Aggregate Demand and Aggregate Supply: Fluctuations in Real GDP and Price Level

Aggregate Demand and Aggregate Supply

Introduction

This chapter explains the causes of fluctuations in real GDP, employment, and the price level using the aggregate demand and aggregate supply (AD-AS) model. The AD-AS model is central to understanding short-run economic fluctuations and long-run economic equilibrium.

Aggregate Demand (AD)

Definition and Components

• Aggregate Demand (AD) is the total demand for goods and services in an economy at different price levels, measured as real GDP.

• Real GDP (Y) is composed of four main components:

  • Consumption (C): Spending by households on goods and services.

  • Investment (I): Spending by firms on capital goods and inventories.

  • Government Purchases (G): Government spending on goods and services.

  • Net Exports (NX): Exports minus imports.

• The aggregate demand equation is:

$Y = C + I + G + NX$

The Aggregate Demand Curve

• The AD curve shows the relationship between the price level and the quantity of real GDP demanded by households, firms, and the government.

• The AD curve is downward sloping due to three main effects:

  • Wealth Effect: Higher price levels reduce the real value of household wealth, leading to lower consumption.

  • Interest Rate Effect: Higher price levels increase the demand for money, raising interest rates and reducing investment spending.

  • International Trade Effect: Higher domestic price levels make exports more expensive and imports cheaper, reducing net exports.

• Movement along the AD curve occurs when the price level changes, holding all other factors constant.

• Shifts of the AD curve occur when a component of real GDP (C, I, G, or NX) changes for reasons other than the price level.

Variables That Shift Aggregate Demand

• Monetary Policy: Actions by the central bank that change the money supply and interest rates, affecting investment and consumption.

• Fiscal Policy: Government changes in taxes and spending that directly affect aggregate demand.

• Expectations: If households or firms become more optimistic, consumption and investment rise, shifting AD right. Pessimism shifts AD left.

• Foreign Income: If foreign incomes rise faster than domestic incomes, exports increase, shifting AD right. If foreign incomes fall, exports decrease, shifting AD left.

Aggregate Supply (AS)

Definition and Types

• Aggregate Supply (AS) is the total 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, leading to two curves:

  • Short-Run Aggregate Supply (SRAS)

  • Long-Run Aggregate Supply (LRAS)

Long-Run Aggregate Supply (LRAS)

• The LRAS curve is vertical, indicating that in the long run, the economy's output is determined by resources, technology, and institutions, not by the price level.

• LRAS represents the full employment level of output (YF), where only structural and frictional unemployment exist.

Short-Run Aggregate Supply (SRAS)

• The SRAS curve is upward sloping because some input prices (like wages) are slow to adjust, and firms may misjudge changes in the price level.

• The short run is not defined by a specific time period but by the presence of price and wage stickiness.

Variables That Shift SRAS

• Factors of Production: Increases in labor or capital shift SRAS right (more output at any price level).

• Technology: Improvements in technology increase productivity, shifting SRAS right.

• Supply Shocks: Unexpected events that change input prices or productivity.

  • Negative Supply Shock: Sudden increase in input prices (e.g., oil crisis) shifts SRAS left, raising prices and reducing output.

  • Positive Supply Shock: Sudden decrease in input prices shifts SRAS right, lowering prices and increasing output.

Macroeconomic Equilibrium

Short-Run and Long-Run Equilibrium

• Short-run equilibrium occurs where the AD and SRAS curves intersect.

• Long-run equilibrium occurs where AD, SRAS, and LRAS all intersect at the full employment level of output (YF).

Stagflation and Supply Shocks

• Stagflation is a combination of inflation and recession, typically caused by a negative supply shock (e.g., the 1970s OPEC oil crisis or the COVID-19 pandemic).

• Negative supply shocks shift SRAS left, causing higher prices and lower output.

Historical Examples

• 2007-2009 Recession was caused by:

  • The end of the housing bubble

  • The financial crisis

  • A rapid increase in oil prices

• COVID-19 Pandemic created a negative supply shock, shifting SRAS left and reducing output.

Development of Macroeconomics

Historical Context

• Macroeconomics emerged as a separate field after the Great Depression to explain large-scale economic fluctuations.

• New Keynesian Economics emphasizes the stickiness of prices and wages, which helps explain why economies do not always return quickly to full employment after shocks.

Summary Table: Factors Shifting Aggregate Demand and Aggregate Supply

Curve	Shifting Factor	Direction of Shift	Example
AD	Increase in government spending	Right	Stimulus package
AD	Decrease in consumer confidence	Left	Recession fears
SRAS	Improvement in technology	Right	Automation
SRAS	Negative supply shock	Left	Oil price spike

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

Additional info: The explanations of the AD and AS curves, as well as the effects of supply shocks and policy changes, have been expanded for clarity and completeness. The summary table is inferred to help organize the main factors affecting the curves.