Aggregate Demand and Aggregate Supply: Macroeconomic Fluctuations and Equilibrium

Aggregate Demand and Aggregate Supply

Introduction

The Aggregate Demand (AD) and Aggregate Supply (AS) framework is a central model in macroeconomics, used to explain short-run fluctuations in economic activity around its long-run trend. This model demonstrates how output and inflation are simultaneously determined in both the short and long run.

• Aggregate Demand (AD): The total quantity of all goods and services demanded in the economy at any given price level.

• Aggregate Supply (AS): The total quantity of goods and services that firms produce and sell at any price level.

• Output (Y): The commodity being bought and sold, representing all goods and services (real GDP).

• Price Level (π): The overall level of prices or inflation in the economy.

Long-run vs Short-run

Classical Dichotomy and Money Neutrality

The classical dichotomy separates economic variables into real (measured in physical units) and nominal (measured in money terms). According to this view, changes in the money supply affect only nominal variables, not real variables like output or unemployment. This is known as money neutrality.

• Quantity Equation: $MV = PY$

• Implications:

  • Velocity of money (V) is stable over time.

  • Changes in money supply (M) cause proportional changes in nominal output (PY).

  • Real output (Y) is determined by factor supplies and technology, not by money.

  • In the long run, changes in money supply affect only the price level (P), not output (Y).

Additional info: In the short run, money is not neutral; changes in money supply can affect real variables due to price and wage rigidities.

Aggregate Demand (AD)

Short-run Aggregate Demand (SRAD)

The SRAD curve shows the relationship between the price level (inflation) and the quantity of goods and services demanded, holding other factors constant. It slopes downward for three main reasons:

• Wealth Effect: A lower price level increases the real value of money, making consumers wealthier and increasing consumption.

• Interest Rate Effect: A lower price level reduces money demand, lowers interest rates, and increases investment.

• Exchange Rate Effect: Lower domestic interest rates lead to currency depreciation, boosting net exports (NX).

Formula: $Y = C + I + G + NX$

Shifts in Aggregate Demand

Any event that changes consumption, investment, government spending, or net exports at every price level will shift the AD curve.

• Consumption: Changes in consumer confidence or preferences.

• Investment: Technological advances or changes in monetary policy affecting interest rates.

• Government Spending: Fiscal policy changes (e.g., increased government expenditure).

• Net Exports: Changes in foreign demand for domestic goods.

Aggregate Supply (AS)

Long-run Aggregate Supply (LRAS)

The LRAS curve is vertical, reflecting the economy’s potential or full employment output (natural level of output). In the long run, output is determined by resources and technology, not by the price level.

• Shifts in LRAS:

  • Changes in labor supply (e.g., immigration, demographic shifts).

  • Changes in capital stock (physical or human capital).

  • Changes in natural resources (e.g., discovery of minerals, weather events).

  • Changes in technology (e.g., technological progress).

Short-run Aggregate Supply (SRAS)

The SRAS curve is upward sloping, showing that as the price level rises, firms are willing to produce more output in the short run. This is due to:

• Inflation Inertia: Output deviates from its long-run level when actual inflation differs from expected inflation.

• Sticky Wage Theory: Nominal wages are slow to adjust, so lower-than-expected prices raise real wages, reducing employment and output.

• Sticky Price Theory: Some firms cannot adjust prices quickly, leading to reduced sales and output when prices fall unexpectedly.

• Misperception Theory: Firms may misinterpret changes in the overall price level as changes in relative prices, affecting output decisions.

SRAS Equation: $Quantity\ of\ Output\ Supplied = Natural\ Level\ of\ Output + a(Actual\ Price\ Level - Expected\ Price\ Level)$

Shifts in SRAS

• Changes in labor, capital, natural resources, or technology.

• Changes in expected price level (lower expected prices shift SRAS right).

• Inflation shocks (e.g., sudden changes in oil prices).

Long-run Equilibrium

Definition and Output Gaps

Long-run equilibrium occurs when AD, SRAS, and LRAS intersect at the natural level of output (Y*), and expected price level equals actual price level. Output gaps can occur:

• Recessionary Gap: $Y < Y^*$ (output below potential, negative gap)

• Expansionary Gap: $Y > Y^*$ (output above potential, positive gap)

Causes of Economic Fluctuations

Shifts in Aggregate Demand

Decreases in AD (e.g., lower consumption, investment, or net exports) shift the AD curve left, causing output to fall below potential (recessionary gap). Policymakers can respond by:

• Doing nothing (letting prices and wages adjust over time, shifting SRAS right and restoring equilibrium at lower inflation).

• Stimulating AD (increasing government spending or cutting taxes), which restores output but may increase inflation.

Shifts in Aggregate Supply

Negative supply shocks (e.g., oil price increases) shift SRAS left, causing both higher inflation and lower output (stagflation). Policymakers face a tradeoff between fighting inflation and fighting recession.

• Stimulating AD can restore output but raises inflation further.

• Shocks to LRAS (e.g., war, natural disasters) reduce potential output, causing persistent output gaps and inflation changes.

Conclusion

• Short-run: Shifts in AD cause output fluctuations.

• Long-run: Shifts in AD affect only the price level, not output.

• Shifts in SRAS cause stagflation (inflation and stagnation).

• Policymakers cannot offset recession and inflation simultaneously.

• Shocks to LRAS cause sharp changes in potential output, with slow recovery.