Aggregate Demand and Aggregate Supply

Aggregate Demand and Aggregate Supply

Equilibrium

  • Aggregate demand (AD) is downward sloping, while aggregate supply (AS) is upward sloping.
  • They intersect at equilibrium, representing the equilibrium for the entire economy.
  • The quantity at equilibrium represents the current GDP (output).

Shifts in Aggregate Demand and Supply

  • Shifts in AD and AS cause changes in price level and output (GDP).
  • Increase in AD: Price level goes up, and quantity (output) goes up.
  • Decrease in AD: Price level goes down, and quantity goes down.
  • Increase in AS: Price level goes down, and output goes up.
  • Decrease in AS: Price level goes up, and quantity goes down.

Demand Shocks

  • A demand shock is when the AD curve shifts.
  • Example: The Great Depression - a decrease in the stock market reduced consumer wealth and spending, decreasing AD.

Supply Shocks and Stagflation

  • A decrease in the amount of available oil causes the AS curve to shift to the left.
  • This leads to:
    • Higher price level (inflation).
    • Lower quantity (slowed-down economy).
  • This situation is called stagflation, which is considered the worst-case economic scenario due to the combination of inflation and economic stagnation.

Long Run Aggregate Supply (LRAS)

  • In the long run, the economy is self-correcting.
  • Full employment: Economy at full output with 4-6% unemployment.
  • The vertical line represents the long-run aggregate supply (LRAS) curve indicating full employment.

Recessionary Gap

  • A decrease in AD leads to a recessionary gap in the short run.
  • Actual GDP is less than potential GDP (full employment GDP).
  • The economy can self-correct: wages and resource prices fall, increasing AS and restoring full employment.
  • Government intervention is often used to close recessionary gaps because self-correction can be slow due to sticky wages.

Inflationary Gap

  • An increase in AD leads to an inflationary gap in the short run.
  • Actual GDP is beyond potential GDP.
  • In the long run, inflation causes wages and resource prices to increase, decreasing AS and restoring full employment.

Self-Correction Mechanism

  • The LRAS curve represents the economy's self-correction back to full employment.
  • In a recession, wages eventually fall.
  • During inflation, wages eventually rise.