
supply increases thereby shifting the LM curve to the left i.e. LM1
in the top diagram. A new goods/money market equilibrium occurs
with interest rate r1 and output Y1. Charting P0, Y1 on the bottom
panel it is obvious that the aggregate demand curve has shifted to
the right i.e. AD1. It follows that if the nominal money supply is
reduced, ceteris paribus, the aggregate demand curve shifts to the
left.
Again, we can summarise these results as follows:
· Monetary Expansion shifts the aggregate demand curve to the
RIGHT
· Monetary Contraction shifts the aggregate demand curve to the
LEFT.

Aggregate Demand & Supply I 109

 Activity 2
Briefly outline the factors which would cause the aggregate
demand curve to shift.

The Aggregate Supply Curve

For many years the aggregate supply side of macroeconomics was
left rather up in the air. To a large degree this was due to the
dominance of the IS/LM framework which had very little to say
about the supply side of the economy. The aggregate demand/supply
model seeks to rectify this omission.
It is useful to begin by defining the aggregate supply curve.
· The aggregate supply curve shows the combinations of the
general price level and total output where, for a given state of
technical knowledge, the demand for labour equals supply of
labour, and, in this sense, there is a labour market equilibrium.
Before going on to illustrate how an aggregate supply curve is
derived it is useful to review its microeconomic foundations. These
‘microfoundations’ encompass three pieces of theory; first, the
aggregate production function; second, the analysis of the labour
market; and third, the formation of price expectations by the
workforce.

The Aggregate Production Function

The aggregate production function specifies the relationship between
the aggregate volume of factor inputs i.e. labour (N) and capital (K),
and the aggregate volume of outputs (Y).
Hence:
Y  f  N , K

It is usual to hold the number of units of K constant ( K ) and vary

the units of N employed. If this is done a microeconomic law applies,
namely the law of diminishing productivity of a variable factor. An
aggregate production function derived in this way is illustrated in
Figure 9-4 below.

110 Aggregate Demand & Supply I

Y

Y = f (N, K )

Figure 9-4: The Aggregate Production Function

On the vertical axis are units of output (Y), on the horizontal axis are
units of labour (N). As more N is applied to a given capital stock the
total level of output increases but at a diminishing rate, hence the
slope (= the marginal product o labour) gets flatter.

Activity 3
Use a diagram to illustrate and explain the effect on the aggregate
production function of an increase in the given stock of capital, ( K
)

The Labour Market

The aggregate production function does not specify the actual
number of workers employed. In the aggregate demand/supply
framework the volume of employment is determined in the labour
market. More specifically the equilibrium volume of employment is a

Aggregate Demand & Supply I 111

 function of the real wage rate. This position can be illustrated in
Figure 9-5 below.
Real
NS
Wage
(W/P)

W 0/P0

ND

N0 N

Figure 9-5: The Aggregate Labour Market

On the vertical axis is the real wage rate (i.e. the money wage, W,
deflated by the general price level, P), and on the horizontal axis are
units of labour. The labour demand curve (ND) is negatively related to
the real wage, whilst the labour supply curve (Ns) is a positive
function of the real wage. The labour supply curve has imbedded
within it all forms of imperfections and rigidities which exist in the
real world i.e. imperfect information, trade union restrictions,
government regulations etc. It may therefore be called the ‘real
world’ labour supply curve. Where the two curves intersect identifies
the equilibrium real wage (W0/P0), which in turn determines the
equilibrium volume of employment (N0).
It is possible to illustrate the labour market equilibrium using the
money wage rate instead of the real wage - see Figure 9-6 below.
Money
NS (P0)
Wage
(W)

W0

ND (P0)

N0 N

Figure 9-6: The Labour Market (using the money wage)

On the vertical axis is the money wage rate (W), on the horizontal
axis are units of employment (N). The labour demand curve is

112 Aggregate Demand & Supply I

 downward sloping and specified for a given price level, P 0 [i.e.
ND(P0)]. The labour supply curve (Ns) is upward sloping and also
specified for the price level P0 [i.e. Ns(P0)]. An equilibrium money
wage W0, when combined with price level P0, determines an
equilibrium volume of employment N0 - which is consistent with the
position set out in Figure 9-5 above.
In the money wage framework the labour demand and supply curves
are specified for a given price level. If the price level changes the
curves will shift position (see later).
The real wage and money wage illustrations of labour market
equilibrium are inter changeable. In what follows, however, the
money wage framework will be used because of its greater
transparency.

Activity 4
Explain what happens to the demand for labour curve in Figure 9-6
above, when the aggregate price level increases. (Hint; remember
the microeconomic derivation of the labour demand curve.)

The Formation of Price Expectations

There are two groups that form price expectations: the workforce
and firms. The way both groups form expectations needs to be
considered.

