Aggregate Demand and Aggregate Supply Analysis

Introduction to the Aggregate Demand and Aggregate Supply Model

The aggregate demand and aggregate supply (AD-AS) model is a fundamental framework in macroeconomics used to explain short-run fluctuations in real GDP, employment, and the price level. This model extends the analysis of long-run economic growth to include short-run economic dynamics.

• Aggregate Demand (AD): Shows the relationship between the price level and the quantity of real GDP demanded by households, firms, and the government.

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

13.1 Aggregate Demand

Components of Aggregate Demand

Aggregate demand is composed of four main components:

• Consumption (C): Spending by households on goods and services.

• Investment (I): Spending by firms on capital goods and by households on new homes.

• Government Purchases (G): Spending by federal, state, and local governments on goods and services.

• Net Exports (NX): Exports minus imports.

The aggregate demand equation is:

$Y = C + I + G + NX$

Determinants of Aggregate Demand

• The Wealth Effect: As the price level rises, the real value of household wealth falls, leading to lower consumption.

• The Interest-Rate Effect: Higher price levels increase the demand for money, raising interest rates and reducing investment.

• The International-Trade Effect: Higher U.S. price levels make exports more expensive and imports cheaper, reducing net exports.

Movements Along vs. Shifts of the AD Curve

• Movement Along: Caused by a change in the price level, holding all else constant.

• Shift: Caused by changes in components of aggregate demand (C, I, G, NX) due to factors other than the price level.

Variables That Shift the Aggregate Demand Curve

Example: The 2007-2009 Recession and AD Components

• Consumption: Fell relative to potential GDP, which is unusual during recessions.

• Residential Investment: Declined before and during the recession, remaining below pre-recession levels.

• Net Exports: Increased (became less negative) due to a falling dollar, then stabilized post-recession.

13.2 Aggregate Supply

Definition and Types of Aggregate Supply Curves

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

• Long-Run Aggregate Supply (LRAS): Vertical at the level of potential or full-employment GDP, determined by resources, technology, and capital stock. Not affected by the price level.

• Short-Run Aggregate Supply (SRAS): Upward-sloping because input prices adjust more slowly than output prices, and due to wage and price stickiness.

Why the SRAS Curve is Upward-Sloping

• Sticky Wages and Prices: Contracts and slow adjustments prevent immediate wage and price changes.

• Slow Wage Adjustments: Firms review wages annually and dislike wage cuts.

• Menu Costs: Firms face costs to changing prices, so may delay small adjustments.

Shifts of the SRAS Curve

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

• Shift: Caused by changes in factors other than the price level, such as expectations, resources, or technology.

Variables That Shift the SRAS Curve

13.3 Macroeconomic Equilibrium in the Long Run and the Short Run

Equilibrium in the AD-AS Model

Macroeconomic equilibrium occurs where the AD and SRAS curves intersect. In the long run, equilibrium is at the intersection of AD, SRAS, and LRAS, where real GDP equals potential GDP.

• Short-Run Equilibrium: Intersection of AD and SRAS; real GDP may differ from potential GDP.

• Long-Run Equilibrium: Intersection of AD, SRAS, and LRAS; real GDP equals potential GDP.

Adjustment to Shocks

• Negative Demand Shock: AD shifts left, causing recession. Over time, SRAS shifts right as wages and prices adjust, restoring long-run equilibrium at a lower price level.

• Positive Demand Shock: AD shifts right, causing output above potential and lower unemployment. SRAS shifts left as wages and prices rise, restoring equilibrium at a higher price level.

• Supply Shock: SRAS shifts left (e.g., due to higher oil prices), causing stagflation (higher inflation and unemployment). Over time, SRAS may shift back right as input prices adjust, or policy may shift AD right to restore output at the cost of higher prices.

Example: The 2007-2009 Recession

• End of the Housing Bubble: Falling house prices reduced residential investment.

• Financial Crisis: Mortgage defaults led to a credit crunch, reducing consumption and investment.

• Oil Price Shock: Rapidly rising oil prices increased production costs, shifting SRAS left.

Appendix: Macroeconomic Schools of Thought (Brief Mention)

Different schools of thought interpret the AD-AS model and macroeconomic policy differently. For example, Karl Marx's labor theory of value and critique of capitalism contrasts with mainstream economic analysis.

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