Aggregate Demand
The market supply and demand framework explains the behavior of individual markets. Aggregate demand and supply, on the other hand, describes how the total economy works.
Aggregate demand (AD) in an economy equals the level of total expenditures on goods and services at a given moment. In a closed economy, on which does not have external economic relations, aggregate demand (AD) equals the sum of consumer expenditures (C) plus investment (primarily business) expenditures (I) plus government spending on goods and services ( G), or:

AD = C + I + G = GDP
Aggregate demand or the sum of consumption, investment, and government expenditures also equals gross domestic product (GDP), the most common measure of the overall level of economic activity. But it is important to stress that aggregate demand equals nominal not real GDP. Nominal GDP equals the value of consumption plus investment plus government expenditures at current prices. Real GDP equals the total value of expenditures (C+I+G) at constant prices. Real GDP strips away the effects of price changes on the value of output and enables us to see how many more cars, boats, airplanes, and so on, measured in physical units, were actually produced. For example, in the United States, nominal GDP rose from $6,343 billion in 1993 to $6,737 billion in 1997, an increase of 6.2 percent. But the United States was not 6.2 percent richer in real terms because prices rose by 2.1 percent during the year. Therefore, the increase in real GDP was 4.1 percent. (Ted Walters, Global Economy, 2000). GDP can be computed by adding the flow of expenditure (AD) or adding the sources of income (AS).  We can therefore see that if the level of nominal GDP (PQ) is known, real GDP (Q) can be computed by dividing nominal GDP (PQ) by the national price index (P), Q =  (PQ)/P. In other words, in order to compute real GDP one must adjust nominal GDP for changes in the general price level.

Shifts on the Aggregate Demand:
The assumption that other things remain equal in the real world, however, other things do not remain constant and various forces will cause an aggregate demand curve to shift to the left or to the right. Given a constant price level, the AD curve will shift to the right if consumers decide to spend a greater proportion of their income, or if business firms choose to purchase more equipment or add to their plant capacity, or if the government raises its expenditures on goods and services.
 In addition, a tax cut that raises disposable income may lead to higher consumption expenditures and shift the AD curve to the right. And an increase in the money supply may also lead to greater consumption and investment expenditures and shift the AD curve to the right.
The Slope of the Aggregate Demand and International Economics:
There is, in fact, no reason for the AD curve to slope down to the right at all. Recall that nominal GDP or aggregate demand can be computed either as a flow of expenditures, C+I+G, or as a flow of income receipts (wages, interest, rents, and profits). If all expenditures are consumption expenditures and all income receipts are wages. Naturally, if prices drop while wages remain constant, real expenditures will rise and real output will increase. But if prices and wages move in tandem, a drop in prices accompanied by a drop in wages will have no effect on real output.
Suppose there is only one worker and consumer in the society and that she is paid $100 for producing widgets which she spends entirely on widgets, the only good available She will purchase 100 widgets if the price is a dollar.  Suppose her wage drops to $50, but, at the same instant, the price of widgets falls to $.50. In this new environment, she will, as before, purchase 100 widgets. Therefore, despite the fall in the general price level, her demand for widgets in real terms and real GDP will remain constant. If her demand for widgets is the same at every price level, because we assume that price and wages rise and fall together, the AD curve will be a vertical line. Thus, the negative slope of the AD curve must be explained by other forces.
The real balance effect, interest rate effect, and the trade effect are three forces which help explain why the AD curve has a negative slope. In its simplest form, the real balance effect asserts that individuals want to hold a money balance with constant purchasing power. Suppose an individual starts out with a nominal money balance of $100 and the price level is 1. Given this setting, the real and nominal values of the money balance are equal since the real balance equals the nominal balance divided by the price level. Now imagine that the price level doubles. The value of the nominal balance will remain constant at $100, but its purchasing power will be cut in half, which is the same as saying that the value of the real balance is reduced by 50 percent. If an individual wants to maintain a money balance with constant purchasing power, she will have to increase her nominal money balance by $100 to $200. Given this background, it is possible to examine how the real balance effect influences the slope of the aggregate demand curve. If an individual receives a wage income of $100 per month and spends it all on widgets, which, as before, sell for $1, her income and expenditures will equal $100 per month and 100 widgets will be produced and consumed. Now assume also she starts and ends the month with a money balance of $100. The money balance equals 100 percent of her income which is assumed to be the money/income ratio she desires to maintain.
