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 (AD)

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 generally determined by policymakers and are independent of the price level, while consumption, investment, and net exports are influenced by 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.

Summary: Higher price levels lead to lower consumption, investment, and net exports, resulting in a downward-sloping AD curve.

Movements Along vs. Shifts of the AD Curve

Movement Along: Caused by a change in the price level, holding all else constant.
Shift: Caused by changes in any component of AD (C, I, G, NX) other than the price level, such as fiscal or monetary policy changes.

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 it right.
Fiscal Policy: Changes in government spending or taxation. Increased government purchases or lower taxes shift AD right; decreased spending or higher taxes shift AD left.
Changes in Foreign Variables: Increases in foreign income or a depreciation of the domestic currency increase net exports and shift AD right; the opposite shifts AD left.

Aggregate Supply (AS)

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): Vertical at the level of potential GDP, determined by the number of workers, capital stock, and technology. Not affected by the price level.
Short-Run Aggregate Supply (SRAS): Upward sloping because some input prices (like wages) are sticky in the short run, so higher output prices increase profits and output.

Why the SRAS Curve is Upward Sloping

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, preferring layoffs or lower wages for new hires.
Menu Costs: The costs of changing prices discourage frequent price adjustments.

Shifts in the Short-Run Aggregate Supply Curve

Changes in Expectations: If workers and firms expect higher future prices, SRAS shifts left as they demand higher wages and prices.
Changes in Resource Availability: Increases in labor, capital, or technology shift SRAS right; decreases shift it left.
Supply Shocks: Unexpected events (e.g., natural disasters, pandemics) that change input prices or availability, shifting 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: Output and price level where AD = SRAS.
Long-Run Equilibrium: Output at potential GDP, where AD = SRAS = LRAS.

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, SRAS may shift right as wages and prices adjust, restoring long-run equilibrium at a lower price level.
Supply Shocks: A negative supply shock (e.g., pandemic) shifts SRAS left, causing stagflation (higher prices and lower output). Recovery depends on the speed of wage and price adjustments or policy interventions.

Case Study: The Covid-19 Recession

Aggregate Demand and Supply During the Pandemic

AD Effects: Consumption, investment, and exports all fell sharply due to lockdowns, uncertainty, and global economic contraction.
SRAS Effects: Supply chain disruptions and business closures shifted SRAS left.
Result: The economy experienced a sharp decline in real GDP with relatively stable prices, illustrating a leftward shift in both AD and SRAS.

Summary Table: Factors Shifting AD and SRAS

Factor	Shifts AD	Shifts SRAS
Interest Rates	Yes (higher rates shift left)	No
Government Purchases	Yes (higher G shifts right)	No
Expectations of Future Prices	Yes (optimism shifts right)	Yes (higher expected prices shift left)
Resource Prices (e.g., oil)	No	Yes (higher input prices shift left)
Technology	No	Yes (improvements shift right)
Foreign Income	Yes (higher foreign income shifts right)	No

Key Terms and Definitions

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

Example Application

Example: During the Covid-19 recession, U.S. consumption of services declined while residential construction increased, illustrating how different components of AD can move in opposite directions in response to economic shocks and policy interventions.