Economics | Variations in economic activity— aggregate demand and aggregate supply

Welcome to Macroeconomics: Understanding the Engine of the Economy!

Hi everyone! This chapter, Variations in economic activity—aggregate demand and aggregate supply, is arguably the most crucial unit in macroeconomics. Why? Because the models we study here—AD and AS—are the primary tools governments and central banks use to fight recessions, control inflation, and manage economic growth.

Think of the national economy as a giant engine. Aggregate Demand (AD) is the fuel flowing in (spending), and Aggregate Supply (AS) is the maximum power the engine can generate (production). Understanding how these two forces interact explains why we have good times (booms) and bad times (recessions).

Don't worry if these concepts seem large at first. We will break them down step-by-step!

Section 1: The Context – Economic Activity and Fluctuations

Before diving into AD and AS, remember what we learned about measuring economic activity (Unit 3.1):

• Economic Activity is typically measured using Real GDP (Gross Domestic Product adjusted for inflation).
• Economies naturally fluctuate in a pattern known as the Business Cycle, moving between booms (peaks), slow-downs (contractions/recessions), and recoveries (troughs).

AD and AS are the fundamental forces that cause these movements in Real GDP and the overall Price Level.

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Section 2: Aggregate Demand (AD)

Definition and the AD Curve

Aggregate Demand (AD) is the total amount of spending on goods and services in an economy over a period of time, at a given overall price level.

Analogy Alert: When you study microeconomics, demand (D) is about one good (e.g., apples). AD is the total demand for *everything* produced in the country (apples, cars, haircuts, roads, defense services, etc.).

The Components of Aggregate Demand

The AD is calculated using the expenditures approach to GDP measurement. It is often summarized by the famous equation:

$$AD = C + I + G + (X - M)$$

Let's break down these essential components:

1. C – Consumption: Spending by households on goods and services (e.g., buying food, getting a haircut, purchasing a new television). This is usually the largest component.
2. I – Investment: Spending by firms on capital goods (e.g., buying new machinery, building a new factory, increasing inventory). Note: This is NOT financial investment like buying stocks.
3. G – Government Spending: Spending by the government on goods and services (e.g., building roads, paying salaries for teachers and police). Note: Transfer payments (like unemployment benefits) are excluded as they don't involve the purchase of goods/services.
4. (X – M) – Net Exports: The value of Exports (X) minus the value of Imports (M). (X > M = Trade Surplus; X < M = Trade Deficit).

Why the AD Curve Slopes Downward

Unlike the micro demand curve, the AD curve slopes down for three specific reasons (as the overall Price Level (P) falls, Real GDP demanded (Y) increases):

• 1. The Wealth Effect: When the price level falls, the real value (purchasing power) of consumers' assets (like savings) increases. People feel richer, leading them to spend more.
• 2. The Interest Rate Effect: When the price level falls, people need less money to buy goods. This reduces the demand for money, lowering interest rates. Lower interest rates encourage more borrowing for consumption and investment.
• 3. The International Trade Effect (or Net Export Effect): If the domestic price level falls relative to other countries, domestic goods become cheaper. This causes exports (X) to rise and imports (M) to fall, increasing net exports ($X-M$).

Determinants of Aggregate Demand (Shifts)

A change in the overall price level causes a movement *along* the AD curve. A change in any factor other than the price level will shift the entire AD curve (either right, increasing AD; or left, decreasing AD).

Here are the key determinants, categorized by their component:

1. Changes Affecting Consumption (C):

• Consumer Confidence: If households expect a good economic future, they spend and borrow more ($\uparrow$ AD).
• Interest Rates: Higher interest rates make borrowing (and thus big purchases like cars or homes) more expensive ($\downarrow$ AD).
• Taxes (Income Tax): Lower income taxes mean more disposable income ($\uparrow$ AD).
• Household Debt Levels: High existing debt means less capacity for new spending ($\downarrow$ AD).

