Macro Wk9: Aggregate Demand and Supply

Introduction to Economic Activity

  • Economic activity varies yearly, with periods of growth and recession.

    • Example: Between the mid-1990s and 2019, Australia experienced positive real GDP growth.

    • Economic Growth: The rate of change in real GDP over time.

  • Two primary occurrences:

    • Recessions: Declining real output and income, increasing unemployment (Y↓, U↑).

    • Depressions: Extended and severe recessions (ex: Great Depression in 1930s).

Economic Changes and Business Cycle

  • Economic fluctuations are irregular and unpredictable.

    • These fluctuations are termed the business cycle (boom & bust).

  • For analysis of short-run fluctuations, the Aggregate Demand – Aggregate Supply (AD-AS) model is utilized.

The Aggregate Demand Curve (AD)

  • The AD curve represents the total quantity of goods and services demanded at different price levels.

    • AD formula: Y=C+I+G+NXY = C + I + G + NX, where C = Consumption, I = Investment, G = Government spending, NX = Net Exports.

Reasons for Downward Sloping AD Curve

  • Wealth Effect:

    • If price level (P) rises, real wealth decreases, leading to lower consumption (C) and thus lower AD.

  • Interest-Rate Effect:

    • A rise in P increases the money needed for purchases, leading to higher interest rates (r↑), discouraging investment (I), falling AD.

  • Exchange-Rate Effect:

    • An increase in P triggers a rise in interest rates, appreciating the currency (AUD), reducing exports (X) as they become expensive abroad, decreasing net exports (NX) and AD.

Shifts in the AD Curve

The AD curve shifts due to changes in:

  • C (Consumption): Influenced by stock market trends, consumer preferences, and tax policies.

  • I (Investment): Affected by firm investments in technology or economic outlook.

  • G (Government Spending): Changes in spending, such as infrastructure projects.

  • NX (Net Exports): Influenced by external conditions impacting export demand and currency value.

The Aggregate Supply Curve (AS)

  • The AS curve indicates total goods and services produced at varying price levels.

    • Short-Run AS (SRAS): Upward-sloping due to price and wage stickiness.

    • Long-Run AS (LRAS): Vertical, representing full-employment output or potential output (YN).

    • LRAS also reflects the economy's output at its natural unemployment rate.

Shifts in the LRAS Curve

  • LRAS shifts can occur due to:

    • Population changes (e.g., immigration), technological advancements, or natural resource availability.

  • Examples:

    • Increased workforce due to immigration shifts RLAS right, allowing higher output.

Short-Run Aggregate Supply (SRAS)

  • The SRAS curve is positively sloped. In the short-run (1-2 years), higher prices lead to increased production.

Theories Underpinning SRAS:

  1. Sticky Wage Theory:

    • Real wages are slow to adjust; higher P leads to lower real wages, encouraging firms to produce more.

  2. Sticky Price Theory:

    • Firms may delay price adjustments, prompting increased demand for their cheaper products, leading to higher output.

  3. Misperception Theory:

    • Firms may mistake general price rises for relative price changes, increasing output based on perceived profitability.

Shifts in the SRAS Curve

  • Shifts can occur due to changes in input costs:

    • Increase in wages or costs shifts SRAS left (lower supply).

    • Decrease in wages or costs shifts SRAS right (higher supply).

Economic Equilibrium and Fluctuations

  • Short-Run Equilibrium: Intersection of AD and SRAS indicates short-run output.

  • Long-Run Equilibrium: Occurs when AD intersects LRAS; indicates full employment and natural unemployment rate.

Analyzing Economic Fluctuations

  • Steps to assess economic shifts:

    1. Determine which curve (AD or AS) shifts.

    2. Identify the direction of shift (left or right).

    3. Use the AD-AS diagram to analyze short-run impacts on output (Y) and price (P).

    4. Transition to long-run equilibrium based on shifts.

Summary of AD-AS Model

  • The model illustrates average price determination and output levels.

  • AD reflects demand levels, whereas AS reflects production capacity.

  • Short-run equilibrium defined by AD and SRAS intersection; long-run defined by AD and LRAS.

  • Economic fluctuations stem from shifts in AD and AS.