Aggregate Demand and Supply: Key Concepts and Effects

Wealth Effect

Wealth increases → AD increases; Wealth decreases → AD decreases.

Example of Wealth Effect

Going to Starbucks 4x a week instead of 2x increases consumption → AD increases.

Expectations of Future Prices

Expect higher future prices → AD increases; Expect lower future prices → AD decreases.

Example of Expectations Effect

If gas prices are expected to rise next week, people buy more gas now → AD increases.

Interest Rates and AD

Interest rates increase → borrowing decreases → consumption and AD decrease.

Income Taxes and AD

Higher taxes → less disposable income → AD decreases; Lower taxes → AD increases.

Sticky Wages

Firms hire based on real wages. If CPI rises, real wages fall → labor cheaper → firms hire more → SRAS shifts right.

Worker Misconceptions

Workers may not know CPI, misjudge real wages, and reduce work → lower supply; theory criticized since firms don't hire on real wages.

Effect of Wage Rates on SRAS

Higher wages → higher production costs → SRAS shifts left; Lower wages → SRAS shifts right.

Effect of Non-Labor Input Prices on SRAS

Higher input prices (e.g., oil) → higher costs → SRAS shifts left; Lower input prices → SRAS shifts right.

Productivity and SRAS

Higher productivity → lower production costs → more output → SRAS shifts right.

Example of Productivity Increase

New technology makes shirt production faster → costs fall → SRAS shifts right.

Adverse vs. Beneficial Supply Shocks

Adverse shocks decrease SRAS (shift left); Beneficial shocks increase SRAS (shift right).

Example of Adverse Supply Shock

Terrorist attack destroys factories → production falls → SRAS shifts left.

Example of Beneficial Supply Shock

New oil source found → cheaper oil → production rises → SRAS shifts right.

Short-Run Equilibrium: Price Too High (P1)

QS > QD → surplus → suppliers lower price and production until equilibrium.

Short-Run Equilibrium: Price Too Low (P2)

QS < QD → shortage → suppliers raise price and production until equilibrium.

Long Run Aggregate Supply (LRAS)

LRAS is a vertical line showing full employment output (Qn); price level doesn't affect it.

Disequilibrium and LRAS

If economy not at LRAS → not at full employment → disequilibrium.

Real Balance Effect

Price level falls → purchasing power rises → people buy more goods.

Interest Rate Effect

Price level falls → people save more → interest rates drop → investment and AD increase.

International Trade Effect

CPI falls in U.S. → U.S. goods cheaper → exports increase → AD increases.