Aggregate Demand and Aggregate Supply

Aggregate Demand (AD)

  • Definition: A schedule or curve showing the amounts of real output (real GDP) that buyers collectively desire to purchase at various price levels.
    • Buyers: Households, businesses, government, and foreign entities.
  • Inverse Relationship:
    • Price level rises ➔ quantity of real GDP demanded decreases.
    • Price level falls ➔ quantity of real GDP demanded increases.
  • Downward-Sloping Curve: Indicates inverse relationship between price levels and real output purchased.
    • Real Balances Effect: As prices fall, the purchasing power of money increases, leading to higher demand.
    • Interest-Rate Effect: When the price level falls, interest rates typically fall, stimulating borrowing and spending.
    • Foreign Trade Effect: A decrease in domestic price level makes exports cheaper and imports more expensive, increasing net exports.

Shifts in Aggregate Demand

  • Determinants of Aggregate Demand:
    • Consumer Spending: Affected by wealth, borrowing, expectations, taxes.
    • Investment Spending: Influenced by expected returns, technology, excess capacity, business taxes.
    • Government Spending:
    • Increases in spending lead to increases in AD (e.g., more computers for agencies).
    • Decreases in spending lead to decreases in AD (e.g., fewer transportation projects).
    • Net Exports:
    • A rise in national income abroad increases foreign demand for products.
    • Changes in dollar exchange rates impact Canadian exports/imports and thus aggregate demand.

Aggregate Supply (AS)

  • Definition: A schedule or curve showing the relationship between price level and the amount of real output firms produce.
  • Time Horizons:
    • Immediate Short Run: Fixed input and output prices; AS curve is horizontal at current price levels.
    • Short Run: Output prices are flexible, but input prices are relatively fixed; upward-sloping AS curve indicating a positive relationship between price level and output.
    • Long Run: All input and output prices are flexible; AS curve is vertical at full employment level of GDP.

Determinants of Aggregate Supply

  • Input Prices: Costs of domestic and imported resources; productivity affects costs.
  • Legal-Institutional Environment: Taxes, subsidies, and regulations that impact business costs.

Economy's Equilibrium

  • Equilibrium Price Level and Real GDP: Occurs at the intersection of AD and AS curves; determines the economy's output.
    • Increased AD leads to demand-pull inflation (if AD shifts right).
    • Decreased AD can cause recession and cyclical unemployment (if AD shifts left).
    • Changes in AS can lead to cost-push inflation (if AS shifts left).

Impact of Shifts in AD/AS on the Economy

  • Demand-Pull Inflation: Increase from AD1 to AD2 raises price levels while real output only increases minimally due to higher prices.
  • Recession: Decrease in AD leads to lower output and potential unemployment due to sticky prices that do not adjust downward easily.
  • Cost-Push Inflation: Leftward shifts in AS raise price levels and decrease output simultaneously, exemplified by the oil-price shock.
  • Stimulus Measures (e.g., COVID-19): Government interventions aimed to sustain aggregate demand and supply during economic disruptions; various benefits provided support to workers and businesses.

Key Concepts for Review

  • Recall how aggregate demand and aggregate supply influence output and price levels in an economy.
  • Understand the mechanisms behind shifts in these curves and their implications for economic stability and growth.