Lecture [09] Aggregate Demand and Aggregate Supply

Aggregate Demand and Aggregate Supply

Lecture based on Mankiw, Principles of Economics, Chapter 34

Learning Outcomes

• LO1: Explain the shape of the aggregate demand curve and identify causes for its shifts.

• LO2: Explain the shape of the aggregate supply curve and identify causes for its shifts.

• LO3: Use the aggregate demand-supply model to explain macroeconomic instability and the business cycle.

Aggregate Demand (AD)

• Definition: Aggregate Demand represents the total demand for goods and services in an economy at various price levels, illustrating how much of the national output (GDP) is demanded.

• Components: The aggregate demand is composed of four main components:

  • Consumption (C): Expenditures by households on goods and services. It is the largest component of AD, influenced by factors such as disposable income, consumer confidence, and interest rates.

  • Investment (I): Spending on capital goods that will be used for future production. This includes business investments in structures, equipment, and residential construction.

  • Government Expenditure (G): Total government spending on goods and services, which can stimulate economic activity through public services and infrastructure projects.

  • Net Exports (NX): The value of a country's exports minus its imports. A positive net export indicates more goods sold abroad than bought from foreign countries, adding to GDP.

• Equation: Aggregate demand can be summarized with the equation: Y = AD = C + I + G + NX.

Shape of the Aggregate-Demand Curve

• Downward Slope: The aggregate demand curve slopes downward due to four main effects:

  • Wealth Effect: When the price level decreases, the real value of money increases, which enhances consumer wealth and encourages higher spending on goods and services.

  • Income Effect: A reduction in price levels increases the purchasing power of money income, resulting in an increase in the quantity demanded as consumers feel richer and purchase more.

  • Interest-Rate Effect: Lower price levels lead to lower interest rates, making borrowing cheaper, which in turn stimulates business investments and consumer spending on durable goods.

  • Exchange-Rate Effect: A decline in U.S. price levels can lead to a depreciation of the dollar in foreign exchange markets, making U.S. goods cheaper for foreign buyers and thus increasing net exports.

Shifts in the AD Curve

• The aggregate demand curve can shift due to various factors affecting anyone of its components, including:

  • Changes in consumer confidence impacting consumption.

  • Variations in business expectations affecting investment.

  • Fluctuations in government spending due to policy changes.

  • Changes in foreign income levels influencing net exports.

Aggregate Supply (AS)

• Definition: The aggregate supply curve shows the total output of goods and services that firms are willing and able to sell at different price levels in the economy.

• Short-Run Aggregate Supply (SRAS): The short-run AS curve is typically upward-sloping, meaning that as prices rise, the quantity of goods and services supplied also increases due to inflexible input prices, such as wages.

Shifts in the AS Curve

• The aggregate supply curve can shift due to factors such as:

  • Input Prices: Changes in the costs of production inputs like wages and raw materials.

  • Productivity: Advances in technology or improvements in resource efficiency can increase output without increasing costs.

  • Taxes and Regulations: Increases in taxes and stringent business regulations can dampen supply, while reductions encourage production.

Macroeconomic Equilibrium and Business Cycles

• Equilibrium: Macroeconomic equilibrium occurs when the quantity of goods and services demanded equals the quantity supplied at a particular price level, resulting in no inherent force for change.

• Business Cycles: Economic fluctuations are attributed to shifts in either the aggregate demand or aggregate supply curves, influencing inflation rates and unemployment levels. For instance, an increase in AD can lead to higher output and employment but may also generate inflation, while a left shift in AS can lead to stagflation, characterized by rising prices and falling