Aggregate Demand and Aggregate Supply Analysis – Study Notes

Aggregate Demand and Aggregate Supply Analysis

Introduction

This chapter explores the core concepts of aggregate demand (AD) and aggregate supply (AS), which are fundamental to understanding short-run and long-run fluctuations in real GDP and the price level in a macroeconomy. The intersection of the AD and short-run aggregate supply (SRAS) curves determines equilibrium output and prices in the short run, while the long-run aggregate supply (LRAS) curve represents the economy's potential output.

Aggregate Demand (AD)

Definition and Components

• Aggregate Demand (AD) Curve: Shows the relationship between the price level and the quantity of real GDP demanded by households, firms, and the government (both domestic and foreign).

• Equation: $Y = C + I + G + NX$ where $C$ = Consumption, $I$ = Investment, $G$ = Government Purchases, $NX$ = Net Exports

• Downward Sloping: A fall in the price level increases the quantity of real GDP demanded.

Key Effects Explaining the Downward Slope

• Wealth Effect: - As price levels rise, the real value of household wealth (held in nominal assets) declines, leading to less consumption. - Implication: Higher price level leads to lower consumption.

• Interest-Rate Effect: - Higher prices increase the demand for money, raising interest rates. - Higher interest rates discourage investment spending. - Implication: Higher price level leads to lower investment.

• International-Trade Effect: - When the domestic price level rises relative to other countries, exports become more expensive and imports cheaper. - Net exports fall. - Implication: Higher price level leads to lower net exports.

Movements vs. Shifts of the AD Curve

• Movement along the AD curve: Caused by changes in the price level, holding other factors constant.

• Shift of the AD curve: Occurs when a component of real GDP changes (e.g., government purchases, consumer confidence).

Variables That Shift the AD Curve

1. Changes in Monetary Policy

• Monetary Policy: Actions by the Federal Reserve to manage the money supply and interest rates to pursue macroeconomic objectives.

An increase in...	Shifts AD curve...	Because...
Interest rates	Left	Higher interest rates raise borrowing costs, reducing consumption and investment.

2. Changes in Fiscal Policy

• Fiscal Policy: Changes in federal taxes and purchases to achieve macroeconomic objectives.

An increase in...	Shifts AD curve...	Because...
Government purchases	Right	Government purchases are a component of aggregate demand.
Personal income taxes or business taxes	Left	Consumption and investment spending fall when taxes rise.

3. Changes in Expectations

An increase in...	Shifts AD curve...	Because...
Households' expectations of future income	Right	Consumption and investment increase.
Firms' expectations of future profitability	Right	Investment spending increases.

4. Changes in Foreign Variables

An increase in...	Shifts AD curve...	Because...
Growth rate of domestic GDP relative to foreign GDP	Left	Imports increase faster than exports, reducing net exports.
Exchange rate (value of the dollar)	Left	Exports fall and imports rise, reducing net exports.

Aggregate Supply (AS)

Definition

• Aggregate Supply: The quantity of goods and services firms are willing and able to supply at different price levels.

• The effect of price level changes on aggregate supply differs in the short run and long run.

Long-Run Aggregate Supply (LRAS) Curve

• LRAS Curve: Shows the relationship in the long run between the price level and the quantity of real GDP supplied.

• Vertical Line: LRAS does not depend on the price level; it is determined by the number of workers, technology, and capital stock.

• Potential or Full-Employment GDP: LRAS occurs at the level of potential output, which increases over time.

Short-Run Aggregate Supply (SRAS) Curve

• SRAS Curve: Upward sloping; as the price level increases, firms supply more goods and services.

• Reasons for Upward Slope:

  • Prices of inputs (wages, resources) rise more slowly than prices of final goods and services.

  • Some firms are slow to adjust their prices.

  • Some firms and workers fail to accurately predict changes in the price level.

Sticky Wages and Prices

• Contracts: Make some wages and prices 'sticky' (slow to adjust).

• Slow Wage Adjustment: Salary reviews are infrequent; firms dislike cutting wages.

• Menu Costs: Costs to firms of changing prices; small changes may not be worth the hassle.

Movements vs. Shifts of the SRAS Curve

• Movement along SRAS: Caused by changes in the price level, holding other factors constant.

• Shift of SRAS: Caused by changes in factors other than the price level (e.g., technology, input prices).

Variables That Shift the SRAS Curve

1. Changes in Factors of Production and Technology

An increase in...	Shifts SRAS curve...	Because...
Labor force or capital stock	Right	More output can be produced at every price level.
Productivity (technology)	Right	Costs of producing output fall.

2. Changes in Expected Prices

An increase in...	Shifts SRAS curve...	Because...
Expected future price level	Left	Workers and firms expect higher prices, increasing wages and prices.
Workers/firms adjusting to previously underestimated price level	Left	Attempt to catch up by increasing wages and prices.

3. Supply Shocks

• Supply Shock: Unexpected event (e.g., oil price spike, natural disaster, pandemic) that shifts SRAS.

An increase in...	Shifts SRAS curve...	Because...
Price of important input or occurrence of disaster	Left	Costs of producing output rise or firms are forced to close.

• Example: Oil price increases cause SRAS to shift left, reducing output and raising prices (stagflation).

Macroeconomic Equilibrium

Long-Run Equilibrium

• Occurs when AD and SRAS curves intersect at the LRAS level (full-employment GDP).

• Assume no inflation and no growth for simplicity.

Short-Run and Long-Run Effects of Shocks

1. Decrease in Aggregate Demand (Recession)

• Interest rates rise, planned investment falls, AD shifts left.

• Short-run equilibrium moves left; unemployment rises.

• Workers accept lower wages, firms expect lower prices; SRAS shifts right, restoring long-run equilibrium at a lower price level.

2. Increase in Aggregate Demand (Expansion)

• Firms become optimistic, increase investment, AD shifts right.

• Short-run equilibrium moves right; unemployment falls below natural rate, wages rise.

• Firms and workers raise expectations about prices; SRAS shifts left, restoring long-run equilibrium at a higher price level.

3. Supply Shock (Stagflation)

• Sudden increase in input prices (e.g., oil) shifts SRAS left.

• Results in stagflation: inflation and recession.

• Lower output, higher unemployment; eventually, lower wages and prices shift SRAS right, restoring equilibrium.

Summary Table: Effects of Shocks on Equilibrium

Shock Type	Short-Run Effect	Long-Run Adjustment
Decrease in AD	Lower output, higher unemployment	SRAS shifts right, lower price level
Increase in AD	Higher output, lower unemployment	SRAS shifts left, higher price level
Supply Shock	Lower output, higher prices (stagflation)	SRAS shifts right, output returns to potential

Key Terms

• Aggregate Demand (AD)

• Aggregate Supply (AS)

• Short-Run Aggregate Supply (SRAS)

• Long-Run Aggregate Supply (LRAS)

• Stagflation

• Supply Shock

• Monetary Policy

• Fiscal Policy

Example Application

• Example: In 2008, a rapid increase in oil prices (a supply shock) shifted SRAS left, causing both inflation and recession (stagflation). Over time, as wages and prices adjusted downward, SRAS shifted right, restoring equilibrium.

Additional info: These notes expand on the textbook slides by providing definitions, equations, and structured tables for clarity and exam preparation.