Chapter 11: The Aggregate Demand and Aggregate Supply Model

MACROECONOMIC PERSPECTIVES ON DEMAND AND SUPPLY

• Macroeconomists are often divided into two primary schools of thought regarding the size and health of the macroeconomy:

  • Group 1 Argument: Supply is the most important determinant of the size of the macroeconomy; demand simply follows or "tags along."

  • Group 2 Argument: Demand is the most critical factor in determining the size of the macroeconomy; supply follows or "tags along."

• Synthesis: A successful and comprehensive economic approach must account for the interaction of both supply and demand.

SAY’S LAW AND THE MACROECONOMICS OF SUPPLY

• Say’s Law Defined: The principle that "Supply creates its own demand."

• Economic Logic: Each time a good or service is produced and sold, the act of production generates income for someone (workers, managers, or owners), which in turn provides the means to purchase other goods and services.

• Neoclassical Economists: This group of economists generally emphasizes the primary importance of aggregate supply in determining the size of the macroeconomy over the long run.

• Long-Run Perspective: Say’s law is considered a reliable approximation for the long run. Over periods spanning years or decades, as an economy's productive capacity to supply goods and services increases, total demand tends to grow at roughly the same pace.

• Short-Run Limitation: Over shorter time horizons (months or a few years), Say's law may not hold as economies can face recessions or depressions. In these periods, firms as a whole may experience a distinct lack of demand for their products.

KEYNES’ LAW AND THE MACROECONOMICS OF DEMAND

• Keynes’ Law Defined: The principle that "Demand creates its own supply."

• Economic Logic: The level of Gross Domestic Product ($GDP$) is not primarily determined by the economy's supply potential, but rather by the total amount of demand from all sectors.

• Short-Run Perspective: Keynes’ law is particularly applicable in the short run (months to years). During a recession, firms experience drops in demand for their output; during an economic boom, demand may be so high that firms struggle to produce sufficient quantities.

• Limitations of Demand-Side Focus: If demand were the only factor, governments could theoretically expand the economy indefinitely through increased spending or large tax cuts to boost consumption. However, economies face genuine limits on production capacity (supply constraints).

BUILDING A MODEL OF AGGREGATE DEMAND AND AGGREGATE SUPPLY

• Aggregate Demand/Aggregate Supply (AD/AS) Model: A macroeconomic model designed to show what determines total supply and total demand in an economy and how these two forces interact.

• Aggregate Supply ($AS$): The total quantity of output (measured as real $GDP$) that firms within an economy are willing to produce and sell.

• Aggregate Supply ($AS$) Curve: A graphical representation showing the total quantity of output (real $GDP$) that firms produce and sell at different price levels.

• Potential GDP: The maximum quantity an economy can produce given the full employment of its existing resources, including labor, physical capital, technology, and institutional frameworks.

• Full-employment GDP: An alternative term for potential $GDP$, referring to the level of production achieved when the economy is at its potential and unemployment is at its natural rate.

THE AGGREGATE SUPPLY CURVE CHARACTERISTICS

• Slope: The $AS$ curve slopes upward. This occurs because as the price level for outputs rises while input prices remain fixed, firms have a higher profit incentive to produce more.

• Potential GDP Line: Usually represented as a vertical line, showing the upper limit of production with full employment of resources.

• Discussion Question: How can the $AS$ curve cross the Potential $GDP$ line? (This implies exploring scenarios where an economy temporarily produces beyond its sustainable capacity).

THE AGGREGATE DEMAND CURVE CHARACTERISTICS

• Aggregate Demand ($AD$) Defined: The total amount of spending on domestic goods and services within an economy.

• Components of $AD$:

  1. Consumption spending ($C$)

  2. Investment spending ($I$)

  3. Government spending ($G$)

  4. Net Exports ($X - M$), which is exports minus imports.

• Aggregate Demand ($AD$) Curve: Shows total spending on domestic goods and services at each price level.

• Slope: The $AD$ curve slopes downward. As the price level rises, total spending on domestic goods and services declines.

• Reasons for Downward Slope:

  1. Interest Rate Effect: Higher prices lead to higher demand for money, raising interest rates and reducing investment/consumption.

  2. Wealth Effect: Higher prices reduce the real value of money holdings, diminishing consumer wealth and spending.

  3. Foreign Price Effect: Higher domestic prices make exports more expensive and imports cheaper, reducing net exports.

EQUILIBRIUM IN THE AD/AS MODEL

• Intersection: The equilibrium level of real $GDP$ and the equilibrium price level are found where the $AS$ and $AD$ curves intersect.

• Example Data: In a specific model, equilibrium occurs at a price level of $90$ and an output level of $8,800$.

• Interpreting the Model (Hypothetical Scenario):

  • Price Level: $130$

  • Real GDP: $\$680$

  • Question for Analysis: Is this country risking inflationary pressures or facing high unemployment? The state of the economy is inferred by comparing this equilibrium to potential $GDP$.

DEFINING SRAS AND LRAS

• Short Run Aggregate Supply ($SRAS$) Curve: Represents the positive short-run relationship between price levels for output and real $GDP$, assuming the prices of inputs are held fixed.

• Long Run Aggregate Supply ($LRAS$) Curve: Represented as a vertical line at the level of potential $GDP$. It indicates that in the long run, there is no relationship between the price level of output and the real $GDP$ produced.

