Chapter 11: The Aggregate Demand/Aggregate Supply Model

Macroeconomists Divisions:
- Economists are often divided into two schools of thought regarding the importance of demand and supply in determining the size of the macroeconomy:
- Supply Side Dominance: Supply is seen as the primary determinant, while demand is secondary.
- Demand Side Dominance: Demand is viewed as the critical factor, with supply following.
- A balanced economic approach must consider both supply and demand.

Definition of Say’s Law: "Supply creates its own demand."
- Each good/service produced provides income to someone, fostering demand for other goods/services.
Neoclassical Economists:
- Emphasize aggregate supply's role over the long term in determining the macroeconomy.
- Say’s law is approximated in the long run, where supply and total demand grow at similar rates.
- Short-Term Implications: Recessions/depressions can occur where firms face a demand deficiency despite available supply.

Definition of Keynes’ Law: "Demand creates its own supply."
- The economy's GDP level is primarily dictated by total demand rather than supply potential.
- The law is pertinent during short economic cycles (months to years).
- Economic Limits: Heavy reliance on demand could mislead to belief that increases in government spending could indefinitely enlarge the economy.

Aggregate Demand/Aggregate Supply Model:
- Illustrates determinants of total demand and supply in the economy, and their interaction at a macroeconomic level.
Key Terms:
- Aggregate Supply (AS): Total quantity of output (real GDP) produced by firms.
- AS Curve: Displays output quantity firms will produce and sell at every price level.
- Potential GDP: Maximum possible production with full employment of current workers, capital, technology, and institutions.
- Full-Employment GDP: Equivalent to potential GDP, indicating production at full capacity and natural unemployment rate.

The AS curve slopes upward because higher output prices motivate firms to increase production for greater profits.
- Potential GDP Line: Marks maximum production with all resources employed.
Discussion Point: How can the AS intersect Potential GDP?

Definition of Aggregate Demand (AD): Total expenditure on domestic goods/services.
- Comprises four components: consumption, investment, government spending, and net exports.
AD Curve: Depicts overall spending on domestic goods/services at various price levels.
The AD curve slopes downward: as prices rise, total spending decreases.

The intersection of the AS and AD curves indicates equilibrium real GDP and price levels.
- Example: Equilibrium occurs at price level 90 and output level 8,800.

Use of hypothetical equilibrium (e.g., price level 130 and real GDP $680):
- Determines inflation risks and unemployment states based on the economy's position relative to Potential GDP.

Short Run Aggregate Supply (SRAS) Curve: Represents the positive relationship between output price levels and real GDP, with input prices constant.
Long Run Aggregate Supply (LRAS) Curve: Vertical line at potential GDP, showing no relation between prices and output in the long run.

Factors Leading to Shifts in AS Curve:
- Productivity Growth: Enhances output capabilities.
- Input Prices Changes: Affect production capacity.
- Unexpected Shocks: Resilience against natural disasters or wars.
Stagflation: Simultaneity of high inflation and stagnant growth.

Graph (a): Rise in productivity shifts the SRAS right, increasing equilibrium outputs and exerting downward price pressure.
Graph (b): Higher input costs shift SRAS left, reducing output and raising price levels at new equilibrium.

Components of aggregate demand include:
- Consumption spending
- Investment spending
- Government spending
- Net exports
AD Curve Shifts:
- Rightward shift indicates increased spending at every price level.
- Leftward shift reflects decreased spending at every price level.

Consumer Confidence: Higher confidence boosts consumption; lower confidence decreases it.
Business Confidence: High confidence leads to greater investment spending; low confidence reduces it.

Graph (a): Increased confidence shifts AD right, also indicating a new equilibrium closer to potential GDP.
Graph (b): Decreased confidence shifts AD left, resulting in lower output and price levels, distancing from potential GDP.

Government Spending Effects: Increased spending shifts AD right, while decreased spending shifts AD left.
Tax Policy Implications: Cuts promote consumption while increases can stifle it; targeted tax breaks can stimulate investment.

Recession depiction is based on equilibrium proximity to potential GDP:
- Equilibrium Y0 indicates recession, while Y1 is close to potential GDP, indicating low unemployment.

Economic Growth in AD/AS Diagram: Long-term productivity increases shift AS rightward and gradually advance potential GDP.
Recession Visualization: Equilibrium below potential GDP signifies recessionary times; growth periods align closer to potential GDP.

Types of Unemployment:
- Short-term (cyclical) variation linked to business cycles.
- Long-term (commonly around 5% in stable economies).
Cyclical Unemployment Assessment: Low unemployment is seen when output nears potential GDP, high unemployment when it's considerably leftward.

Inflation tendencies fluctuate short-term, rising during booms, falling in recessions.
Inflationary Pressures Sources:
- Rightward AD shifts at or near potential GDP leading to equilibrium shifts upward in price level.
- Increased input prices causing AS shifts left, raising price levels.

Graph (a): AD shifting right influences equilibrium toward a higher price level.
Graph (b): AS moving left results in reduced real GDP alongside higher price levels.

Model Application: The AD/AS model can effectively display both Say’s law and Keynes’ law through various aggregate supply scenarios.

Definition: A flat region of the SRAS where GDP is significantly below potential, indicating recession and high cyclical unemployment without the immediate threat of inflation.

Description: Steep part of SRAS near potential GDP where low cyclical unemployment prevails; real GDP can only grow with AS shifts.

Characteristics: Output is below potential but not significantly, with SRAS sloping upward. AD shifts can either reduce unemployment (right shift) or increase it (left shift), affecting inflation oppositely.