Study Notes on Aggregate Demand/Aggregate Supply Model

Aggregate Demand/Aggregate Supply: A Macroeconomic Model and Macroeconomic Concepts

AD/AS Model Outline

  • Aggregate Demand Curve

    • Characteristics

    • Effects and shift factors

    • Relation to Real Gross Domestic Product (RGDP) equation

  • Short Run Aggregate Supply Curve

    • Characteristics

    • Effects and shift factors

  • Long Run Aggregate Supply Curve

    • Characteristics

    • Shift factors

  • Combining AD, SRAS, and LRAS Curves

  • Understanding Inflationary and Recessionary Gaps

  • Impacting AD & AS through Policies

The AD/AS Model

  • The Aggregate Demand/Aggregate Supply (AD/AS) model is vital for understanding key macroeconomic variables such as:

    • Inflation

    • Unemployment

    • RGDP

    • Economic growth

    • Macroeconomic equilibrium

  • This model serves as a foundation for exploring policy issues in macroeconomics.

The Aggregate Demand (AD) Curve

  • The AD curve's concept, while appearing similar to a regular demand curve, differs significantly:

    • Aggregate Demand quantifies the total demand for all goods and services in an economy rather than focusing on individual goods or services.

    • It encapsulates macroeconomic perspectives.

  • Characteristics of the AD Curve

    • The AD curve has a downward slope.

    • X-axis: Represents RGDP, indicating output levels in the economy (it may be labeled as "output," "aggregate output," or "Y" in some graphs).

    • Y-axis: Represents the price level in the macro-economy.

    • This curve illustrates how the quantity of goods and services demanded changes at varying price levels.

Movement along the AD Curve

  • Changes in the price level yield movements along the same AD curve:

    • As the price level increases, RGDP (real output) demanded decreases.

    • Conversely, as the price level decreases, RGDP demanded increases.

    • There exists an inverse relationship between the price level and the quantity of RGDP demanded.

The Negative Slope of the Aggregate Demand Curve

  • The AD curve is negatively sloped for three primary reasons:

    • The Wealth Effect

    • The Interest Rate Effect

    • The Open Economy Effect (also referred to as the export effect or foreign price effect by some authors).

The Wealth Effect

  • Movements on the AD curve reflect the wealth effect as follows:

    • When the price level increases, the value of real wealth decreases, leading to reduced purchasing power and lower RGDP demand.

    • Conversely, when prices fall, the real wealth increases, leading to higher RGDP demand.

  • Example: If an individual has $2,000 saved and experiences a bout of high inflation, their purchasing power diminishes, affecting demand.

The Interest Rate Effect

  • An increased price level necessitates holding more money to purchase goods and services, leading to decreased savings:

    • This results in a lower availability of loanable funds and an increase in interest rates.

    • Higher interest rates discourage consumer spending (C) and business investments (I), leading to decreased RGDP demand.

  • Conversely, a lower price level reduces interest rates and encourages investment spending, thus increasing RGDP demand.

The Open Economy Effect

  • The impact of price levels on exports and imports must be considered:

    • If domestic prices rise relative to foreign markets, exports become more expensive while imports become cheaper.

    • Foreign consumers may reduce purchases of domestic goods leading to a decline in net exports (X - M) and consequently, RGDP.

    • In contrast, lower domestic prices make exports less expensive and imports more expensive, boosting net exports and RGDP.

Aggregate Demand Formula

  • The relationship between AD and RGDP is encapsulated in the expenditure approach:

    • RGDP=C+I+G+(X−M)RGDP = C + I + G + (X - M)

  • Thus, Aggregate Demand (AD) can be expressed as:

    • AD=C+I+G+(X−M)AD = C + I + G + (X - M)

Shift Factors for Aggregate Demand

  • Determinants of Aggregate Demand: These factors can cause shifts in the AD curve.

  • Stick with the formula AD=C+I+G+(X−M)AD = C + I + G + (X - M) to analyze these shifts.

