AD AS

▪ Distinguish between “demand” for a product and “aggregate demand”.

▪ Explain why the aggregate demand (AD) curve is downward-sloping.

▪ Explain how the AD curve could shift due to a change in consumption, investment, govt spending and net exports.

EQMIN MICROECONOMICS

EqM IN MACROECONOMICS

0
Quantity

Price

Supply

Demand

P

Q

Product / Factor Market

0
Real national output

General price level

Aggregate
supply (AS)

Aggregate

Demand (AD)

P

Y

Economy

EQM IN MICROECONOMICS

EqM IN MACROECONOMICS

0
Quantity

Price

Supply

Demand

P

Q

1. Why does the price of oil fall?
2. Why is the market for luxury cars

such as BMW growing?

0
Real national output

General price level

Aggregate
supply (AS)

Aggregate

Demand (AD)

P

Y

1. What is the impact of falling oil price on

the Singapore economy?

2. What is the impact of rising world sales of BMW cars on the German economy?

Aggregate demand is the planned spending on domestic goods and services at
different avg or GPLs, per period of time. It consists of consumption, investment
and government expenditures plus net exports.

Consumption Expenditure (C)

Investment Expenditure (I)

Government Expenditure (G)

Net Exports (X-M)

AD = C + I + G + (X – M)

• Shows the r/s between total amount of o/p that will be demanded at each price

level

• Downward-sloping. Reasons being:

• Wealth / Real Balance effect
• Substitution effect
• Interest rate effect

General price level

0

Real national
output

AD

P2

P1

Y2
Y1

The higher the general price level, the lower the
o/p demanded by the economy, c.p.

A change in GPL --> movement along the AD curve

a. Wealth or Real Balance effect

↑ prices

Real value of households’ assets such as cash and bank deposits ↓

Real income ↓ (assuming wages lag behind ↑ price)

↓ wealth in real terms+ ↓ purchasing power of $ Y/ real Y →↑ savings and ↓C

↓ aggregate

quantity demanded

b. Substitution effect

↑ prices

X become relatively more expensive

M become relatively cheaper

if PED > 1 for X, ↑P leads to more than proportionate ↓ in QDD for X, ceteris paribus

Export revenue ↓

Import expenditure ↑
Hence, net exports ↓

↓ aggregate quantity

demanded

c. Interest rate effect

↑ prices

Real value of money ↓→ Borrow more money

↑ DD for money

Interest rate ↑ → C & I ↓

↓ aggregate quantity

demanded

Multiple Choice

What causes a movement along the AD curve?

• Changes in GPL

• Changes in consumption expenditure

• Changes in interest rates

• Changes in government expenditure

Multiple Choice

Which of the following is not reason for the shape of the AD curve?

• Wealth Effect

• Substitution Effect

• Interest Rate Effect

• Tax Effect

Change in any of its component parts which is not due to changes in the price levels

Consumption

Net Exports

Government Expenditure

Investment

Real national output

General price level

AD
AD2

AD1

0

Increase in AD

Decrease in AD

Figure 2: Shifts of AD curve

CAUSES OF SHIFTS OF AD CURVE

Consumption

Consumption refers to the spending by households on durable and non-durable
goods and on services over a period of time.

↑ Consumption

↓ taxation (i.e. personal income tax)

→ ↑ disposable income, where

disposable income = income - tax

Consumption

Consumers’ expectation of the future (future px & $ Y) →
e.g. expectations on ↑ in pxs → increase CURRENT spending

Consumption

↑ Consumption

↑ wealth e.g. inherit a fortune → ↑ spending even though no

change in Y

household indebtedness→committed to installment

payments on previous purchases or little accumulated past

savings → ↓ current C to ↓ indebtedness

Consumption

↑ Consumption

↓ interest rate (cost of borrowing money or the reward for

saving money over a period of time expressed as a

percentage)→ ↓ cost of borrowing -->--likely to borrow at any

given Y

↑ consumer confidence (a measure of how optimistic

consumers are about their future income and the future of
the economy)→ expect Y to increase or more optimistic about

the future → ↑ C now

Change in any of its component parts which is not due to changes in the price levels

Consumption

Investment
Government
Expenditure
Net Exports

taxation

Consumers’ expectation

of the future

Wealth, present debt

position

Cost & availability of

credit (i/r)

Consumer confidence

Multiple Choice

Which of the following will lead to a fall in consumption expenditure?

