Aggregate Demand

I. The Axes

  • The axes in this model represent the price level on the y-axis (all prices in the economy) and real GDP on the x-axis (total output of the economy).

    • The price level is not the same as inflation. Inflation is the rate of change in the price level, not the level itself.

    • Real GDP refers to the total output in the economy, adjusted for inflation.

II. The Shape of Things (Aggregate Demand)

  • The aggregate demand (AD) curve slopes downward, similar to a typical demand curve. It shows the relationship between the price level and real GDP in the economy.

    • As the price level increases, real GDP decreases, which initially makes sense, as higher prices would reduce purchasing power and demand.

    • However, the reason for the downward slope of the AD curve isn’t just that people buy less when prices rise. A key factor is the interest rate effect:

      • When prices rise, people demand more money for transactions. If the money supply doesn’t increase, this leads to higher interest rates.

      • Higher interest rates make borrowing more expensive, reducing investment and consumption, which in turn lowers real GDP.

    • In this case, the relationship isn’t driven solely by the consumption of goods but by the broader effects on the economy.

III. The Shape of Things (Long-Run Aggregate Supply)

  • The Long-Run Aggregate Supply (LRAS) curve is vertical, indicating that real GDP is determined by the fundamental factors of production (capital, labor, technology, etc.), and is not influenced by the price level in the long run.

    • Real GDP remains constant at full employment, regardless of inflation, because wages and prices are assumed to be completely flexible in the long run.

    • If output doesn't match the full-employment level, adjustments in wages and prices will occur to bring it back to the equilibrium level, ensuring that only natural unemployment remains.

IV. A Sticky Situation (Short-Run Adjustments)

  • In the short run, things get "sticky"—prices and wages do not adjust immediately to changes in the money supply or other economic changes. This is known as price and wage stickiness.

    • Contracts prevent immediate adjustments. For example, a fixed-price contract for lettuce or a fixed wage contract can prevent quick price changes.

    • Menu costs prevent firms from quickly adjusting prices. It’s costly to update menus or change prices frequently, so firms may absorb cost increases.

    • Consumer expectations also limit price changes. Consumers prefer price stability, so firms may avoid passing on all cost increases to consumers and instead absorb some of the costs, especially if the price changes are expected to be temporary.

V. The Shape of Things (Types of Curves)

  • In the long run, both input (like wages) and output prices are flexible, resulting in a vertical LRAS curve.

  • In the immediate short run, both input and output prices are sticky, resulting in a horizontal aggregate supply curve (this is rarely used in practical analysis).

  • In the short run, only input prices are sticky, while output prices are flexible, resulting in an upward-sloping aggregate supply curve. This curve is convex, meaning that as real GDP increases, the price level tends to increase as well, due to higher costs of production.

I. Shifting Aggregate Demand (AD)

  • Consumer Spending

    • Real interest rates: Higher interest rates discourage investment and spending, shifting AD left. Lower interest rates encourage spending and shift AD right.

    • Expectations: If consumers expect economic improvement, they spend more, shifting AD right.

    • Wealth: An increase in consumer wealth (e.g., rising asset prices) leads to higher spending, shifting AD right.

    • Personal Taxes: Lower taxes increase disposable income, leading to more spending and a rightward shift in AD.

  • Investment Spending

    • Real interest rates: Higher rates increase the cost of borrowing, reducing investment and shifting AD left. Lower rates make borrowing cheaper, shifting AD right.

    • Expected returns: If expected returns from investments rise (due to factors like better business conditions or technology), investment increases and AD shifts right.

  • Government Spending: More government spending increases AD directly, shifting the curve right. This assumes no changes in taxes or interest rates from the spending increase.

  • Net Export Spending

    • National income abroad: If foreign countries become wealthier, they buy more U.S. goods, shifting AD right.

    • Exchange rates: If the dollar depreciates, U.S. goods become cheaper for foreigners, increasing exports and shifting AD right.

  • Money Supply: An increase in the money supply directly shifts AD right, as more money is available for spending. A decrease in the money supply shifts AD left.

II. Shifting Long-Run Aggregate Supply (LRAS)

  • Real Shocks: When the LRAS shifts, it reflects a fundamental change in the economy:

    • Positive shocks: Things like technological improvements, increased capital, or a higher population increase real GDP, shifting LRAS right.

    • Negative shocks: Events like disasters, wars, or decreases in education or population can reduce real GDP, shifting LRAS left.

III. Shifting Short-Run Aggregate Supply (SRAS)

  • Productivity: Increased productivity means more output for the same input, effectively reducing costs and shifting SRAS right.

  • Legal Environment: Regulatory changes can increase the cost of production, shifting SRAS left, or reduce costs, shifting it right.

  • Taxes/Subsidies: Higher taxes increase production costs, shifting SRAS left. Subsidies reduce costs, shifting SRAS right.

  • Input Prices: A decrease in wages or lower import costs (e.g., from a stronger dollar) shifts SRAS right. Higher input costs shift SRAS left.

  • Relationship Between LRAS and SRAS: When LRAS shifts due to real shocks, SRAS typically shifts in the same direction, as the shock impacts the short-run as well.

IV. Understanding Shifts and Long-Run Adjustments

  • Time and Equilibrium: Eventually, all three curves (AD, SRAS, and LRAS) must intersect at the same point, leading the economy back to equilibrium. The question to ask is whether the real GDP changes or only the price level.

  • Imbalance and Correction: If one curve shifts and causes an imbalance, the other curves will shift to restore equilibrium. For example, demand-pull inflation:

    • Step 1: AD shifts right due to an increase in the money supply.

    • Step 2: Increased demand causes upward pressure on prices and wages, leading to an inflationary gap.

    • Step 3: Higher input prices and wages reduce profits, shifting SRAS left (upward).

    • Step 4: The inflationary gap closes as the economy adjusts.

    • Step 5: In the long run, real GDP returns to the potential output (LRAS), but the price level is higher, reflecting inflation.