Aggregate Supply and Aggregate Demand: Macroeconomic Equilibrium and Growth

Aggregate Supply

Objectives

• Explain what determines aggregate supply

• Explain what determines aggregate demand

• Explain macroeconomic equilibrium

• Explain the effects of changes in aggregate supply and aggregate demand on economic growth, inflation, and business cycles

Long-Run Aggregate Supply (LAS)

The macroeconomic long run is a time frame that is sufficiently long for all adjustments to be made so that real GDP equals potential GDP and there is full employment.

• The long-run aggregate supply curve (LAS) shows the relationship between the quantity of real GDP supplied and the price level when real GDP equals potential GDP.

• The LAS curve is vertical because potential GDP is independent of the price level.

Example: A LAS curve with potential GDP of $1,000 billion is vertical, indicating that changes in the price level do not affect potential output.

Short-Run Aggregate Supply (SAS)

The macroeconomic short run is a period during which real GDP has fallen below or risen above potential GDP. During this time, the unemployment rate may rise above or fall below the natural unemployment rate.

• The short-run aggregate supply curve (SAS) shows the relationship between the quantity of real GDP supplied and the price level in the short run, when the money wage rate, the prices of other resources, and potential GDP remain constant.

• The SAS curve is upward sloping because a rise in the price level increases the quantity of real GDP supplied.

Changes in Aggregate Supply

When potential GDP increases, both the LAS and SAS curves shift rightward. Potential GDP changes for three main reasons:

• Change in the full-employment quantity of labour

• Change in the quantity of capital (physical or human)

• Advances in technology

Example: A diagram may show how increases in labour, capital, or technology shift both LAS and SAS curves to the right, indicating economic growth.

Aggregate Demand

Definition and Formula

The Aggregate Demand Curve shows the quantity of real GDP demanded, Y, as the sum of consumption expenditures (C), investment (I), government purchases (G), and net exports (X - M):

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

The quantity of real GDP demanded is the total amount of final goods and services produced that people, businesses, governments, and foreigners plan to buy.

Determinants of Aggregate Demand

• The price level

• Expectations

• Fiscal and monetary policy

• The world economy

The Aggregate Demand Curve (AD)

The aggregate demand curve plots the quantity of real GDP demanded against the price level. The AD curve is downward sloping because a higher price level reduces the quantity of real GDP demanded.

Changes in Aggregate Demand

A change in any influence on buying plans other than the price level shifts the aggregate demand curve.

• Expectations: Expectations about future income, future inflation, and future profits change aggregate demand. For example, increased expected future income raises current consumption and aggregate demand.

• Fiscal Policy: Government attempts to influence economic activity by changing tax rates, government spending, and debt policies. For example, a tax cut or increase in transfer payments increases households' disposable income, raising aggregate demand.

• Government Expenditure: An increase in government purchases increases aggregate demand.

• Monetary Policy: Changes in the interest rate and quantity of money. For example, an increase in the quantity of money increases buying power and aggregate demand; a decrease in the interest rate increases expenditure and aggregate demand.

International Effects

The world economy influences aggregate demand in two main ways:

• A fall in the foreign exchange rate lowers the price of domestic goods and services relative to foreign goods and services, increasing exports and aggregate demand.

• An increase in foreign income increases the demand for domestic exports and aggregate demand.

Macroeconomic Equilibrium

Short-Run Macroeconomic Equilibrium

Occurs when the quantity of real GDP demanded equals the quantity of real GDP supplied at the point of intersection of the AD curve and the SAS curve.

• If real GDP is below equilibrium GDP, firms increase production.

• If real GDP is above equilibrium GDP, firms decrease production.

Long-Run Macroeconomic Equilibrium

Occurs where the AD and LAS curves intersect, meaning real GDP equals potential GDP and the economy is at full employment.

Economic Growth

Sources of Economic Growth

Economic growth occurs because the quantity of labour grows, capital is accumulated, and technology advances. All of these increase potential GDP and shift the LAS curve rightward.

• Growth in labour supply

• Capital accumulation

• Technological progress

Example: A diagram may show the LAS curve shifting rightward as potential GDP increases due to these factors.

Summary Table: Aggregate Supply and Demand Curves

Curve	Shape	Key Determinants	Shift Factors
LAS (Long-Run Aggregate Supply)	Vertical	Potential GDP	Labour, Capital, Technology
SAS (Short-Run Aggregate Supply)	Upward Sloping	Price Level, Wages, Resource Prices	Same as LAS, plus wage and resource price changes
AD (Aggregate Demand)	Downward Sloping	Price Level, Consumption, Investment, Government, Net Exports	Expectations, Fiscal Policy, Monetary Policy, World Economy

Additional info: Diagrams referenced in the notes typically show the intersection of AD, SAS, and LAS curves, illustrating equilibrium and the effects of shifts due to changes in policy, expectations, or economic growth factors.