• Rise in consumer confidence

• Rise in interest rates

• Rise in income

• Rise in wealth

Open Ended

Explain how recession affects the AD of an economy?

Investment

Investment refers to spending by firms on capital goods such as machines, tools, equipment and factories.

Investment

↑ Investment

△ govt policy i.e. ↓ corporate tax →↑ post-tax profits → ↑

investment

e.g. reduction in Singapore’s corporate tax from18% to 17%

(from 2009 onwards)

Investment

↑ Investment

↓ interest rate → ↓ cost of borrowing

Extent of ↑ investment depends on interest elasticity of demand for investment

i.e. if DD for investment is interest elastic → ↓ i/r leads to a

more than proportionate ↑ in investment

Investment

↑ Investment

↑ in efficiency in machines→-->more output can be produced

with same amt of capital --> → ↑ returns from investment

improvement in tech -- -->development of more sophisticated &

better capital goods -->→ present stock of capital becomes

obsolete --> → new investment necessary

Investment

↑ Investment

↑ business confidence (a measure of the degree of

optimism that businesses have about the economic future)

→optimism about future economic conditions→expect ↑ in

revenues from I

↓ level of corporate indebtedness (the sum of what a

corporation owes to banks or other holders of its debt) →
↓ funds channeled to debt-servicing → ↑ fund for investment

Change in any of its component parts which is not due to changes in the price levels

Consumption

Investment
Expenditure
Net Exports

Rate of interest

Cost and efficiency of

capital equipment

Govt policies –

taxation, regulation

Business expectations

Level of corporate indebtedness

taxation

Consumers’ expectation

of the future

Wealth, present debt

position

Cost & availability of

credit (i/r)

Consumer confidence

Multiple Choice

Which of the following leads to a rise in Investment?

• Rise in interest rates

• Fall in corporate tax rates

• Rise in corporate indebtedness

• Poor economic outlook

Open Ended

Explain how a rise in interest rates affect investment components of the AD?

Open Ended

What other components of the AD does a rise in interest rates affect? Explain how it is affected.

Government
Expenditure

For component of AD,
✓ Includes expenditure on goods and services e.g. on MRT
⨯ Excludes transfer payments



E.g.  in G to boost the economy



Former Japanese PM Shinzo Abe:  govt spending on
infrastructure products (one of the arrows in
“Abenomics”)

Government expenditure refers to all spending by the govt that is distinguished
into current expenditures, capital expenditures and transfer payments.

Multiple Choice

Which of the following causes an increase in government expenditure?

• Recession

• Rise in unemployment benefits

• Rise in healthcare subsidies

• Economic Boom

Net Exports

The difference between export earnings and import expenditure on goods and
services is known as net exports.

Net exports = Export revenue – Import expenditure

•Expenditure by foreigners on a
country’s domestically produced goods

•Direct contribution to country’s national
income

•Country’s purchases of goods & services
from other countries

•Do not generate income for the country

Hence, should be deducted.

Net Exports

Net exports = Export revenue – Import expenditure

1.

Change in the exchange rates

2.

Change in relatively Y levels (to be revisited in IBDP2)

3.

Government trade policies (to be studied in IBDP2)

Net Exports

Net exports = Export revenue – Import expenditure

1. Change in the exchange rates

Year

Singapore

dollars
(SGD)

Malaysia
Ringgit
(MYR)

2015

1

2.60

2023

1

3.45

Singapore dollars appreciates/
Malaysian ringgit depreciates

Net Exports

Net exports = Export revenue – Import expenditure

1. Change in the exchange rates

If Singapore dollar appreciates,
•Singapore’s export are more expensive in foreign currencies

•Assuming DD for exports are price elastic, qty demanded for exports ↓ more than
proportionately, ceteris paribus →export revenue ↓

If Singapore dollar appreciates,
•Singapore’s imports are cheaper in domestic currency

•Assuming DD for imports are price elastic, qty demand for imports ↑ more than
proportionately, ceteris paribus →import expenditure ↑

Net Exports

Net exports = Export revenue – Import expenditure

1. Change in the exchange rates

•Export revenue ↓ and import expenditure ↑

•(X-M) ↓

•Ceteris paribus, AD ↓

Real national output

General price level

AD
AD2

AD1

0

Increase in AD due to  C, I, G

and/or (X-M)

Decrease in AD due to
 C, I, G and/or (X-M)

Figure 2: Shifts of AD curve

Multiple Choice

Which of the following does not cause a change in net exports of Singapore?

