Notes on Macroeconomics: Aggregate Supply and Demand

Macroeconomic Performance Targets

  • Potential GDP and Long-Run Aggregate Supply
    • Long-run aggregate supply (LAS) models potential GDP and full employment outcomes.

Understanding Potential GDP and Long-Run Aggregate Supply

  • Potential GDP (full-employment output) represents:
    • Points on the production possibilities frontier (PPF).
    • LAS is depicted as a vertical line at potential GDP; it remains constant as the price level changes.
  • Positioning
    • Existing inputs determine PPF and LAS position.
    • Unused or unemployed inputs are found inside the PPF, reflecting quantities of real GDP less than potential GDP.

Time Considerations in Macroeconomic Analysis

  • Long Run
    • A time frame where all prices and wages adjust for equilibrium, indicating the economy is at potential GDP.
  • Short Run
    • A limited duration where some input prices remain fixed, leading to situations where not all prices adjust.

Short-Run Aggregate Supply (SAS)

  • Supply Plans
    • Macroeconomic players develop two supply plans: one for existing inputs, and another to increase inputs.
  • Law of Short-Run Aggregate Supply
    • As the price level increases, the aggregate quantity of real GDP supplied also increases, causing movements along the SAS curve.

Changes Affecting Short-Run Aggregate Supply

  • Increasing input quantity or quality raises aggregate supply, shifting both LAS and SAS rightward.
  • Variable Input Prices
    • Rising input prices shift SAS leftward, while falling prices shift it rightward.
  • Supply shocks impact SAS:
    • Negative Supply Shocks: Drive costs up or reduce input availability, shifting SAS leftward.
    • Positive Supply Shocks: Lower costs or improve productivity, shifting SAS rightward.

Aggregate Demand (AD)

  • Demand Plans
    • Macroeconomic players plan demand similar to microeconomic choices.
    • Law of Aggregate Demand: An increase in price level leads to a decrease in quantity of real GDP demanded.

Components of Aggregate Demand

  • Formula for Planned Spending: AD=C+I+G+(X−IM)AD = C + I + G + (X - IM) where:
    • C = Consumer Spending
    • I = Business Investment
    • G = Government Spending
    • X = Exports; IM = Imports
  • Factors Influencing Aggregate Demand:
    • Changes in expectations, interest rates, government policy, world GDP, exchange rates, etc.

Equilibrium in the Macroeconomy

  • Short-Run and Long-Run Equilibrium
    • Short-Run Equilibrium: Where SAS and AD intersect with prevailing inputs.
    • Long-Run Equilibrium: Occurs where SAS, AD, and LAS intersect; reflects equilibrium real GDP and potential GDP.

Economic Shock Implications

  • Demand Shock Outcomes:
    • Negative shocks lead to recessive gaps with decreasing GDP and rising unemployment.
    • Positive shocks create inflationary gaps with rising GDP and falling unemployment.
  • Supply Shock Effects:
    • Negative supply shocks result in stagflation, whereas positive supply shocks increase GDP.

Using the AS/AD Model

  • Approach:
    • Begin at long-run macroeconomic equilibrium to model changes from shocks.
    • Analyze variations in GDP, unemployment, and inflation resulting from negative/positive supply/demand shocks.

Conclusion

  • Understanding the interplay between aggregate supply and demand is crucial for macroeconomic performance analysis, guiding toward stable economic growth, full employment, and controlled inflation over time.