01/02/2016

Aggregate Supply &

Aggregate Demand
Asst. Prof. Justine Diokno-Sicat
UP Virata School of Business

Questions to be answered
What determines national income
(aggregate supply)?
Who receives income from
production?
Who buys the output of the
economy?
What equilibrates the demand for
and supply of goods & services?

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Market for factors

Factor payments
of production

Income

Financial markets
Private saving
Government deficit

Households
Taxes

Government

Inv

Government purchases

Consumption

Firms
Firms revenues

Market for Goods

& Services

Aggregate Supply

What determines the total production of

goods & services?
AS: the total production of goods and
services in an economy, GDP.

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Aggregate Supply: Factors affecting GDP

Factors of production:
Capital, K: set of tools a worker
uses; and,
Labor, L: time people spend
working.
These are assumed to be fixed and
fully-employed in the short-run

Aggregate Supply: Factors affecting GDP

Production function: represents the
available technology which determines
how much Y is produced given K, L and
the pattern of wage prices in the economy.

Y F ( K , L)
Y F ( K , L, )

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Aggregate Supply: Production function

Characteristics:

If only 1 input changes there will be

diminishing returns;
If all inputs change there are three
kinds of returns to scale:
a. Constant returns to scale, CRS;
b. Increasing returns to scale, IRS; and,
c. Decreasing returns to scale, DRS.

Aggregate Supply:
National income distribution & factors of production

How is national income distributed

among factors of production?

Assumptions:

perfect competition, PC;

firms maximize profits

(PF
wL RK
PF
K(,KL,)L)wL
RK

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Aggregate Supply:
National income distribution & factors of production

1. Demand for factors of production with

fixed supply:

Factor prices are determined by demand;

Follows the law of diminishing marginal product;

A firms demand for labor depends on

w PMP MRP
L
MP w
P
L

Aggregate Supply:
National income distribution & factors of production

2. Demand for factors of production with

flexible supply. Rewrite AS fn. as:

Y F[LD(w/ P, K , ), K ]

Factors affecting AS are:

Real wage ( ) indirect affect via

production function;
Capital () and technology () both direct
(through the production function) and indirect
(through the ) effects are positive

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Aggregate Supply:
The supply of factors of production

How do factors of production supply

their services?
Labor supply:
Involves a labor-leisure choice;
Depends on the substitution and
income effects;
Also depends on the real wage
level;
Curve is upward sloping.

Aggregate Supply:
The supply of factors of production
Labor supply, depends on:
Substitution effect: ;
Income effect:
Income tax affects labor supply
Empirically in Sweden as tax rates
increase, labor supply decreases.
Backward bending labor supply curve

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Aggregate Demand

What determines the demand for

goods & services?
How is GDP allocated?
AD: the total demand for goods &
services in an economy, GDP;

Aggregate Demand
A closed economys use of goods &
services:

Y C I G

where:
C is consumption
I is investment
G is government purchases

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Aggregate Demand: Y = C+I+G

Consumption, C, depends on:
disposable income: income left after taxes;
marginal propensity to consume: the
amount C changes when disposable
income increases by PhP1.

C C(Y T )
C C(Y T )

Aggregate Demand: Y = C+I+G

Investment, I:
goods that firms buy to add to their stock of
capital or to replace existing capital; and,
quantity of I depends on the interest rate

I I (r )
I I (r)

Firms will invest only if return on investment is

greater than cost.
Nominal vs real interest rate.

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Aggregate Demand: Y = C + I + G
Government purchases, G, depends on
fiscal policy

G T
G
G T

GTG T

budget balance
budget surplus
budget deficit

What Brings the Economy into

Equilibrium?: AS=AD
Market for goods & services: interest rates
equilibrates AS & AD via the supply &
demand of:
a. Goods & services
b. Loanable funds

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What brings the market into equilibrium?

AS=AD
Market for goods & services

Y C I G

Since it is assumed that

K, L and, thus, Y are
fixed, NIA can be
rewritten as:

C C (Y T )
I I (r )

AS AD
Y C (Y T ) I (r ) G

G G

r is the only variable that

can adjust to equilibrate
AS & AD.

T T

What Brings the Economy into

Equilibrium?: AS=AD Financial market
Financial market: the market for loanable
funds
NIA identity rewritten:

I Y C G

Can be defined in public & private sector terms:

I (Y T C) (T G)
private saving

public saving

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AS = AD: Financial markets

In financial markets:
The good: loanable funds
The price: interest rates
Supply of loanable funds: saving
Demand for loanable funds:
investment

Financial Markets:
How does r adjust to bring equilibrium?
With fixed S and because of fixed Y, T, &
G, investment, I, will have to adjust to
changes in other variables:

Y C (Y T ) G I ( r )
Y C (Y T ) G I ( r )
S I (r )

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01/02/2016

What Brings the Economy into

Equilibrium?: AS=AD
Fiscal policy, saving behavior & r:
increases in government spending,
G; and,
decreases in taxes, T;

Changes in I because of
technological innovations; and,
Saving is no longer assumed to be
fixed but is now a function of r.

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