Aggregate Demand and Supply Model & Business Cycles

The Aggregate Demand and Supply Model

Model of Macroeconomic Fluctuations

Calculating GDP (Expenditure Approach)

  • Real GDP (π‘Œ) is given by: π‘Œ = 𝐢 + 𝐼 + 𝐺 + 𝑋 - 𝑀

    • Where:

    • 𝐢 = Household expenditure

    • 𝐼 = Investment

    • 𝐺 = Government expenditure

    • 𝑋 = Exports

    • 𝑀 = Imports

  • Real GDP represents the total value of goods and services produced within a country.

  • 𝐢, 𝐼, 𝐺, and 𝑁𝑋 reflect components of aggregate demand while π‘Œ represents aggregate supply.

Relationship Between Aggregate Demand and Price Level

  • Aggregate demand stems from various sources, making it complex.

  • Consumption:

    • Depends on price level, disposable income, interest rates, preferences, and expectations.

    • Negative relationship between price level and consumption.

  • Investment:

    • Involves business investments in machinery/property.

    • Higher price levels decrease investment due to greater costs and higher interest rates.

    • Liquidity Preference Theory: Demand for money is negatively related to interest rates.

    • Figure 4: Theory of Liquidity Preference paradigm without price level shift directly affecting money supply.

  • Government Expenditure:

    • Decisions do not directly correlate with price levels.

  • Net Exports:

    • Domestic price level increases lead to higher imports and lower exports causing negative net exports.

Aggregate Demand Function

  • Aggregate demand components (except for government expenditure) exhibit a negative relationship with price level.

  • Figure 5: Illustrates the Aggregate Demand Function.

Aggregate Demand Shifters

  • Changes leading to shifts include:

    • Increases in investment due to incentives or expectations shifting aggregate demand right.

    • Government policy changes affecting aggregate demand through fiscal policies (expansionary or contractionary).

    • Interest rate changes affecting investment and consumption impacting shifts in aggregate demand function.

  • Fiscal Policy: Changes in government spending directly correlate to changes in aggregate demand.

    • Expansionary fiscal policy (increase in spending) shifts aggregate demand function to the right.

    • Contractionary fiscal policy (decrease in spending) shifts aggregate demand function to the left.

  • Monetary Policy: Central Bank (Fed) adjustments to the money supply affect aggregate demand as per the Liquidity Preference Theory.

    • Increase in money supply = lower interest rates = increase in consumption/investment; shifts function right (expansionary).

    • Decrease shifts left (contractionary).

Aggregate Supply

Long-run vs Short-run Aggregate Supply

  • Long-run Aggregate Supply (LRAS): Economic output depends on available production factors and technology; does not vary with price level.

  • Short-run Aggregate Supply (SRAS): Price level affects aggregate supply due to sticky nominal wages.

  • Sticky Wage Theory: Nominal wages do not adjust quickly, creating a positive relationship between price level and aggregate supply in the short run.

  • Diagram of LRAS and SRAS shows their respective price level relationships.

Aggregate Supply Shifters

  • Changes in production factors and technology cause shifts.

  • Rising input costs lead to leftward shifts of SRAS; reduced costs lead to rightward shifts.

Economic Fluctuations: The Model at Work

Technological Improvements and Production Factors

  • Improved technology increases LRAS and SRAS, enhancing economic output.

    • Figure 7 shows effects of an upward shift in LRAS and SRAS due to technological advancements.

Positive Aggregate Demand Shocks

  • Example: Increase in investment cause rightward shift of AD.

  • Temporary equilibrium above full employment output leads to rising price levels; ultimately covers nominal wage adjustments in the long run.

  • Figure 8 outlines the short and long-run effects of a positive shock.

Self-Correction Mechanism

  • Nominal input price adjustments restore full employment levels in the economy.

  • A negative shock would decrease AD, slowing adjustment toward equilibrium.

Stabilization Policy

Policy Response to Economic Shocks

  • Examples of Economic Hardships: Covid Pandemic

    • Short-run shifts in SRAS with no effect on LRAS.

    • Resulting Drops in output underlines stagflation.

Fiscal and Monetary Policies Implemented

  • Fiscal Policy:

    • Increases in government expenditure boost aggregate demand and output during recessions.

    • Potential Crowding Out Effect could occur, reducing overall aggregate demand indirectly.

    • Multiplier Effect: Further increases consumption due to increased disposable income.

    • A graphic representation of the multiplier effect shows a consecutive and compounding impact of increased income leading to increased consumption continually until exhaustion (MPC).

  • Monetary Policy: Expanding money supply = reducing interest rates = boosting consumption = aggregate demand increase.

  • Limitations of Policy: Timing of policy implementation can affect outcomes.

    • Delays in passing new fiscal measures may hinder timely responses during economic downturns.

    • Previous crisis responses have illustrated the importance of intervention timing to combat significant recessions.