Aggregate demand and supply
This page introduces the concept of aggregate demand and aggregate supply and your students will need to understand that the AD of an economy is the sum of the collective individual demand curves. You should also emphasise that governments have considerable ability to control the level of AD in the economy and also that the control of this variable is a crucial part of government economic policy. Similarly, that aggregate supply is a combination or aggregate of all of the individual supply curves in the economy. Like an individual supply curve this slopes upwards from left to right.
What do aggregate demand and supply mean? What factors might lead to a change in either AD and / or AS?
Lesson time: 70 minutes
Distinguish between the microeconomic concept of demand for a product and the macroeconomic concept of aggregate demand.
Construct an aggregate demand curve, and explain why the AD curve has a negative slope.
Describe consumption, investment, government spending and net exports as the components of aggregate demand.
Define the term aggregate supply. Explain, using a diagram, why the short-run aggregate supply curve (SRAS curve) is upward sloping.
Explain, using a diagram, how the AS curve in the short run (SRAS) can shift due to factors including changes in resource prices, changes in business taxes and subsidies and supply shocks.
Aggregate demand - the total spending in an economy consisting of consumption, investment, government expenditure and net exports. This is calculated by the formulae: C+G+I+(X-M).
Private consumption (C) - spending by households on domestic consumer goods and services over a period of time.
Government spending (G) - public sector spending whether by national or local governments. This includes spending on public services such as health, education, public transport, defence and infrastructure projects.
Investment (I) - expenditure by firms on capital equipment and is an injection into the economy.
Net exports (X-M) - the value of exports (ie export revenues) - value of import (ie import expenditures).
Aggregate supply - also known as total output, is the total supply of goods and services produced within an economy at a given time and at an overall price level.
Supply shock - an unexpected event that impacts on the supply of a product or commodity, resulting in a sudden change in price. Supply shocks are generally negative, resulting in a sudden fall in supply but can also sometimes be positive, leading to increased supply.
Price level / average price level - the average of current prices across the entire spectrum of goods and services produced in the economy.
The activities are available in PDF at: Aggregate demand and supply
Draw a normal demand and supply curve for a good or service. Now consider how this might look if you were drawing a demand and supply curve for the whole economy? Instead of price write average price and instead of quantity label the horizontal axis real GDP, real national output or real national income.
Now consider what determines the level of aggregate demand and supply within any economy?
Watch the following short video and then answer the questions that follow:
1. The diagram to the right illustrates the aggregate demand curve for a nation.
(a) What is the formulae for calculating AD in the economy?
(b) Explain the inverse relationship between average price level and quantity demanded.
(c) Provide examples of durable and non-durable goods.
(d) Why are individuals 'investing' in the stock market or placing their savings in bank deposits not included under investment in AD calculations?
(e) What is net investment spending?
(f) How is the external balance (X-M) calculated?
(g) What is the opportunity cost of any investment decision.
(h) The government is forced to cut spending on services and public works. Outline the consequence of this for aggregate demand in the economy?
Activity 3: Aggregate supply
Begin with the following short video before completing the questions that follow:
1. The diagram to the left illustrates a short run AS curve.
(a) Explain the relationship between average price level and the aggregate supply of goods and services in the economy?
(b) Explain what happens to SRAS when real output in the economy moves from Y1 to Y2.
Activity 4: Shifts in the AS curve
An economy is in equilibrium at PL1 and Y1. Calculate the new equilibrium as a result of the following supply shocks:
1. The government raises the level of minimum wage in the country, above the rate of productivity growth.
2. A sharp fall in oil prices, resulting from a glut in global supply.
3. A significant fall in the value of a nation's currency compared to its main trading partners.
4. A period of very low interest rates, over a sustained period of time.
5. A rise in the rate of sales tax.
Activity 5: Practise questions
Illustrate the effect on either AS and / or AD of the following:
(a) A rise in income tax in the economy.
(b) A fall in oil prices.
(c) A rise in interest rates in the economy.
(d) A rise in minimum wage.
(e) A rise in the value of the currency relative to the country's main trading partners.
(f) A fall in corporation tax rates.
Watch the following short video and then answer the questions which follow:
1. Outline the factors currently contributing to the growth of aggregate demand in the UK economy?
2. Evaluate the outlook for overall demand in the UK economy described in the video?
Activity 7: Link to the paper one examination
Examples of typical paper one questions include:
(a) Explain how a rise in either business or consumer confidence can affect economic growth. [10 marks]
(b) Using real world examples, discuss the view that rises in economic growth will also lead to improved living standards in a country. [15 marks]