Economics Chapter 8 Summary
AGGREGATE DEMAND AND AGGREGATE SUPPLYf4fdb330838e4f65f0538beddd297386.jpg

Macroeconomics seems like a hard topic to understand this is why it is always good to know the topic in simple terms beforehand. So let's watch an intro video first!

When we talk about macroeconomics, it is important to understand the key points of Aggregate Demand and aggregate supply.


  • Fluctuations in the growth of real output, consisting of alternating periods of expansion (increasing real output) and contraction (decreasing real output) are called business cycles or trade cycle or economic fluctuations.
  • Each cycle consists of a period of expansion or growth in real GDP, followed by a period of contraction or decline in real GDP (negative growth).

  • Expansion- occurs when there is positive growth in real GDP. During periods of growth in real GDP, employment of resources increases and the general price level of the economy usually begins to rise more rapidly than before. (In other words, inflation)
  • Peak- represents the cycle's max level of real GDP and marks the end of the expansion.
  • Contraction- following the peak, economy experiences falling real GDP (negative growth). If it lasts more than 6 months = recession. There is unemployment of resources and an increase in price level slows down considerably.
Trough- the cycle's minimum level of GDP. There is widespread unemployment and it is followed by a new cycle.
  • As real GDP increases, unemployment falls and as real GDP falls, unemployment increases.
  • Full employment level of output or real GDP (also known as potential output or potential GDP)- is the level of real GDP at which unemployment is equal to the natural rate of unemployment. The natural rate is the unemployment that exists when there is "full employment".
  • When actual GDP lies above potential GDP or below potential GDP, there results a GDP gap or output gap. The output gap is simply actual GDP minus potential GDP and may ne positive or negative.
  • Aggregate Demand- is the total quantity of goods and services that all buyers in an economy want to buy at different price levels, ceteris paribus. It it represented by real GDP.
  • The aggregate demand curve shows the relationship between the real GDP demanded and the economy's price level, ceteris paribus.
  • Aggregate demand includes: The demand of consumers (C), the demand of business (I), the demand of government (G), the demand of foreigners for exports (X) minus the demand for imports (M) (X-M or net exports).
  • The aggregate demand curve is downward sloping; there is an inverse relationship.
  • Aggregate demand slopes down because of: The wealth effect- changes in price level affect the real value of people's wealth. The interest rate effect- changes in price level impact upon rates of interest, which in turn affect aggregate demand. The international trade effect- if price levels increase in the domestic economy while in other countries it remains the same, exports will be more expensive and demand for exports will fall. At the same time, will increase because they are relatively cheaper.

So, now let's get to the fun part! Let's get to see how shifts occur:

  • Factors that can shift the aggregate demand curve: changes in wealth, changes in expectations about future income, and expectations about the future of the economy. Changes in interest rates, changes in personal income taxes, changes in the level of household indebtedness and changes in the attitude towards spending. Investment spending: changes in expectations about future sales, changes (improvements) in technology, changes in interest rates, changes in business taxes, legal/institutional changes. Government spending: changes in political priorities, efforts to influence aggregate demand. Net Exports: changes in real national income abroad and changes in exchange rates.
Increase in Demand Curve
Decrease in Demand Curve

  • The short run in macroeconomics is the period of time during which the nominal prices of resources, particularly the price of labour (wages), do not change in response to changes in the price level.
  • The long run in macroeconomics is the period of time in which the nominal prices of all resources, including labour, change so as to reflect fully any change in the price level.
  • In the short run wages are constant, whereas in the long run, wages change accordin to price level.
  • Aggregate supply is the total quantity of goods and services produced in an economy at different price levels, ceteris paribus.
  • The short run aggregate supply (SRAS) curve shows the relationship between the price level and the quantity of real GDP produced by firms when resource prices do not change.
  • Factors that can cause the SRAS curve shifts: changes in wages, changes in non-labour rescource prices, changes in non- labour resource prices, changes in business taxes, changes in subsidies offered to business and supply shock.
  • The three kinds of short-run equilibrium are:
  • Recessionary gap: the intersection of the AD and SRAS curves determines a level of equilibrium real GDP, Ye, that lies to the left ot potential GDP. In other words, with aggregate demand represented by AD, there is not enough total demand in the economy to make it worthwhile for firms to produce potential GDP.

  • Inflationary gap: The intersection of the AD and SRAS curves determines a lecel of equilibrium real GDP, Ye, that lies to the right of potential GDP. There is too much total demand in the economy and firms respond by producing more real GDP than potential GDP.

