Aggregate Supply and Aggregate Demand: Macroeconomic Equilibrium and Growth

Aggregate Supply

Long-Run Aggregate Supply (LAS)

The long-run aggregate supply curve (LAS) represents the relationship between the quantity of real GDP supplied and the price level when real GDP equals potential GDP. In the long run, all adjustments have been made so that the economy is at full employment.

• Potential GDP: The level of output the economy can produce at full employment.

• LAS Curve: The LAS curve is vertical because potential GDP does not depend on the price level.

• Example: If potential GDP is $1,000 billion, the LAS curve is vertical at this output level.

Short-Run Aggregate Supply (SAS)

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 some input prices (like wages) are sticky.

• Short-run: The period during which real GDP may be above or below potential GDP, and unemployment may differ from its natural rate.

• SAS Curve: The SAS curve is upward sloping because a rise in the price level increases profits, encouraging firms to increase output.

Changes in Aggregate Supply

Aggregate supply curves shift due to changes in potential GDP. Both LAS and SAS curves shift rightward when potential GDP increases.

• Reasons for changes in potential GDP:

  • Change in the full-employment quantity of labour

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

  • Advances in technology

• Diagram: Illustrates how these factors shift the LAS and SAS curves to the right.

Aggregate Demand

Definition and Components

The aggregate demand curve (AD) shows the relationship between the quantity of real GDP demanded and the price level. Aggregate demand is the total spending on domestic goods and services at different price levels.

• Formula: $Y = C + I + G + X - M$ Where:

  • C: Consumption expenditure

  • I: Investment

  • G: Government purchases

  • X: Exports

  • M: Imports

• AD Curve: The AD curve slopes downward, indicating that as the price level falls, the quantity of real GDP demanded increases.

Factors Affecting Aggregate Demand

Several factors influence aggregate demand, causing the AD curve to shift.

• Expectations: About future income, inflation, and profits.

• Fiscal and Monetary Policy: Changes in government spending, taxes, and the money supply.

• The World Economy: Exchange rates and foreign income levels.

Changes in Aggregate Demand

• Expectations:

  • Higher expected future income increases current consumption and aggregate demand.

  • Expected inflation encourages purchases before prices rise, increasing aggregate demand.

  • Higher expected profits boost investment spending.

• Fiscal Policy:

  • Tax cuts or increased transfer payments raise disposable income, increasing aggregate demand.

  • Increased government expenditure directly increases aggregate demand.

• Monetary Policy:

  • Increasing the money supply lowers interest rates, boosting investment and consumption.

  • Lower interest rates make borrowing cheaper, increasing aggregate demand.

• International Effects:

  • A fall in the foreign exchange rate makes domestic goods cheaper for foreigners, increasing exports and aggregate demand.

  • Rising foreign income increases demand for domestic exports.

Macroeconomic Equilibrium

Short-Run Equilibrium

Short-run macroeconomic equilibrium occurs when the quantity of real GDP demanded equals the quantity of real GDP supplied at the intersection of the AD and SAS curves.

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

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

Long-Run Equilibrium

Long-run equilibrium occurs where the AD and LAS curves intersect, meaning the economy is at full employment and real GDP equals potential GDP.

Economic Growth

Sources of Economic Growth

Economic growth is driven by increases in the quantity of labour, accumulation of capital, and advances in technology. These factors raise potential GDP and shift the LAS curve to the right.

• Labour: Growth in the workforce increases productive capacity.

• Capital: Investment in physical and human capital enhances productivity.

• Technology: Innovations improve efficiency and output.

Example: A technological breakthrough increases potential GDP, shifting the LAS curve rightward and enabling higher long-run output.