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 helps 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.
Long-Run Aggregate Supply (LRAS) Curve: Shows the relationship in the long run between the price level and the quantity of real GDP supplied; it is vertical at the level of potential or full-employment GDP.

Key Point: 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 homes.
Government Purchases (G): Spending by governments on goods and services.
Net Exports (NX): Exports minus imports.

Government purchases are generally 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.

Why the Aggregate Demand Curve Slopes Downward

The Wealth Effect: As the price level rises, the real value of household wealth declines, leading to lower consumption. Implication: Higher price level leads to lower consumption.
The Interest Rate Effect: Higher prices increase the demand for money, raising interest rates and discouraging investment. Implication: Higher price level leads to lower investment.
The International-Trade Effect: Higher U.S. price levels make exports more expensive and imports cheaper, reducing net exports. Implication: Higher price level leads to lower net exports.

Each of these effects contributes to the downward slope of the aggregate demand curve.

Movements Along vs. Shifts of the Aggregate Demand Curve

Movement Along: Caused by a change in the price level, holding all else constant.
Shift: Caused by changes in components of real GDP (C, I, G, NX) other than the price level, such as changes in government policy or foreign income.

Variables That Shift the Aggregate Demand Curve

Monetary Policy: Actions by the Federal Reserve to manage the money supply and interest rates. Higher interest rates shift AD left; lower rates shift AD right.
Fiscal Policy: Changes in federal taxes and purchases. Increased government purchases or lower taxes shift AD right; decreased purchases or higher taxes shift AD left.
Foreign Income: Higher foreign income increases demand for exports, shifting AD right.
Exchange Rates: A stronger dollar makes exports more expensive and imports cheaper, shifting AD left.

Variable	Effect on AD Curve	Reason
Interest rates increase	Shift left	Higher borrowing costs reduce consumption and investment
Government purchases increase	Shift right	Direct component of aggregate demand
Personal/business taxes increase	Shift left	Reduces disposable income and investment
Foreign income increases	Shift right	Increases demand for exports
Exchange rate ($US) increases	Shift left	Exports fall, imports rise

Case Study: The 2020 Recession

Consumption: Fell sharply, especially in services.
Investment: Residential investment increased due to low interest rates and stimulus checks.
Net Exports: Decreased due to a stronger dollar and relatively smaller decline in U.S. GDP 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 quantity supplied and the price level differs in the short run and long run.

Long-Run Aggregate Supply (LRAS): Vertical at the level of potential GDP, determined by resources, technology, and capital stock. Not affected by the price level.
Short-Run Aggregate Supply (SRAS): Upward sloping because input prices (like wages) adjust more slowly than output prices, and due to price/wage stickiness.

Why the SRAS Curve is Upward Sloping

Contracts make some wages and prices "sticky": Long-term contracts prevent immediate adjustment to price changes.
Firms are slow to adjust wages: Wage reviews are infrequent, and firms avoid wage cuts to maintain morale.
Menu costs: The costs of changing prices discourage frequent adjustments, making some prices sticky.

Example: During recessions, firms may lay off workers or freeze pay rather than cut wages for existing employees.

Movements Along vs. Shifts of the SRAS Curve

Movement Along: Caused by a change in the price level, holding all else constant.
Shift: Caused by changes in factors such as expectations of future prices, availability of factors of production, productivity, or input prices.

Variable	Effect on SRAS Curve	Reason
Labor force/capital stock increases	Shift right	More output can be produced at every price level
Productivity increases	Shift right	Lower costs of production
Expected future price level increases	Shift left	Firms raise wages and prices in anticipation
Input prices (e.g., oil) increase	Shift left	Higher production costs
Supply shock (e.g., pandemic)	Shift left	Sudden increase in costs or reduction in supply

Macroeconomic Equilibrium

Short-Run and Long-Run Equilibrium

Short-Run Equilibrium: Occurs at the intersection of the AD and SRAS curves.
Long-Run Equilibrium: Occurs when AD, SRAS, and LRAS all intersect at the same point, meaning the economy is at full employment and potential GDP.

Adjustments to Shocks

Decrease in Aggregate Demand: AD shifts left, causing a recession (output and prices fall). Over time, SRAS shifts right as wages and input prices fall, 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 labor and goods may shift SRAS back right as wages and prices adjust downward.

Case Study: The Covid-19 Pandemic

The pandemic caused both AD and SRAS to shift left, resulting in a sharp decline in real GDP and a relatively stable price level in the short run.
Policy responses (fiscal and monetary) can help speed recovery by shifting AD right.

Key Terms and Concepts

Stagflation: A combination of inflation and recession, typically caused by a supply shock.
Potential GDP: The level of real GDP in the long run when the economy is at full employment.
Supply Shock: An unexpected event that changes the supply of goods and services, shifting the SRAS curve.
Menu Costs: The costs to firms of changing prices.
Sticky Wages/Prices: Wages and prices that do not adjust quickly to changes in economic conditions.

Sample Questions for Review

What are the main effects that explain the downward slope of the aggregate demand curve?
How do monetary and fiscal policy affect the aggregate demand curve?
What causes the SRAS curve to shift?
What is the difference between short-run and long-run macroeconomic equilibrium?
How does the economy adjust to a negative demand shock in the long run?