23.1 The demand side of the economy
Exogenous changes in the price level
The AE curve shifts in response to the change in the price level. This shift occurs because a
change in the price level affects desired consumption expenditure and desired net exports.
Changes in consumption:
The relationship between the price level and desired consumption has to do with how changes
in the price level lead to a change in household wealth and therefore to changes in desired
What money can buy is its real value which depends on the price level.
A rise in the price level lowers their real value of money halted by the private sector. A fall in
the price level raises the real value of money held by the private sector.
And other examples of assets that have fits nominal values include governments and corporate
bonds. The bondholder has lent money to the issuer of the bond and receives a repayment
from the issuer when the bond matures.
A rise in the price level means that the repayment to the bondholder is lower in real value than
it otherwise would be. This is a decline in wealth for the bondholder. However, the issuer of
the bond, had been made the repayment of lower real value because of the increase in the price
level, has experienced an increase in wealth.
Changes in the price level change the wealth of bondholders and bond issuers, but because
the changes off set each other, there is no change in aggregate wealth.
Overall, erasing the price level leads to a reduction in the real value of the private sectors
wealth, which leads to a decrease in autonomous desired consumption and therefore a
downward shift in the AE function. And vice versa.
Changes in net exports:
When the domestic price level rises (and the exchange rate remains unchanged), Canadian
goods becomes more expensive religion to foreign goods, therefore Canadian consumers
reduces their purchases of Canadian made goods and increases their purchases of foreign
goods, which have now became relatively less expensive. At the same time, consumers in other
countries reduces their purchases of the now relatively more expensive Canadian made goods.
A rise in the domestic price level (with a constant exchange rate) shifts the net exports
function downward, which causes a downward shift in the AE curve. A fall in the domestic
price level shares than net exports function upward and therefore the AE curve upward.
Changes in equilibrium GDP
Because it causes downward shifts in both net export function and the consumption function,
and exogenous rise in the price level causes a downward shift in the AE curve, causing the
equilibrium level of real GDP to fall. Oppositely, with a fall in the price level, Canadian good became relatively cheaper
internationally so net export rises and also purchasing power of nominal assets increases so
households spend more. The resulting increase in desired expenditure on Canadian good causes
the AE curve to shift upward. The equilibrium level of real GDP therefore rises.
The aggregate demand curve
Aggregate demand (AD) curve: occur showing combinations of real GDP and the price level that
make desired aggregate expenditure equal to actual national income.
It will be plotted with the price level on the vertical axis and a real GDP on the horizontal axis.
Because of rising to axes of both the AE and the AD curves measure real GDP, the two curves
can be placed on one above the other so that the levels of GDP on both can be compared
Given the valid price level, P0, equilibrium GDP is determined in part (i) at the point where the
AE0 curve crosses the 45° line. The equilibrium of real GDP is Y0. Part (ii) shows the same
equilibrium of GDP, Y0, plotted against the price level P0. The equilibrium point in part (i), E0
corresponds to a point E0 in the AD curve in part (ii). As the level of price rises to P1, the AE
curves shipped down to AE1, and the equilibrium level of a real GDP falls to Y1. This determines
the second point on the AD curve, E1. By joining these points trace out the AD curve.
For any given price level, the AD curve shows the level of real GDP for which desired aggregate
expenditure equals to actual GDP.
Because the AD curve relates to equilibrium GDP to the price level, changes in the price level
that causes shifts in the AE curve are simply movements along the AD curve. A movement along
the AD curve thus traces out the response of the equilibrium GDP to a change in the price level. The AD curve it’s not a micro demand curve:
The AD curve is negatively sloped
1. A rise in the price level causes the AE curve to shift downward and hence to a movement
upward and to the left along the AD curve, reflecting a fall in the equilibrium level of GDP.
2. A fall in the price level causes the AE curve to shift upward and hence leads to a movement
downward and to the right along the AD curve, reflecting a rise in the equilibrium level of GDP.
A micro demand curve describes a situation in which the price of one commodity changes while
the prices of all other commodities and consumers dollar incomes are constant. However, for
AD curve, a dollar value of national income is not being held constant as the price level changes
and we move along the AD curve.
Also, a change is price does not change the relative prices of the domestic good and thus does
not cause consumer to substitute between then, however, a change in the domestic price level,
(for a given exchange rate) does lead to a change in international relative price and thus to some
substitution between domestic and foreign products.
The AD curve in negatively sloped for 2 reasons:
A fall in the price level leads to a rise in private sector wealth, which increases desired
consumption and thus leads to an increase in the equilibrium GDP.
A fall in the price level (for a given exchange rate) leads t a rise in the net export and thus leads
to an increase in equilibrium GDP.
shifts in the AD Curve:
For a given price level, any event that needs to win a change in equilibrium GDP will cause the
AD curve to shift. The event could be a change in government policy such as the level of
government purchases or taxation. Or it could be a change in households’ consumption
expenditure, firms’ investment behaviour or filter foreigners’ demand for Canadian exports.
Any changes other than a change in the price level that causes the AE curve to shift will also
cause the AD curve to shift.
Aggregate demand shock: any shift in the aggregate demand curve
For a given price level, an increase in autonomous and aggregate expenditure shifts the AE
curve upward and the AD curve to the right. A fall in the autonomous aggregate expenditure
shifts the AE curve downward and the AD curve to the left.
In order to shift the AD curve, the change in autonomous expenditure must be caused by
something other than a change in the domestic price level. The simple multiplier and the AD curve:
The simple multiplier measures the science in the change in equilibrium national income in
response to a change in autonomous expenditure when the price level is held constant. It
follows that this multiplier gives the size of the horizontal shift in that AD curve in response to a
change in autonomous expenditure.
The simple multiplier measures the horizontal shift in the AD curve in response to a change in
autonomous desired expenditure.
23.2 the supply side of the economy
The aggregate supply curve
And if supply refers to the total output of goods and services that firms would like to produce.
Adequate supply (AS) curve: a curve showing the relation between the price level and the
quantity of aggregate output supplied, for given technology and factor prices
The positive slope of the AS curve:
Costs and output:
Unit costs: cost per unit of output, equal to total cost divided by total output
The aggregate supply curve is drawn on the assumption that technology and the prices of all
factors of production remain constant, however, this does not mean that unit costs will be
As output increases, less efficient standby plants may have to be used, and less efficient to
workers may have to be hired, to while existing workers may have to be paid overtime rates for
additional work. For these and other similar reasons, unit costs will tend to rise as output rises,
even when technology and input prices are constant.
Price and output:
To consider their relationship between price and output, and we need to consider firms that sell
until a distinct type of markets: those in which firms are price takers and those in which forms
are price setters
If the unit costs rise as with output, price taking firms will produce more only if price
increases. They will produce less if only the price falls.
If the demand for the output of price setting firms increases sufficiently to take their outputs
into the range in which their unit costs rise, these firms will not increase their outputs unless
they can pass at least some of these extra costs on through higher prices. When demand falls,
they will reduce output, and competition among them will tend to cause the production in
prices whenever there unit cost falls.
Price setting firms will increase their prices when the