If both her wages and the price of widgets fall by 50 percent, nothing happens in real terms. Her wage income of $50 is used to purchase 100 widgets that now cost $.50 each. However, since she started out with a money balance equal to $100, its value or purchasing power has doubled and is now twice her income. Measured either way, she clearly has an excess money balance. Advocates of the real balance effect argue that she will spend her excess money balance in the attempt to restore her original money/income ratio or real balance. In the process, she will spend an additional $50 and purchase 100 additional widgets.
The implications of this real balance effect is that, of nominal money supply equals $100 at both the initial and second price level. When the price level equals 1, 100 widgets are demanded. If the price level drops to .5, the demand for widgets rises to 200 units. Thus, given a constant nominal money balance, a decrease (increase) in the price level leads to greater (lower) demand. Aggregate demand and the price level, therefore, are inversely related.
The slope of the aggregate demand curve is also determined by the interest rate effect. The interest rate effect argues that given a higher price level, individuals will demand more money to carry out transactions. This increased demand for money will raise interest rates. And in turn, higher interest rates will curtail investment expenditures and some consumption expenditures. If the price level and interest rates are correlated or move together, a higher price level will raise interest rates and contract aggregate expenditures. Some economists claim that the higher interest rates that follow an increase in the price level are sufficient by themselves to contract aggregate expenditures.
The relationship can be spelled out formally: MS = kPQ
MS equals the money supply and k equals the proportion of nominal income, PQ, that one desires to hold in the form of money. If k equals 1, the relationship can be rewritten as MSP/P = Q. If it is also assumed that the money supply is constant, the last equation shows the inverse relationship between a change in the price level and a change in the level of real output demanded.
Equation of exchange: MS*V = P*Q where money supply (M) times velocity of money in circulation equal to the level of aggregate spending in the economy. The monetarist believe that monetary policies can control inflation by increasing the money supply at a steady rate equal to the growth of the economy.
The slope of the AD curve, therefore, is affected by the strength of the real balance effect. If the real balance effect is strong, the AD curve is flat or flatter; if it is nonexistent, the AD curve is a vertical line and a change in the price level will not, other things remaining equal, affect the level of real demand.
Regardless of whether the real balance effect is strong or weak, the foreign trade effect leads to a flatter AD curve. Indeed, even if the real balance effect is nonexistent, the AD curve will slope down from left to right due to the trade effect. A first step toward understanding why this is the case is to compare the aggregate demand equation for an open economy with the aggregate demand equation for a closed economy. In an open economy, aggregate demand equals:
AD = Y = C + I + G + (X-M)
G, I, and G were previously defined. X and M equal exports and imports respectively. Consumption, investment, and government expenditures on goods and services may not be directly influenced by a change in the price level, but exports and imports are. An increase in the domestic price level will raise the price of the nation's exports and reduce the quantity sold. Higher domestic prices will also encourage domestic consumers to purchase foreign-made products in place of domestic brands. For these two reasons, a change in the domestic price level will increase or decrease aggregate demand in an open economy.
Shifts on Export and Import Curves
Export and import curves shift about for many reasons. When they do shift, the aggregate demand curve also shifts in most instances. For example, an increase in world income shifts the export curve and the aggregate demand curve to the right. An increase in the world price level will increase the nation's exports at all domestic price levels and the export and aggregate demand curves will move to the right. The same result occurs if the foreign rate of inflation exceeds the domestic rate of inflation. Currency depreciation will also shift the export curve to the right and lead to a shift in the aggregate demand curve.
The import curve react to similar developments. An increase in the foreign price level or a depreciation of the dollar shifts the U.S. import curve to the left. If imports drop at all price levels, and other things remain constant, the U .S. aggregate demand curve shifts right.
However, an increase in aggregate demand that shifts the aggregate demand curve to the right also shifts the import curve in the same direction. An expansionary fiscal policy ( government expenditures, taxes, rules and regulations), for example, raises the level of aggregate demand at all price levels and the AD curve shifts to the right. Given a higher income, Americans spend a portion of their additional income on imports so that imports rise at all price levels. The import curve, therefore, shifts right.

Lending or Borrowing from Net Exports
Exports and imports are affected by many forces. A nation's exports and imports are hard to balanced  for an extended period. In reality, the majority of nations run either trade surpluses or trade deficits most of the time.
There are advantages and disadvantages in running a trade deficit. When a nation's imports race ahead of its exports, it is able to absorb more goods and services than it produces. Absorption equals the total sum of expenditures on goods and services, both domestic and foreign produced, for use within the domestic economy. (Absorption equals the sum of C + I + G.  The definition applies to both open and closed economies, but there is a fundamental difference between the two cases. In a closed economy, total expenditures cannot exceed domestic production or a nation can only absorb what it produces. In an open economy, absorption can exceed domestic production. If the domestic production of personal computers is limited to 100,000 units, citizens can absorb more of them by purchasing them abroad. The relationship can be defined more precisely. In an open economy output equals absorption, A, plus the trade balance, TB, or in symbols:
Y = A + TB
Thus it is possible for absorption, A, to exceed domestic output, if the trade balance, TB, is negative or imports, M, exceed exports, X.
