Fundamentals of Economics 1: Aggregate Demand and Aggregate Supply

Aggregate Demand (AD) Fundamentals

Definition: Aggregate Demand (AD) refers to the quantity demanded of all goods and services (Real GDP) in an economy at various price levels, ceteris paribus.
Downward Sloping Nature: The AD curve displays an inverse relationship between the price level and the quantity demanded of Real GDP.
Price Relationships:
- As the price level rises, the quantity demanded of Real GDP falls.
- As the price level falls, the quantity demanded of Real GDP rises.

Theoretical Explanations for the Downward Sloping AD Curve

A downward sloping AD curve is explained by three distinct economic effects:

Real Balance (Wealth) Effect:
- This effect states that a fall in the price level causes the real purchasing power of money to rise.
- Purchasing Power: Defined as the number of goods or services that can be purchased with a single unit of currency.
- An increase in purchasing power increases an individual’s Monetary Wealth.
- As people become wealthier in real terms, the quantity demanded of Real GDP rises because more goods and services are bought.
- Conversely, a rise in the price level causes real purchasing power to fall, decreasing monetary wealth and reducing the quantity demanded of Real GDP.
Interest Rate Effect:
- This effect establishes the inverse relationship through changes in household and business spending sensitive to interest rate fluctuations.
- Scenario: Price Level Falls:
  - Purchasing power rises.
  - Less money is needed to buy a fixed bundle of goods.
  - Savings increase, leading to a rise in the supply of credit.
  - Interest rates fall due to the increased supply of credit.
  - Businesses and households borrow more at these lower rates, leading to more goods being purchased ( $AD$ increases).
- Scenario: Price Level Rises:
  - Purchasing power falls.
  - Households and firms must borrow money to continue buying a fixed bundle of goods.
  - The demand for credit rises.
  - Interest rates rise accordingly.
  - Businesses and households borrow less at higher rates, buying fewer goods ( $AD$ decreases).
International Trade Effect:
- This effect states that the inverse relationship is established through foreign sector spending, including domestic spending on foreign goods (imports) and foreign spending on domestic goods (exports).
- Example: Suppose the price level in Malaysia rises relative to foreign price levels.
  - Malaysian goods become relatively more expensive compared to foreign goods.
  - Consequently, both locals and foreign consumers buy fewer Malaysian products.
  - This leads to a decrease in the quantity demanded of Real GDP for Malaysia.

Changes in Quantity Demanded vs. Changes in Aggregate Demand

A Change in the Quantity Demanded of Real GDP:
- Brought about exclusively by a change in the price level.
- Results in a movement along the existing AD curve.
- The factors driving this movement are the three effects: Real Balance (Wealth), Interest Rate, and International Trade.
A Change in Aggregate Demand (AD):
- Refers to a shift of the entire AD curve.
- Right Shift: Indicates an increase in Aggregate Demand.
- Left Shift: Indicates a decrease in Aggregate Demand.
- Mathematical Model: $Y = C + I + G + (X – M)$ , where:
  - $Y$ = Real GDP
  - $C$ = Consumption
  - $I$ = Investment
  - $G$ = Government Purchases
  - $X - M$ = Net Exports (NX)
- At a given price level, an increase in $C, I, G, \text{ or } NX$ shifts the AD curve to the right.
- At a given price level, a decrease in $C, I, G, \text{ or } NX$ shifts the AD curve to the left.

Impact of Government Policies on Aggregate Demand

Government policies, namely Monetary and Fiscal policies, are primary influencers of AD shifts.

Monetary Policy:
- Actions taken by a central bank to manage the money supply ( $M_s$ ) or interest rates to achieve economic goals.
- The AD curve is drawn for a fixed value of money supply.
- Increase in $M_s$ : Reduces the interest rate, leading to a rightward shift of the AD curve and increased aggregate output at every price level.
- Decrease in $M_s$ : Causes the AD curve to shift to the left.
Fiscal Policy:
- Involves changes in Government Spending ( $G$ ) and Taxes ( $T$ ), which influence disposable income.
- Expansionary Fiscal Policy: Helps speed up the economy. Includes increasing $G$ or decreasing $T$ , shifting AD to the right.
  - An increase in $G$ increases aggregate output at every price level.
  - A decrease in $T$ causes consumption to rise as disposable income increases, leading to higher output at every price level.
- Contractionary Fiscal Policy: Helps slow down the economy by reducing $G$ or increasing $T$ , shifting AD to the left.

