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 in an economy 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

Definition and Components

Aggregate demand represents the relationship between the price level and the quantity of real GDP demanded by households, firms, the government, and the foreign sector.

Formula:
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 changes in the price level. 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 spending.
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 aggregate demand (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 Federal Reserve to change the money supply and interest rates. Higher interest rates shift AD left; lower rates shift AD right.
Fiscal Policy: Changes in government spending or taxes. Increased government spending or lower taxes shift AD right; decreased spending or higher taxes shift AD left.
Foreign Income and Exchange Rates: Higher foreign incomes or a weaker domestic currency increase exports and shift AD right; the opposite shifts AD left.

Aggregate Supply

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 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 potential GDP, determined by resources, technology, and capital stock.
Short-Run Aggregate Supply (SRAS): Shows the relationship in the short run, when some prices or wages are sticky. SRAS is upward sloping.

Why the SRAS Curve is Upward Sloping

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 wages, and wage reviews are infrequent.
Menu Costs: Firms face costs to changing prices, so they may delay price adjustments.

Example: During the Covid-19 pandemic, supply shocks and sticky prices led to shifts in SRAS.

Shifts in the Short-Run Aggregate Supply Curve

Changes in Resource Availability: Increases in labor, capital, or technology shift SRAS right; decreases shift it left.
Expectations of Future Prices: If firms expect higher future prices, SRAS shifts left as they raise wages and prices now.
Supply Shocks: Unexpected events (e.g., natural disasters, pandemics) that change input prices or availability 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: Where AD and SRAS intersect, determining actual output and price level.
Long-Run Equilibrium: Where AD, SRAS, and LRAS all intersect, with output at potential GDP.

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., sudden increase in oil prices) shifts SRAS left, causing stagflation (higher prices and lower output). Over time, SRAS may shift back as expectations adjust.
Policy Responses: Fiscal or monetary policy can be used to shift AD and counteract recessions or inflation.

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 chain 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 and a relatively stable price level in the short run.

Consumption: Fell sharply, especially in services.
Investment: Initially declined, but residential investment increased due to low interest rates and stimulus.
Net Exports: Decreased due to a stronger dollar and weaker foreign demand.

Example: The U.S. economy's real GDP fell to $19.0 trillion in the second quarter of 2020, with the price level remaining steady.

Summary Table: Key Differences Between AD, SRAS, and LRAS

Curve	Shape	Key Determinants	What Causes a Shift?
Aggregate Demand (AD)	Downward sloping	C, I, G, NX; price level	Changes in C, I, G, NX; fiscal/monetary policy; foreign income/exchange rates
Short-Run Aggregate Supply (SRAS)	Upward sloping	Input prices, expectations, resource availability	Changes in input prices, technology, expectations, supply shocks
Long-Run Aggregate Supply (LRAS)	Vertical	Resources, technology, capital stock	Changes in labor, capital, technology

Key Formulas and Definitions

Aggregate Demand Equation:
Potential GDP: The level of real GDP attained when all firms are producing at capacity.
Stagflation: A combination of inflation and recession, typically resulting from a supply shock.
Wealth Effect: The effect of a change in the price level on consumption via changes in the real value of wealth.
Interest-Rate Effect: The effect of a change in the price level on investment via changes in interest rates.
International-Trade Effect: The effect of a change in the price level on net exports via changes in relative prices.

Applications and Examples

Covid-19 Recession: Both AD and SRAS shifted left, causing a sharp drop in output.
Housing Market: During the pandemic, residential construction increased due to low interest rates and stimulus, even as other sectors declined.

Additional info: Some explanations and examples have been expanded for clarity and completeness based on standard macroeconomics textbooks.