Understanding Aggregate Demand and Supply | CFA Level I Economics

PREREQUISITE LESSON

This lesson is a prerequisite for the course. While you won’t be directly tested on its content in the exam, it’s assumed you’ve gained this knowledge or skill during your university studies. We strongly recommend reviewing this lesson, as its content may be essential for understanding subsequent parts of the curriculum.

Today, we’ll dive into the fascinating world of aggregate demand and aggregate supply curves. But don’t worry, we’ve simplified this lesson to make it easier for you. Just focus on the big picture and the basics, and you’ll be golden!

Aggregate Demand Curve: The Basics

First, let’s understand the aggregate demand curve, which shows the relationship between the overall price level of goods and services and the real output (real GDP) of an economy. As you may recall, real GDP is also equal to the real income of an economy.

We’ll need two important curves to derive the aggregate demand curve: the IS curve and the LM curve. Fortunately, you do not need to know how these two curves are derived for the exam.

Deriving the Aggregate Demand Curve

When we combine the IS and LM curves, the point where they intersect represents the equilibrium levels of real interest rate and income in both the goods and money markets. These intersections help us derive the aggregate demand curve of an economy.

The aggregate demand curve slopes downward because higher price levels:

• Reduce real wealth
• Increase real interest rates
• Make domestically produced goods more expensive compared to goods produced abroad

Aggregate Supply Curve

Now that we’ve explored aggregate demand, let’s move on to the aggregate supply curve, which is much easier to grasp.

Aggregate supply reflects the amount of output that domestic producers are willing to provide at various prices. We must distinguish between the very short, short, and long-run aggregate supply curves due to differences in how input prices respond to changes in production levels.

Very Short-Run Aggregate Supply

In the very short run, input prices remain fixed regardless of production level changes. This results in a perfectly elastic supply curve, as companies can increase or decrease output without changing prices.

Short-Run Aggregate Supply

In the short run, only some input prices change as production increases or decreases. This results in an upward sloping aggregate supply curve, as some input prices (e.g., wages) may be slow to adjust.

Long-Run Aggregate Supply

In the long run, all input prices tend to adjust to changes in their demand. In other words, wages and other input prices that are slow to adjust in the short run adjust to changes in their demand the long run, resulting in a perfectly inelastic supply curve. 

So, there you have it – the slopes of the aggregate demand curve and the various aggregate supply curves explained. In our next lesson, we’ll study the factors that can cause these curves to shift.