Aggregate Demand and Aggregate Supply: Macroeconomic Equilibrium and Dynamics

Aggregate Demand and Aggregate Supply

Introduction

This chapter explores the core concepts of aggregate demand (AD) and aggregate supply (AS) in macroeconomics, focusing on how they interact to determine real GDP and the price level in both the short run and long run. Understanding these models is essential for analyzing economic fluctuations, policy impacts, and macroeconomic equilibrium.

Aggregate Demand

Definition and Model

• Aggregate demand (AD) curve: Shows the relationship between the price level and the quantity of real GDP demanded by households, firms, and the government (domestic and foreign).

• Aggregate demand and aggregate supply model: A framework that explains short-run fluctuations in real GDP and the price level.

Why is the AD Curve Downward Sloping?

The AD curve slopes downward due to three main effects:

• Wealth Effect: As the price level rises, the real value of household wealth falls, 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: An increase in the domestic price level makes exports more expensive and imports cheaper, reducing net exports.

Movements vs. Shifts of the AD Curve

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

• Shift of the AD curve: Occurs when a component of real GDP (such as government purchases, investment, or net exports) changes for reasons other than the price level.

Variables That Shift the AD Curve

Variable	Shifts the AD Curve	Reason
Interest rates	Left	Higher interest rates raise the cost of borrowing, reducing consumption and investment spending.
Government purchases	Right	Government purchases are a component of aggregate demand.
Personal income taxes, business taxes	Left	Consumption spending falls when personal taxes rise, and investment falls when business taxes rise.

• Monetary policy: Actions by the Federal Reserve to manage the money supply and interest rates to pursue macroeconomic policy objectives.

• Fiscal policy: Changes in federal taxes and purchases intended to achieve macroeconomic policy objectives.

Aggregate Supply

Definition and Model

• Aggregate supply: The quantity of goods and services that firms are willing and able to supply at different price levels.

• Long-run aggregate supply (LRAS) curve: Vertical line showing the relationship between the price level and the quantity of real GDP supplied in the long run. Determined by the number of workers, technology, and capital stock.

• Short-run aggregate supply (SRAS) curve: Upward sloping curve showing the relationship between the price level and the quantity of real GDP supplied in the short run.

Why is the SRAS Curve Upward Sloping?

• Sticky wages and prices: Contracts and slow adjustments make some wages and prices resistant to change.

• Slow adjustment of wages: Firms are often slow to adjust wages in response to changes in the price level.

• Menu costs: The costs of changing prices make some prices sticky.

Movements vs. Shifts of the SRAS Curve

• Movement along the SRAS curve: Caused by a change in the price level, holding other factors constant.

• Shift of the SRAS curve: Caused by changes in factors such as labor force, capital stock, expected future prices, and supply shocks.

Variables That Shift the SRAS Curve

Variable	Shifts the SRAS Curve	Reason
Labor force or capital stock	Right	More output can be produced at every price level.
Costs of production	Left	Higher costs reduce output at every price level.
Expected future price level	Left	Expecting higher prices leads workers and firms to increase wages and prices.
Supply shock (e.g., oil price increase, pandemic)	Left	Unexpected events raise costs and reduce output.

Macroeconomic Equilibrium

Short-Run and Long-Run Equilibrium

• Short-run equilibrium: Occurs at the intersection of the AD and SRAS curves, determining the current level of real GDP and the price level.

• Long-run equilibrium: Occurs when AD, SRAS, and LRAS intersect, and the economy is at full employment (potential GDP).

Effects of Shifts in AD and SRAS

• Decrease in AD: Leads to recession, lower output, and higher unemployment. Over time, lower wages and prices restore equilibrium.

• Increase in AD: Leads to higher output and lower unemployment in the short run, but eventually raises wages and prices, shifting SRAS left and restoring equilibrium.

• Supply shock: Causes stagflation (combination of inflation and recession). Recovery depends on the severity and duration of the shock.

Dynamic Aggregate Demand and Aggregate Supply Model

Incorporating Growth and Inflation

• Dynamic model: Accounts for continually increasing real GDP (shifting LRAS right), AD shifting right, and SRAS shifting right except during periods of high expected inflation.

• Inflation: Usually caused by aggregate spending increasing faster than production, shifting AD further right than LRAS.

Applications and Examples

• Recession of 2007-2009: Aggregate demand did not keep pace with potential GDP due to the housing bubble and financial crisis, while increasing oil prices shifted SRAS left, resulting in higher prices and real GDP below potential.

• COVID-19 pandemic: Created a supply shock (SRAS left) and also affected AD, resulting in a new equilibrium with lower output and higher unemployment.

Key Formulas

• Aggregate Demand Equation: $AD = C + I + G + (X - M)$ Where: $C$ = Consumption $I$ = Investment $G$ = Government Purchases $X$ = Exports $M$ = Imports

Summary Table: Effects of Shifts in AD and SRAS

Event	Short-Run Effect	Long-Run Adjustment
Decrease in AD	Lower output, higher unemployment	Wages and prices fall, SRAS shifts right, equilibrium restored
Increase in AD	Higher output, lower unemployment	Wages and prices rise, SRAS shifts left, equilibrium restored
Supply shock	Stagflation: inflation and recession	SRAS shifts right as costs fall, equilibrium restored over time

Additional info: The dynamic AD-AS model is essential for understanding real-world macroeconomic phenomena such as inflation, recession, and long-term growth. It provides a framework for analyzing the effects of monetary and fiscal policy, as well as external shocks.