2. Changes Affecting Investment (I):

• Business Confidence: Optimistic firms invest in new factories and machinery ($\uparrow$ AD).
• Interest Rates: Investment is highly sensitive to interest rates, as firms often borrow to fund projects. Higher rates ($\downarrow$ AD).
• Technology/Innovation: New breakthroughs spur firms to invest in new equipment to remain competitive ($\uparrow$ AD).
• Business Taxes (Corporate Taxes): Lower profit taxes leave firms more money for investment ($\uparrow$ AD).

3. Changes Affecting Government Spending (G):

• This is primarily determined by political decisions (Fiscal Policy) regarding public infrastructure, healthcare, or defense.

4. Changes Affecting Net Exports (X-M):

• Exchange Rate: A depreciation of the domestic currency makes exports cheaper to foreigners and imports more expensive to domestic buyers ($\uparrow$ X, $\downarrow$ M, thus $\uparrow$ AD).
• Incomes Abroad: If trading partners experience a boom, they buy more of our exports ($\uparrow$ AD).
• Protectionism: If foreign countries impose tariffs on our goods, our exports fall ($\downarrow$ AD).

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Section 3: Aggregate Supply (AS)

Aggregate Supply (AS) is the total quantity of goods and services produced in an economy (Real GDP) over a period of time, at a given overall price level.

Analogy Alert: If AD is the fuel, AS is the potential output of the engine. It depends on the number of workers, the quality of machinery, and the technology available.

Economists usually divide AS into two perspectives based on time and assumptions about resource prices (especially wages): Short-Run Aggregate Supply (SRAS) and Long-Run Aggregate Supply (LRAS).

Short-Run Aggregate Supply (SRAS)

The short run is defined as a period where the prices of factors of production, especially resource prices (like wages), are "sticky" (do not adjust immediately to changes in the price level).

• The SRAS Curve: Slopes upward and to the right.
• Why it slopes up: If the overall price level (P) increases, firms' revenues increase. Since wages and input costs are fixed (sticky) in the short run, profits rise. Firms are thus encouraged to increase production (Real GDP).

Determinants of SRAS (Shifts)

SRAS shifts primarily due to changes in the costs of production:

• Change in Wage Rates: If unions negotiate higher wages, costs rise ($\downarrow$ SRAS, shifts left).
• Change in Non-Labour Costs: Changes in the price of key inputs (e.g., oil, electricity, raw materials) ($\uparrow$ costs, $\downarrow$ SRAS).
• Taxes on Firms (Indirect Taxes or Subsidies): Higher sales taxes mean lower profits, discouraging production ($\downarrow$ SRAS).

Memory Aid: SRAS = Short Run costs. If costs go UP, SRAS shifts LEFT (less supply).

Long-Run Aggregate Supply (LRAS)

The long run is defined as a period where the prices of all factors of production are fully flexible and can adjust to the price level.

In the long run, the economy automatically adjusts to its Potential Output ($Y_P$), which is determined only by the quantity and quality of its factors of production (FOPs).

The LRAS concept has two main schools of thought:

1. The Neoclassical/Monetarist View (Vertical LRAS)

• Shape: The LRAS curve is perfectly vertical at the level of Potential GDP ($Y_P$), also called the full employment level of output.
• Logic: In the long run, workers realize that inflation has eroded their real wages and demand higher nominal wages. As wages rise, firms' costs return to normal, eliminating temporary profits. Therefore, output returns to $Y_P$, regardless of the price level.
• Key Implication: Changes in AD only cause inflation in the long run; they do not affect real output.

2. The Keynesian View (Horizontal/Upward-Sloping/Vertical Segments)

John Maynard Keynes argued that economies could get stuck in a recession for a long time. The Keynesian AS curve is drawn with three distinct sections:

1. Horizontal (Recessionary) Segment: Output is very low. There is significant spare capacity (unemployed workers, idle factories). Firms can increase output without raising wages or prices.
2. Intermediate Segment: As output increases, resources become scarcer, and costs start to rise, leading to upward-sloping AS.
3. Vertical (Full Employment) Segment: The economy reaches its maximum capacity ($Y_{max}$). Any further increase in AD only causes inflation, as no more output can be produced.

Did you know? The main policy difference between these models is their view on intervention. Neoclassicals believe the economy self-corrects (vertical LRAS), while Keynesians argue government intervention (like Fiscal Policy) is necessary to pull the economy out of the horizontal segment.

