Economics (9708) | Aggregate Demand and Aggregate Supply analysis

Welcome to Macroeconomics! Understanding Aggregate Demand and Aggregate Supply

Hello future economists! This chapter, Aggregate Demand and Aggregate Supply (AD/AS) analysis, is arguably the most important model you will learn in macroeconomics. Think of it as the 'big picture' version of the supply and demand curves you studied in microeconomics.

Why is this model essential? It allows us to analyze the entire economy—answering crucial questions like:

• Why does the price level (inflation) change?
• How does a country achieve economic growth?
• What causes mass unemployment?

Mastering AD/AS will equip you to understand government policies (Fiscal and Monetary Policy) and how they try to manage the economy. Let's dive in!

Part 1: Aggregate Demand (AD)

What is Aggregate Demand? (4.3.1, 4.3.2)

In simple terms, Aggregate Demand (AD) is the total demand for all goods and services produced in an economy over a specific period, at a given overall price level.

It represents the total spending by households, firms, the government, and foreigners on domestically produced goods and services.

The Components of Aggregate Demand (The Formula)

The AD is calculated using the four main sectors of the economy. This should look familiar from your studies of National Income (GDP): $$AD = C + I + G + (X - M)$$

• C: Consumption - Spending by households on goods and services (e.g., buying a sandwich, a new car). This is usually the largest component.
• I: Investment - Spending by firms on new capital goods (e.g., machinery, factories) and spending on new housing. (Note: In economics, Investment means spending on capital, not buying stocks or shares.)
• G: Government Spending - Spending by the government on public services, infrastructure, and wages (e.g., new schools, paying teachers).
• (X - M): Net Exports - The value of Exports (X) minus the value of Imports (M).
  • Exports (X) are spending by foreigners on domestic goods (increases AD).
  • Imports (M) are spending by domestic residents on foreign goods (decreases AD).

The Downward Slope of the AD Curve (4.3.4)

The AD curve slopes downwards, showing an inverse relationship: as the overall Price Level (P) falls, the Real Output (Y) (or real GDP) demanded increases.

There are three main reasons why a lower price level leads to higher aggregate demand:

1. The Wealth Effect (or Real Balances Effect):

   When the price level falls, the money you hold (cash in your wallet, savings in the bank) has a higher real value (it buys more goods). People feel wealthier and therefore increase their consumption (C). (Example: If milk and bread prices halve, your £100 savings can now buy twice as much, so you might spend more freely.)

2. The Interest Rate Effect:

   A lower price level typically reduces the demand for money. If money demand falls, interest rates fall. Lower interest rates make borrowing cheaper, encouraging firms to undertake more Investment (I) and households to increase Consumption (C, especially for big items like homes or cars).

3. The International Trade Effect (or Net Exports Effect):

   When the domestic price level falls (assuming the exchange rate and foreign prices stay the same), domestic goods become relatively cheaper compared to foreign goods. This causes Exports (X) to increase and Imports (M) to decrease, leading to a rise in Net Exports (X-M).

Shifts in the AD Curve (4.3.5)

A shift in the AD curve means that total spending changes at every price level. This is caused by changes in the determinants of AD (C, I, G, or X-M), excluding a change in the price level itself.

AD Shifts Right (AD increases): Caused by events that encourage spending:

• Increase in Consumer Confidence (C increases).
• Decrease in Interest Rates (I and C increase).
• Decrease in Income Taxes (C increases).
• Increase in Government Spending (G increases).
• A weaker domestic Exchange Rate (X increases, M decreases).

AD Shifts Left (AD decreases): Caused by events that discourage spending (often during recessions):

• Decrease in Business Confidence (I decreases).
• Increase in Interest Rates (I and C decrease).
• Increase in Income Taxes (C decreases).
• Stronger domestic Exchange Rate (X decreases, M increases).

Part 2: Aggregate Supply (AS)

What is Aggregate Supply? (4.3.6)

Aggregate Supply (AS) is the total quantity of goods and services that firms across the economy are willing and able to produce and supply at a given overall price level.

It tells us about the capacity and costs of production in the economy.

The Shapes of the AS Curve (4.3.8)

Unlike AD, AS is analyzed over two time periods: the short run and the long run.

1. Short-Run Aggregate Supply (SRAS)

The SRAS curve shows the total output supplied when the price level changes, assuming that some costs of production (like wage rates or rents) are fixed (or 'sticky') in the short run.

Shape: Upward Sloping

Why? If the overall price level rises, but wages remain fixed (sticky), firms see their revenue increase faster than their costs. Since production is now more profitable, firms are incentivized to increase output (Real GDP). (Don't worry if this seems tricky at first. Just remember: Higher prices + Fixed costs = Higher profits = More production.)

2. Long-Run Aggregate Supply (LRAS)

The LRAS curve shows the economy's maximum potential output when all factors of production are fully employed. In the long run, costs (like wages) are fully flexible and have adjusted to the price level.

Shape: Vertical

The LRAS is typically drawn as a vertical line at the level of Potential Output ($Y_{FE}$).

