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Aggregate Demand and Supply Model

Overview of Aggregate Demand (AD) and Aggregate Supply (AS) Model

  • Purpose: Analyze fluctuations in real GDP (Y) and the average price level (P) in an inflationary economy.
  • Key Outcomes:
    • Explain how AD and AS interact to affect GDP and price levels.
    • Assess medium-run supply adjustments towards long-run equilibrium.
    • Understand and evaluate complex chain reactions in an open economy.

Keynesian Model Context

  • In previous chapters, the Keynesian model assumed:
    • Constant average price levels and inflation.
    • Focus on real income (Y) and unemployment, especially during the Great Depression.
  • The IS/LM model illustrated relationships between Y and real interest rates (r).
  • The AD/AS model replaces constant price assumptions and introduces dynamic responses between Y and P.

Key Economic Concepts

Types of Unemployment

  • Seasonal Unemployment: Fluctuations in seasonal jobs.
  • Frictional Unemployment: Individuals transitioning between jobs.
  • Cyclical Unemployment: Linked to economic cycles; rises during downturns.
  • Structural Unemployment: Mismatches between skills and job requirements.
  • Natural Rate of Unemployment: Long-run unemployment rate; reflects job market efficiency.

Essentials of AD/AS Model

  • Assumptions Relaxed: Unlike previous models, the AD/AS model:
    • Allows for supply-side responses to changes in demand.
    • Illustrates price levels as a variable.
  • AD Curve: All combinations of Y and P at equilibrium.
    • Derived from the 45° line and IS-LM curve, demonstrating a negative slope.
  • AS Curve: Represents supply side; typically upward sloping.
    • Divided into short-run (ASSR) and long-run (ASLR) components.

Understanding Aggregate Demand (AD)

Definitions

  • AD illustrates combinations of real income and price levels that yield market equilibrium.
  • Derivation of AD:
    • From 45° Diagram:
    • At equilibrium Y0, P0, upward shifts in prices lower aggregate expenditure leading to new equilibrium Y1, P1.
    • Points connect to form the AD curve.
    • From IS-LM Model: An increase in prices shifts the LM curve left, lowering real income.
  • Negative Slope Factors:
    • Interest Rate Effect: Higher prices contract real money supply, increasing interest rates and decreasing expenditure.
    • Wealth Effect: Higher prices diminish purchasing power, hence reducing consumption.
    • Foreign Trade Effect: Increased prices reduce exports and increase imports, decreasing expenditure.
    • Tax and Real Income Effects: Higher prices push consumers into higher tax brackets, reducing disposable income.

Shifts in AD Curve

  • Factors beyond P or Y affecting aggregate expenditure lead to shifts in AD:
    • Stimulating Factors: Shift AD to the right.
    • Contracting Factors: Shift AD to the left.

Aggregate Supply (AS)

AS Curve Dynamics

  • Definitions: The AS curve shows real output (Y) contingent upon various price levels (P).
  • Determinants of AS:
    • Size and productivity of the labor force, wages, raw material costs, technology, and capital availability.
  • Short-run vs Long-run:
    • Short-run: Expected prices differ from actual; output adjusts accordingly.
    • Long-run: Expected prices equal actual prices; output returns to structural equilibrium.

Short-run and Long-run AS Relationships

  • Positive Relationship: Higher prices generally motivate higher production in the short run due to various adjustment mechanisms:
    • Rigid Input Prices: Slow to adjust, causing temporary mismatches between actual and expected prices.
    • Declining Productivity: Increased input usage raises average costs; output increases only if compensated through higher prices.
    • Scarcity of Inputs: As production increases, input prices rise, necessitating higher output prices for increased production.

Long-Run AS (ASLR) and Economic Shifts

Long-run Output Levels

  • In the long run, firms utilize inputs to maximum output, resulting in a vertical ASLR curve.
  • Shifts in ASLR: Shifts can occur due to natural disasters, productivity changes, or cost fluctuations affecting inputs.

Short-run AS Adjustments (ASSR)

  • ASSR curve reflects a positive relationship between prices and production levels over varying capacity conditions:
    • Initially flatter when inputs are ample; steeper as capacity limits are approached.

Aggregate Demand and Aggregate Supply Interaction

Short-run and Long-run Equilibrium

  • Short-run equilibrium determined by AD and ASSR intersection.
  • Long-run equilibrium at the intersection of AD and ASLR.
  • All adjustments and marketplace interactions strive towards this equilibrium.

Dynamic Adjustment Process

  • Demand shifts can lead to supply-side adjustments due to changing expectations.
  • Economic Disturbances: Shifts in aggregate demand/expenditure can initiate complex feedback effects impacting price levels and income (Y).

Conclusion

  • Policymaking lessons emphasize that sustained expenditure increases can lead to inflation, while investment expenditure strategies support economic growth with lesser inflationary consequences.

Typical Test Questions

  • Evaluate short, medium, and long-term impacts of economic shifts on price levels, income, and balance of payments using AD/AS frameworks.