• Appreciation of SGD

• Increase in real national income of SG

• Recession in trading partners' economies

• Increase in income tax rates in Sg

▪ Explain why the short-run aggregate supply (SRAS) curve is upward-

sloping.

▪ Explain how the AS curve in the short run can shift.

▪ Explain the monetarist/ new classical model of the LRAS curve.

▪ Explain the Keynesian model of the AS curve.

▪ Compare and contrast, using the monetarist/ new classical & Keynesian

models, the shift of the AS curve in the long run.

Aggregate supply is the planned level of output domestic firms are willing and
able to offer at different average or general price levels.

Short-Run aggregate supply curve (SRAS)

SRAS curve shows the amount of goods and services that all firms are willing
and able to produce for sale at each price level, assuming that prices of FOPs,
technology and total supply of FOPs remain constant

-

• Upward sloping

• The higher the general price level, the

higher will be the real output supplied for
the economy, ceteris paribus.

Why?

• Firms’ profitability → ↑ prices, assuming

resource prices remain unchanged → COP
remains unchanged → profit increases →
firms ↑ qty of output produced

• Thus, +ve relationship between GPL and real GDP

△ price → movement along the SRAS curve

•includes GST

•↑ COP for firms

•SRAS ↓

△ in indirect taxes

e.g. △ in prices of oil,

equipment, capital goods,

land inputs

•↑ input prices, assuming
prices remain constant →

COP ↑ → SRAS ↓ →

leftward shift

△ in non-labour
resources prices

Change in any of the factors which is not due to changes in the price levels

e.g. △ in minimum wage legislation, △s
brought about by labour union bargaining

with employers

•↑ wages, assuming prices remain constant

→ COP ↑ → SRAS ↓ → leftward shift

△ in costs of FOPs → e.g. △ in wages

Real national output

General price level

SRAS1

SRAS3

SRAS2

0

Increase in SRAS due to
fall in COP in economy

and indirect taxes

Decrease in SRAS due to
rise in COP in economy

and indirect taxes

Figure 4: Shifts of SRAS curve

Draw

Sketch how an increase in oil prices would affect the SRAS.

5 minutes

reading time
(Pg 36-37)

Real national output

General price level
LRAS1

0

In the long run, GPL
has no effect on level
of output produced in

an economy

Figure 5: LRAS curve

Yf

Vertical at

potential GDP/full
employment level

of real GDP, Yf

According to Monetarist/ New Classical economists: All resource prices

including wages change to match changes in price level in LR

E.g. ↑ GPL → firms’ profits ↑ in SR → firms ↑ production → move
upward along an upward sloping SRAS curve → real GDP ↑ in SR

But in LR, wages (or other resource prices) will adjust/ ↑ by the

same amount as ↑ in GPL

→No change in firms’ profits  No incentive to produce more

According to Monetarist/ New Classical economists: All resource prices

including wages change to match changes in price level in LR

E.g. ↓ GPL → firms’ profits ↓ in SR → firms ↓ production → move

downward along an upward sloping SRAS curve → real GDP ↓ in SR

But in LR, wages (or other resource prices) will adjust/ ↓ by the

same amount as ↓ in GPL

→No change in firms’ profits  No incentive to lower production

Changes in
quantities of

FOP

Changes in

qualityof FOP

Improvements
in technology

Changes in
efficiency

Institutional

changes

Reduction in the

natural rate of
unemployment

Changes in quality of FOP

• ↑ in quality of FOP → e.g. greater levels of education, skills or health →

produce > o/p than the same no. of unskilled or less healthy workers →
LRAS curve shifts right

Improvements in technology

• Improved technology of production → e.g. improved machines and equipment as a

result of technological innovations → produce more o/p in the same amt of time ---> LRAS curve shifts right

Summary:

Even as GPL ↑ or ↓, with constant real costs

(△ in wages/other resources prices match △ in GPL)

