Aggregate Demand and Aggregate Supply Analysis – Study Notes

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Aggregate Demand and Aggregate Supply Analysis

Introduction

This chapter explores the aggregate demand and aggregate supply (AD-AS) model, a fundamental tool in macroeconomics for understanding short-run fluctuations in real GDP, employment, and the price level. The AD-AS model helps explain how various factors influence the overall economy and how equilibrium is achieved in both the short run and long run.

Aggregate Demand

Components of Aggregate Demand

Aggregate demand (AD) represents the total quantity of goods and services demanded across all sectors of an economy at different price levels. Real GDP has four main components:

Consumption (C): Spending by households on goods and services.
Investment (I): Expenditures by firms on capital goods and inventories.
Government Purchases (G): Spending by the government on goods and services.
Net Exports (NX): Exports minus imports.

The aggregate demand equation is:

Aggregate Demand and Aggregate Supply Model

The AD-AS model explains short-run fluctuations in real GDP and the price level. In the short run, real GDP and the price level are determined by the intersection of the aggregate demand (AD) curve and the short-run aggregate supply (SRAS) curve.

Aggregate demand (AD) curve: Shows the relationship between the price level and the quantity of real GDP demanded by households, firms, and the government.
Short-run aggregate supply (SRAS) curve: Shows the relationship in the short run between the price level and the quantity of real GDP supplied by firms.

Why the Aggregate Demand Curve Slopes Downward

The Wealth Effect: As the price level rises, the real value of household wealth declines, leading to lower consumption.
The Interest-Rate Effect: Higher price levels increase the demand for money, raising interest rates and discouraging investment.
The International-Trade Effect: Higher domestic price levels make exports more expensive and imports cheaper, reducing net exports.

Movements Along vs. Shifts of the AD Curve

Movement along the AD curve: Caused by a change in the price level, holding all else constant.
Shift of the AD curve: Caused by changes in components of aggregate demand (C, I, G, NX) due to factors other than the price level.

Variables That Shift the Aggregate Demand Curve

An increase in ...	Shifts the AD curve ...	Because ...
Interest rates	Left	Higher interest rates raise borrowing costs, reducing consumption and investment.
Government purchases	Right	Government purchases are a component of aggregate demand.
Personal income taxes or business taxes	Left	Higher taxes reduce disposable income and investment.
Households' expectations of future incomes	Right	Optimism increases consumption and investment.
Growth rate of domestic GDP relative to foreign GDP	Left	Imports rise faster than exports, reducing net exports.
Exchange rate (value of dollar)	Left	Exports become more expensive, imports cheaper, reducing net exports.

Aggregate Supply

Short-Run vs. Long-Run Aggregate Supply

Aggregate supply refers to the quantity of goods and services that firms are willing and able to supply at different price levels. The relationship between quantity supplied and the price level differs in the short run and long run.

Long-run aggregate supply (LRAS) curve: Shows the relationship in the long run between the price level and the quantity of real GDP supplied. The LRAS is vertical, indicating that in the long run, output is determined by resources, technology, and capital stock, not the price level.
Short-run aggregate supply (SRAS) curve: Shows the relationship in the short run between the price level and the quantity of real GDP supplied by firms.

Determinants of Aggregate Supply

Labour force and capital stock: Increases allow more production at any price level.
Productivity: Improvements in technology increase output at any price level.
Expected future price level: If workers and firms expect higher prices, SRAS shifts left as wages and prices rise.
Supply shocks: Unexpected events (e.g., oil price spikes, pandemics) can shift SRAS left (decrease supply) or right (increase supply).

Variables That Shift the Short-Run Aggregate Supply Curve

An increase in ...	Shifts the SRAS curve ...	Because ...
Labour force or capital stock	Right	More output can be produced at every price level.
Productivity	Right	Costs of producing output fall.
Expected future price level	Left	Workers and firms increase wages and prices.
Expected price of a key natural resource	Left	Costs of production rise.

Macroeconomic Equilibrium

Short-Run and Long-Run Equilibrium

Macroeconomic equilibrium occurs where the AD and SRAS curves intersect. In the long run, equilibrium is at the intersection of AD, SRAS, and LRAS, corresponding to potential or full-employment GDP.

Short-run equilibrium: May occur at output levels above or below potential GDP, leading to inflation or unemployment.
Long-run equilibrium: Output returns to potential GDP as wages and prices adjust.

Effects of Changes in Aggregate Demand

Decrease in AD: Leads to lower output and higher unemployment in the short run. Over time, wages and prices fall, SRAS shifts right, and the economy returns to full employment.
Increase in AD: Leads to higher output and lower unemployment in the short run. Wages and prices rise, SRAS shifts left, restoring long-run equilibrium.

Effects of Supply Shocks

Negative supply shock: SRAS shifts left, causing inflation and recession (stagflation). Over time, wages and prices adjust, and SRAS shifts right, restoring equilibrium.
Policy response: Fiscal or monetary policy can be used to increase AD, but may result in permanently higher prices.

Appendix: Macroeconomic Schools of Thought

Keynesian Model

Emphasizes the role of aggregate demand in determining output and employment.
Wages and prices are sticky, leading to fluctuations in real GDP.

Monetarist Model

Associated with Milton Friedman.
Argues that fluctuations in real output are mainly caused by changes in the money supply.
Advocates a monetary growth rule: increase the money supply at a constant rate.

New Classical Model

Emphasizes rational expectations by workers and firms.
Fluctuations occur when expectations about prices are incorrect.
Advocates policies that help form correct expectations.

Real Business Cycle Model

Focuses on real (not monetary) causes of business cycles, such as productivity shocks.
Assumes wages and prices adjust quickly.
SRAS is vertical; only real shocks affect output.

Marxist Critique

Karl Marx argued that capitalism would eventually be replaced by communism due to worker exploitation.
Believed that value is determined by the labour embodied in goods and services.

Summary Table: Shifts in AD and SRAS

Factor	AD Shift	SRAS Shift
Interest rates	Left (if increase)	None
Government purchases	Right (if increase)	None
Labour force/capital stock	None	Right (if increase)
Productivity	None	Right (if increase)
Expected future price level	None	Left (if increase)
Supply shock	None	Left (if negative shock)

Key Equations

Aggregate Demand:

Example Application

If the Bank of Canada raises interest rates, investment and consumption fall, shifting AD left. In the short run, output and employment decrease. Over time, wages and prices adjust downward, SRAS shifts right, and the economy returns to full employment at a lower price level.

Additional info:

Tables have been reconstructed and summarized for clarity.
Some explanations have been expanded for academic completeness.