Chapter 13 - Aggregate Demand-Aggregate Supply Model

Aggregate Demand-Aggregate Supply Model

Overview

  • The AD-AS model is utilized to study short-run business cycles and their impact on the economy. It is based on demand and supply principles, examining the total demand and supply for all final goods in an economy.

  • Two key avenues of macroeconomic study exist:

    • Long-run growth and development: Focuses on theories and policies that affect economic conditions over decades.

    • Short-run fluctuations (business cycles): Focuses on economic variations within timeframes of five years or less.

Economic Patterns

  • GDP Growth: Typically positive during expansions and negative during recessions.

    • Example of U.S. Real GDP levels from 1990 to 2020:

    • 24,000 (billion dollars)

    • 22,000

    • 20,000

    • 18,000

    • 16,000

    • 14,000

    • 12,000

    • 10,000

    • 8,000

Unemployment Trends

  • In recessions, unemployment tends to rise, while it falls during economic expansions.

    • Example of U.S. Unemployment Rate from 1990 to 2020:

    • 16%

    • 14%

    • 12%

    • 10%

    • 8%

    • 6%

    • 4%

    • 2%

    • 0%

Aggregate Demand

Definition

  • Aggregate Demand (AD): The total demand for final goods and services in an economy, expressed as the sum of consumption (C), investment (I), government spending (G), and net exports (NX).

  • Relation: AD = C + I + G + NX

Components Influencing AD

  1. Consumption: Accounts for approx. 70% of GDP spending and is influenced by:

    • Changes in real wealth (affected by stock market trends, real estate values)

    • Expectations about the future and future income

    • Consumer confidence

    • Tax changes

  2. Investment: Influenced by:

    • Investor confidence (higher confidence leads to higher investment)

    • Interest rates (lower interest rates boost investment)

    • Quantity of money in circulation (more money leads to lower interest rates)

  3. Government Spending: Directly influenced by policymakers and may vary based on economic conditions (e.g., increased spending during downturns).

  4. Net Exports: Changes affected by:

    • Foreign income (increased foreign incomes boost demand for U.S. goods)

    • Value of the U.S. dollar (stronger dollar leads to decreased net exports).

AD Curve Dynamics

  • Movement along the AD curve: Caused by changes in price levels affecting aggregate demand through:

    • Wealth effect

    • Interest rate effect

    • International trade effect

  • Shifts in the AD curve: Occur due to factors beyond price level changes (e.g., changes in consumer confidence, investment levels, etc.).

Aggregate Supply

Distinction Between Short-run and Long-run

  • Short-run Aggregate Supply (SRAS): Affected by factors such as:

    • Sticky input prices (e.g., wages fixed by contracts)

    • Menu costs (costs associated with changing prices)

    • Money illusion (misinterpretation of nominal wage changes)

  • Long-run Aggregate Supply (LRAS): A vertical representation of the economy's output at full employment, unaffected by price levels. Adjusts with changes in resources, technology, and institutions.

Understanding SRAS and LRAS

  • Long-run: Represents a period for all prices to adjust; where output aligns with the natural unemployment rate ($u^*$ full employment).

  • Short-run: Duration in which not all prices have adjusted (sticky prices leading to a positive relation between price level and quantity of aggregate supply).

Impacts of Shocks

  • Positive SRAS Shift (e.g., technology advancement): Leads to increased output, stable unemployment and decreased price level.

  • Negative SRAS Shift (e.g., supply chain shock): Results in output decline, increased unemployment and rising price levels.

Long-run Equilibrium Analysis

  • Long-run equilibrium exists when aggregate demand equals aggregate supply in both short and long-term perspectives (denoted as LRAS = SRAS = AD, reaching full employment).

  • Mechanisms to return to a new long-run equilibrium involve shifts in the SRAS curve, equalizing output, employment rates, and price levels over time.