FACTORS SHIFTING AGGREGATE SUPPLY

• Primary Factors for AS Shifts:

  1. Productivity Growth: Improvements in how efficiently inputs are converted to outputs.

  2. Changes in Input Prices: Fluctuations in the cost of labor, energy, or raw materials.

• SRAS Shifts: Generally caused by changes that affect the costs of production.

• LRAS and SRAS Shifts: Caused by improvements in the quantity or quality of the factors of production (labor, capital, technology).

• Unexpected Shocks: The $AS$ curve can shift due to external shocks, such as:

  • Large weather events (e.g., droughts affecting crops).

  • Overseas wars requiring labor resources to be diverted from production.

• Stagflation: A specific economic condition characterized by stagnant growth (low output) and high inflation occurring simultaneously.

ILLUSTRATING AS SHIFTS

• Case (a) Rightward Shift: A rise in productivity shifts $SRAS$ to the right ($SRAS_0 \rightarrow SRAS_1 \rightarrow SRAS_2$). This leads to higher output levels and downward pressure on the price level. Equilibrium moves from $E_0$ to $E_1$ and then $E_2$.

• Case (b) Leftward Shift: A higher price for inputs (such as oil) means lower real $GDP$ is produced at every price level. $SRAS$ shifts left ($SRAS_0 \rightarrow SRAS_1$). The new equilibrium $E_1$ features reduced output and a higher price level compared to $E_0$.

SHIFTS IN AGGREGATE DEMAND

• Directional Shifts:

  • Rightward Shift: Indicates at least one component of $AD$ ($C, I, G, X-M$) has increased, leading to greater total spending at every price level.

  • Leftward Shift: Indicates at least one component of $AD$ has decreased, leading to lesser total spending at every price level.

• Influence of Confidence:

  • Consumer Confidence: High confidence leads to increased consumption; low confidence leads to spending declines.

  • Business Confidence: High confidence encourages investment spending; low confidence results in investment drops.

GOVERNMENT POLICY AND AD SHIFTS

• Government Spending ($G$): Increases in spending shift $AD$ to the right; decreases shift it to the left.

• Tax Policy:

  • Individual Tax Cuts: Typically increase consumption demand.

  • Individual Tax Increases: Tend to diminish consumption demand.

  • Corporate Tax Reductions: Can stimulate investment demand through lower rates or specific investment benefits.

• Recession Strategy: The U.S. often passes tax cuts during recessions when unemployment is high and profits are low to stimulate spending.

AD SHIFT ILLUSTRATIONS

• Graph (a) Increase: Rising confidence, higher government spending, or tax cuts shift $AD_0$ to $AD_1$ (right). The new equilibrium $E_1$ has higher output and a higher price level, moving closer to potential $GDP$.

• Graph (b) Decrease: Falling confidence, lower government spending, or higher taxes shift $AD_0$ to $AD_1$ (left). The new equilibrium $E_1$ has lower output and a lower price level, moving further below potential $GDP$.

GROWTH, UNEMPLOYMENT, AND INFLATION IN THE AD/AS MODEL

• Recession Identification: Indicated by how far the equilibrium output ($Y_0$) is from the potential $GDP$ line ($LRAS$). A large gap signifies heavy recession and high unemployment.

• Full Employment Identification: If the equilibrium ($E_1$ at $Y_1$) is close to the potential $GDP$ line, the economy has low unemployment.

• Long-Run Growth: Represented by a gradual rightward shift of both the $AS$ curve and the vertical potential $GDP$ line over time due to productivity gains.

• Types of Unemployment:

  • Cyclical Unemployment: Short-run variations caused by the business cycle (expansion and contraction). This is shown by the horizontal distance between equilibrium output and potential $GDP$.

  • Natural Rate of Unemployment: The long-run rate when the economy is healthy, typically hovering around $5\%$ in the U.S.

• Inflationary Pressure Sources:

  1. Demand-Pull: $AD$ shifts right when the economy is already at or near potential $GDP$, pushing the equilibrium into the steep portion of the $AS$ curve.

  2. Cost-Push: A rise in input prices (e.g., labor or oil) affecting the whole economy and shifting the $AS$ curve to the left.

• Inflation Trends: Typically occurs during or after economic booms; rates usually decline during recessions.

ZONES WITHIN THE SRAS CURVE

• The Keynesian Zone:

  • Location: The portion of the $SRAS$ curve where $GDP$ is significantly below potential and the curve is relatively flat.

  • Characteristics: Economy is in recession, cyclical unemployment is high, and there is little worry regarding inflationary price pressure.

• The Neoclassical Zone:

  • Location: The portion of the $SRAS$ curve where $GDP$ is at or near potential output and the curve is steep.

  • Characteristics: Cyclical unemployment is low (though structural unemployment may exist). Real $GDP$ can only increase if $AS$ shifts right. Changes in $AD$ primarily create price level changes.

• The Intermediate Zone:

  • Location: The portion of the $SRAS$ curve where $GDP$ is below potential but not as far as the Keynesian zone; the curve is upward-sloping but not vertical.

  • Observations: Unemployment and inflation move in opposite directions.

    • Shift $AD$ Right: Moves output closer to potential, reduces unemployment, but increases price levels/inflation.

    • Shift $AD$ Left: Moves output further from potential, increases unemployment, and lowers price levels/inflation.

ATTRIBUTION

• Source: CH. 11 The Aggregate Demand/Supply Model

• Institution: Shoreline Community College

• Reference ID: 54

• URL Reference: mgflip.com