However, if a nation absorbs more than it produces or imports more than it exports, it must run down any cash reserve on hand or borrow funds to finance its deficit. A nation is no different than a private citizen. If an individual's expenditures exceed his income, he must somehow finance the gap. In a two-country world, if the United States is to run a trade deficit with Japan, America must either borrow yen from the Japanese or induce the Japanese to accept dollar-denominated IOUs. Simply put, in a two-country world, if the United States must borrow, the Japanese must lend.
The drawback in such a lending-borrowing arrangement is that the United States will have to reduce its absorption relative to its output and run a trade surplus in order to repay the principal and interest charges on the debt or service the debt. The Japanese, in turn, will have to absorb more than they produce and run a trade deficit in order for the United States to service the debt.
The Japanese, however, will obtain future benefits if they produce more today than they absorb today. Due to its trade surplus and requisite lending, Japan can be able to absorb more tomorrow than would have been possible if their present trade position were balanced. How much more depends on two factors: its current level of lending and real rate of return it receives on such lending.
If the Japanese prefer future consumption to current consumption, their current lending makes sense. If they are indifferent to future versus present consumption or if they prefer current consumption, they should not run a trade surplus today.
The United States borrowing abroad and running a trade deficit is not necessarily a step on the road to ruin. Families, after all, borrow to purchase houses, cars, and college educations. In fact, there are times when a nation, like an individual, may want to borrow external funds to finance an import surplus or to absorb more than it produces.
Such a surplus when used prudently, for example, to import badly needed investment goods, may lead to an expansion in income not only sufficient to pay off both the principal and interest charges of the loan, but to raise national income as well.
In the 1960s, South Korea ran trade deficits and financed them by borrowing abroad. It used the import surplus to build up basic industries such as steel, cement, petrochemicals, and shipbuilding. Once these and other industries had been built up, South Korean exports expanded dramatically. And although the country is still paying off its external debts, its export surpluses have been deployed to reduce its international indebtedness and the country has enjoyed a rapid rate of economic growth about 8.7 percent per annum between 1970 and 1990. (World Bank, 1999).

Aggregate Supply
Y = AS = r + w/s + I + p + depreciations + indirect business taxes
On the other hand, not much can be said in favor of external borrowing that is used to finance current consumption. A country that devotes its import surplus to raising its level of consumption will increase its external debt but not its capacity to repay it. Such unwise borrowing took place in the 1970s and 1980s when many South American countries ran up hefty external debts; many experts feel that this same pattern is occurring in the United States at the present time. In the last decade, the United States has shifted from being the world's largest creditor nation to being the world's largest debtor and it does not have too much to show for it. The price of an individual commodity is determined by market demand and supply. In a similar manner, the general price level is determined by the interplay of aggregate demand and aggregate supply. For example, an increase in aggregate demand at all price levels shifts the AD curve to the right. What proportion of the increase in nominal income will show up as an increase in the price level and how much will reflect an increase in real GDP depends on the slope of the aggregate supply curve. If it is flat, the increase in aggregate demand leads to an increase in real income and output; if the aggregate supply curve is vertical, the increase in aggregate demand leads to a higher price level alone. Thus if the aggregate supply curve is somewhere between a horizontal or vertical line, a shift in the AD curve leads to an increase in both output and the price level.
The slope of a supply curve may depend on the increase in labor costs per unit of output that takes place as production expands. Labor costs per unit of output are explained by the wage rate, the number of workers employed, and the level of labor productivity. An increase in the wage rate raises labor costs per unit of output while an increase in labor productivity reduces labor costs per unit of output.
Labor productivity measures output per unit of labor; and is normally reckoned as either output per worker or output per worker hour. Labor productivity depends on a whole host of elements such as levels of health and education, public infrastructure investment, the business climate, the speed of technological innovation, and so on.
Economists tend to emphasize the quantity of capital per worker as a primary determinant of labor productivity (MPPL/w/s greater than MMPk/i). Give a worker more and better capital equipment to work with and her output per hour will rise.
In the short run, the quantity of capital and other determinants of productivity are pretty much set. Therefore, as additional laborers are employed, capital per worker declines and output per worker on average and at the margin decreases illustrating once again the law of diminishing returns. Since the wage rate is assumed constant, output per worker declines as more workers are employed, which means that labor costs per unit of output increase.
