Aggregate Demand and Aggregate Supply

Introduction

This chapter explains the causes of fluctuations in real GDP, employment, and the price level using the aggregate demand and aggregate supply (AD-AS) model. The AD-AS model is central to understanding short-run economic fluctuations and long-run economic equilibrium.

Aggregate Demand (AD)

Definition and Components

• Aggregate Demand (AD) is the total quantity of goods and services demanded across all sectors of an economy at various price levels.

• Real GDP (Y) is composed of four main components:

  • Consumption (C)

  • Investment (I)

  • Government Purchases (G)

  • Net Exports (NX) (Exports minus Imports)

• The aggregate demand equation is:

The Aggregate Demand Curve

• The AD curve shows the relationship between the price level and the quantity of real GDP demanded by households, firms, and the government.

• The AD curve is downward sloping due to three main effects:

  • Wealth Effect: Higher price levels reduce the real value of household wealth, leading to lower consumption.

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

  • International Trade Effect: Higher domestic price levels make exports more expensive and imports cheaper, reducing net exports.

• Movement along the AD curve occurs when the price level changes, holding all else constant.

• Shifts of the AD curve occur when a component of real GDP (C, I, G, NX) changes for reasons other than the price level.

Variables That Shift Aggregate Demand

• Monetary Policy: Central bank actions that change the money supply and interest rates, affecting investment and consumption.

• Fiscal Policy: Government changes in taxes and spending that directly affect aggregate demand.

• Expectations: If households or firms become more optimistic, consumption and investment rise, shifting AD right. Pessimism shifts AD left.

• Foreign Income: Rising incomes abroad increase demand for exports, shifting AD right; falling foreign incomes shift AD left.

Aggregate Supply (AS)

Definition and Types

• Aggregate Supply (AS) is the total quantity of goods and services that firms are willing and able to supply at different price levels.

• The relationship between output and price level differs in the short run and long run, leading to two curves:

  • Short-Run Aggregate Supply (SRAS)

  • Long-Run Aggregate Supply (LRAS)

Long-Run Aggregate Supply (LRAS)

• The LRAS curve is vertical, indicating that in the long run, output is determined by resources, technology, and institutions, not the price level.

• At LRAS, the economy is at full employment (YF), with only structural and frictional unemployment.

Short-Run Aggregate Supply (SRAS)

• The SRAS curve is upward sloping because some input prices (like wages) are sticky and do not adjust immediately to changes in the price level.

• Firms may misjudge changes in the overall price level, leading to changes in output in the short run.

Variables That Shift SRAS

• Factors of Production: Increases in labor or capital shift SRAS right (more output at any price level).

• Technological Change: Improvements in technology increase productivity and shift SRAS right.

• Supply Shocks: Unexpected events that change input prices or productivity.

  • Negative Supply Shock: Sudden increase in input prices (e.g., oil crisis) shifts SRAS left, raising prices and reducing output.

  • Positive Supply Shock: Sudden decrease in input prices shifts SRAS right, lowering prices and increasing output.

Macroeconomic Equilibrium

Short-Run and Long-Run Equilibrium

• Short-run equilibrium occurs where the AD and SRAS curves intersect.

• Long-run equilibrium occurs where AD, SRAS, and LRAS all intersect, and the economy is at full employment output (YF).

Effects of Supply Shocks

• Stagflation: A combination of inflation and recession, typically caused by a negative supply shock (e.g., the 1970s OPEC oil crisis or the COVID-19 pandemic).

• Negative supply shocks shift SRAS left, causing higher prices and lower output.

Historical Examples

• 2007-2009 Recession: Caused by the end of the housing bubble, the financial crisis, and a rapid increase in oil prices.

• COVID-19 Pandemic: Created a negative supply shock, shifting SRAS left and reducing output.

Development of Macroeconomics

• Macroeconomics emerged as a separate field after the Great Depression to explain large-scale economic fluctuations.

• New Keynesian Economics: Emphasizes the 'stickiness' of prices and wages, which helps explain why economies do not always adjust quickly to shocks.

Summary Table: Key Differences Between AD, SRAS, and LRAS

Example: The OPEC Oil Crisis

• In the early 1970s, OPEC restricted oil supply, causing a negative supply shock.

• SRAS shifted left, leading to higher prices (inflation) and lower output (recession), a phenomenon known as stagflation.

Example: COVID-19 Pandemic

• The pandemic disrupted supply chains and labor markets, shifting SRAS left and causing a new, lower equilibrium output and higher prices.

Additional info: The AD-AS model is a foundational tool for analyzing the effects of policy changes, shocks, and expectations on the overall economy. Understanding the causes and consequences of shifts in AD and AS is essential for interpreting real-world economic events.