Econ1103_W24_Chp12

Aggregate Demand and Aggregate Supply

Chapter Topics/Questions

• What is the aggregate demand curve?

• How does it illustrate the relationship between the aggregate price level and the quantity of aggregate output demanded?

• What is the aggregate supply curve?

• How does it illustrate the relationship between the aggregate price level and the quantity of aggregate output supplied?

• What is the difference between the aggregate supply curve in the short run vs long run, and why does this matter?

• How is the AD–AS model used to analyze economic fluctuations?

The Aggregate Demand Curve

• Definition: The aggregate demand curve (AD) depicts the relationship between the aggregate price level and the quantity of aggregate output demanded by households, businesses, the government, and the rest of the world.

• Equation Recall: GDP = C + I + G + X − IM

• Shape: Downward sloping; as the price level decreases, the quantity of output demanded increases, similar to regular market demand curves, but the reasons for this relationship can be complex.

Reasons for Downward Slope of Aggregate Demand Curve

1. Wealth Effect:

   • Higher price levels reduce purchasing power of wealth, decreasing consumer spending.

2. Interest Rate Effect:

   • Higher price levels lead to increased interest rates which lower investment and consumer spending.

The Aggregate Demand Curve & the Income–Expenditure Model

• The AD curve is derived from the income–expenditure model and reflects changes in planned expenditure.

• Effect of Price Level Changes:

  • A drop in price levels raises planned expenditures across all output levels due to wealth and interest rate effects.

  • This creates a multiplier effect, moving the equilibrium from E1 to E2 and raising real GDP from Y1 to Y2.

Shifts of the Aggregate Demand Curve

• Demand Shocks: Factors that shift the aggregate demand at every price level include:

  • Expectations: Optimism raises spending; pessimism lowers spending.

  • Wealth: Increased real value of assets lifts purchasing power; decreased value lowers it.

  • Existing Capital Stock: Firms adjust investment plans based on their current capital.

  • Fiscal Policy: Government spending directly affects demand; taxes and transfers influence disposable income.

  • Monetary Policy: An increase in money supply lowers interest rates, boosting consumption and investment.

Impact of Demand Curve Shifts

• Rightward Shift: Increases in aggregate output demanded at every price level.

• Leftward Shift: Decreases in aggregate output demanded at every price level.

Factors That Shift Aggregate Demand

• Changes in expectations (optimism vs pessimism) affect aggregate demand.

• Changes in wealth can increase or decrease aggregate demand based on asset values.

• Fiscal policies (government spending/tax changes) directly influence aggregate demand.

• Changes in monetary supply also affect the aggregate demand through interest rates.

Aggregate Supply Overview

• The aggregate supply curve shows the relationship between the aggregate price level and the quantity of aggregate output producers are willing to supply.

• Important distinctions:

  • Short-Run Aggregate Supply (SRAS)

  • Long-Run Aggregate Supply (LRAS)

Short-Run Aggregate Supply Curve

• Positive relationship between price level and aggregate output supplied.

• Increased price levels typically lead to increased output supplied, with the caveat of sticky wages.

Sticky Wages and SRAS

• Definition:

  • Nominal wages are sticky; they do not easily adjust to economic conditions.

• Implications: When product prices rise faster than producer costs, firms increase output to boost profits.

Shifts of the Short-run Aggregate Supply Curve

• Events that change production levels and shift the SRAS include:

  • Commodity Prices: Rising commodity prices increase production costs, shifting supply to the left.

  • Nominal Wages: Increased wages shift the SRAS curve leftward due to higher costs.

  • Productivity: Higher productivity shifts the SRAS curve rightward.

Long-Run Aggregate Supply

• In the long run, nominal wages adjust fully to aggregate price levels, reflecting flexibility.

• Potential Output: Represents full employment output; not maximum output but the level where the economy is neither expanding nor contracting.

Output Gap

• Definition: The output gap is the percentage difference between actual aggregate output and potential output.

• Measuring the output gap helps in evaluating economic performance and formulating policies.

From Short Run to Long Run

• If the economy is away from the LRAS, wages will adjust, leading to shifts in SRAS toward equilibrium.

The AD-AS Model

• The AD-AS model integrates both aggregate demand and aggregate supply to analyze economic fluctuations.

Demand and Supply Shocks

• Demand Shocks: Adjust aggregate demand, affecting price level and output in the same direction.

• Supply Shocks: Shift SRAS, affecting price level and output in opposite directions.

Long-Run Macro Equilibrium

• Equilibrium occurs when short-run macroeconomic equilibrium aligns with the long-run aggregate supply curve, determining recessionary and inflationary gaps.

Policymaking Responses to Economic Fluctuations

• Active Stabilization Policy: Governments should use monetary and fiscal policies to mitigate economic downturns and control expansions.

• Policymakers balance the need for action with awareness of potential long-term costs and unintended effects.