Aggregate Demand and Aggregate Supply Model

Introduction to the 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 dynamics, helping us understand business cycles and economic shocks.

• Aggregate Demand (AD): Represents the total quantity of goods and services demanded across the economy at different price levels.

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

• Short-run vs. Long-run: The model distinguishes between short-run fluctuations and long-run growth, with different determinants in each period.

Aggregate Demand (AD)

Definition and Components

Aggregate demand is the total demand for final goods and services in an economy at a given time and price level. It 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 housing.

• Government Purchases (G): Expenditures by government on goods and services.

• Net Exports (NX): Exports minus imports.

The aggregate demand equation is:

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

Why the Aggregate Demand Curve Slopes Downward

The AD curve slopes downward due to three main effects:

• Wealth Effect: As price levels rise, the real value of household wealth falls, 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.

Wealth Effect

• Household consumption is strongly determined by income and wealth.

• If price levels rise, the real value of nominal assets (such as cash and bonds) falls.

• Result: Higher price level leads to lower consumption.

Interest-Rate Effect

• When prices rise, households and firms need more money for transactions.

• This increases the demand for money, causing interest rates to rise.

• Higher interest rates discourage investment spending.

• Result: Higher price level leads to lower investment.

International-Trade Effect

• Higher U.S. price levels make U.S. exports more expensive and imports cheaper.

• Net exports fall as exports decrease and imports increase.

• Result: Higher price level leads to lower net exports.

Summary Table: Effects of Price Level on AD Components

Aggregate Supply (AS)

Short-Run Aggregate Supply (SRAS)

The short-run aggregate supply curve shows the relationship between the price level and the quantity of real GDP supplied by firms in the short run. It is typically upward sloping because:

• As prices of final goods and services rise, input prices (such as wages and raw materials) adjust more slowly.

• Some firms are slow to adjust prices due to contracts, menu costs, or imperfect information.

Long-Run Aggregate Supply (LRAS)

The long-run aggregate supply curve is vertical, indicating that in the long run, the level of real GDP supplied is determined by the economy's resources (labor, capital, technology) and is independent of the price level.

• Potential GDP: The level of output when the economy is at full employment.

• LRAS occurs at the level of potential GDP.

Macroeconomic Equilibrium

Short-Run Equilibrium

In the short run, equilibrium occurs at the intersection of the AD and SRAS curves, determining the actual level of real GDP and the price level.

Long-Run Equilibrium

Long-run equilibrium occurs when the AD, SRAS, and LRAS curves intersect at the full-employment level of GDP.

Shifts in Aggregate Demand and Aggregate Supply

Factors Shifting Aggregate Demand

• Monetary Policy: Changes in the money supply and interest rates by the central bank.

• Fiscal Policy: Changes in government spending and taxation.

• Changes in Expectations: Consumer and business confidence.

• Foreign Income and Exchange Rates: Changes in foreign demand for exports and currency values.

Factors Shifting Short-Run Aggregate Supply

• Changes in Input Prices: Wages, raw materials, and energy costs.

• Supply Shocks: Unexpected events such as natural disasters or pandemics.

• Changes in Productivity: Technological improvements.

• Expectations of Future Prices: If firms expect higher prices, they may adjust wages and prices upward.

Examples and Applications

Covid-19 Recession Case Study

• During the Covid-19 recession, services declined while residential construction increased due to low interest rates and stimulus checks.

• Social distancing and closures reduced demand for services, but demand for housing rose.

Graphical Representation

• The intersection of the AD and SRAS curves determines short-run equilibrium real GDP and price level.

• Shifts in either curve can lead to recessions (falling GDP) or inflation (rising price level).

Key Terms

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

• Aggregate Supply (AS): Total supply of goods and services in the economy.

• Short-Run Aggregate Supply (SRAS): Supply curve in the short run, upward sloping.

• Long-Run Aggregate Supply (LRAS): Supply curve in the long run, vertical at potential GDP.

• Potential GDP: The maximum sustainable output of the economy.

• Wealth Effect: Impact of price level changes on real wealth and consumption.

• Interest-Rate Effect: Impact of price level changes on interest rates and investment.

• International-Trade Effect: Impact of price level changes on net exports.

Example: If the price level rises, households feel poorer (wealth effect), interest rates rise (interest-rate effect), and exports fall (international-trade effect), all leading to a decrease in aggregate demand.

Additional info: The notes also reference the Covid-19 recession as a real-world application of the AD-AS model, illustrating how different sectors are affected by economic shocks.