Aggregate Demand & Supply, Determinants, and Economic Fluctuations Lecture Notes

Aggregate Demand (AD)

• AD = total planned expenditure on the economy’s output at each overall price level.
  • Formulaic components: $AD = C + I + G + (X - M)$ where
  • $C$ = consumption
  • $I$ = investment
  • $G$ = government purchases
  • $(X-M)$ = net exports

Price‐level changes vs. shifts

• A change in the overall price level does not shift AD; it causes movement along the curve.
  • Price ↓ ⇒ move down along AD to a larger quantity demanded.
  • Price ↑ ⇒ move up along AD to a smaller quantity demanded.

Non-price determinants that shift AD

1. Consumption (C)
   • Stock-market boom → perceived wealth ↑ → $C$ ↑ ⇒ AD shifts right.
   • Stock-market crash → wealth ↓ → $C$ ↓ ⇒ AD shifts left.
   • Tax policy
     • Tax hike → disposable income ↓ → $C$ ↓ ⇒ AD ←.
     • Tax cut → disposable income ↑ → $C$ ↑ ⇒ AD →.
2. Investment (I)
   • Firms buy new capital (factories, computers) → $I$ ↑ ⇒ AD →.
   • Expectations
     • Optimistic future sales/profits → $I$ ↑ ⇒ AD →.
     • Pessimistic outlook → $I$ ↓ ⇒ AD ←.
3. Government Purchases (G)
   • Increases in federal, state, or local spending on defense, roads, schools, etc. shift AD →; cutbacks shift AD ←.
4. Net Exports (X – M)
   • Foreign boom (trading partners expand) → their income ↑ → U.S. exports ↑ ⇒ AD →.
   • Foreign recession → exports ↓ ⇒ AD ←.
   • Exchange-rate changes
     • Dollar depreciation → U.S. goods cheaper abroad → exports ↑, imports ↓ ⇒ AD →.
     • Dollar appreciation → exports ↓, imports ↑ ⇒ AD ←.

Aggregate Supply (AS)

Long-Run Aggregate Supply (LRAS)

• LRAS is vertical at the economy’s natural rate of output ($Y_n$), also called
  • Potential output
  • Full-employment output
• $Y_n$ occurs when unemployment is at its natural rate (frictional + structural + cyclical ≈ 0).

LRAS determinants (any change shifts LRAS)

1. Labor (size or participation)
   • Immigration surge → labor force ↑ → LRAS →.
   • Baby-boom retirements → labor ↓ → LRAS ←.
2. Capital
   • Physical (machines, factories) or human (education)
   • New investment or more college degrees → LRAS →.
   • Capital destroyed by natural disaster (fire, hurricane) → LRAS ←.
3. Natural Resources
   • Discovery of new mineral deposit → LRAS →.
   • Reduced oil imports → energy input ↓ → LRAS ←.
   • Adverse weather hurting agriculture → LRAS ←.
4. Technology (often the most important)
   • Productivity-boosting innovations or technology transfer to developing nations → LRAS →.

Short-Run Aggregate Supply (SRAS)

• SRAS slopes upward; over 1–2 years, higher price level ⇒ higher output supplied.
• Price level affects output in the short run through production costs (wages, raw-materials prices, taxes, subsidies, tariffs).
• In the long run, price level does not affect output (LRAS vertical).

Theories explaining upward SRAS slope (all rely on market imperfections)

1. Sticky-Wage Theory
   • Nominal wages set by contracts/social norms are slow to adjust.
   • If actual P > P_e (expected price), revenues ↑ while labor cost stays fixed ⇒ production more profitable ⇒ output supplied ↑.
2. Sticky-Price Theory
   • Some firms face menu costs (catalogues, printed menus) ⇒ prices adjust slowly.
   • Firms without menu costs (e-commerce) can change prices instantly; others lag.
   • Unexpected $P$ rise leaves slow-adjusting firms’ prices relatively low ⇒ sales ↑ ⇒ output ↑.
3. Misperceptions Theory
   • Suppliers may misread overall $P$ changes as changes in relative price of their product.
   • Believe their good’s price ↑ relative to others ⇒ produce more; converse if $P$ falls.

▶ Common thread: Output deviates from potential whenever actual price level deviates from expected price level.

• Compact expression: $Y = Y<em>n + a\,(P - P</em>e)$ where a > 0 measures sensitivity.

SRAS shifters

• All LRAS shifters (labor, capital, resources, technology) also shift SRAS.
• Expected price level ($P_e$)
  • Higher $P_e$ → workers seek higher nominal wages, firms face higher cost → SRAS shifts left (for any given $P$, output ↓).
  • Lower $P_e$ → SRAS →.

Price vs. Quantity Recap

• LRAS: $P$ no effect on $Y$; real factors set output.
• SRAS: $P$ changes influence $Y$ via wage/price rigidities & misperceptions.
• AD: $P$ changes move along curve; real (non-price) factors shift curve.

Four-Step Framework for Analyzing Economic Fluctuations

1. Identify the event/ policy that shifts AD or AS.
2. Determine which curve shifts and in which direction (→ or ←).
3. Use AD–AS diagram to find new short-run equilibrium ($P<em>{SR}, Y</em>{SR}$).
4. Trace adjustment toward long-run equilibrium (price expectations adjust, SRAS moves) and describe outcomes for $P, Y, u$.

Historical AD Shocks

The Great Depression (1929-1933)

• Money supply ↓ $28\%$ (bank failures).
• Stock market ↓ $90\%$ ⇒ wealth ↓ ⇒ $C$ & $I$ ↓.
• Real output ↓ $26\%$.
• Unemployment ↑ from $3\%$ to $25\%$.
• Price level ↓ $22\%$ (deflation).

World War II Boom (1939-1944)

• Government outlays ↑ from $\$9.1\text{ bn}$ to $\$91.3\text{ bn}$ ( ≈ $+900\%$ ).
• Production ↑ $90\%$, especially military goods.
• Prices ↑ (wartime inflation).
• Unemployment ↓ from $17\%$ to $1\%$ (men drafted; women enter labor force).

Business Cycle Basics

• Four phases: Expansion → Peak → Contraction (Recession) → Trough.
• Represents short-run deviations around long-run growth trend explained by AD–AS shifts.

Policy Levers Affecting AD (Preview)

• Monetary policy: Central bank (Federal Reserve) changes money supply & interest rates.
• Fiscal policy: President & Congress alter government spending ($G$) and taxation (affects $C$ & $I$).
  • Next lecture will examine how these shift AD.

Key Takeaways

• Price level vs. curve shifts: remember distinction for both AD and AS.
• Determinants:
  • AD: $C, I, G, (X-M)$.
  • LRAS/SRAS: labor, capital, resources, technology (+ $P_e$ for SRAS).
• Three SRAS theories underpin the short-run upward slope via wage rigidity, price rigidity, misperceptions.
• Major historical episodes (Great Depression, WWII) illustrate large AD shifts and resultant macro outcomes.