Aggregate Demand and Aggregate Supply

Definition: Aggregate Demand (AD) is the total quantity of goods and services demanded across all levels of the economy at a given price level.

Households (Personal Consumption): The total spending by individuals on goods and services.
Other Firms (Investment): Business investments in capital goods to enhance production capabilities.
Government Agencies (Government Purchases): Spending by government on goods, services, and public projects.
Foreign Markets (Net Exports): Exports minus imports, reflecting the demand from foreign economies.

Downward Sloping: AD is downward sloping, but this is not due to the same reasoning as conventional demand curves. Factors influencing the slope include:
- Wealth Effect: Higher price levels reduce consumer purchasing power, leading to lower consumption.
- Interest Rate Effect: Higher price levels can lead to higher interest rates, which reduce investment spending.
- International Trade Effect: Higher domestic price levels may lead to reduced exports and increased imports, leading to a decrease in net exports.

Shifts in AD can be broken down into the components of GDP:
- Personal consumption
- Investment
- Government purchases
- Net exports

Consumer Confidence: High confidence levels typically boost consumer spending.
Tax Policy: Changes in personal taxes can directly affect disposable income, thus impacting consumption.
Government Stimulus: Government spending can enhance overall demand, influencing consumption patterns.
Price Levels: Illustrated by a price level graph, where:
- An increase in AD shifts the curve to the right (AD1 to AD2).
- A decrease in AD shifts the curve to the left.

Business Expectations: Optimism regarding the future economic environment can increase investment.
Interest Rate Policy: Decisions made by central banks affect the cost of borrowing and hence business investments.
Tax Policy: Corporate and capital gains tax levels also play a role in influencing businesses’ investment decisions.

Categories of Spending:
- Defense
- Infrastructure
- Education
Some government spending may offset or crowd out personal consumption due to the reallocation of resources.

Foreign Income: The income levels of foreign consumers can affect demand for exports.
Exchange Rates: Fluctuations in currency value can influence the competitiveness of domestic versus foreign goods.
Foreign Price Levels: Changes in price levels in foreign markets impact import/export dynamics.
Trade Policies: Tariffs, quotas, and trade agreements can alter net exports significantly.

Concept: Illustrates how changes in one component of AD can cause a greater overall change in the economy.
Circular Flow: Links between expenditures and incomes mean that an initial increase in spending can lead to further rounds of consumption.
Marginal Propensity to Consume (MPC): The proportion of additional income that becomes consumption.
Equivalence and Leakages: Recognizes how savings, taxes, and imports can limit the multiplier effect.

Definition: The total output that an economy can produce when labor and capital are fully employed.
Difference between Short-run and Long-run:
- Long-Run Aggregate Supply (LRAS): Represents potential output when all resources are used efficiently.
- Short-Run Aggregate Supply (SRAS): Reflects how production can increase in response to demand in the short term, often influenced by wage and price rigidity.
- Illustrations:
- Panel (a): Shows the interplay of LRAS with price levels and employment.
- Panel (b): Distinction between SRAS and AD showing potential GDP versus actual GDP.

Influencers of LRAS shifts include:
- Productivity: Efficiency of economic resources in producing goods.
- Technology: Advances in technology can enhance productivity.
- Factors of Production: Availability and quality of labor, capital, and natural resources.
- Institutional Arrangements: Policies impacting productivity indirectly, such as regulations or incentives.

Background: Significant economic downturn linked to housing market failures.
- House Price Fluctuations: From 2002 to 2006, house prices rose by approximately 90%. During the latter half of 2006, prices began to decline.
- Stock Market Dynamics: Stock prices skyrocketed and then fell dramatically starting in 2007.
- Consumer and Investor Confidence: Declines in confidence as both housing and stock markets crashed, juxtaposed with soaring energy prices, resulting in drastic cuts in spending.

Definition: Occurs when actual GDP is less than potential GDP (Yp).
- Illustration: Panel demonstrating the positions of AD, SRAS, and LRAS in the context of a recessionary gap showing lost real GDP output.

Definition: Occurs when actual GDP exceeds potential GDP, typically leading to upward pressure on prices.
- Illustration: Panel detailing the relationships between AD, SRAS, and LRAS in the inflationary gap context, emphasizing potential risks of overheating the economy.

Government Purchases: Increasing spending can shift AD right, correcting an inflationary gap.
- Illustrated shifts reflect adjustments as nominal wages adjust alongside policy impacts.
Market Adjustments: Over time, wages may adjust downwards in a recessionary context, moving SRAS back to intersect with AD and restoring potential GDP output.

Nonintervention Policy: A hands-off approach allowing the economy to self-correct.
Stabilization Policy: Targeting the economy through active measures.
Expansionary Policy: Strategies to stimulate the economy when facing a recession.
Contractionary Policy: Approaches to cool down an overheated economy.
Fiscal Policy: Involves government spending and taxation decisions to influence the economy.
Monetary Policy: Central bank policies impacting interest rates and money supply.

Challenges: Various time lags complicate the effective timing of discretionary fiscal policy changes.
Automatic Stabilizers: Mechanisms that automatically adjust government spending and taxes in response to economic conditions, including:
- Unemployment Compensation: Help to stabilize income during downturns.
- Corporate Profit Tax: Fluctuating revenues influence stabilization measures.
- Progressive Income Tax: Higher income taxes during times of prosperity and lower during recessions, providing stability.