Aggregate Demand & Aggregate Supply - Study Notes

Aggregate Demand

  • Definition: Aggregate Demand (AD) is the total spending on goods and services in a period of time.
    • AD is downward sloping: there is an inverse relationship between the average price level and real output (national income).
  • Formula: AD = C + I + G + (X - M)
    • C = Consumption
    • I = Investment
    • G = Government Spending
    • X = Exports, M = Imports; (X - M) = Net Exports
  • Components of AD
    • Consumption (C): Total spending by consumers on domestic goods/services.
    • Includes: Durables (used over time: cars, computers) and Non-durables (used quickly: rice, newspapers).
    • Investment (I): Addition of capital stock to the economy by firms.
    • Includes: Replacement investment (maintaining productivity) and Induced investment (increasing output due to higher demand).
    • Government Spending (G): Spending by all levels of government on goods/services (e.g., healthcare, education, defense).
    • Excludes transfer payments.
    • Net Exports (X - M): Exports (domestic goods/services bought by foreigners) minus Imports (foreign goods/services bought by residents).
  • Shape of the AD Curve
    • Downward sloping: when the average price level falls, the quantity of output demanded rises because C + I + G + (X - M) increases.
  • Movement vs Shift in AD
    • Movement along the AD curve = a change in the average price level.
    • A shift of the AD curve = a change in one or more components of AD (C, I, G, (X - M)).
  • Causes of Change in Consumption (C)
    1) Income taxes (higher → less disposable income).
    2) Interest rates (lower → more borrowing/spending).
    3) Wealth (housing/stock values).
    4) Consumer confidence.
    5) Household indebtedness (more debt → less spending).
  • Causes of Change in Investment (I)
    1) Interest rates (lower → more investment).
    2) Business taxes.
    3) Technological change.
    4) Business confidence/expectations.
    5) Corporate indebtedness.
  • Causes of Change in Government Spending (G)
    • Determined by political/economic priorities.
    • Increases may target industries, correct market failures, or expand education/healthcare.
  • Causes of Change in Net Exports (X - M)
    • Exports depend on: foreign income, exchange rates, trade policies, relative inflation.
    • Imports depend on: national income, exchange rates, trade policies, relative inflation.

Aggregate Supply

  • Definition: Aggregate Supply (AS) is the total quantity of goods and services produced in an economy over a period of time at different price levels.
  • Short-run Aggregate Supply (SRAS): Relationship between price level and real output when costs of production (especially wages) are constant. Essentially the sum of all firms’ supply curves.
  • Short run vs Long run
    • Short run: resource costs (especially wages) are fixed.
    • Long run: resource costs are flexible, moving with the price level.
  • Why wages are rigid
    • Labor contracts, minimum wage laws, union resistance, and negative effects of wage cuts on morale.
  • Shape of SRAS
    • Upward sloping: as output rises, costs rise (e.g., overtime pay), so prices increase.
  • Shifts of SRAS
    • Caused by factors affecting production costs:
      1) Wage rates
      2) Costs of raw materials
      3) Prices of imports
      4) Indirect taxes/subsidies
      5) Supply shocks (war, natural disasters, etc.)
  • Short-run equilibrium
    • Determined by the intersection of AD and SRAS → sets the price level, real GDP, and employment.
  • Long-run Aggregate Supply (LRAS)
    • Shows potential output at full employment.
    • Debate between New Classical/Monetarist and Keynesian views.
  • New Classical LRAS
    • Vertical at full employment (Y_f).
    • Belief: market forces return the economy to Y_f without government intervention.
  • Keynesian LRAS
    • Three phases:
      1) Elastic (spare capacity): output rises without a price change.
      2) Upward sloping: resources scarcer, output rises with inflation.
      3) Inelastic (full capacity): output fixed, only prices rise.
  • Shifts of LRAS
    • Caused by increases in quantity or quality of factors of production (similar to a PPC shift).
  • Notes
    • The transcript explicitly outlines these distinctions and does not provide numerical data beyond phase descriptions and component counts.