Aggregate Demand and Aggregate Supply

Macroeconomics: Aggregate Demand & Aggregate Supply

Key Concepts

  • Full Capacity GDP (Potential Output GDP):   - The level of real GDP attained when an economy is operating at full capacity.   - Symbol: Y*   - Characteristics:     - Represents the condition when all of the economy’s resources are fully employed at normal utilization rates.

  • Actual GDP (Y0):   - The real GDP that fluctuates around the potential GDP (Y*).   - In the short term, actual GDP experiences variations due to business cycles, leading to expansions and contractions.

  • Business Cycle:   - The fluctuations in GDP, characterized by peaks (high points) and troughs (low points).   - Recessionary Gap: Occurs when actual GDP (Y0) is less than potential GDP (Y0 < Y).   - Inflationary Gap: Occurs when actual GDP (Y0) is greater than potential GDP (Y0 > Y).

Aggregate Demand (AD)

  • Definition:   - Aggregate demand is the total demand for goods and services from all four sectors of the economy.   - Represents planned expenditures for the entire economy.   - Formula:     AD=C+I+G+(X−M)AD = C + I + G + (X - M)

  • Components of AD:   - C: Consumption Expenditure   - I: Investment Expenditure   - G: Government Expenditure   - X - M: Net Exports (Exports - Imports)

Aggregate Supply (AS)

  • Definition:   - The overall planned output of goods and services and the associated costs of production.

  • Components of Aggregate Supply:   - Short-Run Aggregate Supply (SAS):     - Reflects the relationship between price level and total goods/services produced when factor prices are constant (upward sloping curve).     - Positive slope indicates increasing average cost with each additional unit produced.      - Long-Run Aggregate Supply (LAS):     - Represents the output level (Y*) when full employment occurs.     - The LAS curve is vertical and is independent of price level, since only one level of output can be achieved under full capacity due to fixed resources and technology.

Market Equilibrium

  • Equilibrium Point:   - The point at which Aggregate Demand (AD) and Short-Run Aggregate Supply (SAS) intersect, indicating market equilibrium or short-run equilibrium.   - Actual output of the economy at equilibrium is given by Y0.

  • Long-Run Equilibrium:   - Occurs when AD, SAS, and LAS intersect at the same point.   - Involves a GDP gap when actual output differs from potential output (Y0 ≠ Y*).

GDP Gap

  • Definition:   - The difference between actual GDP and potential GDP, indicating either a recessionary gap (Y0 < Y) or an inflationary gap (Y0 > Y).

Determinants of Aggregate Supply (AS)

  1. Costs of Inputs (Factor Prices):    - Includes wage rates, energy prices, resource prices.

  2. Change in Productivity:    - Influenced by technology enhancements and improved education for the workforce.

Determinants of Long-Run Aggregate Supply (LAS)

  1. Change in Productivity:    - Can significantly affect potential output over the long term.

  2. Quality of Resources:    - Involves changes in human or physical capital capacity.    - Examples: Increase in labor force size, discovery of new resources (e.g., oil).

  3. Costs of Inputs:    - Shifts SAS, but typically does not shift LAS curves directly.

Effects of Changes in Inputs/Costs

  • A shift in SAS occurs due to changes in input costs, while shifts in productivity can impact both SAS and LAS.

  • Any shift in LAS (to the right or left) results in a corresponding shift in SAS.

Determinants of Aggregate Demand (AD)

  • Each sector's aggregate demand has distinct determinants influencing their respective expenditures.

  • Movement Along AD Curve:   - Only a change in the price level will result in movement along the curve.   - Other determinants cause shifts in the AD curve.

Household Consumption (C)

  1. Disposable Income (Yd):    - Income left after taxes; a crucial determinant for consumption.    - Increased disposable income leads to higher consumption (C↑, AD↑).

  2. Wealth:    - Value of household assets increases willingness to spend (C↑, AD↑).

  3. Interest Rates (r):    - Higher interest costs reduce consumer spending (C↓, AD↓).

  4. Consumer Confidence:    - Anticipations of future income can increase willingness to consume (C↑, AD↑).

  5. Expected Future Prices:    - If prices are expected to rise, consumers may increase current spending (C↑, AD↑).

  6. Debt:    - Increased debts lead to reduced spending (C↓, AD↓).

Investment (I)

  1. Interest Rates (r):    - Influences investment spending similarly to consumer expenditure (I↑, AD↑ if rates are low).

  2. Expected Input Prices:    - If input prices are expected to increase, investment may decline (I↓, AD↓).

  3. Expected Output Prices:    - Rising expected output prices can stimulate investment (I↑, AD↑).

  4. Business Confidence:    - Positive expectations regarding future demand lead to increased investment (I↑, AD↑).

Government Expenditure (G)

  • Unlike other components, government spending directly influences AD without specific determinants.

  • Increased G leads to increased AD and vice versa.

Net Exports (X − M)

  1. Foreign Income:    - Higher foreign incomes increase export demand (X↑, X − M↑, AD↑).

  2. Relative Prices:    - If Canadian goods are relatively more expensive, imports may rise while exports fall (X↓, M↑, AD↓).

  3. Tariffs:    - Higher tariffs can reduce imports (M↓, X − M↑, AD↑).

  4. Exchange Rates:    - Depreciation of the currency encourages exports (X↑) and discourages imports (M↓), ultimately increasing AD.