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

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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 dynamics, helping us understand business cycles and economic shocks.

Aggregate Demand (AD): Represents the total quantity of goods and services demanded across the economy at different price levels.
Aggregate Supply (AS): Represents the total quantity of goods and services firms are willing and able to supply at different price levels.
Short-run vs. Long-run: The model distinguishes between short-run fluctuations and long-run growth, with different determinants in each period.

Aggregate Demand (AD)

Definition and Components

Aggregate demand is the total demand for final goods and services in an economy at a given time and price level. It is composed of four main components:

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.

The aggregate demand equation is:

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 AD curve is downward sloping 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.
International Trade Effect: Higher domestic price levels make exports more expensive and imports cheaper, reducing net exports.

Wealth Effect

Household consumption is influenced by wealth, which is often held in nominal assets.
When price levels rise, the real value of these assets decreases, reducing consumption.
Conclusion: Higher price level leads to lower consumption.

Interest Rate Effect

Rising prices increase the need for money for transactions.
Households and firms withdraw funds from financial assets, increasing the demand for money and driving up interest rates.
Higher interest rates discourage investment spending.
Conclusion: Higher price level leads to lower investment.

International Trade Effect

Higher U.S. price levels make U.S. exports more expensive and imports cheaper.
Net exports decrease as exports fall and imports rise.
Conclusion: Higher price level leads to lower net exports.

Movements vs. Shifts in the AD Curve

Movement along the AD curve: Caused by changes in the price level, holding other factors constant.
Shift of the AD curve: Occurs when one of the components (C, I, G, NX) changes due to factors other than the price level, such as fiscal or monetary policy.

Aggregate Supply (AS)

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 other factors constant. In the short run, the SRAS curve is upward sloping.

Sticky Wages and Prices: Wages and some prices do not adjust immediately to changes in economic conditions, causing the SRAS to slope upward.
Slow Adjustment: Firms may be slow to adjust wages and prices due to contracts, menu costs, and morale concerns.

Long-Run Aggregate Supply (LRAS)

The long-run aggregate supply curve is vertical, indicating that in the long run, the level of real GDP supplied is determined by the economy's resources and technology, not by the price level.

Determinants: Number of workers, capital stock, and technology.
Potential GDP: The level of output when the economy is at full employment.

Macroeconomic Equilibrium

Short-Run and Long-Run Equilibrium

Macroeconomic equilibrium occurs at the intersection of the AD and SRAS curves. Long-run equilibrium is achieved when this intersection also coincides with the LRAS curve, meaning the economy is at full employment and potential GDP.

Short-run equilibrium: Real GDP and price level are determined by the intersection of AD and SRAS.
Long-run equilibrium: Occurs when AD, SRAS, and LRAS all intersect at the same point.

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: Changes in foreign demand for domestic goods and currency values.

Factors Shifting Short-Run Aggregate Supply

Expectations of Future Price Levels: If firms and workers expect higher prices, SRAS shifts left.
Changes in Resource Availability: Increases in labor, capital, or technology shift SRAS right; decreases shift it left.
Input Prices: Sudden increases (supply shocks) shift SRAS left; decreases shift it right.

Application: The Covid-19 Recession

Impact on Aggregate Demand and Supply

The Covid-19 pandemic caused both a negative demand shock and a negative supply shock, shifting both the AD and SRAS curves to the left. This resulted in a decrease in real GDP and, in some cases, stable or falling price levels.

Reduced Consumption: Social distancing and closures reduced spending, especially on services.
Reduced Investment: Uncertainty and suspended projects lowered investment.
Reduced Exports: Global recession reduced demand for U.S. exports.

Summary Table: Effects of Price Level Changes on AD Components

Effect	Component Affected	Result of Higher Price Level
Wealth Effect	Consumption (C)	Decrease
Interest Rate Effect	Investment (I)	Decrease
International Trade Effect	Net Exports (NX)	Decrease

Key Formulas

Aggregate Demand:

Examples and Applications

Covid-19 Recession: Services declined, residential construction increased due to low interest rates and stimulus checks.
Supply Shocks: Sudden increases in input prices (e.g., oil) shift SRAS left, causing stagflation (inflation + recession).

Additional info:

Sticky wages and prices are a central reason for the upward slope of the SRAS curve.
Long-run aggregate supply is not affected by the price level, but by resources and technology.
Business cycles are not uniform in length or severity; recovery times vary across recessions.