Ch. 10: Aggregate Supply and Aggregate Demand: Core Concepts and Applications

Aggregate Supply and Aggregate Demand

Aggregate Supply (AS)

The aggregate supply curve shows the total quantity of goods and services that firms in an economy are willing to produce at each overall price level. It is a key concept in understanding how the economy responds to changes in demand and supply conditions.

• Definition: Aggregate supply is the relationship between the quantity of real GDP supplied and the price level, holding all else constant.

• Short-run vs. Long-run: The shape and determinants of aggregate supply differ in the short run and long run.

Long-Run Aggregate Supply (LAS)

The long-run aggregate supply curve (LAS) represents the economy's potential output when all resources are fully employed. It is vertical because, in the long run, output is determined by factors such as technology, capital, and labor, not by the price level.

• Vertical LAS: The LAS curve is vertical at the level of potential GDP.

• Reason for Verticality: In the long run, changes in the price level do not affect the quantity of real GDP supplied.

• Equation: $Y = Y^*$ (where $Y$ is real GDP and $Y^*$ is potential GDP)

• Example: If the labor force and capital stock are fully utilized, the economy produces at its potential output regardless of the price level.

Short-Run Aggregate Supply (SAS)

The short-run aggregate supply curve (SAS) is upward-sloping, indicating that as the price level rises, firms are willing to produce more due to temporarily higher profits.

• Upward Slope: In the short run, some input prices (like wages) are sticky, so higher output prices increase profitability and output.

• Equation: $Y = Y^* + \alpha (P - P_e)$ (where $P$ is the actual price level, $P_e$ is the expected price level, and $\alpha$ is a positive parameter)

• Example: If the price level rises unexpectedly, firms increase production because their costs have not yet adjusted.

Shifts in LAS and SAS

Both LAS and SAS can shift due to changes in the economy's productive capacity, but some factors affect only SAS in the short run.

• Shifts in LAS: Occur due to changes in potential GDP, such as:

  • Growth in labor force

  • Increase in capital stock

  • Technological progress

• Shifts in SAS: Occur due to:

  • All factors that shift LAS

  • Changes in input prices (e.g., wages, raw materials)

  • Temporary supply shocks (e.g., oil price spikes)

• Factors affecting only SAS: Changes in nominal wages or input prices shift SAS but not LAS.

• Example: An increase in oil prices raises production costs, shifting SAS leftward, but LAS remains unchanged.

Aggregate Demand (AD)

The aggregate demand curve (AD) shows the total quantity of goods and services demanded across all sectors of the economy at each price level.

• Definition: Aggregate demand is the relationship between the quantity of real GDP demanded and the price level.

• Downward Slope: The AD curve is downward-sloping due to:

  • Wealth effect

  • Interest rate effect

  • International substitution effect

• Equation: $AD = C + I + G + (X - M)$ (where $C$ is consumption, $I$ is investment, $G$ is government spending, $X$ is exports, $M$ is imports)

• Four factors determining buying plans:

  • Expectations about the future

  • Fiscal policy and monetary policy

  • The world economy

  • Wealth

• Example: A fall in the price level increases real wealth, boosting consumption and aggregate demand.

Shifts in Aggregate Demand

Aggregate demand shifts when any component of spending changes, other than the price level.

• Factors that shift AD:

  • Changes in expectations (optimism/pessimism)

  • Changes in fiscal policy (taxes, government spending)

  • Changes in monetary policy (interest rates, money supply)

  • Changes in the world economy (exchange rates, foreign income)

• Example: An increase in government spending shifts AD to the right.

Short-Run and Long-Run Equilibrium

Equilibrium occurs where aggregate demand equals aggregate supply. The nature of equilibrium depends on whether the economy is in the short run or long run.

• Short-run equilibrium: Occurs where AD intersects SAS. Output may be above or below potential GDP.

• Long-run equilibrium: Occurs where AD, SAS, and LAS all intersect at potential GDP.

• Example: If AD increases, output rises above potential in the short run, but in the long run, SAS shifts left as wages rise, restoring equilibrium at potential GDP.

The Business Cycle and Output Gaps

The business cycle reflects fluctuations in real GDP around its long-term trend. Output gaps measure the difference between actual and potential output.

• Full-employment equilibrium: Real GDP equals potential GDP; unemployment is at its natural rate.

• Above full-employment equilibrium: Real GDP exceeds potential GDP; unemployment is below the natural rate (inflationary gap).

• Below full-employment equilibrium: Real GDP is less than potential GDP; unemployment is above the natural rate (recessionary gap).

• Output gap: $\text{Output Gap} = Y - Y^*$

• Inflationary gap: Output gap is positive.

• Recessionary gap: Output gap is negative.

• Example: During a boom, the economy operates above potential, creating an inflationary gap.

Effects of Fluctuations in AD and AS

Shocks to aggregate demand or supply can cause economic fluctuations, including inflation, unemployment, and changes in output.

• Fluctuations in AD: An increase in AD raises output and price level in the short run; in the long run, only the price level rises.

• Fluctuations in AS: A negative supply shock (e.g., higher oil prices) reduces output and raises the price level (stagflation).

• Stagflation: A combination of rising prices and falling output, typically caused by a leftward shift in SAS.

• Example: The 1970s oil crisis led to stagflation in many economies.

Macroeconomic Schools of Thought

There are three main schools of thought regarding how the economy functions and how policy should respond to fluctuations.

School	Key Beliefs	Role of AD & AS
Classical / New-Classical	Markets are self-correcting; wages and prices are flexible; economy returns to full employment quickly.	AD changes affect only prices, not output, in the long run. AS determines output.
Keynesian	Wages and prices are sticky; markets may not clear quickly; government intervention can stabilize output.	AD changes can affect output and employment in the short run and possibly the long run.
Monetarist	Emphasizes the role of money supply; markets tend toward equilibrium but slowly; policy should focus on stable money growth.	AD affects output in the short run; in the long run, only prices are affected.

• Classical/New-Classical: Believe in rapid market adjustment; policy intervention is unnecessary.

• Keynesian: Support active policy to manage demand and reduce unemployment.

• Monetarist: Advocate for predictable, rule-based monetary policy.

Additional info: The above table summarizes the main differences between the three schools of thought, as inferred from standard macroeconomic theory.