Aggregate Demand and Aggregate Supply: Macroeconomic Fluctuations and Equilibrium

Aggregate Demand and Aggregate Supply Model

Introduction to the Model

The aggregate demand and aggregate supply (AD-AS) model is a fundamental framework in macroeconomics used to explain short-run fluctuations in real GDP and the price level. It helps analyze how the economy responds to various shocks and policy interventions.

• Aggregate Demand (AD): Total quantity of goods and services demanded across all sectors at different price levels.

• Aggregate Supply (AS): Total quantity of goods and services firms are willing and able to produce at different price levels.

Aggregate Demand

Components of Aggregate Demand

Aggregate demand consists of the sum of expenditures from households, firms, government, and net exports.

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

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

• Government Purchases (G): Expenditures by the government on goods and services.

• Net Exports (NX): Exports minus imports.

Aggregate Demand Equation:

$Y = C + I + G + NX$

Aggregate Demand Curve

The AD curve shows the relationship between the price level and the quantity of real GDP demanded. It is downward sloping due to three main effects:

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

• Interest Rate Effect: Higher price levels lead to higher interest rates, reducing investment and consumption.

• International Trade Effect: Higher price levels make domestic goods more expensive relative to foreign goods, reducing net exports.

Movements Along and Shifts of the AD Curve

• Movement Along: Caused by a change in the price level, holding all else constant.

• Shift: Caused by changes in components of AD (C, I, G, NX).

Variables That Shift the Aggregate Demand Curve

Variable	Direction of Shift	Explanation
Interest rates	Left	Higher interest rates reduce consumption and investment.
Government purchases	Right	Government purchases are a component of AD, so an increase shifts AD right.
Business taxes	Left	Higher taxes reduce investment and consumption.
Growth rate of domestic GDP relative to foreign GDP	Left	Imports will increase faster than exports, reducing net exports.
Exchange rate (value of dollar relative to foreign currencies)	Left	Imports will rise and exports will fall, reducing net exports.

Aggregate Supply

Short-Run Aggregate Supply (SRAS)

The SRAS curve shows the relationship between the price level and the quantity of goods and services firms are willing to supply in the short run. It is upward sloping due to sticky wages and prices, and slow adjustment of input costs.

• Sticky Wages and Prices: Contracts and menu costs cause wages and prices to adjust slowly.

• Firms Adjust Output: Firms may increase output when prices rise before input costs catch up.

Variables That Shift the Short-Run Aggregate Supply Curve

Variable	Direction of Shift	Explanation
Labor force or capital stock	Right	More output can be produced at every price level.
Productivity	Right	Costs of production fall, output increases.
Expected future price level	Left	Higher expected prices lead to higher wage demands, increasing costs.
Workers/firms adjusting to higher prices	Left	Higher wages and input prices reduce output.
Price of important natural resources	Left	Higher resource prices increase costs, reducing output.

Long-Run Aggregate Supply (LRAS)

The LRAS curve is vertical, indicating that in the long run, output is determined by resources, technology, and institutions, not by the price level. The economy is at full employment when operating on the LRAS.

• Determinants: Labor, capital, technology, and efficiency.

• Potential GDP: The level of output at full employment.

Macroeconomic Equilibrium

Short-Run and Long-Run Equilibrium

Equilibrium occurs where AD and SRAS intersect. If the economy is not at full employment, it is in short-run equilibrium. Long-run equilibrium occurs when AD, SRAS, and LRAS all intersect.

• Short-run equilibrium: Real GDP may be above or below potential GDP.

• Long-run equilibrium: Real GDP equals potential GDP, and the economy is at full employment.

Effects of Changes in Aggregate Demand and Supply

Short-Run and Long-Run Effects of a Decrease in Aggregate Demand

A decrease in AD leads to lower output and lower price levels in the short run. In the long run, wages and input prices adjust, and the economy returns to potential GDP but at a lower price level.

• Short-run: Output falls, unemployment rises, price level falls.

• Long-run: Input prices adjust, output returns to potential, price level remains lower.

Application: The 2020 Recession

Components of Aggregate Demand During the 2020 Recession

Analysis of the 2020 recession shows significant changes in components of aggregate demand:

• Residential investment: Stable before the recession, then increased sharply in the later part of 2020.

• Net exports: Declined due to a sharp increase in the value of the U.S. dollar.

• Consumption of goods: Rose sharply before stabilizing.

Supply Shocks and SRAS Shifts

Supply Shocks

Supply shocks are unexpected events that cause the SRAS curve to shift, such as sudden changes in oil prices or natural disasters.

• Negative supply shock: SRAS shifts left, output falls, price level rises.

• Positive supply shock: SRAS shifts right, output rises, price level falls.

Expectations and SRAS

Role of Expectations

Expectations about future price levels can shift the SRAS curve. If workers and firms expect higher prices, they will adjust wages and prices upward, shifting SRAS left.

• Self-fulfilling expectations: Widespread expectations of price increases can cause actual price increases.

Does It Matter Which Component Causes a Decline in Aggregate Demand?

Research suggests that recessions caused by financial crises tend to be longer and more severe than those caused by other factors, such as declines in housing.

• Financial crises: Lead to larger and longer-lasting recessions.

• Other factors: May cause shorter or less severe recessions.

Additional info: These notes expand on the original content by providing definitions, explanations, and context for key macroeconomic concepts, as well as recreating and summarizing tables and diagrams from the source material.