Page 79 - DECO201_MACRO_ECONOMICS_ENGLISH

Macro Economics

Notes Aggregate Supply (AS) is the total supply of the final goods and services in the economy.
AD Curve shows the relationship between aggregate income (Y) and the overall price level.
AS Curve shows the relationship between the aggregate quantity of output supplied by all the
firms in the economy and the overall price level.
AD curve shows the relationship between P and Y. When P changes AE also changes. When AE
changes equilibrium Y changes. AD curve is the locus of different equilibrium aggregate incomes
(or equilibrium AEs) at different overall price levels. This establishes negative relationship
between P and equilibrium Y at each P. We will study the derivation of this negative relationship.

AS curve shows the relationship between P and aggregate output. It shows how aggregate
output responds to change in the overall price level. Therefore, it is also called 'price-output
response' curve. Overall the AS curve is upward sloping establishing positive relation between
P and aggregate output, but there are different phases in its slope. We will explain these phases.

4.2.1 Aggregate Demand Curve

The AD curve shows inverse relationship between the change in the overall price level (P) and
the consequent change in the equilibrium aggregate income (Y). A change in P not only displaces
goods market equilibrium, it also displaces money market equilibrium. But the change in P also
releases forces leading to establishment of new equilibrium in both the money market and the
goods market. In this way each point on the AD curve is a point at which both the goods market
and the money market are in equilibrium. How? We will learn this during the explanation of
the process of derivation of the AD curve.

Assumptions

During the process of derivation it is assumed that government expenditure (G), net taxes (T)
and money supply (MS) remain unchanged. G and T are the fiscal policy measures and MS the
monetary policy measure which can be taken to offset the effects of changes in P so that there is
either no change in equilibrium Y or the extent of change is reduced.

Derivation of Inverse Relation between P and Equilibrium Y

Suppose the overall price level (P) rises. This leads to the following changes in the money
market and the goods market:
Demand for money (Md) increases because with the rise in P people require more money
to carry out transactions.
Increase in Md leads to rise in the rate of interest. How? Ms remaining unchanged. Md
becomes higher than Ms. It means that people do not have enough money to facilitate
ordinary transactions. They start selling bonds to hold more money. In this environment
when people are shifting out of bonds, the corporations can sell new bonds only at a
higher rate of interest to make people buy bonds.
Rise in the rate of interest leads to fall in investment.
Rise in the rate of interest also leads to fall in consumption expenditure (C). It is on account
of two reasons. First, the opportunity cost of consumption rises, leading to fall in
consumption. Second, rise in rate of interest leads to fall in the real value of the money
wealth, called the real wealth affect or the real balance effect. To compensate the fall in
assets the asset holder tries to save more which suggests spending less on consumption.
Fall in investment (I) and consumption expenditure (C) decrease AE.

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