Aggregate Demand and Aggregate Supply: Short-Run and Long-Run Macroeconomic Fluctuations

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 account for business cycles and economic shocks.

• Key variables explained: Real GDP, employment, and the price level.

• Purpose: To understand the causes of economic fluctuations and the effects of policy interventions.

Aggregate Demand (AD)

Definition and Components

The 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.

• Formula: $Y = C + I + G + NX$

• Components:

  • 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.

Why the AD Curve Slopes Downward

Three main effects explain the downward slope of the AD curve:

• The Wealth Effect: As the price level rises, the real value of household wealth falls, leading to lower consumption.

• The Interest Rate Effect: Higher price levels increase the demand for money, raising interest rates and reducing investment.

• The International-Trade Effect: Higher U.S. price levels make exports more expensive and imports cheaper, reducing net exports.

Implication: Higher price levels lead to lower values of real GDP demanded.

Movements Along vs. Shifts of the AD Curve

• Movement along the AD curve: Caused by a change in the price level, holding all else constant.

• Shift of the AD curve: Caused by changes in components of GDP (C, I, G, NX) due to factors other than the price level.

Variables That Shift the AD Curve

• Monetary Policy: Actions by the Federal Reserve to manage the money supply and interest rates.

• Fiscal Policy: Changes in federal taxes and government purchases.

• Other Factors: Changes in foreign income, exchange rates, consumer and business expectations.

An increase in...	Shifts the AD curve...	Because...
Interest rates	Left	Higher interest rates raise the cost of borrowing, reducing consumption and investment.
Government purchases	Right	Government purchases are a component of aggregate demand.
Personal income or business taxes	Left	Higher taxes reduce disposable income and consumption/investment.
Foreign GDP	Right	Foreigners buy more exports, increasing net exports.
Exchange rate (value of $US)	Left	Stronger dollar makes exports more expensive, reducing net exports.

Example: 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 dollar and relatively smaller GDP decline in the U.S. compared to trading partners.

Aggregate Supply (AS)

Definition

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

Long-Run Aggregate Supply (LRAS)

• The LRAS curve is vertical, indicating that in the long run, real GDP is determined by resources, technology, and capital stock—not by the price level.

• Potential (full-employment) GDP: The level of output when all resources are fully employed.

Short-Run Aggregate Supply (SRAS)

• The SRAS curve is upward sloping because input prices (like wages) adjust more slowly than output prices.

• Reasons for upward slope:

  • Contracts make some wages and prices "sticky".

  • Firms are slow to adjust wages (e.g., annual salary reviews, morale concerns).

  • Menu costs make some prices sticky (costs of changing prices).

Shifts of the SRAS Curve

• Movement along SRAS: Caused by a change in the price level, holding other factors constant.

• Shift of SRAS: Caused by changes in expectations, resource availability, technology, or input prices.

An increase in...	Shifts SRAS...	Because...
Labor force or capital stock	Right	More output can be produced at every price level.
Productivity (technology)	Right	Costs of producing output fall.
Expected future price level	Left	Firms and workers expect higher prices, so they increase wages and prices.
Input prices (e.g., oil)	Left	Higher input costs reduce supply at any price level.

• Supply shock: An unexpected event (e.g., oil price spike, pandemic) that shifts SRAS.

• Stagflation: A combination of inflation and recession, usually caused by a negative supply shock.

Macroeconomic Equilibrium

Short-Run and Long-Run Equilibrium

• Short-run equilibrium: Occurs where AD and SRAS intersect.

• Long-run equilibrium: Occurs where AD, SRAS, and LRAS all intersect—real GDP is at its potential level.

Adjustment to Shocks

• Decrease in AD: Causes a recession in the short run (output and prices fall). Over time, lower wages and input prices shift SRAS right, restoring long-run equilibrium at a lower price level.

• Increase in AD: Causes output and prices to rise in the short run. Over time, higher wages and input prices shift SRAS left, restoring long-run equilibrium at a higher price level.

• Supply shock (e.g., oil price spike): SRAS shifts left, causing stagflation. Over time, lower wages and prices may shift SRAS back right, restoring equilibrium.

Example: 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 employment.

• Policy responses (fiscal and monetary) aimed to shift AD right to speed recovery.

Practice Questions

• What does the AD curve show? The relationship between the price level and the quantity of real GDP demanded.

• Why does the AD curve slope downward? Due to the wealth effect, interest rate effect, and international-trade effect.

• What shifts the AD curve? Changes in government policy, expectations, foreign income, and exchange rates.

• What determines the position of the LRAS curve? The economy's resources, technology, and capital stock.

• What causes the SRAS curve to shift? Changes in input prices, expectations, technology, and resource availability.

Key Terms and Concepts

• Aggregate Demand (AD)

• Aggregate Supply (AS)

• Short-Run Aggregate Supply (SRAS)

• Long-Run Aggregate Supply (LRAS)

• Potential GDP

• Stagflation

• Supply Shock

• Wealth Effect

• Interest Rate Effect

• International-Trade Effect

• Monetary Policy

• Fiscal Policy

• Menu Costs

• Sticky Wages/Prices

Summary Table: Effects of Shocks on Macroeconomic Equilibrium

Shock	Short-Run Effect	Long-Run Adjustment
Decrease in AD	Lower output, lower prices, higher unemployment	SRAS shifts right, output returns to potential, lower price level
Increase in AD	Higher output, higher prices, lower unemployment	SRAS shifts left, output returns to potential, higher price level
Negative Supply Shock	Lower output, higher prices (stagflation)	SRAS shifts right as wages/input prices fall, output returns to potential

Additional info: This guide synthesizes content from lecture slides and handwritten notes, expanding on definitions, mechanisms, and examples for clarity and exam preparation.