Aggregate Supply and Aggregate Demand: Macroeconomic Equilibrium, Growth, and Policy

Aggregate Supply

Quantity Supplied and Supply

The quantity of real GDP supplied is the total quantity that firms plan to produce during a given period. Aggregate supply describes the relationship between the quantity of real GDP supplied and the price level. Two time frames are distinguished:

• Long-run aggregate supply (LRAS)

• Short-run aggregate supply (SRAS)

Long-Run Aggregate Supply

Long-run aggregate supply is the relationship between the quantity of real GDP supplied and the price level when real GDP equals potential GDP. Potential GDP is independent of the price level, so the long-run aggregate supply curve (LAS) is vertical at potential GDP.

Short-Run Aggregate Supply

Short-run aggregate supply is the relationship between the quantity of real GDP supplied and the price level when the money wage rate, prices of other resources, and potential GDP remain constant. A rise in the price level, with no change in the money wage rate and other factor prices, increases the quantity of real GDP supplied. The short-run aggregate supply curve (SAS) is upward sloping.

Graphical Representation

• In the long run, the quantity of real GDP supplied is potential GDP. As the price level rises and the money wage rate changes by the same percentage, the quantity of real GDP supplied remains at potential GDP.

• In the short run, the quantity of real GDP supplied increases if the price level rises. The SAS curve slopes upward. A rise in the price level with no change in the money wage rate induces firms to increase production.

Intersection of SAS and LAS

• With a given money wage rate, the SAS curve cuts the LAS curve at potential GDP.

• If the price level falls below a certain point (e.g., 110), the quantity of real GDP supplied decreases along the SAS curve.

• If the price level rises above that point, the quantity of real GDP supplied increases along the SAS curve, and real GDP exceeds potential GDP.

Changes in Aggregate Supply

Aggregate supply changes if an influence on production plans other than the price level changes. These influences include:

• Changes in potential GDP

• Changes in the money wage rate (and other factor prices)

Changes in Potential GDP

• When potential GDP increases, both the LAS and SAS curves shift rightward.

• Potential GDP changes for three reasons:

  • An increase in the full-employment quantity of labor

  • An increase in the quantity of capital (physical or human)

  • An advance in technology

Changes in the Money Wage Rate

• A rise in the money wage rate decreases short-run aggregate supply and shifts the SAS curve leftward.

• Long-run aggregate supply does not change.

Aggregate Demand

Definition and Components

The quantity of real GDP demanded, $Y$, is the total amount of final goods and services produced in the United States that people, businesses, governments, and foreigners plan to buy. It is the sum of:

• Consumption expenditures ($C$)

• Investment ($I$)

• Government expenditure ($G$)

• Net exports ($X - M$)

Aggregate demand equation:

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

Determinants of Aggregate Demand

• The price level

• Expectations

• Fiscal policy and monetary policy

• The world economy

The Aggregate Demand Curve

Aggregate demand is the relationship between the quantity of real GDP demanded and the price level. The aggregate demand curve (AD) plots the quantity of real GDP demanded against the price level. The AD curve slopes downward for two reasons:

• Wealth effect

• Substitution effects

Wealth Effect

• A rise in the price level decreases the quantity of real wealth (money, stocks, etc.), leading people to increase saving and decrease spending. The quantity of real GDP demanded decreases.

• A fall in the price level increases the quantity of real wealth, which increases the quantity of real GDP demanded.

Substitution Effects

• Intertemporal substitution effect: A rise in the price level decreases the real value of money and raises the interest rate. Higher interest rates lead to less borrowing and spending, decreasing real GDP demanded. A fall in the price level lowers the interest rate, increasing borrowing and spending.

• International substitution effect: A rise in the price level increases the price of domestic goods relative to foreign goods, increasing imports and decreasing exports, which decreases real GDP demanded. A fall in the price level has the opposite effect.

Changes in Aggregate Demand

A change in any influence on buying plans other than the price level changes aggregate demand. The main influences are:

• Expectations

• Fiscal policy and monetary policy

• The world economy

Expectations

• Expectations about future income, inflation, and profits change aggregate demand.

• Increases in expected future income or profits increase aggregate demand.

• A rise in expected inflation increases aggregate demand as people buy more now.

Fiscal Policy and Monetary Policy

• Fiscal policy involves government actions on taxes, transfer payments, and purchases. Tax cuts or increased transfer payments raise disposable income, increasing consumption and aggregate demand.

• Monetary policy involves the central bank changing interest rates and the quantity of money. An increase in the quantity of money or a cut in interest rates increases aggregate demand.

The World Economy

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

• An increase in foreign income increases demand for U.S. exports and aggregate demand.

Shifts in the Aggregate Demand Curve

• When aggregate demand increases, the AD curve shifts rightward.

• When aggregate demand decreases, the AD curve shifts leftward.

Explaining Macroeconomic Trends and Fluctuations

Short-Run Macroeconomic 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, firms increase production and raise prices.

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

• In short-run equilibrium, real GDP can be greater than or less than potential GDP.

Long-Run Macroeconomic Equilibrium

Long-run macroeconomic equilibrium occurs when real GDP equals potential GDP—at the intersection of the AD and LAS curves.

• Adjustment to long-run equilibrium involves changes in the money wage rate until the SAS curve passes through the long-run equilibrium point.

Economic Growth and Inflation in the AS-AD Model

• Economic growth occurs as the quantity of labor grows, capital is accumulated, and technology advances, shifting the LAS curve rightward.

• If the quantity of money grows faster than potential GDP, aggregate demand increases more than long-run aggregate supply, causing inflation (AD curve shifts rightward faster than LAS).

The Business Cycle in the AS-AD Model

• The business cycle occurs because aggregate demand and short-run aggregate supply fluctuate, but the money wage does not change rapidly enough to keep real GDP at potential GDP.

• Above full-employment equilibrium: Real GDP exceeds potential GDP (inflationary gap).

• Full-employment equilibrium: Real GDP equals potential GDP.

• Below full-employment equilibrium: Potential GDP exceeds real GDP (recessionary gap).

Fluctuations in Aggregate Demand and Supply

• An increase in aggregate demand shifts the AD curve rightward, increasing production and the price level in the short run (inflationary gap).

• The money wage rate rises, shifting the SAS curve leftward, and real GDP returns to potential GDP.

• A rise in the price of oil or other resource prices shifts the SAS curve leftward, decreasing real GDP and raising the price level (stagflation).

Macroeconomic Schools of Thought

Classical School

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

• Business cycle fluctuations are efficient responses to shocks, such as technological change.

Keynesian School

• The economy rarely operates at full employment without active fiscal and monetary policy.

• Wages and prices are sticky, preventing automatic adjustment to full employment.

Monetarist School

• The economy is self-regulating and will operate at full employment if monetary policy is stable and money growth is steady.

Summary Table: Aggregate Supply and Demand Curves

Curve	Shape	Key Determinants
LAS	Vertical at potential GDP	Potential GDP (labor, capital, technology)
SAS	Upward sloping	Price level, money wage rate, factor prices
AD	Downward sloping	Price level, expectations, fiscal/monetary policy, world economy

Key Equations

• Aggregate Demand: $Y = C + I + G + X - M$

Example Application

If the government increases spending and the central bank lowers interest rates, aggregate demand will increase, shifting the AD curve rightward. In the short run, this raises real GDP and the price level. Over time, wages adjust, and the economy returns to potential GDP at a higher price level.

Additional info: This guide expands on the textbook slides by providing definitions, context, and examples for each concept, ensuring a comprehensive understanding for exam preparation.