Aggregate Demand and Aggregate Supply

AD-AS Model

This model ties together total output (GDP), overall price level, and unemployment to show how they function as a single economic equilibrium.
It is used to explain short-run fluctuations in economic activity around its long-run trend.

The AD curve illustrates the relationship between the overall price level and the total demand for goods and services in the economy.
It aggregates individual demand for goods and services across all markets.
Price changes are measured by the price index or inflation.
The level of AD is inversely related to the overall price level.

AD = C + I + G + NX
Consumption (C): As P (price level) increases, real wealth falls, leading to decreased consumption, and vice versa. This is known as the wealth effect or real-balances effect.
Investment (I): As P increases, interest rates rise, causing borrowing and investment spending to decrease, and vice versa. This is known as the interest rate effect.
Government Spending (G): Most government spending is independent of the price level; thus, G does not cause AD to slope downward.
Net Exports (NX): As domestic P increases, domestic goods become relatively more expensive compared to foreign goods, leading to increased imports and decreased exports, thus decreasing NX, and vice versa. This is known as the exchange rate effect.

There is a negative relationship between the overall price level and GDP.
A decrease in the price level leads to an increase in the quantity of goods and services demanded in the economy, representing a movement along the AD curve.

The equilibrium Aggregate Expenditure (AE) model can be used to trace out the AD curve.
An increase in P (price level) leads to a downward shift of the Planned Aggregate Expenditure (PAE) curve.
Plotting (Y, P) pairs that correspond to equilibrium AE levels and P levels derives the AD curve.

The AD curve can shift due to factors other than price level changes.
An increase in AD shifts the curve to the right, while a decrease shifts it to the left.

Category	Increase (shift right)	Decrease (shift left)
Consumption	High expectations about future income, tax cuts	Low expectations about future income, higher interest rates
Investment	Confidence in the future of the economy, a tax credit for small businesses	Recession reduces firm profitability, taxes on capital increase
Government	Increase in government spending	Decrease in government spending
Net exports	Reduced trade restrictions, economic growth abroad	Increase trade restrictions on domestic goods, the exchange rate increases

Increase: Consumers feel confident that incomes will increase significantly in the next year.
Decrease: The government reduces government spending.
Decrease: China increases the tariffs on U.S. goods.
Increase: The government awards small factories a tax credit to build new manufacturing plants.

Expenditure Multiplier:
- Formula: \frac{1}{1-MPC}
- Example: If the government increases spending by $20 billion and the MPC = 0.8, the total effect on AD is:
  \frac{1}{1-0.8} * 20 = 5 * 20 = $100 \text{ billion}
Taxation Multiplier:
- Formula: \frac{-MPC}{1-MPC}
- Example: If the government decreases taxes by $20 billion and the MPC = 0.8, the total effect on AD is:
  \frac{-0.8}{1-0.8} * (-20) = -4 * (-20) = $80 \text{ billion}

The AS curve shows the relationship between the overall price level in the economy and total production by firms.
The economy operates differently in the short run and long run, leading to the distinction between the Long-Run Aggregate Supply (LRAS) curve and the Short-Run Aggregate Supply (SRAS) curve.

In the short run, the SRAS curve slopes upward.
Prices of final goods increase more quickly than input prices.
Thus, an increase in the final goods’ price level increases firms’ profits, leading them to increase production in the short run.

The short-run AS curve shifts when input prices change due to: supply shocks (temporary or permanent) or changes in labor, capital, natural resources, education, or technology.
Changes in the expected price level also cause shifts in SRAS.

The long run is the time required for input prices to fully adjust to economic conditions.
When input costs adjust, firms no longer earn positive economic profits, and output returns to potential output.

The long-run AS curve shifts if potential GDP changes due to permanent supply shocks or changes in labor, capital, natural resources, education, or technological knowledge.

Short-Run (SR) Equilibrium: AD = SRAS (the economy is always here).
Long-Run (LR) Equilibrium: AD = LRAS = SRAS (prices at expected levels and at potential output).

Increase in consumer confidence:
- Short run: AD increases → output is above long-run potential and prices increase.
- Long run: Expected price level increases → SRAS decreases → LR equilibrium.
Other examples include a decrease in government spending or a negative supply shock.

Short run: SRAS decreases → output falls below long-run potential, and prices increase.
Long run: The decrease in SRAS causes Y < Y_P, leading to increased unemployment → wages fall in the long run → SRAS increases.

Example: A temporary increase in the oil price will:
- Decrease in AD: causes lower P and Y
- Decrease in SRAS: causes higher P and lower Y

A change in AD causes a change in P in the long run.
A change in SRAS causes no change in P in the long run.
Both sides could be affected at the same time.
- Example: The Great Recession affected AD (reduced wealth from falling house prices) and SRAS (decrease in business lending).

Consumer confidence increases: Positive AD shock
A hurricane destroys many factories: Negative LRAS shock
Discovery of new oil reserves causes a temporary decrease in the price of oil: Positive SRAS shock
Large surge in the number of immigrants into the U.S.: Positive LRAS shock

The government can try to boost the economy out of a recession through government spending, which causes aggregate demand to increase.
This approach is challenging to implement because:
- It is difficult to gauge the overall effect.
- It is hard to perfectly design policy to restore AD to its original level.
- Government intervention impacts the long-run outcomes.

The long-run result of government intervention is higher prices, but long-run output may return more quickly.
Governments intervene because the speed of recovery could be slow otherwise, and lower prices are not always beneficial.
Government spending is a short-term policy action used to address short-term shocks. Government intervention impacts the long-run outcomes.