Why is it vertical? In the long run, output is determined entirely by the quantity and quality of the Factors of Production (FOPs)—Land, Labour, Capital, and Enterprise. It doesn't matter if the price level is $P_1$ or $P_{100}$; if all resources are already being used efficiently, the economy cannot produce any more goods. (Analogy: If a factory has 10 machines and 10 workers, output is capped. Changing the price of the final product won't magically give them an 11th machine.)

Did you know? Some economists (Keynesians) also use an AS curve composed of three sections: highly elastic (lots of spare capacity), upward sloping (approaching full employment), and vertical (full capacity). However, for AS analysis, focusing on the distinction between the upward-sloping SRAS and the vertical LRAS (Potential Output) is usually sufficient at this level.

Determinants and Shifts in the AS Curve (4.3.7, 4.3.9)

Shifts in the AS curves reflect changes in the underlying capacity or costs of the economy.

Shifts in the SRAS (Short-Run)

SRAS shifts are caused by changes in the cost of production, at any given level of output.

SRAS Shifts Right (SRAS increases): Costs fall, so firms produce more cheaply.

• Decrease in raw material costs (e.g., global oil prices fall).
• Decrease in wage rates.
• Decrease in indirect taxes (e.g., VAT reduction).
• Increase in subsidies given to producers.

SRAS Shifts Left (SRAS decreases): Costs rise, so firms produce less at the same price level.

• Increase in raw material costs (a supply shock, like a natural disaster impacting crops).
• Increase in wage rates due to strong union bargaining.
• Increase in indirect taxes (e.g., an increase in duties on tobacco).

Shifts in the LRAS (Long-Run)

LRAS shifts are caused by changes in the productive capacity of the economy—the factors that increase the potential output ($Y_{FE}$). This is equivalent to an outward shift of the Production Possibility Curve (PPC).

LRAS Shifts Right (LRAS increases): Potential output increases.
These are usually the result of long-term economic policies (Supply-Side Policies):

• Discovery of new natural resources (Land).
• Increase in the size or productivity of the workforce (Labour) (e.g., through better education and training).
• Increase in the quantity or quality of capital stock (Capital) (e.g., new technology, better infrastructure).
• Improvements in efficiency and innovation (Enterprise).

LRAS Shifts Left (LRAS decreases): Potential output decreases (this is rare, but possible).

• Massive emigration (loss of skilled labour).
• Widespread destruction of infrastructure (e.g., due to war or natural disaster).

Part 3: Macroeconomic Equilibrium and Effects of Shifts

Establishing Equilibrium (4.3.11)

The macroeconomic equilibrium is established where the Aggregate Demand (AD) curve intersects the Aggregate Supply (AS) curve (SRAS).

The point of intersection determines the current equilibrium Price Level ($P_e$) and the equilibrium level of Real Output ($Y_e$), which directly influences the level of employment in the economy.

If the economy is in short-run equilibrium ($Y_e$), but this level is less than the long-run potential output ($Y_{FE}$), the economy is experiencing a recessionary gap (high unemployment). If $Y_e$ is greater than $Y_{FE}$, it is an inflationary gap (low unemployment, overheating economy).

The Effects of Shifts in AD and AS (4.3.12)

Understanding how shifts affect $P_e$, $Y_e$, and employment is vital for analysis. Assume the economy starts in equilibrium.

Scenario 1: Increase in AD (Expansionary Policy or Confidence Boom)

Example: Government increases spending (G rises) or interest rates are cut.

Shift: AD shifts right (AD to $AD_1$).
Effects:

• Real Output ($Y_e$): Increases (Economic Growth).
• Price Level ($P_e$): Increases (Demand-Pull Inflation).
• Employment: Increases (Unemployment falls).

This is generally associated with a boom phase, but the cost is higher inflation.

Scenario 2: Decrease in AD (Contractionary Policy or Recession)

Example: Consumers lose confidence following a banking crisis (C falls) or taxes are raised.

Shift: AD shifts left (AD to $AD_2$).
Effects:

• Real Output ($Y_e$): Decreases (Recession/Contraction).
• Price Level ($P_e$): Decreases (Disinflation or Deflation).
• Employment: Decreases (Unemployment rises, known as Cyclical Unemployment).

Scenario 3: Decrease in SRAS (Adverse Supply Shock)

Example: A sudden, large increase in the price of imported oil or significant wage increases across the economy.

Shift: SRAS shifts left (SRAS to $SRAS_2$).
Effects:

• Real Output ($Y_e$): Decreases (Economy shrinks).
• Price Level ($P_e$): Increases (Cost-Push Inflation).
• Employment: Decreases (Unemployment rises).

This combination of high prices, low output, and high unemployment is called Stagflation, a very difficult situation for governments to manage!

Scenario 4: Increase in LRAS/SRAS (Productivity Improvement)

Example: Government invests heavily in education and infrastructure, leading to major efficiency gains (a successful supply-side policy).

Shift: LRAS and SRAS shift right (LRAS to $LRAS_1$ and SRAS to $SRAS_1$).
Effects:

• Real Output ($Y_e$): Increases (Sustainable Economic Growth).
• Price Level ($P_e$): Decreases (Lower inflation or Deflation).
• Employment: Increases (Full employment maintained at a higher output level).

This is the ideal outcome—growth without inflation. Government policies often aim to achieve this long-run shift.