Introduction to Aggregate Demand and Aggregate Supply

Overview

The aggregate demand and aggregate supply (AD-AS) model is a fundamental framework in macroeconomics used to explain short-run fluctuations in real GDP, unemployment, and the price level. This model extends the analysis of long-run economic growth to include short-run dynamics, helping us understand business cycles and economic shocks such as recessions.

Aggregate Demand (AD)

Definition and Components

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

• Formula: where:

  • C: Consumption

  • I: Investment

  • G: Government purchases

  • NX: Net exports (Exports - Imports)

• Government purchases are typically determined by policymakers and are independent of the price level, while consumption, investment, and net exports are affected by changes in the price level.

Determinants of Aggregate Demand

• Wealth Effect: As price levels rise, the real value of household wealth falls, leading to lower consumption. Conclusion: Higher price level leads to lower consumption.

• Interest-Rate Effect: Higher prices increase the demand for money, raising interest rates and discouraging investment. Conclusion: Higher price level leads to lower investment.

• International-Trade Effect: Higher domestic prices make exports less competitive and imports more attractive, reducing net exports. Conclusion: Higher price level leads to lower net exports.

Shape of the Aggregate Demand Curve

• Each of the three effects above causes higher price levels to result in lower values of consumption, investment, and net exports, thus reducing real GDP.

• This explains why the aggregate demand curve slopes downward.

Aggregate Supply (AS)

Short-Run Aggregate Supply (SRAS)

• 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.

• In the short run, real GDP and the price level are determined by the intersection of the aggregate demand curve and the short-run aggregate supply curve.

Long-Run Aggregate Supply (LRAS)

• Long-run aggregate supply (LRAS) curve: Represents the relationship in the long run between the price level and the quantity of real GDP supplied. In the long run, GDP is determined by the number of workers, the level of technology, and the capital stock, and is independent of the price level.

• LRAS is depicted as a vertical line at the level of potential or full-employment GDP.

Macroeconomic Equilibrium

Short-Run Equilibrium

• Occurs at the intersection of the AD and SRAS curves, determining the actual level of real GDP and the price level in the economy.

Long-Run Equilibrium

• Occurs when the AD, SRAS, and LRAS curves intersect at the full-employment level of GDP.

Applications: The Covid-19 Recession

Sectoral Impacts

• During the Covid-19 recession, service sector output declined due to social distancing and closures, while residential construction increased, spurred by low interest rates and stimulus checks.

• Firms in sectors affected by social distancing (e.g., entertainment) saw reduced demand, while home builders benefited from increased demand for housing.

Summary Table: Effects of Price Level Changes on AD Components

Key Terms

• Aggregate Demand (AD): Total demand for goods and services in the economy at different price levels.

• Aggregate Supply (AS): Total supply of goods and services that firms in an economy plan on selling during a specific time period.

• Short-Run Aggregate Supply (SRAS): The relationship between the price level and real GDP supplied in the short run.

• Long-Run Aggregate Supply (LRAS): The relationship between the price level and real GDP supplied in the long run, independent of the price level.

• Macroeconomic Equilibrium: The point where aggregate demand equals aggregate supply, determining the overall price level and output.

Example Application

• Covid-19 Recession: The pandemic caused a negative shock to both aggregate demand (due to reduced consumption and investment) and aggregate supply (due to business closures and supply chain disruptions), shifting both curves to the left and resulting in lower output and employment.

Additional info: These notes expand on the brief points in the slides, providing definitions, formulas, and context for the AD-AS model and its application to real-world events such as the Covid-19 recession.