Aggregate Demand and Aggregate Supply: Principles and Applications

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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, unemployment, and the price level. This model extends the analysis of long-run economic growth to include short-run economic dynamics.

Aggregate Demand (AD): The total quantity of goods and services demanded across all levels of an economy at various price levels.
Aggregate Supply (AS): The total quantity of goods and services that firms are willing and able to supply at different price levels.
Short-run vs. Long-run: The short run is a period in which some prices or wages are sticky, while the long run is when all prices and wages are flexible.

Aggregate Demand

Definition and Components

Aggregate demand represents the total spending on a country's goods and services at different price levels. It is composed of four main components, summarized by the equation:

Consumption (C): Spending by households on goods and services.
Investment (I): Spending by firms on capital goods and by households on new housing.
Government Purchases (G): Expenditures by government on goods and services.
Net Exports (NX): Exports minus imports.

Government purchases are typically determined by policymakers and are not directly affected by changes in the price level, while consumption, investment, and net exports are sensitive to price level changes.

Why the Aggregate Demand Curve Slopes Downward

The downward slope of the AD curve is explained by 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: Higher domestic price levels make exports more expensive and imports cheaper, reducing net exports.

Summary Table: Effects of a Price Level Increase

Effect	Mechanism	Impact on AD Components
Wealth Effect	Reduces real wealth	Lower consumption (C)
Interest-Rate Effect	Raises interest rates	Lower investment (I)
International-Trade Effect	Exports fall, imports rise	Lower net exports (NX)

Shifts vs. Movements Along the AD Curve

Movement along the AD curve: Caused by a change in the price level, holding all else constant.
Shift of the AD curve: Occurs when a component of aggregate demand changes for reasons other than the price level (e.g., changes in government policy, consumer confidence, foreign income).

Factors That Shift the Aggregate Demand Curve

Monetary Policy: Actions by the central bank (e.g., Federal Reserve) to change the money supply and interest rates. Higher interest rates shift AD left; lower rates shift AD right.
Fiscal Policy: Changes in government spending and taxation. Increased government purchases or lower taxes shift AD right; decreased spending or higher taxes shift AD left.
Foreign Factors: Changes in foreign income or exchange rates can affect net exports and shift AD.

Aggregate Supply

Short-Run vs. Long-Run Aggregate Supply

Aggregate supply describes the total output firms are willing to produce at various price levels. The relationship differs in the short run and long run.

Long-Run Aggregate Supply (LRAS): Shows the relationship between the price level and the quantity of real GDP supplied when all prices, including wages, are flexible. LRAS is vertical at potential GDP, determined by resources, technology, and capital stock.
Short-Run Aggregate Supply (SRAS): Shows the relationship when some prices or wages are sticky. SRAS is upward sloping because input prices adjust more slowly than output prices.

Why the SRAS Curve Slopes Upward

Sticky Wages and Prices: Contracts and slow adjustments make wages and some prices inflexible in the short run.
Slow Wage Adjustments: Firms are reluctant to cut nominal wages; wage reviews are infrequent.
Menu Costs: Firms face costs to changing prices, so they may delay price adjustments.

Shifts in the Short-Run Aggregate Supply Curve

Changes in Resource Availability: Increases in labor, capital, or natural resources shift SRAS right; decreases shift it left.
Technological Change: Improvements in technology increase productivity and shift SRAS right.
Expectations of Future Prices: If firms expect higher future prices, SRAS shifts left as they adjust wages and prices upward.
Supply Shocks: Unexpected events (e.g., natural disasters, pandemics) that affect input prices or production capacity can shift SRAS.

Macroeconomic Equilibrium

Short-Run and Long-Run Equilibrium

Macroeconomic equilibrium occurs where the AD and SRAS curves intersect. In the long run, equilibrium is at the intersection of AD, SRAS, and LRAS, corresponding to potential GDP and full employment.

Short-Run Equilibrium: The economy may be above or below potential GDP, with unemployment deviating from the natural rate.
Long-Run Equilibrium: Adjustments in wages and prices return the economy to potential GDP.

Effects of Shocks and Policy Responses

Demand Shocks: A decrease in AD (e.g., due to higher interest rates) leads to lower output and higher unemployment in the short run. Over time, lower wages and input prices shift SRAS right, restoring long-run equilibrium at a lower price level.
Supply Shocks: A negative supply shock (e.g., sudden increase in oil prices) shifts SRAS left, causing stagflation (higher prices and lower output). Recovery may take years or require policy intervention to boost AD.

Case Study: The Covid-19 Recession

Simultaneous Shocks: The pandemic caused both a negative supply shock (SRAS left) and a demand shock (AD left), leading to a sharp drop in output with relatively stable prices.
Sectoral Impacts: Services declined, while residential construction increased due to low interest rates and stimulus checks.
Policy Response: Fiscal and monetary stimulus aimed to support AD and facilitate recovery.

Summary Table: Shifts in Aggregate Demand and Supply

Event	Curve Shifted	Direction	Short-Run Effect	Long-Run Adjustment
Increase in government spending	AD	Right	Higher output, higher prices	SRAS shifts left, output returns to potential, prices higher
Negative supply shock (e.g., oil price spike)	SRAS	Left	Lower output, higher prices (stagflation)	SRAS shifts right as input prices adjust, output returns to potential
Decrease in consumer confidence	AD	Left	Lower output, lower prices	SRAS shifts right, output returns to potential, prices lower

Key Terms and Definitions

Aggregate Demand (AD): Total demand for goods and services in an economy at different price levels.
Aggregate Supply (AS): Total supply of goods and services in an economy at different price levels.
Short-Run Aggregate Supply (SRAS): The relationship between the price level and real GDP supplied when some prices are sticky.
Long-Run Aggregate Supply (LRAS): The relationship between the price level and real GDP supplied when all prices are flexible; vertical at potential GDP.
Potential GDP: The level of output when the economy is at full employment.
Stagflation: A situation of rising prices and falling output, typically caused by a negative supply shock.
Supply Shock: An unexpected event that changes the supply of goods and services.

Example Application

Example: During the Covid-19 recession, U.S. services declined while residential construction increased due to low interest rates and stimulus checks. This illustrates how different components of AD can be affected differently by economic shocks and policy responses.

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