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 sectors of the economy at various price levels.
Aggregate Supply (AS): The total quantity of goods and services that firms are willing and able to produce 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 typically determined by policymakers and are not directly affected by 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 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.
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: Occurs when a component of AD (C, I, G, NX) changes due to factors other than the price level, such as fiscal or monetary policy.

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 it 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 it left.

Aggregate Supply (AS)

Short-Run vs. Long-Run Aggregate Supply

Aggregate supply refers to the total output firms are willing to produce at various price levels. The relationship between output and the price level 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 in the long run, when all prices and wages are flexible. LRAS is vertical at the level of potential GDP (full employment output).
Short-Run Aggregate Supply (SRAS): Shows the relationship in the short run, when some prices or wages are sticky. The SRAS curve is upward sloping.

Why the SRAS Curve Slopes Upward

Sticky Wages and Prices: Contracts and slow adjustments make some wages and prices inflexible in the short run.
Slow Wage Adjustments: Firms are reluctant to cut nominal wages, often preferring layoffs.
Menu Costs: The costs of changing prices discourage frequent price adjustments.

As a result, when the price level rises, firms increase output because their costs rise more slowly than prices.

Shifts in the Short-Run Aggregate Supply Curve

Changes in Expectations: If workers and firms expect higher future prices, SRAS shifts left (upward); if they expect lower prices, SRAS shifts right (downward).
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 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 causes recession and unemployment in the short run; over time, lower wages and prices restore full employment.
Supply Shocks: Negative supply shocks (e.g., oil price spikes, pandemics) cause stagflation (recession + inflation). Recovery may take years or require policy intervention.

Case Study: The Covid-19 Recession

Aggregate Demand and Supply During the Pandemic

The Covid-19 pandemic caused both a negative supply shock (SRAS shifted left due to business closures and supply disruptions) and a negative demand shock (AD shifted left due to reduced consumption, investment, and exports). The result was a sharp decline in real GDP with relatively stable prices in the short run.

Consumption: Fell sharply, especially for services.
Investment: Initially declined, but residential investment increased due to low interest rates and stimulus.
Net Exports: Decreased as global demand fell and the dollar appreciated.

Summary Table: Factors Shifting AD and SRAS

Factor	Shifts AD	Shifts SRAS	Direction of Shift	Explanation
Interest Rates	Yes	No	Higher rates: AD left; Lower rates: AD right	Higher rates reduce investment and consumption
Government Purchases	Yes	No	Increase: AD right; Decrease: AD left	Directly changes G in AD equation
Expectations of Future Prices	No	Yes	Higher expected prices: SRAS left	Firms adjust wages/prices in anticipation
Resource Availability	No	Yes	Increase: SRAS right; Decrease: SRAS left	More resources increase potential output
Supply Shock	No	Yes	Negative: SRAS left; Positive: SRAS right	Unexpected events affect input costs/availability

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 at different price levels.
Short-Run Aggregate Supply (SRAS): The relationship between the price level and output when some prices/wages are sticky.
Long-Run Aggregate Supply (LRAS): The relationship between the price level and output when all prices/wages are flexible; vertical at potential GDP.
Potential GDP: The level of output at full employment.
Stagflation: A combination of stagnation (recession) and inflation, often caused by negative supply shocks.
Wealth Effect: The impact of price level changes on the real value of wealth and thus on consumption.
Interest-Rate Effect: The impact of price level changes on interest rates and investment.
International-Trade Effect: The impact of domestic price level changes on exports and imports.

Example: The Wealth Effect

Suppose the price level falls. The real value of household wealth rises, leading to increased consumption. This is an example of the wealth effect, which contributes to the downward slope of the AD curve.

Additional info:

Some content was inferred and expanded for clarity and completeness, such as the summary table and definitions.
Equations and diagrams referenced in the notes are standard in macroeconomics and were included for academic completeness.