Other factors could cause the aggregate supply curve to shift to the left or to the right: the price of a foreign produced input such as oil drops, the AS curve shifts to the right. And if the value of the domestic currency appreciates, the price of foreign inputs will fall in terms of the domestic currency and shift the curve to the right. Japan, for example, benefited from this double whammy in the 1980s when the price of a barrel of oil fell some 45 percent from $31.38 to $14.14 per barrel between 1982 and 1988, while the yen appreciated by 50 percent from ¥249/$ to ¥128/$ during the same period. Since oil is normally priced in dollars, falling oil prices and yen appreciation had a powerful impact on the Japanese economy.
Indeed, employing the figures already cited, the yen price of a barrel of oil fell from roughly ¥7900 in 1982 to roughly ¥1800 in 1988.(Source: World Bans Annual Report, 2000, www.wb.org)
 In turn, the decline in the price of this essential input shifted Japanese industry supply curves and Japan's aggregate supply curve to the right, and powerfully so in the case of Japan because of the importance of oil in the production process. Source: Economic Report to the President, 1997
Market supply and aggregate supply curves are similar in only some respects. If there is a change in relative commodity prices within an economy, industry supply curves shift to the right and to the left as labor and capital migrate from one industry to another in the wake of the change in relative profit opportunities. However, the aggregate AS curve will not shift as a result of change in relative prices. If the price of textiles rises while the price of wheat declines, the composition of an aggregate supply curve may change but the curve itself will not shift.
Equilibrium
By combining AD and AS, it is possible to show the equilibrium position of the economy. An internal or external shock can cause the AD, AS, export or import curves to shift or move the economy from the equilibrium position to another. Exactly how much and in which direction the economy moves would depend on the state of the economy or the world economy and the shock or shocks of that take place. For example, export booms will shift the AD to the right and the economy will end up with higher levels of output and higher price levels. The AD and AS concepts can be use to trace out possible implications of selected economic policies for both a nation and the rest of the world.
National income can be more formally derived. In an open economy, the equilibrium level of nominal income is attained when output (1) equals aggregate demand or when:
Y= C + I+ G + X- M.
The consumption function is often written in the following form: C = Ca + b(Y - T). Consumption, therefore, is composed of two parts: an autonomous element, Ca, which does not depend on the level of income, and another component, b(y- T), which does. If Ca equals $10, it will equal $10 regardless of whether income is $0 or $1000. The second or income-induced component of the consumption function depends on the level of income or, more correctly, on the level of disposable income. Given an increase in her disposable income, an individual will spend some of it to purchase additional goods and services.
Disposable income equals income minus taxes, or Y-T: In this example, it is assumed that taxes, T; are a given sum of money such as $10. Taxes, therefore, are similar to a poll or head tax and not an income tax. Lowercase b in the consumption function represents the marginal propensity to consume (mpc). The mpc describes the increase in consumption resulting from an increase in disposable income. In most examples, it is assumed that mpc is greater than zero and less than one or that 0 < mpc < 1. Since the mpc is less than 1, if an individual receives an additional dollar of income, she will not spend all of it purchasing goods and services, but will save some of it.
How much of this additional income she saves depends on her mpc. If it is .9 and her disposable income increases by $50, she will spend $45 purchasing additional consumption goods and save the remaining $5. Her additional savings can also be computed by multiplying the increase in her disposable income by her marginal propensity to save (mps). Since the sum of the mpc and the mps equals one, or mpc + mps = 1, her mps, s, equals .1 in this example.
Thus if an individual's disposable income increases by $50, her additional savings changes by the change in income.
MPC = change in income over the change in savings.
Like consumption, imports are divided into two parts. One, Ma, is autonomous and does not depend on income. It will increase regardless of the level of income when the domestic price level rises or when the domestic currency appreciates. A second portion of imports, Mi ( induced imports): does depend on income. These rise or fall as income expands or contracts. The mpm,, is assumed to be greater than zero but less than one  or O<M<l.
Finally, it is assumed that investment (I), government spending on goods and services (G), and exports (X) are given or not determined by income. Given these definitions and relationships, the national income equation is written as follows:
Y = Ca + b(Y -T) + I + G + X -Ma –Mi
 Y = Ca + b Y -bT + I + G + X -Ma -Mi- cY –mY
Y = Ca + I + G -bT + X -Ma
Y(1 -b + m) = Co + I+ G -bT + X -Ma
since 1 -b = s,
Y(s + m) = Ca + 1 + G -bT -Ma
Y = (l/s + M)Ca + 1 +G -bT + X -Ma
If the mps and the mpm each equal .1, then the value of the open economy multiplier is (l/S + M). The multiplier tells us how much income will change when any of the autonomous elements in the income equation rise or fall.

