Chapter 13: Aggregate Demand and Aggregate Supply Analysis

Aggregate Demand

The aggregate demand (AD) curve represents the relationship between the price level and the quantity of real GDP demanded by households, firms, and the government. Understanding the determinants of aggregate demand and the distinction between movements along the curve and shifts of the curve is essential for macroeconomic analysis.

• Components of Real GDP: Consumption (C), Investment (I), Government Purchases (G), Net Exports (NX). The sum of these components gives real GDP.

• Government Purchases: Generally determined by policymakers and independent of changes in the price level.

• Consumption, Investment, and Net Exports: These are affected by changes in the price level.

Aggregate Demand and Aggregate Supply Model: This model explains short-run fluctuations in real GDP, employment, and the price level.

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

• Short-Run Aggregate Supply (SRAS) Curve: Shows the relationship in the short run between the price level and the quantity of real GDP supplied by firms.

The Wealth Effect

As the price level rises, the real value of household wealth declines, leading to reduced consumption. Thus, higher price levels result in lower consumption.

The Interest-Rate Effect

When prices rise, households and firms need more money, increasing the demand for money and causing interest rates to rise. Higher interest rates discourage investment spending.

The International-Trade Effect

Higher U.S. price levels make exports more expensive and imports cheaper, reducing net exports.

Downward Slope of the AD Curve

Each of the above effects contributes to the downward slope of the aggregate demand curve.

Movements vs. Shifts of the AD Curve

• Movement Along the Curve: Occurs when the price level changes, holding other factors constant.

• Shift of the Curve: Occurs when a component of real GDP changes (e.g., government purchases, consumer confidence).

Variables That Shift the Aggregate Demand Curve

Aggregate Demand During the 2020 Recession

• Consumption: Fell sharply, especially in services.

• Investment: Residential investment increased due to low interest rates and stimulus.

• Net Exports: Decreased due to a stronger dollar and lower foreign demand.

Aggregate Supply

Aggregate supply is the total quantity of goods and services firms are willing and able to supply. The relationship between this quantity and the price level differs in the short and long run.

• Long-Run Aggregate Supply (LRAS) Curve: Vertical, showing that real GDP is determined by labor, capital, and technology, not the price level.

• Short-Run Aggregate Supply (SRAS) Curve: Upward sloping due to sticky wages/prices, slow wage adjustments, and menu costs.

Why Is the SRAS Curve Upward Sloping?

• Sticky Wages and Prices: Contracts and slow adjustments cause wages and prices to lag behind changes in the price level.

• Menu Costs: Firms may avoid changing prices due to associated costs.

Movements vs. Shifts of the SRAS Curve

• Movement Along the Curve: Caused by changes in the price level, holding other factors constant.

• Shift of the Curve: Caused by changes in factors such as labor, capital, technology, expected future prices, and supply shocks.

Variables That Shift the SRAS Curve

Macroeconomic Equilibrium in the Long Run and the Short Run

Macroeconomic equilibrium occurs when aggregate demand and aggregate supply intersect. In the long run, equilibrium is at the full-employment level of GDP.

• Long-Run Equilibrium: AD and SRAS intersect at LRAS.

• Short-Run Equilibrium: AD and SRAS intersect, but not necessarily at LRAS.

Effects of Changes in Aggregate Demand

• Decrease in AD: Causes recession; SRAS eventually shifts right, restoring equilibrium at a lower price level.

• Increase in AD: Causes expansion; SRAS eventually shifts left, restoring equilibrium at a higher price level.

Effects of Supply Shocks

• Supply Shock: SRAS shifts left, causing stagflation (inflation + recession). SRAS may shift back right over time, or policy may be used to increase AD.

Covid-19 Pandemic Effects

• Both AD and SRAS shifted left, resulting in lower real GDP and steady prices.

• Consumption, investment, and exports all declined due to pandemic-related closures.

Dynamic Aggregate Demand and Aggregate Supply Model

This model incorporates continual increases in real GDP, shifting LRAS to the right, and typically rightward shifts in AD and SRAS, except when inflation expectations are high.

• Inflation: Occurs when AD increases faster than LRAS.

• Recession of 2007–2009: Caused by the housing bubble burst, financial crisis, and oil price spike.

Macroeconomic Schools of Thought

Macroeconomics includes several schools of thought, each with distinct views on economic fluctuations and policy.

• Keynesian: Emphasizes sticky wages/prices and government intervention.

• Monetarist: Focuses on money supply and advocates a monetary growth rule.

• New Classical: Rational expectations; fluctuations minimized by correct expectations.

• Real Business Cycle: Productivity shocks as main source of fluctuations; supply is vertical even in short run.

• Austrian: Market system superiority; business cycles caused by central bank-induced low interest rates.

• Marxist: Critiques capitalism; labor theory of value; predicts eventual transition to communism.

Comparison of Macroeconomic Schools of Thought

Key Formulas

• Real GDP:

• Aggregate Demand:

• Long-Run Aggregate Supply:

Additional info: Academic context and explanations have been expanded for clarity and completeness. Tables and images have been included only where directly relevant to the explanation of the paragraph.