Aggregate Demand and Supply - In Depth Notes

Aggregate Demand and Supply

Overview of Economic Fluctuations

  • Economy’s behavior can be understood through:
    • Aggregate Demand (AD)
    • Aggregate Supply (AS)

Economic Fluctuations Model

  • Purpose: Explain short-run fluctuations in economic activity around its long-term trend.
  • AD Curve: Represents the quantity of goods and services demanded at various price levels.
  • AS Curve: Represents the quantity of goods and services firms are willing to produce at various price levels.

Understanding Aggregate Demand

  • Components of GDP: Aggregate Demand (Y) is defined as:
    • Y=C+I+G+(X−M)Y = C + I + G + (X - M)
    • Where:
    • $C$ = Consumption
    • $I$ = Investment
    • $G$ = Government spending
    • $X$ = Exports
    • $M$ = Imports

Characteristics of the AD Curve

  • Downward Sloping
    • Wealth Effect: Lower price levels increase purchasing power, enhancing spending.
    • Interest Rate Effect: Higher price levels raise interest rates, discouraging investment.
    • International Trade Effect: Lower domestic prices encourage exports.

Factors Affecting AD

  • Shifts in AD can occur due to several factors:
    • Increased consumer confidence
    • Business cycle fluctuations
    • Government fiscal policies (spending/taxation changes)
    • Global economic conditions affecting trade

Shifting the AD Curve

  • Rightward Shift (Increase):
    • High expectations of future income
    • Tax cuts
    • Increased government spending
    • Global economic growth
  • Leftward Shift (Decrease):
    • Low future income expectations
    • Higher taxes or interest rates
    • Decreased government spending

Short-Run Aggregate Supply Curve (SRAS)

  • Characteristics: The SRAS curve slopes upward due to:
    • Faster price increases for goods than for input prices (e.g., wages).
    • Higher production costs reduce producer profits, affecting output.

Shifts of the SRAS Curve

  • Factors Leading to Rightward Shift:
    • Decrease in commodity prices
    • Decrease in nominal wages
    • Increase in productivity
  • Factors Leading to Leftward Shift:
    • Increase in input prices
    • Increase in nominal wages
    • Decline in productivity

Long-Run Aggregate Supply (LRAS)

  • Characteristics: The LRAS is vertical at potential output
  • It reflects long-term output when prices are fully flexible.
  • Influencing Factors: Depend on labor, capital, natural resources, and technology, regardless of price levels.

Shifts in the LRAS Curve

  • Factors that shift LRAS outward include:
    • Technological innovations
    • Increases in capital (investment)
    • Increases in labor supply (e.g., immigration)

Long-Run Macroeconomic Equilibrium

  • The economy reaches equilibrium when short-run equilibrium aligns with long-run aggregate supply.

Demand and Supply Shocks

  • Negative Demand Shock: Decreases both price levels and output.
  • Negative Supply Shock: Increases price levels while reducing output.

Policy Responses to Economic Shocks

  • Government may increase spending to boost AD during negative shocks.
  • Policymaking involves assessing the balance between long-term economic stability and short-term recovery efforts.

Summary of Relationships in the AD-AS Model

  • Demand-side Shocks: Short-run—output and prices increase; Long-run—prices increase without change in output.
  • Supply-side Shocks: May cause short-run output changes with varying impacts on prices.