Shifts in Aggregate Supply and Exports and Imports
A shift in the aggregate supply curve will affect exports and the imports in a range of possibilities. First, assuming that everything else remains constant, including the AD curve, a shift in the AS curve to the right will drop the national price level. As a result, the economy will move down its existing export and import curves. Given this movement, exports will increase and imports will decrease and the economy's balance of trade will improve.
Second, an increase in productivity will shift the export curve to the right and the import curve to the left. The shift in the export curve follows logically from the drop in labor costs per unit of output.
The shift in the import curve results from the increase in labor productivity and the drop in unit costs of production in import substitute industries. As a result, the increased competitiveness in the import substitute industries reduces the demand for imports at all price levels and causes the import curve to shift to the left. Thus an increase in productivity that shifts the AS curve to the right improves a nation's export-import balance because it (1) drops the price level and (2) reduces unit costs of production in the export and import substitute industries.
Suppose there is an increase in investment that raises labor productivity and shifts the AS curve to the right. Also assume that the increase in investment comes at the expense of consumption. Investment rises and consumption falls, so that the shift in the AS curve is unaccompanied by a shift in the AD curve.
Since in this example investment increases as a percentage of output, labor productivity should rise. Given the higher labor productivity, the nation should be able to produce exports at a lower cost since labor cost per unit of output declines in the export industry. Under such conditions, the export curve should shift to the right. In addition, the decrease in labor costs per unit of output across the economy means that domestic

Investment and Exports
The relation between investment and export expansion is presented  by the average growth of the volume of exports and the investment/GDP ratios. The volume rather than the value of exports may increase the price of exports, although certainly good for the exporting country, could be the result of an abnormal state of affairs. The rise in the value of oil exports in the two oil shocks of the 1970s is an example. However, the shifts in the export and import curves will shift the AD curve to the right. Recall the income formula previously given where an increase in exports or a decrease in autonomous imports raised aggregate demand. An increase in aggregate demand will stimulate induced imports so that the import curve will shift back to the right. In the end, the nation's income will be higher and its trade balance lower than previously indicated.
It is unlikely that an increase in investment will be offset by a decline in consumption and thus it is improbable that the AD curve will remain fixed following an increase in investment. An increase in investment will normally lead to an increase in consumption and imports via the multiplier process. Suppose the increase in investment does not displace consumption, but rather that it is a net addition to aggregate demand. Both the AS and AD curves shift to the right. If they shift by the same degree, output rises and the price level remains constant.
Higher productivity leads to lower unit labor costs and shifts the curve to the left, but higher aggregate demand shifts it to the right. If these two forces offset each other, the curve will not shift. Nevertheless, the export curve will shift due to the productivity effect and the nation's trade balance position will improve, although not to the degree in the previous example. Since the price level remains constant, the price effect on exports and imports will not take place.
Economic theory usually assumes that an increase in investment will shift the aggregate demand curve to greater degree than it shifts the aggregate supply curve, particularly in the short run. An increase in investment increases consumption, and aggregate demand, by some multiple of the expansion in investment. Thus a $10 increase in investment raises aggregate demand by $50 at all price levels. However, the additional $10 investment will not necessarily shift the aggregate supply curve by $10 at all price levels.
The degree of the shift of the AS curve depends on how much the additional investment increases productivity. The greater the increase in productivity, the greater the shift in the AS curve.
On the other hand, if the AD curve shifts further to the right than the AS curve, the domestic price level will rise. A higher price level will reduce exports and increase imports as the economy moves along its given export and import curves and cause a net trade deficit. In addition, the import curve will shift to the right at all price levels as in- come climbs, further increasing the nation's trade deficit.
These forces, however, will be countered by the productivity or competitiveness effect resulting from greater in- vestment. The competitive effect will shift the export curve to the right and the import curve to the left. The interaction of all these factors means that it will be difficult to spell out exactly the nation's ultimate trade balance position.
Given all the possibilities, the final trade position of economy given a shift in its AS curve would be mixed depending on the time period under observation. In the short run, it is likely that an increase in economic growth will lead to a trade deficit as imports initially outrace exports. But there is little doubt that the combination of high investment, price stability, and strong economic growth leads to trade surpluses and appreciating currencies over the longer run. Whether investment-led economic growth leads to a trade surplus or a trade deficit depends on the time frame analyzed.