The Workforce
To decide how much labour to supply the labour force must estimate
the real wage rate. This may be represented in equational form as,
W 
Ns  f  E 
P 

Aggregate Demand & Supply I 113

 where Ns is labour supply, W is the money wage and P E is the
expected price level.
It should be easy for workers to estimate the money wage rate on
offer (especially for those in employment). Determining the expected
price level, especially when it is not stable, is the difficult part. For
ease of exposition it may be assumed that workers estimate the future
price level by reference to the actual price level. In equational terms
this is represented in the following way:
Pt E 1  p  Pt  (0  p   1)

PE
where t  1 is the expected price level in the next time period, Pt is the
actual price level in the present time period and p' is called the
coefficient of adjustment.
The value of the coefficient of adjustment specifies how well workers
anticipate changes in the future price level when the actual price level
varies.

Case 1: p' = 0
When the value of p' is zero workers do not adjust their price
expectations when the actual price level varies. If, therefore, the
actual price level (Pt) increases by 10%, workers will not anticipate
Pt E 1
any increase in the future price level ( ). This unanticipated
increase in the price level means that for workers the actual price
PE
level and the expected price level are not equal (i.e. t  1 > Pt).
The assumption that p' equals zero is referred to as a condition of
complete money illusion. In this case the labour supply decision by
workers effectively depends only on the level of money wage rates
i.e.
Ns  f  W 
The complete money illusion case is useful in analysing the very short
run periods immediately after a disturbance to the level of aggregate
demand. This assumption will be used when constructing the Extreme
Keynesian Aggregate Supply Curve (see below).

Case 2: 0 < p' < 1

If the value of p' is greater than zero but less than one, workers
partially adjust their price expectations when the actual price level
varies. If, therefore the actual price level (Pt) increases by 10%, and
the value of p' is 0.4, workers will anticipate a 4% increase in the
PE
future price level ( t  1 ). However, the other 6% increase in the price
level will be unanticipated. Once again, from the viewpoint of the
PE
workers, the actual and expected price levels are not equal: (i.e. t  1
> Pt).

114 Aggregate Demand & Supply I

The assumption that O < p' < 1 is referred to as a condition of
imperfect foresight. The imperfect foresight assumption is useful
when analysing the short to medium term impact of a change in
aggregate demand. This assumption will be used when constructing
the General Keynesian Aggregate Supply Curve (see below).

Case 3: p' = 1
The last case where p' is unity relates to a situation where workers
have completely adjusted expectations of the future price level for a
change in the actual price level. If the actual price level (Pt) increases
by 10%, workers fully anticipate a 10% increase in the future price
PE
level ( t  1 ). There is no unanticipated inflation, and the actual and
expected price levels are equal.
The assumption that p' equals unity is called perfect foresight, and is
most usefully applied when considering the long run consequences of
a disturbance to aggregate demand. This assumption will be used
when constructing the Classical Aggregate Supply Curve (see below).

Firms
For ease of exposition it is assumed that firms have perfect foresight
i.e. p' = 1. If a firm's actual product price changes it is immediately
aware of this, and, it is reasonable to suppose, the firm is able to fully
adjust its expectation of the future product price. Hence from the
perspective of firms their actual and expected prices are always equal
and they are clear about the ‘true value’ of the real wage they offer.
This assumption will greatly simplify the analysis which follows.
With these microfoundations it is possible to construct an aggregate
supply curve relevant to a number of different situations.

Activity 5
1. Why do workers form price expectations?

2. Complete the following table assuming that there is a 5%

increase in the actual price level.

Aggregate Demand & Supply I 115

 Price expectation % increase in expected price
level

Complete money illusion

Imperfect foresight (p' = 0.7)

Perfect foresight

Summary
r The aggregate demand and supply (AD/AS) model brings together the IS/LM
analysis of the demand side of the economy with the supply side analysis
based on the labour market and the aggregate production function to
show how the price level and output are simultaneously determined.
r The aggregate demand curve shows the combinations of the price level and
total output where the goods and asset markets are in equilibrium. It is
derived by varying the price level in the IS/LM model.
r Many variables are held constant when drawing an AD curve. Changes in any
of them will cause the AD curve to shift. Most important are changes in
fiscal and monetary policy
r The aggregate supply curve is based on the microeconomic foundations of the
production function, the labour market and price expectations. It shows
the combinations of the price level and total output where, for a given
state of technology, the aggregate labour market is in equilibrium.
r Labour supply depends on the expected real wage; i.e. the money wage
divided by the expected price level in the next period. Workers’
expectation of the future price level are related to changes in the actual
price level according to the coefficient of adjustment, p'.
r Three types of price expectation are possible. Complete money illusion (p' = 0)
where workers do not adjust their expected price level when the actual
price level changes; imperfect foresight (0 < p' < 1) where there is only a
partial adjustment; and perfect foresight (p' = 1) where workers'
expected price level is always equal to the actual price level.

Further Reading
Dornbusch & Fischer: Chapter 7
Burda & Wyplosz: Chapter 12.2
Branson: Chapter 7

116 Aggregate Demand & Supply I