Aggregate Supply and Aggregate Demand: Foundations and Fluctuations in Macroeconomics

Unit 2: Aggregate Supply and Aggregate Demand

Introduction

This unit explores the core macroeconomic concepts of aggregate supply (AS) and aggregate demand (AD), their determinants, graphical interpretations, and their roles in explaining economic growth, inflation, and business cycles. It also introduces the main schools of thought in macroeconomics.

Aggregate Supply

Definition and Key Concepts

• Aggregate Supply (AS): The relationship between the total quantity of real GDP supplied and the price level in the economy.

• Quantity Supplied: The total amount of goods and services that firms plan to produce during a given period.

• Two time frames are important for AS analysis:

  • Long-Run Aggregate Supply (LRAS): The relationship when real GDP equals potential GDP; the LRAS curve is vertical at potential GDP, indicating that potential GDP is independent of the price level.

  • Short-Run Aggregate Supply (SRAS): The relationship when the money wage rate, prices of other resources, and potential GDP are constant; the SRAS curve is upward sloping, showing that an increase in the price level increases the quantity of real GDP supplied.

Graphical Interpretation

• The LRAS curve is vertical at the level of potential GDP.

• The SRAS curve slopes upward, indicating that as the price level rises (with constant money wage rate), firms increase production.

Changes in Aggregate Supply

• AS changes if influences on production (other than the price level) change.

• Factors shifting AS:

  • Changes in Potential GDP: Increases in the full-employment quantity of labor, capital (physical or human), or technological advances shift both LRAS and SRAS rightward.

  • Changes in Money Wage Rate (and other factor prices): An increase in the money wage rate shifts the SRAS curve leftward (decreases SRAS), but does not affect LRAS.

Aggregate Demand

Definition and Components

• Aggregate Demand (AD): The relationship between the total quantity of real GDP demanded and the price level.

• Components of AD:

  • Consumption Expenditure (C)

  • Investment (I)

  • Government Expenditure (G)

  • Net Exports (X - M)

• Aggregate Demand Equation:

$Y = C + I + G + X - M$

Determinants of Aggregate Demand

• Price Level: Affects the quantity of real GDP demanded via the wealth effect and substitution effects.

• Expectations: About future income, inflation, and profits influence current consumption and investment.

• Fiscal Policy: Government actions on taxes, transfer payments, and spending.

• Monetary Policy: Central bank actions affecting interest rates and the money supply.

• The World Economy: Foreign income and exchange rates affect exports and imports.

Graphical Interpretation

• The AD curve slopes downward due to:

  • Wealth Effect: A higher price level reduces real wealth, decreasing consumption and real GDP demanded.

  • Substitution Effects:

    • Intertemporal Substitution: Higher price levels raise interest rates, reducing borrowing and spending.

    • International Substitution: Higher domestic prices make exports less competitive, reducing net exports.

Shifts in Aggregate Demand

• AD shifts right (increases) with higher expected future income, higher government spending, lower taxes, increased money supply, or higher foreign demand.

• AD shifts left (decreases) with the opposite changes.

Macroeconomic Equilibrium

Short-Run Equilibrium

• Occurs where the AD and SRAS curves intersect.

• At this point, the quantity of real GDP demanded equals the quantity supplied.

• Real GDP can be above, below, or at potential GDP.

Long-Run Equilibrium

• Occurs where AD, SRAS, and LRAS all intersect.

• At this point, real GDP equals potential GDP, and the economy is at full employment.

Adjustment to Equilibrium

• If real GDP is below potential GDP, wages and prices tend to fall, shifting SRAS rightward until long-run equilibrium is restored.

• If real GDP is above potential GDP, wages and prices tend to rise, shifting SRAS leftward until long-run equilibrium is restored.

Economic Growth, Inflation, and Business Cycles

Economic Growth

• Driven by increases in labor, capital, and technological progress, shifting LRAS and SRAS rightward.

Inflation

• Occurs when AD increases faster than LRAS, causing the price level to rise.

Business Cycles

• Short-run fluctuations in real GDP, employment, and inflation.

• Caused by shifts in AD and/or SRAS, with wages and prices adjusting slowly.

• Types of Equilibrium:

  • Above Full-Employment Equilibrium: Real GDP exceeds potential GDP (inflationary gap).

  • Full-Employment Equilibrium: Real GDP equals potential GDP.

  • Below Full-Employment Equilibrium: Real GDP is less than potential GDP (recessionary gap).

Key Terms Table

Term	Definition	Example
Stagflation	Simultaneous occurrence of high inflation and high unemployment	1970s oil crisis in the US
Hyperinflation	Extremely rapid or out of control inflation	Zimbabwe in the late 2000s
Recessionary Gap	Amount by which real GDP is less than potential GDP	During the 2008 global financial crisis
Inflationary Gap	Amount by which real GDP exceeds potential GDP	Economic boom periods

Macroeconomic Schools of Thought

Classical School

• Believes the economy is self-regulating and always at full employment.

• Business cycles are seen as efficient responses to external shocks.

• Associated with economists like Adam Smith, David Ricardo, and John Stuart Mill.

Keynesian School

• Argues that the economy may not self-correct to full employment.

• Active fiscal and monetary policy is needed to achieve and maintain full employment.

• Prices and wages are 'sticky' and do not adjust quickly.

• Named after John Maynard Keynes.

Monetarist School

• Believes the economy is self-regulating if monetary policy is stable and predictable.

• Emphasizes the importance of controlling the money supply to avoid economic instability.

• Associated with Milton Friedman and Karl Brunner.

Summary Table: AS-AD Model Features

Curve	Shape	Key Determinants	Shifts When...
LRAS	Vertical	Potential GDP	Labor, capital, or technology changes
SRAS	Upward sloping	Price level, money wage rate	Money wage rate or potential GDP changes
AD	Downward sloping	Price level, C, I, G, (X-M)	Expectations, fiscal/monetary policy, world economy

Conclusion

The AS-AD model is central to understanding macroeconomic fluctuations, growth, and policy debates. Mastery of these concepts is essential for analyzing real-world economic events and policy responses.