→ firms’ profits are also constant

→ Firms have no incentive to change their o/p level

Changes in quantities of FOP

• ↑ in quantities of FOP → LRAS curve

shifts right

• E.g. ↑ in quantity of physical capital

(i.e. new oil reserves) → ↑ in
capability to produce more real GDP

• LRAS1 to LRAS2→ potential output ↑

from Yf1 to Yf2

Real national
output

General price level

LRAS1

0

Figure 6: Shift in the LRAS curve

Yf1

LRAS2

Yf2

Changes in efficiency

• ↑ in efficiency → makes better use of its scarce resources → produce a greater qty of o/p → increase potential o/p → rightward shift of LRAS

Institutional changes

•E.g. govt introduces more competition by deregulating mkts  allows for more
firms in the market → Rise in efficiency in economy (related to previous point)

Reductions in natural rate of unemployment

• Natural rate of unemployment @ Yf

• unemployment that is ‘normal’ or ‘natural’ for an economy when it is

producing at its ‘full employment’ level of output

• Includes: unemployed people who are in between jobs; retaining etc.
• i.e. full employment → when unemployment = natural rate of unemployment

• Natural rate of unemployment differs from country to country & can change over

time.

• If natural rate of unemployment decreases → LRAS curve shift to the right

Real national
output

General price level

LRAS1

0

Figure 6: Shift in the LRAS curve

Yf1

LRAS2

Yf2

Possible causes:
•↑ in quantity of resources

•↑ in quality of resources

•Improvement in tech

•Institutional changes

•Fall in natural rate of unNt

LRAS3

Yf3

Possible causes:
•↓ in quantity of resources

•↓ in quality of resources

•Improvement in tech

•Institutional changes

•Increase in natural rate
of unNt

Multiple Select

Which of the following results in an increase in the LRAS?

• Increase access to healthcare service

• Substantial increase in skilled labour flowing into the country

• New discovery of oil reserves within the country

• Increase in internal conflicts

Draw

Sketch the impact using an appropriate diagram.

John Maynard Keynes
(1883-1946)

Monetarist/ new classical
model where:
• All resource prices & product

prices are fully flexible and;

• Economy automatically tends

towards full employment

Keynesian model of AS:
•Wages & prices are sticky downwards

•When unemployment is low, wages quickly ↑

•BUT when in recession, wages do not fall readily
due to labour contracts. Since COP does not fall,
firms will not be willing to lower prices of goods (i.e.
product prices)

•Economy cannot move into long run

In the Keynesian model, inflexible
wages and prices mean that the
economy cannot move into the long run.
Inflexible wages and prices are shown
graphically by a horizontal section of
the Keynesian aggregate supply (AS)
curve.

General price level

0
Y1
Yf

Figure 7: Keynesian AS
curve

Real national
output

AS

General price level
AS

0
Y1
Yf

Figure 7: Keynesian AS
curve

Between Y1
and Yf:
•PES 
•Less spare
capacity in the
economy ➔
in COP

Output < than Y1: perfectly price elastic AS becos’ of abundance of
unemployed resources ➔ increase in production without rise in prices

At Yf: Full employment,
also known as country’s
potential/full-
employment level of
national output ➔ No
change in output when
prices , i.e. perfectly
price inelastic AS

Real national output

1. Changes in the quantity & quality of the country’s
resources such as land, labour and capital

Change in any of the factors which is not
due to changes in the price levels

▪ ↑ stock of a country’s resources, e.g. productivity of

labour force through training and education

▪ ↑ productive capacity

▪ ↑ potential output or full-employment level of real

GDP to Yf1

▪ Vertical portion of AS shifts right

Real
GDP

General Price
Level

Yf0
0

AS1
AS0

Yf1

Whole vertical
section of AS
curve shifts right

Fig 8: Shift of AS curve

2. Changes in the level of technology

Change in any of the factors which is not
due to changes in the price levels

▪ E.g. better machine leading to more efficient

production

▪ ↑ productive capacity

▪ ↑ potential output or full-employment level of real

GDP to Yf1

▪ Vertical portion of AS shifts right

Real
GDP

General Price
Level

Yf0
0

AS1
AS0

Yf1

Whole vertical
section of AS
curve shifts right

Fig 8: Shift of AS curve

▪ Changes in the quantity & quality of country’s resources & changes in the

level of technology → cause full-employment level of real GDP/potential
output to rise in the LR

▪ The other factors that shift the Keynesian AS are similar to the ones under

“Factors that change AS (shift LRAS curve) over the long term”

Short-Run aggregate supply curve (SRAS)

B. Keynesian aggregate supply curve

A. Monetarist/ New Classical model of the
long-run aggregate supply curve (LRAS)

Alternative Views of AS:

Multiple Choice

A change in the country's productive capacity will have an impact on the LRAS.

