Aggregate Demand and Aggregate Supply: Key Concepts and Applications

Aggregate Demand and Aggregate Supply

Introduction

The Aggregate Demand (AD) and Aggregate Supply (AS) model is a central framework in macroeconomics for analyzing fluctuations in output, prices, and employment in the economy. This study guide covers the main concepts, shifts, and implications of changes in AD and AS, including the effects on GDP, price levels, and economic policy.

Aggregate Demand (AD)

Aggregate Demand represents 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.

• Definition: The AD curve shows the relationship between the price level and the quantity of output demanded.

• Formula: $AD = C + I + G + (X - M)$ Where:

  • C = Consumption

  • I = Investment

  • G = Government Spending

  • X = Exports

  • M = Imports

• Shifts in AD:

  • AD shifts right when there is an increase in aggregate demand (e.g., higher consumer confidence, increased government spending).

  • AD shifts left when there is a decrease in aggregate demand (e.g., lower investment, reduced exports).

• Movement along the AD curve: Caused by changes in the price level, not by changes in the components of AD.

• Example: If consumer spending increases due to higher confidence, the AD curve shifts right.

Aggregate Supply (AS)

Aggregate Supply represents the total quantity of goods and services that producers in an economy are willing and able to supply at a given overall price level.

• Short-Run Aggregate Supply (SRAS): The SRAS curve is upward sloping, reflecting that as prices rise, producers are willing to supply more.

• Long-Run Aggregate Supply (LRAS): The LRAS curve is vertical, indicating that in the long run, output is determined by resources and technology, not by the price level.

• Shifts in AS:

  • AS shifts right when there is an increase in productive capacity or lower input costs.

  • AS shifts left when there is a decrease in productive capacity or higher input costs.

• Movement along the AS curve: Caused by changes in the price level.

• Example: If wages increase, the SRAS curve may shift left due to higher production costs.

Shifts and Movements: AD and AS Curves

• AD Curve:

  • Shift right: Increase in AD (e.g., expansionary fiscal policy)

  • Shift left: Decrease in AD (e.g., contractionary monetary policy)

  • Movement along: Change in price level only

• AS Curve:

  • Shift right: Increase in AS (e.g., technological improvement)

  • Shift left: Decrease in AS (e.g., higher input prices)

  • Movement along: Change in price level only

Determinants of GDP and Price Level

• Equilibrium GDP and Price Level: Determined by the intersection of the AD and AS curves.

• Example: If AD increases and AS remains unchanged, both GDP and the price level rise.

• Formula for Equilibrium: $Y^* = AD = AS$

Stagflation

Stagflation is a situation where the economy experiences stagnant growth (or recession) and inflation simultaneously.

• Causes: Often results from a leftward shift in the AS curve (e.g., oil price shocks).

• Effects: GDP falls, price level rises, and unemployment increases.

• Example: 1970s oil crisis led to stagflation in many developed economies.

The Phillips Curve

The Phillips Curve illustrates the inverse relationship between inflation and unemployment in the short run.

• Short-Run Phillips Curve: Shows trade-off between inflation and unemployment.

• Long-Run Phillips Curve: Vertical at the natural rate of unemployment; no trade-off in the long run.

• Assumptions:

  • Aggregate supply and demand curves shift

  • Expectations adjust over time

• Example: Expansionary policy may lower unemployment but increase inflation in the short run.

Long-Run vs. Short-Run Equilibrium

• Short-Run Equilibrium: Where AD and SRAS intersect; output may be above or below potential GDP.

• Long-Run Equilibrium: Where AD, SRAS, and LRAS intersect; output equals potential GDP.

• Adjustment Process: If output exceeds potential, wages and prices rise, shifting SRAS left until equilibrium is restored.

• Example: After a demand shock, the economy may temporarily operate above or below full employment.

Summary Table: Shifts in AD and AS

Curve	Shift Right	Shift Left
Aggregate Demand (AD)	Higher GDP, higher price level	Lower GDP, lower price level
Aggregate Supply (AS)	Higher GDP, lower price level	Lower GDP, higher price level (stagflation)

Key Terms

• Aggregate Demand (AD)

• Aggregate Supply (AS)

• Short-Run Aggregate Supply (SRAS)

• Long-Run Aggregate Supply (LRAS)

• Stagflation

• Phillips Curve

• Equilibrium GDP

Additional info: Some explanations and examples have been expanded for clarity and completeness beyond the original questions.