Aggregate Demand and Aggregate Supply: Curves, Shifts, and Macroeconomic Equilibrium

Aggregate Demand and Aggregate Supply

Building the Aggregate Demand (AD) Curve

The Aggregate Demand (AD) curve illustrates the relationship between the overall price level in an economy and the total quantity of goods and services demanded (real GDP), holding all else constant (ceteris paribus).

• Negative Relationship: As the price level (P) increases, consumption (C) and investment (I) decrease, leading to a decrease in real GDP (Y).

• Movement Along the Curve: Caused only by changes in the price level (P).

• Shifts of the AD Curve: Occur when factors other than the price level change:

  • Consumption: Increased optimism about future income shifts AD right.

  • Investment: Increased optimism about future profits shifts AD right.

  • Government Policies: Higher government spending (G) or lower taxes (T) shift AD right.

  • Net Exports: Higher foreign GDP or a favorable foreign currency shifts AD right.

Example: If consumers expect higher future incomes, they spend more now, shifting the AD curve to the right.

Building the Short-Run Aggregate Supply (SRAS) Curve

The Short-Run Aggregate Supply (SRAS) curve shows the positive relationship between the price level and the quantity of real GDP supplied in the short run, holding all else constant.

• Why Upward Sloping?

  • As P increases, firms' revenues rise, encouraging higher output.

  • Input prices (like wages and natural resources) are "sticky" and adjust slowly, so costs do not rise immediately.

• Sticky Wages: Wages are often fixed in the short run due to contracts, making them slow to adjust to changing economic conditions.

Example: If the price level rises but wages remain fixed due to contracts, firms find production more profitable and increase output.

Building the Long-Run Aggregate Supply (LRAS) Curve

The Long-Run Aggregate Supply (LRAS) curve is vertical, indicating that in the long run, the quantity of real GDP supplied is independent of the price level.

• Why Vertical?

  • In the long run, input prices (including wages) are flexible and fully adjust to changes in the price level.

  • Firms' profits are unaffected by changes in P, so output remains at the economy's potential (full-employment) level.

• Flexible Wages: Over time, contracts are renegotiated and wages adjust to reflect economic conditions.

Example: After several years, wage contracts are updated to match inflation, so firms' costs rise with prices, and output returns to potential GDP.

SRAS vs. LRAS Curves: Shifts and Determinants

• Variables Shifting Both SRAS and LRAS:

  • Increase in labor force or capital stock shifts both curves right.

  • Technological improvements increase productivity, shifting both curves right.

• Variables Shifting Only SRAS:

  • Negative supply shock (e.g., sudden oil price increase) shifts SRAS left.

  • Higher expected future prices (leading to higher wages) shift SRAS left.

Example: A new technology that boosts productivity shifts both SRAS and LRAS right, increasing potential output.

The Macroeconomic Equilibrium in the AD-AS Model

Equilibrium in the AD-AS model occurs where the AD, SRAS, and LRAS curves intersect, determining the economy's output and price level.

• Short-Run Equilibrium: Intersection of SRAS and AD curves. The economy may be in expansion or recession.

• Long-Run Equilibrium: Intersection of SRAS, AD, and LRAS curves. The economy is at potential (full-employment) GDP, with only structural and frictional unemployment.

Example: If actual GDP is below potential, the economy is in a recession; if above, it is in an expansion.

Short-Run Business Cycle in the AD-AS Model

• Recession:

  • Caused by a decrease in C, I, G, or NX (components of GDP).

  • AD shifts left; actual GDP falls below potential GDP (recessionary gap).

  • Firms' profits and employment decline.

  • Over time, lower price levels lead workers to accept lower wages; SRAS shifts right, returning to potential GDP (automatic mechanism).

• Expansion:

  • Caused by an increase in spending; AD shifts right.

  • Actual GDP exceeds potential GDP; unemployment falls.

  • Demand-pull inflation occurs as higher demand raises prices.

  • Over time, higher prices lead workers to demand higher wages; SRAS shifts left, returning to potential GDP.

• Stagflation:

  • Combination of recession and inflation, often due to a negative supply shock (e.g., oil price spike).

  • SRAS shifts left; GDP falls and prices rise (cost-push inflation).

  • Higher unemployment eventually leads to lower wage demands; SRAS shifts right, but the price level remains higher than before.

Example: An oil embargo increases energy costs, shifting SRAS left, causing stagflation (recession + inflation).

Key Terms and Formulas

• Aggregate Demand (AD): Total demand for goods and services in the economy at different price levels.

• Aggregate Supply (AS): Total supply of goods and services at different price levels.

• Potential GDP: The level of output when the economy is at full employment.

• Recessionary Gap: The difference between actual and potential GDP during a recession.

• Demand-Pull Inflation: Inflation caused by an increase in aggregate demand.

• Cost-Push Inflation: Inflation caused by a decrease in short-run aggregate supply.

Equation for Aggregate Demand:

$AD = C + I + G + NX$

where:

• $C$ = Consumption

• $I$ = Investment

• $G$ = Government Spending

• $NX$ = Net Exports (Exports - Imports)

Summary Table: Shifts in AD, SRAS, and LRAS

Factor	Shifts AD?	Shifts SRAS?	Shifts LRAS?
Consumer Optimism	Yes (right)	No	No
Investment Optimism	Yes (right)	No	No
Government Spending Increase	Yes (right)	No	No
Foreign GDP Increase	Yes (right)	No	No
Labor Force/Capital Stock Increase	No	Yes (right)	Yes (right)
Technological Change	No	Yes (right)	Yes (right)
Negative Supply Shock (e.g., oil)	No	Yes (left)	No
Higher Expected Future Prices	No	Yes (left)	No

Additional info: The table summarizes how different factors affect the AD, SRAS, and LRAS curves, helping to predict macroeconomic outcomes.