• True

• False

Multiple Choice

The same factors that affect the LR Keynesian AS also affect the LRAS of the monetarist/new classical model.

• False

• True

▪ Explain the determination of short-run equilibrium.

▪ Explain changes in short-run equilibrium.

▪ Explain the determination of long-run equilibrium using the monetarist/ new classical

model.

▪ Explain changes in long-run equilibrium using the monetarist/ new classical model.

▪ Explain that the economy may be in equilibrium at any level of real output using the

Keynesian model.

▪ Contrast the Keynesian model with the monetarist/ new classical model in explaining

impact on GPL when AD rises.

Macroeconomic equilibrium occurs when the AD
equals to AS. This means that the amount of
output that producers or firms plan to produce is
equal to what the economy desires to purchase.

Real National output

General price level

SRAS

0
Y0

AD

P0

E0

Figure 9: SR Eqm level of real GDP & GPL

At P0, i.e. at P1
•AD = AS

•Total exp by households, firms, govt & rest of
the world is exactly = to total amt of planned
output produced by the firm

Real National output

General price level

SRAS

0
Y0

AD

P0

E0

Figure 9: SR Eqm level of real GDP & GPL

• Eqm is reached when AD=AS, i.e. total desired

spending = amount of output firms plan to
produce

• Determines the level of output & employment in

the economy

Real National output

General price level

SRAS

0
Y0

AD

P0

E0

Figure 9: SR Eqm level of real GDP & GPL

If GPL < P0, i.e. at P1
•shortages in the economy

•drive up prices

•greater incentive for firms to ↑ production
because of ↑ profits

•Real national output ↑ along the AS curve
until equilibrium is reached at E0

P1

If GPL > P0, i.e. at P2
•surplus in the economy

•drive down prices

•GPL keeps falling until equilibrium is reached
at E0

P2

Multiple Select

What are the 2 ways to increase real national output?

• Increase AD

• Increase SRAS

• Increase LRAS

• Decrease in SRAS

SR

Real national output

General price level

SRAS
AD0

P0

Y

AD1

Y1

P1

0

Figure 8: Rise in AD

E0

E1

Original eqm at E0 with real national output and
GPL at Y0 and P0 respectively

Rise in government spending → increase in
AD and AD curve shifts to the right from AD0 to
AD1

•New equilibrium is reached at E1

•Higher GPL and real national output at P1
and Y1 respectively

SR

Original eqm at E0 with real national output and
GPL at Y0 and P0 respectively

fall in COP due to fall in wages → increase in
SRAS and SRAS curve shifts to the right from
SRAS0 to SRAS1

Real national
output

General price level

SRAS0

AD0

P0

Y

Y1

P1

0

Figure 9: Rise in AD

E0

E1

SRAS1

•New equilibrium is reached at E1

•Lower GPL and higher real national
output at P1 and Y1 respectively

MONETARIST/NEW

CLASSICAL MODEL

General price level

SRAS1

0

AD

P0

Figure 12: LR eqm level of real GDP & GPL

Real national
output

LRAS

Recessionary/

deflationary gap:

Real GDP <
Potential GDP

(Yf)

Related concepts:

Recessionary/Deflationary

Gap & Inflationary Gap

Inflationary gap:

Real GDP >
Potential GDP

(Yf)

