What this lesson teaches
I can use AD and AS to find the equilibrium national output and general price level.
Syllabus 9570, 3.1.2(d). Aggregate Demand and Aggregate Supply: How interaction of AD and AS determines equilibrium level of national output and general price level
Make a guess
Overseas orders for Singapore's electronics fall sharply, and the economy has plenty of spare capacity. What happens to real output and prices?
- Output falls a lot; prices fall slightly or hold steady.
- Prices fall a lot; output barely changes.
- Nothing much, because exports are only one small part of AD.
Show the answer
Output falls a lot; prices fall slightly or hold steady.
Exports fall, so AD shifts left. On the flat part of AS, the shift shows up mainly as lower output, not lower prices.
When spending changes, AD shifts, and output and prices move together.
Aggregate demand (AD) is total planned spending on a country's output: AD = C + I + G + (X - M). When any of these parts changes for a reason other than the general price level, the whole AD curve shifts.
Sort these
Which part of AD = C + I + G + (X - M) changes first in each case?
Groups: Consumption (C), Investment (I), Government spending (G), Net exports (X - M).
- A slowdown in China cuts orders for Singapore's electronics
- A stronger S$ makes imports cheaper, so households switch from local goods to imported ones
- Shoppers cut back on restaurant meals as job worries grow
- The Budget funds new hospitals and polyclinics
- Firms order new machines because interest rates have fallen
- Households spend more after a cut in personal income tax
Show the answer
Consumption (C)
- Shoppers cut back on restaurant meals as job worries grow Spending by households on goods and services is consumption, so weaker confidence shows up in C first.
- Households spend more after a cut in personal income tax The tax cut raises disposable income, and household spending on goods and services is consumption.
Investment (I)
- Firms order new machines because interest rates have fallen Spending by firms on capital goods is investment; cheaper borrowing makes the machines worth buying.
Government spending (G)
- The Budget funds new hospitals and polyclinics Spending by the government on goods and services is G, whether on buildings or on the staff inside them.
Net exports (X - M)
- A slowdown in China cuts orders for Singapore's electronics Foreign buyers take fewer of our goods, so exports fall and net exports fall with them.
- A stronger S$ makes imports cheaper, so households switch from local goods to imported ones Total household spending is the same, but more of it goes on foreign goods, so imports rise and net exports fall.
Suppose the Budget raises government spending on MRT lines and hospitals. G rises, so AD shifts right from AD0 to AD1. Firms receive more orders than they planned for, so they raise production and hire more workers. Real national output rises from Y0 to Y1.
The rise in output is larger than the first round of spending. Construction workers spend part of their extra income, which becomes income for someone else. This is the multiplier, covered in its own lesson.
How much of the shift shows up as higher output and how much as higher prices depends on where the economy sits on AS. With plenty of spare capacity, output rises and prices barely move. Near full employment, firms struggle to find workers and machines, so more of the rise in AD becomes a higher general price level.
- AD rises
- Output and the general price level both rise, unless the economy is on a flat or vertical part of AS.
- AD falls
- Output and the general price level both fall, or prices rise more slowly.
- Size depends on AS
- Spare capacity means mostly an output change. Near full employment means mostly a price change.
Write the full chain
Four links
Cause, then component of AD, then AD shift, then the new equilibrium on the diagram.
Name the direction
Say which way AD shifts and label both curves and both equilibria.
| Change | Other curve | Real output | General price level |
|---|---|---|---|
| AD right | AS unchanged | Rises | Rises |
| AD left | AS unchanged | Falls | Falls |
| AS down/right | AD unchanged | Rises | Falls |
| AS up/left | AD unchanged | Falls | Rises |
Worked example: A fall in demand for Singapore's exports
A slowdown in major trading partners cuts overseas orders for Singapore's electronics and chemicals. Here is the chain a strong answer writes out.
- Name the component: foreign demand for Singapore's goods falls, so exports (X) fall.
- Shift the curve: since AD = C + I + G + (X - M), AD falls at every price level and shifts left.
- Explain the mechanism: firms see unsold stock pile up, so they cut production and lay off workers. Households with lower incomes then cut consumption, so output falls by a multiple of the first fall in X.
- State the result: real national output falls from Y0 to Y1 and demand-pull pressure on prices eases, so the general price level falls or rises more slowly.
- Link to the issue: lower output means higher cyclical unemployment, which is why this matters for a small, open economy like Singapore.
Watch out for this
If AD rises by $1 billion, real output rises by $1 billion.
Two things change the size. The multiplier makes the output change bigger than the first injection. The slope of AS decides how much becomes extra output and how much becomes higher prices.
Check your understanding
After the first drop in export orders, why does Singapore's total output shrink by more than the lost exports themselves?
- Imports rise to take the place of exports, so AD falls a second time.
- Prices fall sharply, so firms earn less on each of the units they still sell.
- Export workers earn less and spend less, so other firms' sales fall too.
Show the answer
Export workers earn less and spend less, so other firms' sales fall too.
Right. This is the multiplier: lower export income cuts consumption in later rounds, so AD falls by more than the first drop.