Consumption (C) Factors

  • Increase in AD:

    • Decrease in taxes

    • Increase in income

    • Fall in interest rates

    • Decreased desire to save

    • Rise in wealth

    • Increased expectations of future income

    • Increased consumer confidence

    • Increase in transfer payments

  • Decrease in AD:

    • Rise in taxes

    • Fall in income

    • Rise in interest rates

    • Increased desire to save

    • Decrease in wealth

    • Lower expectations of future income

    • Decreased consumer confidence

    • Decrease in transfer payments

Investment (I) Factors

  • Increase in AD:

    • Increased expected rate of return

    • Decline in interest rates

    • Rise in business confidence

    • Lower business taxes

  • Decrease in AD:

    • Decreased expected rate of return

    • Increased interest rates

    • Fall in business confidence

    • Increased business taxes

Net Exports (NX) Factors

  • Increase in AD:

    • Increased income abroad, boosting demand for exports

    • A depreciation of the domestic currency (e.g., USD) stimulating exports

  • Decrease in AD:

    • Decrease in income abroad, reducing capacity to purchase exports

    • An appreciation of the domestic currency making exports more costly abroad.

Short Run Aggregate Supply (SRAS)

  • Two types of Aggregate Supply curves exist:

    • Short Run Aggregate Supply (SRAS)

    • Long Run Aggregate Supply (LRAS)

  • In the short run, certain input prices remain constant while output prices fluctuate.

  • The SRAS curve is characterized as upward sloping.

Characteristics of SRAS

  • The aggregate supply curve trends upward, indicating:

    • At higher price levels, producers are motivated to supply more real output.

    • At lower price levels, their willingness to supply decreases.

Why is SRAS Positively Sloped?

  • Economists cite two primary effects:

    • The Profit Effect

    • The Misperception Effect

The Profit Effect

  • Some input costs (e.g., wages, rent) remain constant in the short run.

  • Firms often have contracts that do not adjust quickly to changes in output pricing.

  • When output prices rise (CPI), profits increase, thereby encouraging firms to expand production.

  • Conversely, if output prices decrease, willingness to produce contracts.

The Misperception Effect

  • Producers may mistakenly perceive that rising output prices indicate increased product value in real terms, motivating them to supply more.

  • This perception can be misleading due to simultaneous increases in prices of other goods and services.

Long Run Aggregate Supply (LRAS)

  • The LRAS curve is vertical and intersects the X-axis at the point of potential output (RGDP natural rate or RGDP NR).

  • Producing at RGDP NR signifies that the economy is at its potential output.

Shift Factors for Aggregate Supply

  • The following factors influence shifts in aggregate supply:

    • Changes in capital stock affecting goods and services output capacity.

    • Technological advancements which can shift the SRAS curve rightward and permanently increase output, thus shifting the LRAS curve to the right.

  • Further Shift Factors:

    • Changes in human capital can influence supply.

    • Changes in input costs can modify aggregate supply.

    • Regulatory, tax changes, and natural resource variations influence aggregate supply.

    • An increase in labor force (e.g., women joining, baby boomers) tends to lower wages and consequently boosts short-run aggregate supply.

AS/AD Model Representation

  • The AS/AD model can be visually understood, indicating various price levels, AD, LRAS, and SRAS relationships:

    • Y=RGDPY = RGDP

Economic Gaps (Recessionary and Inflationary)

  • Recessionary Gap: When actual RGDP is less than potential RGDP (RGDP NR)

  • Long-Run Equilibrium: Occurs when actual RGDP equals potential RGDP under normal conditions

  • Inflationary Gap: When actual RGDP exceeds potential RGDP, causing upward pressure on prices.

Policies Impacting AD/AS

  • Expansionary Policy: Employed to stimulate economic activity, typically advocating increased AD or AS.

  • Contractionary Policy: Aims to temper economic activity and curb inflation, typically by decreasing AD or AS.