Yf

MONETARIST/NEW

CLASSICAL MODEL

Assume economy initially @ LR eqm

producing @ Yf

General price level

SRAS1

0

AD1

P1

Figure 13a: Creating recessionary gap

Real national output

LRAS

AD falls (for e.g. due to fall in (X-M)) →

AD curve shifts to the left from AD1 to AD2

Recessionary/ Deflationary

Gap arises since Yrec< Yf

AD2

Yrec

P2

Yf

MONETARIST/NEW

CLASSICAL MODEL

As GPL falls from P1 to P2,
wages and other resource

prices also fall

General price level

SRAS1

0

AD1

P1

Figure 13a: Eliminating recessionary gap

Real national output

LRAS

COP falls → SRAS rises →

SRAS curve shifts to the

right from SRAS1 to SRAS2

Economy cannot remain

there in the LR → will adjust

to LR eqm automatically

AD2

Yrec

P2

SRAS2

P3

fall in GPL to P3 and Yf is

attained

Yf

CLASSICAL MODEL

LR eqm attained when LRAS, SRAS and
AD curves intersect at a common point

General price level

SRAS

Yf

AD

P0

Figure 12: LR eqm level of real GDP & GPL

Real national
output

LRAS

LR eqm GPL: P0

LR eqm real GDP: Yf (full Nt level of real

GDP or potential real GDP)

Related concepts:

Recessionary/ Deflationary

Gap & Inflationary Gap

​monetarist/new

0

MONETARIST/NEW

CLASSICAL MODEL

Assume economy initially @ LR eqm

producing @ Yf

General price level

0

AD1

P1

Figure 13b: Creating inflationary gap

Real national output

LRAS

AD rise (for e.g. due to rise in G) → AD
curve shifts to the right from AD1 to AD2

Inflationary Gap arises since

Yinfl > Yf

AD2

Yinfl

P2

SRAS1

Yf

MONETARIST/NEW

CLASSICAL MODEL

General price level

SRAS1

0

AD1

P1

Figure 13b: Eliminating inflationary gap

Real national output

LRAS

AD2

Yinfl

P2

As GPL rises from P1 to P2,
wages and other resource

prices also rise

COP rises → SRAS falls →

SRAS curve shifts to the
left from SRAS1 to SRAS2

Economy cannot remain

there in the LR → will adjust

to LR eqm automatically

Rise in GPL to P3 and Yf

is attained

SRAS2

P3

Yf

KEYNESIAN

Real
national
output

General
price level
AS

0

Figure 4a: Recessionary Gap

AD

-AD intersects AS curve in its
horizontal section

-Y1 < Yf

-UnNt > natural rate

-Recessionary gap

Y1

Yf

KEYNESIAN

Real national
output

General
price level

0

Figure 14b: Inflationary Gap

AD1

AD2

P1

P2

- Producing @ Yf

-Any increase in AD cannot
be met by extra output →
excess demand

-Inflationary gap

-Price level increases

-Demand-pull inflation

AS

Yf

Open Ended

What are the 2 possible SR equilibrium positions of the economy when equilibrium level of real GDP differs from potential GDP?

RECESSIONARY GAPS CAN PERSIST

An economy can remain in a recessionary gap for a long

period of time. Why?

1. Inability of wages & prices to fall (unlike Monetarist/New Classical Model)

2. Insufficient aggregate demand

 There is a need for govt to intervene (through pump priming -Increase G)

KEYNESIAN

Rise in AD need not cause rise in GPL (unlike

Monetarist/ New Classical Model)

RECESSIONARY GAPS CAN PERSIST

Keynesian analysis → a short-run analysis

In the Keynesian perspective, the economy does not

automatically tend towards full Nt eqm.

Open Ended

What is the key difference between the Keynesian view and Monetarist/New Classical view?

Draw

Draw a Keynesian AS curve.

As economy approaches
full employment:  in
AD from AD2 to AD3
 GPL from P1 toP2 with
smaller  in real
national output from Y2
to Yf

0

General Price Level

Real National Output

P0

P1

P2

P3

Assume economy
initially at Y0

AS

AD4

AD3

AD2

AD1

AD0

Because of unemployed
resources:  in AD from
AD0 to AD1 does not
affect GPL. GPL
remains at P0 as real
national output  from
Y0 to Y1

Economy at full
employment:  AD
from AD3 to AD4 
GPL from P2 to P3 with
no  in real national
output

Y1

Yf

Yf

Y0

Y2

Open Ended

Explain why when AD intersects the Keynesian AS at the horizontal part, only real GDP increases without affecting the GPL

Open Ended

Explain why when AD intersects the Keynesian AS at the vertical part, only GPL increases without affecting the real GDP.


AD and AS framework useful to analyse:
Why macroeconomic problems arise e.g. slow economic growth, inflation, unemployment, etc.

How macroeconomic policies can solve the problems

E.g. G --> AD --> NY