Aggregate Supply (AS) Fundamentals

Definition: Aggregate Supply (AS) is the quantity supplied of all goods and services (Real GDP) at various price levels, ceteris paribus.
Short Run vs. Long Run:
- In the short run, the AS curve slopes upward.
- In the long run, the AS curve is vertical.

Short-Run Aggregate Supply (SRAS)

Positive Relationship: SRAS indicates a positive relationship between the price level and the quantity of goods and services supplied.
Theories of Upward Sloping SRAS:
1. Sticky Wage Theory: Nominal wages are slow to adjust or "sticky" in the short run due to fixed labor contracts. If price levels ( $P$ ) rise but wages remain constant, company profits rise, encouraging an increase in SRAS.
2. Sticky Price Theory: Unexpectedly low price levels leave some firms with higher-than-desired prices (as they cannot adjust prices instantly). This depresses their sales and leads them to cut production.
3. Misperception Theory: Changes in overall price levels can temporarily mislead suppliers. For example, if $P$ falls, suppliers may believe their specific profit is falling even though the prices of raw materials have also fallen. This causes them to reduce output despite there being no actual fundamental reason to do so.

Long-Run Aggregate Supply (LRAS)

Vertical Nature: The LRAS curve is a vertical line at the level of Natural Real GDP.
Natural Real GDP: Also known as the Natural Rate of Output, it is the level of Real GDP produced when the economy is at the natural unemployment rate (full employment).
Rationale for Vertical Slope:
- Price level (a nominal variable) does not affect the output level (a real variable) in the long run.
- Prices of resources used in production eventually adjust to match changes in the price level, leading firms to maintain existing production levels regardless of price increases.
Terminology: The constant long-run level of real GDP is called the full-employment level of output or potential level of output.

Economic Equilibrium and AS Shifts

Equilibrium Conditions:
- Short Run: Occurs where the AD curve intersects the SRAS curve.
- Long Run: Occurs where the AD curve intersects the LRAS curve.
Market Indications:
- Each point on the AD curve represents equilibrium in both the goods and money markets.
- Each point on the AS curve represents the price or output responses of all firms in the economy.
Factors That Shift the Aggregate Supply Curve (SRAS and LRAS):
- Changes in input prices (e.g., labor, raw materials).
- Changes in productivity.
- Government subsidies.
- Business taxes.
- Government regulation.
Specific Shifting Dynamics:
- Increase in Labour Force: Shifts SRAS to the right ( $SRAS_1 \rightarrow SRAS_2$ ).
- Increase in Capital Stock: Shifts SRAS to the right ( $SRAS_1 \rightarrow SRAS_2$ ).
- Increase in Productivity: Shifts SRAS to the right ( $SRAS_1 \rightarrow SRAS_2$ ).
- Increase in Expected Future Price Level: Shifts SRAS to the left ( $SRAS_1 \rightarrow SRAS_2$ ).
- Decrease in Expected Price of Raw Materials/Natural Resources: Shifts SRAS to the right ( $SRAS_1 \rightarrow SRAS_2$ ).
- Under-estimated Price Level: Shifts SRAS to the left ( $SRAS_1 \rightarrow SRAS_2$ ).

Questions & Discussion: Identifying the Shifter

Scenario 1: A decrease in consumer spending.

Result: $AD \downarrow$

Scenario 2: The impact on net exports caused by increases in the national incomes of our major trading partners.

Result: $AD \uparrow$

Scenario 3: A large increase in the price of imported oil which impacts the resource cost of businesses.

Result: $AS \downarrow$

Scenario 4: A large increase in government spending on the North-South Highway.

Result: $AD \uparrow$

Scenario 5: A substantial increase in wages that businesses pay their workers.

Result: $AS \downarrow$

Scenario 6: The effect on investment when businesses expect that the economy is heading into recession.

Result: $AD \downarrow$

Scenario 7: A decrease in the interest rate when there is no change in the price level.

Result: $AD \uparrow$