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 and the price level. This model extends the analysis of long-run economic growth to include short-run dynamics, helping us understand why real GDP, employment, and the price level fluctuate over time.

Aggregate Demand (AD) Curve: Shows the relationship between the price level and the quantity of real GDP demanded by households, firms, the government, and foreign buyers.
Short-Run Aggregate Supply (SRAS) Curve: Shows the relationship in the short run between the price level and the quantity of real GDP supplied by firms.
In the short run, real GDP and the price level are determined by the intersection of the AD and SRAS curves.

Aggregate Demand

Components of Aggregate Demand

Real GDP is composed of four main components, represented 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): Spending by governments on goods and services.
Net Exports (NX): Exports minus imports.

Government purchases are typically determined by policy decisions and are independent of the price level, while consumption, investment, and net exports are affected by changes in the price level.

The Wealth Effect

The wealth effect explains how changes in the price level affect consumption:

As the price level rises, the real value of household wealth (held in nominal assets) declines.
This leads to reduced consumption.
Implication: Higher price levels lead to lower consumption.

The Interest Rate Effect

The interest rate effect describes how changes in the price level influence investment:

When prices rise, households and firms need more money for transactions, increasing the demand for money.
This drives up interest rates, making borrowing more expensive and discouraging investment.
Implication: Higher price levels lead to lower investment.

The International-Trade Effect

The international-trade effect shows how the price level affects net exports:

When U.S. price levels rise, U.S. exports become more expensive and imports become relatively cheaper.
This reduces net exports.
Implication: Higher price levels lead to lower net exports.

Downward Slope of the Aggregate Demand Curve

Each of the three effects above demonstrates that higher price levels reduce the components of real GDP.
This establishes that the aggregate demand curve slopes downward.

Movements Along vs. Shifts of the Aggregate Demand Curve

A movement along the AD curve occurs when the price level changes, holding all else constant.
A shift of the AD curve occurs when a component of real GDP (C, I, G, or NX) changes for reasons other than the price level (e.g., changes in government policy).

Variables That Shift the Aggregate Demand Curve

Monetary Policy: Actions by the Federal Reserve to manage the money supply and interest rates. For example, higher interest rates shift AD left; lower rates shift AD right.
Fiscal Policy: Changes in federal taxes and government purchases. Increased government spending or lower taxes shift AD right; decreased spending or higher taxes shift AD left.
Other Factors: Changes in foreign income, exchange rates, and expectations about the future can also shift AD.

Variable	Shift Direction	Reason
Interest rates ↑	AD shifts left	Higher borrowing costs reduce consumption and investment
Government purchases ↑	AD shifts right	Direct increase in aggregate demand
Personal/business taxes ↑	AD shifts left	Lower disposable income and investment
Foreign GDP ↑	AD shifts right	Higher demand for exports
Exchange rate ($US) ↑	AD shifts left	Exports more expensive, imports cheaper

Case Study: The 2020 Recession

Consumption spending fell sharply, especially on services.
Residential investment increased due to low interest rates and stimulus checks.
Net exports decreased, partly due to a stronger U.S. dollar and relatively smaller GDP decline compared to trading partners.

Aggregate Supply

Definition and Types

Aggregate supply is the total quantity of goods and services that firms are willing and able to supply at different price levels. The relationship between aggregate supply and the price level differs in the short run and long run.

Long-Run Aggregate Supply (LRAS) Curve: Shows the relationship in the long run between the price level and the quantity of real GDP supplied. The LRAS is vertical at the level of potential (full-employment) GDP, which is determined by resources, technology, and capital stock, not by the price level.
Short-Run Aggregate Supply (SRAS) Curve: Upward sloping because prices of final goods and services rise faster than input prices (like wages and raw materials) in the short run.

Why is the SRAS Curve Upward Sloping?

Sticky Wages and Prices: Contracts and slow adjustments mean wages and prices do not immediately respond to changes in demand or supply.
Slow Wage Adjustments: Firms typically review wages annually and are reluctant to cut wages, which can affect morale.
Menu Costs: The costs of changing prices discourage firms from adjusting prices for small changes in demand.

Movements Along vs. Shifts of the SRAS Curve

A movement along the SRAS curve is caused by a change in the price level, holding all else constant.
A shift in the SRAS curve is caused by changes in factors other than the price level, such as expectations, resource availability, or technology.

Variables That Shift the Short-Run Aggregate Supply Curve

Variable	Shift Direction	Reason
Labor force or capital stock ↑	SRAS shifts right	More output can be produced at any price level
Productivity ↑	SRAS shifts right	Lower costs of production
Expected future price level ↑	SRAS shifts left	Firms and workers demand higher wages and prices
Input prices (e.g., oil) ↑	SRAS shifts left	Higher production costs
Supply shock (e.g., pandemic)	SRAS shifts left	Sudden increase in costs or reduction in supply

Macroeconomic Equilibrium

Long-Run and Short-Run Equilibrium

Long-run equilibrium: Occurs when AD and SRAS intersect at the LRAS level (potential GDP). The economy is at full employment.
Short-run equilibrium: Occurs at the intersection of AD and SRAS, which may not be at potential GDP.

Short-Run and Long-Run Effects of Shocks

Decrease in Aggregate Demand: AD shifts left, causing a recession (output and prices fall). Over time, lower wages and input costs shift SRAS right, restoring long-run equilibrium at a lower price level.
Increase in Aggregate Demand: AD shifts right, causing output and prices to rise. Unemployment falls below the natural rate, raising wages and shifting SRAS left, restoring long-run equilibrium at a higher price level.
Supply Shock: SRAS shifts left (e.g., due to higher oil prices), causing stagflation (higher prices and lower output). Over time, lower demand for inputs may shift SRAS right again, restoring equilibrium.

Case Study: The Covid-19 Pandemic

The pandemic caused both a negative supply shock (SRAS left) and a decrease in aggregate demand (AD left), resulting in a sharp decline in real GDP and a relatively stable price level.

Practice Questions

Which of the following best describes the wealth effect? When the price level falls, the real value of household wealth rises.
The interest rate effect: An increase in the price level raises the interest rate and reduces investment and consumption spending.
What happens when the U.S. price level falls relative to other countries? Exports rise, imports fall, and net exports increase.
On the long-run aggregate supply curve, what is the effect of a decrease in the price level? No effect on the aggregate quantity of GDP supplied.

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