23.1 The Demand Side of the Economy
The AE curve will shift in response to a change in the price level.
o Due to the fact that the change in the price level will affect
consumption expenditure and desired net exports.
Consumption is affected by a change in the price level because the price level
o A rise in the price level lowers the real value of money held by the
o A fall in the price level raises the real value of money held by the
Changes in the price level change the wealth of bondholders and bond
issuers, but because the changes offset each other, there is no change in
o Rise in the price level benefits the issuer of the bond (they pay less in
real terms; bondholder receives less in real terms).
A rise in the price level (in summary) leads to a reduction in the real value of
the private sector’s wealth.
o A decrease in wealth, in turn, leads to a downward shift in the AE
A rise in the domestic price level (constant exchange rate) shifts the NX
function downward, which causes a downward shift in the AE curve.
A fall in the domestic price level shifts the NX function upward, which causes
an upward shift in the AE curve.
An exogenous change in the price level causes the AE curve to shift and
equilibrium GDP to change.
Aggregate demand (AD) curve: a curve showing combinations of real GDP
and the price level the make desired aggregate expenditure equal to actual
o The price level and real equilibrium GDP are negatively related to
For any given price level, the AD curve shows the level of real GDP for which
desired aggregate expenditure equals actual GDP.
The AD curve is negatively sloped for two reasons:
o 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
o A fall in the price level (for a given exchange rate) leads to a rise in net
exports and thus leads to an increase in equilibrium GDP.
Since the AD curve plots equilibrium GDP as a function of the price level,
anything that alters equilibrium GDP at a given price level must shift the AD
Aggregate demand shock: any shift in the AD curve. For a given price level, an increase in autonomous aggregate expenditure
shifts the AE curve upward and the AD curve to the right (vice-versa).
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
Aggregate supply (AS) curve: a curve showing the relation between the price
level and the quantity of aggregate output supplied, for given technology and
Unit cost: cost per unit of output, equal to total cost divided by total output.
o Will tend to rise as output rises even when technology and input pries
If their unit costs rise with output, price-taking firms will produce more only
if price increases (produce less if the price falls).
Price-setting firms will increase their price when they expand their output
into the range where unit costs are rising.
o They will eventually decrease their prices (usually due to the nature
of competition) if a reduction in their output leads to a reduction in
The actions of both price-taking and price-setting firms cause the price level
and the supply of output to be positively related.
The slope of the AS curve gradually becomes steeper and steeper moving
from left – right (due to the law of diminishing returns).
o This increasing slope of the AS curve is sometimes called the first
asymmetry in the behaviour of AS.
For a given level of output, anything that changes firms’ production costs will
cause the AS curve to shift.
o I.e. changes in the prices of inputs and changes in productivity.
Input prices can change for two reasons:
o Change due to things that are internal to the model (endogenous
I.e. an increase in production raises demand for inputs and will
raise their prices.