  • Full employment level of real GDP: the intersection of the AD and SRAS curve determines a level of equilibrium real GDP that is exactly equal to potential GDP

Section 8.4

Jhon Maynard's effect in American economy

The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.”
| John Maynard Keynes

Jhon Maynard Keynes, is still one of the most famous economist of the 20th century , he questioned the classical economists view of the economic system as a harmonious system that automatically tends towards full employment and istead showed that is is possible for economies to remain in a position of short-run equilibrium for long period of time.
The long-run aggregate supply curve in the neoclassical perspective depends on the principle that all resource price and product prices are fully flexible and respond to the forces of suplly and demand. But Keynesian economist argue that there is an asymmetry between wage movements in the upward and downward directions becuase both wages and price are unlikely to fall even if the economy is in a recessionary gap, and even if the recessionary gap persist iver long periodd of time.

If wages and prices do not fall easily even over long periods of time, this in effect means that the economy may get stuck in the short run, and cannot move into the long run. This happens when the economy is at a point (a) producing potential output Yp. There occurs a decrease in aggregate demand. The fall in the price level and in the wages caused the recessionary gap to dissapear. If the price level cannot fall the economy will be unable to eliminate te recessionary gap, which will be stuck in the short-run and will be unable to mve into the long-run.


The Keynesian AS curveThe shape of the Keynesian aggregate supply curveThe aggregate supply curve has three segments:

Segment 1
  • Real GDP is low, and price level remains constant as real GDP increases.
  • In this range of real GDP there is a lot of unemployment of resources.( which means that if the firm want to increase their output
they can easily do so by employing the unemployed labour.)
Segment 2
  • As the real GDP continue to increase, the AS curve begins to rise, so that real GDP increase are accompanied by increase in price level.
  • Firms are forced to use less and less efficient resource, (which means that even thought wage are held constant, the cost of production p/u
of output increases.)
  • The only way firms will be induced to increase their output is if they can sell it at a higher prices.
Segment 3
  • The AS curve become vertical indicating that real GDP reaches a level beyond which it cannot increase any more.
  • NOTE: Any effort on the part of firms to continue increase their output willonly give rise to greater increase in the price level

Keynesian Aggregate Supply Curve


The Three short-run equilibrium states of the economy in the keynesian perspective:
Recessionary Gap
Inflationary Gap
Full employment equilibrium the AD intersecting the keynesian
AS curve in its horizontal
2. It can be related to the business cycle when there correspond to a point where there is a
recessionary gap.
1.Is experiencing an inflacionary gap. There is strong aggregate
demand, unemployment has fallen below its natural rate,
and the economy approaches its maximun capacity.
2.It can be related to the business cycle when there is an inflationary gap
1. Show the case wherethe economy has achieved full employment equilibrium.
2. It can be related to the business cycle when the economy's actual output s equal to its
potential output, or full employment.

In the Keynesian perspective, an economy can remain for a long period of time in an equilibrium position where there is less full employment, which is caused by insufficient aggregate demand.


Another important principle is that increasing in aggregate demand need not always cause increases in the price level. In the long run incease in agrgregate demand give rise only to increase in the price level, while leaving real GDP unaffected. In Keynesian perspective by contrast, when the economy is in horizontal range , increases in aggregate demand lead to increase in real GDP without affecting the price level

Section 8.5:

Neoclassical perspective:

  • In the neoclassical perspective, the economy is conceived of as a stable system that tends towards long-run equilibrium where there is full employment at the natural rate of unemployment. The system has a built-in tendency to revert to long-run equilibrium by itself.
  • In the neoclassical perspective what the government must do is to ensure that markets work as competitively as possible, so that all resource and product prices will be able to rise or fall as requierd in order to allow theeconomy to settle at its point of long-run equilibrium, which occurs at the level of potential GDP.
  • When it comes to promoting economic growth, aggregate demand cannot affect real GDP in the long run. If aggregate demand increases, in the long run it will only give rise to increasing price levels and inflation. Therefore the government should concentrate on policies that affect the supply side of the economy or policies that attempt to shift the LRAS curve to the right.

Keynesian perspective:

  • In the Keynesian perspective, the economy is viewed as an unstable system because of recurrent short-term fluctuatuions that do not have the ability to automatically correct themselves.
  • John Maynard Keynes himself considered that the fluctuations of the business cycle are cause mainly by changes in investment spending, due to variations in firms' expectations about the future.
  • Keynes referred to alternating waves of optimism and pessimism as "animal spirits".
  • In a recessionary gap the economy can remain in an equilibrium position with less than full employment for long periods.
  • In this case, the government policy should focus on the demand side of the economy, specifically on policies that increase aggregate demand when there is a recessionary gap, and decrease aggregate demand when there is an inflationary gap.