Determinants of LRAS (Shifts - Increasing Potential Output)

LRAS shifts only when the quantity or quality of the factors of production changes. This is equivalent to shifting the Production Possibilities Curve (PPC) outwards.

• Land: Discovery of new resources or improved infrastructure.
• Labour: Better education/training (improved quality) or population growth (increased quantity).
• Capital: Increased investment in technology, machinery, or infrastructure.
• Entrepreneurship: Institutional changes that encourage new businesses (e.g., strong rule of law, reduced bureaucracy).

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Section 4: The AD/AS Equilibrium Model

The macroeconomic equilibrium occurs where Aggregate Demand (AD) equals Aggregate Supply (AS). This intersection determines the current equilibrium level of Real GDP ($Y_e$) and the overall Price Level ($P_e$).

Understanding Shifts and Economic Changes

By shifting the AD or AS curves, we can model various real-world economic events and their consequences for inflation and output.

1. Demand-Side Shocks (Changes in AD)

If AD increases (shifts right), the economy moves to a higher price level and higher output (in the short run).

• Cause: An increase in consumer confidence leading to $\uparrow$ C, or a government spending spree ($\uparrow$ G).
• Impact: Increased Real GDP (economic growth, lower unemployment) and Demand-Pull Inflation (higher price level).
• Example: A major tax cut boosts spending (AD $\rightarrow$ AD$_1$).

2. Short-Run Supply-Side Shocks (Changes in SRAS)

If SRAS decreases (shifts left), this is usually an unwelcome shock.

• Cause: A sudden, sharp increase in the price of key inputs (e.g., oil embargo, crop failure, wage demands).
• Impact: Decreased Real GDP (recession, higher unemployment) and a higher price level. This unpleasant combination is called Stagflation (Stagnation + Inflation).
• Inflation Type: Cost-Push Inflation (inflation caused by rising costs of production).
• Example: In the 1970s, oil shocks dramatically increased production costs (SRAS $\rightarrow$ SRAS$_1$).

3. Long-Run Supply-Side Shocks (Changes in LRAS/Potential Output)

If LRAS increases (shifts right), this represents genuine long-term economic improvement.

• Cause: New technology adoption, significant infrastructure spending, or immigration policies that increase the skilled labour force.
• Impact: The potential output of the economy ($Y_P$) increases. This leads to higher Real GDP and, importantly, can occur without inflation.
• Example: Investment in 5G technology increases productivity across all sectors (LRAS $\rightarrow$ LRAS$_1$).

Connecting the Models: Gaps in the Economy (HL Focus)

The AD/AS model allows us to identify whether an economy is producing at, below, or above its potential.

We use the Neoclassical Model (vertical LRAS) to illustrate these gaps:

1. Full Employment Equilibrium: $AD$ intersects $SRAS$ exactly on the $LRAS$ curve. $Y_e = Y_P$. This is the ideal state.
2. Recessionary Gap (Deflationary Gap): $AD$ intersects $SRAS$ to the left of $LRAS$. $Y_e < Y_P$.
   • Implies: High unemployment and spare capacity.
   • Policy Recommendation: Policies to boost AD (e.g., lower taxes, increased spending).
3. Inflationary Gap: $AD$ intersects $SRAS$ to the right of $LRAS$. $Y_e > Y_P$.
   • Implies: The economy is "overheating," running above sustainable capacity. Very low unemployment, high pressure on wages.
   • Policy Recommendation: Policies to reduce AD (e.g., raise interest rates, increase taxes).

Key Takeaway: The short-run equilibrium may involve unemployment or excessive inflation. Policymakers use demand-side (monetary/fiscal) or supply-side policies to try and shift the curves to reach the stable, long-run, full employment equilibrium ($Y_P$).

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Conclusion: Why This Matters

Mastering AD and AS allows you to analyze every major macroeconomic event—from a pandemic-induced recession (a massive simultaneous drop in AD and AS) to a massive government stimulus (a shift in AD). This model is your lens for interpreting economic news and evaluating government policy effectiveness!

Keep practicing those shifts. You've got this!