Aggregate Demand and Aggregate Supply: Principles of Macroeconomics (ECON 1104)

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 dynamics, helping us understand business cycles and economic shocks.

• Aggregate demand (AD): Total demand for goods and services in an economy at different price levels.

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

Aggregate Demand

Definition and Components

Aggregate demand represents the total quantity of real GDP demanded by households, firms, and the government (both domestic and foreign) at various price levels.

• Formula: $Y = C + I + G + NX$

• 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 independent of the price level, while consumption, investment, and net exports are sensitive to changes in the price level.

Why the Aggregate Demand Curve Slopes Downward

The aggregate demand curve is downward sloping due to three main effects:

1. Wealth Effect: As price levels rise, the real value of household wealth falls, leading to lower consumption. Example: If inflation erodes the purchasing power of savings, households spend less.

2. Interest-Rate Effect: Higher price levels increase the demand for money, raising interest rates and discouraging investment. Example: Firms postpone investment projects when borrowing costs rise.

3. International-Trade Effect: Higher domestic price levels make exports more expensive and imports cheaper, reducing net exports. Example: U.S. goods become less competitive abroad when U.S. prices rise.

Each effect contributes to a lower quantity of real GDP demanded as the price level increases.

Aggregate Supply

Short-Run Aggregate Supply (SRAS)

The short-run aggregate supply curve shows the relationship between the price level and the quantity of real GDP supplied by firms, holding all other factors constant. In the short run, prices of inputs (like wages and raw materials) adjust slowly, causing the SRAS curve to be upward sloping.

• Sticky wages and prices: Contracts and menu costs prevent immediate adjustment to changing economic conditions.

• Slow wage adjustment: Firms are reluctant to cut wages, preferring layoffs or lower starting salaries for new hires.

• Menu costs: Firms incur costs when changing prices, leading to infrequent adjustments.

Long-Run Aggregate Supply (LRAS)

The long-run aggregate supply curve is vertical, indicating that the economy's potential output (full-employment GDP) is determined by resources, technology, and capital stock, not by the price level.

• Potential GDP: The level of output when all resources are fully employed.

• LRAS: Represents the economy's maximum sustainable output.

Macroeconomic Equilibrium

Short-Run and Long-Run Equilibrium

Equilibrium occurs at the intersection of the AD and SRAS curves, determining the actual level of real GDP and the price level in the short run. In the long run, equilibrium is restored at the intersection of AD, SRAS, and LRAS, corresponding to full employment.

• Short-run equilibrium: May result in unemployment or inflation if output deviates from potential GDP.

• Long-run equilibrium: Output returns to potential GDP as wages and prices adjust.

Shifts in Aggregate Demand and Aggregate Supply

Factors Shifting Aggregate Demand

• Monetary policy: Changes in the money supply and interest rates by the central bank.

• Fiscal policy: Changes in government spending and taxation.

• Foreign income and exchange rates: Affect net exports.

For example, higher interest rates reduce investment and shift AD left; increased government spending shifts AD right.

Factors Shifting Short-Run Aggregate Supply

• Changes in resource availability: More labor or capital increases SRAS.

• Technological advances: Improve productivity and shift SRAS right.

• Expectations of future prices: If firms expect higher prices, SRAS shifts left.

• Supply shocks: Unexpected events (e.g., natural disasters, pandemics) can shift SRAS left or right.

Application: The Covid-19 Recession

Impact on Aggregate Demand and Supply

The Covid-19 pandemic caused both a negative demand shock (reduced consumption, investment, and exports) and a negative supply shock (business closures, reduced production). The result was a sharp decline in real GDP and a shift of both AD and SRAS curves to the left.

• Consumption: Fell sharply, especially in services.

• Investment: Initially stable, then increased in housing due to low interest rates.

• Net exports: Decreased due to global economic slowdown and a stronger U.S. dollar.

Summary Table: Effects of Price Level Changes on Aggregate Demand Components

Effect	Component Affected	Result of Higher Price Level
Wealth Effect	Consumption (C)	Lower consumption
Interest-Rate Effect	Investment (I)	Lower investment
International-Trade Effect	Net Exports (NX)	Lower net exports

Key Equations

• Aggregate Demand: $Y = C + I + G + NX$

Conclusion

The AD-AS model is essential for understanding macroeconomic fluctuations, policy impacts, and the effects of shocks such as recessions and pandemics. By analyzing shifts in aggregate demand and supply, economists can predict changes in output, employment, and prices, and recommend appropriate policy responses.