Aggregate Demand and Aggregate Supply: Foundations, Determinants, and Macroeconomic Equilibrium

Aggregate Demand and Aggregate Supply Analysis

Introduction

This section explores the core macroeconomic model used to analyze short-run fluctuations in real GDP and the price level: the Aggregate Demand (AD) and Aggregate Supply (AS) model. Understanding these concepts is essential for analyzing business cycles, inflation, and policy impacts.

Aggregate Demand (AD)

Definition and Components

• Aggregate Demand (AD) is the total quantity of goods and services demanded across all levels of an economy at a given overall price level and in a given period.

• AD is composed of four main components:

  • Consumption (C)

  • Investment (I)

  • Government Purchases (G)

  • Net Exports (NX) (Exports minus Imports)

• The equation for real GDP (Y) is:

$Y = C + I + G + NX$

• Government purchases are typically determined by policy decisions and are not directly affected by the price level, while C, I, and NX are influenced by changes in the price level.

Why the AD Curve Slopes Downward

• The Wealth Effect: As the price level rises, the real value of household wealth (especially nominal assets) falls, 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 prices make exports more expensive and imports cheaper, reducing net exports.

Movements Along vs. Shifts of the AD Curve

• A movement along the AD curve is caused by a change in the price level, holding all else constant.

• A shift of the AD curve occurs when a non-price factor (such as fiscal or monetary policy, expectations, or foreign income) changes one of the components of AD.

Determinants of Aggregate Demand (Table 9.1)

An increase in ...	Shifts the AD curve ...	Because ...
Interest rates	Left	Higher rates raise the cost of borrowing, reducing consumption and investment.
Government purchases	Right	Government purchases are a direct component of AD.
Personal income or business taxes	Left	Higher taxes reduce disposable income and investment.
Household or firm optimism	Right	Increases consumption and investment.
Growth rate of domestic GDP relative to foreign GDP	Left	Imports rise faster than exports, reducing net exports.
Exchange rate (domestic currency appreciates)	Left	Exports become more expensive, imports cheaper; net exports fall.

Examples of Economic Indicators Affecting AD

• Index of Consumer Confidence: Higher values predict increased consumer spending.

• Purchasing Managers Index: Indicates future business investment.

• Other indicators: Taylor’s Hemline Index, Lipstick Index, Skinny Tie Width indicator (all reflect consumer/business sentiment).

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 a given price level.

• The relationship between quantity supplied and price level differs in the short run and long run.

Long-Run Aggregate Supply (LRAS)

• The LRAS curve is vertical, indicating that in the long run, real GDP is determined by resources (labour, capital, technology), not by the price level.

• LRAS occurs at the level of potential or full-employment GDP.

Short-Run Aggregate Supply (SRAS)

• The SRAS curve is upward sloping because:

  • Prices of final goods rise faster than input prices (wages, resources).

  • Some firms are slow to adjust prices or wages due to contracts or menu costs.

• Sticky wages and prices: Contracts and adjustment lags make some wages and prices slow to change.

• Menu costs: The costs of changing prices (e.g., printing new catalogs) can make firms reluctant to adjust prices for small changes in demand.

Movements Along vs. Shifts of the SRAS Curve

• A movement along the SRAS curve is caused by a change in the price level, holding all else constant.

• A shift of the SRAS curve occurs when factors other than the price level (such as expectations, resource availability, or supply shocks) change.

Determinants of Short-Run Aggregate Supply (Table 9.2)

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

Macroeconomic Equilibrium

Short-Run and Long-Run Equilibrium

• Equilibrium occurs where AD and SRAS intersect; in the long run, this point also lies on the LRAS curve (potential GDP).

• Short-run shocks (to AD or SRAS) can cause output and prices to deviate from potential GDP, but in the long run, the economy tends to return to full employment.

Examples of Shocks and Adjustments

• Negative AD shock: AD shifts left (e.g., higher interest rates), causing lower output and higher unemployment in the short run. Over time, lower wages and prices shift SRAS right, restoring full employment at a lower price level.

• Positive AD shock: AD shifts right (e.g., increased optimism), causing higher output and lower unemployment. Over time, higher wages and prices shift SRAS left, restoring full employment at a higher price level.

• Supply shock: SRAS shifts left (e.g., oil price spike), causing higher prices and lower output (stagflation). Recovery depends on the shock's duration and policy responses.

Dynamic Aggregate Demand and Aggregate Supply Model

Incorporating Growth and Inflation

• The dynamic model accounts for ongoing growth in potential GDP (LRAS shifts right), rising AD (due to population and income growth), and SRAS shifts (due to productivity and expectations).

• Inflation occurs when AD increases faster than LRAS and SRAS.

Appendix: Macroeconomic Schools of Thought

Key Schools

• Keynesian: Emphasizes the role of aggregate demand and the stickiness of wages and prices in causing business cycles. Advocates for active policy intervention.

• Monetarist: Focuses on the role of money supply (Milton Friedman). Advocates for a constant growth rule for money supply.

• New Classical: Emphasizes rational expectations and the importance of correct price-level expectations. Fluctuations are minimized if expectations are accurate.

• Real Business Cycle: Attributes business cycles to real (not monetary) shocks, such as productivity changes. Assumes rapid adjustment of prices and wages.

• Marxist Critique: Focuses on labor value and class struggle, predicting eventual replacement of capitalism by communism due to worker exploitation.

Example:

• The 2020 COVID-19 recession involved both supply and demand shocks, but falling prices suggested a larger role for a negative demand shock.

Additional info: The notes above synthesize and expand on the provided slides, including definitions, examples, and tables for clarity and exam preparation.