Lecture 14 - Aggregate Demand and Supply (19/11/25)

Aggregate supply, inflation and unemployment

1. Aggregate Demand (AD)

Aggregate Demand (AD) represents the total demand for all goods and services produced in an economy at a given overall price level and period. It is the sum of consumption, investment, government spending, and net exports.

1.1 Components of Aggregate Demand

  • Consumption (C): Spending by households on goods and services (e.g., food, clothing, housing, medical care).

  • Investment (I): Spending by businesses on capital goods (e.g., factories, equipment) and by households on new housing.

  • Government Spending (G): Spending by local, state, and federal governments on goods and services (e.g., infrastructure, defense, education).

  • Net Exports (Nx): Exports minus imports (exports are goods and services produced domestically and sold abroad; imports are goods and services produced abroad and sold domestically).

Therefore, the aggregate demand equation is: AD = C + I + G + Nx

1.2 The Aggregate Demand Curve

The AD curve shows the relationship between the aggregate price level and the quantity of aggregate output demanded by households, businesses, the government, and the rest of the world.

It slopes downward, indicating an inverse relationship between the price level and the quantity of goods and services demanded. This downward slope is due to three main effects:

  • The Wealth Effect: A lower price level increases the real value of consumers' money holdings, making them feel wealthier and thus encouraging more spending.

  • The Interest-Rate Effect: A lower price level reduces the amount of money households need to hold for transactions, leading them to lend out more. This increases the supply of loanable funds, decreases interest rates, and stimulates investment spending.

  • The Exchange-Rate Effect: A lower price level in the U.S. causes U.S. interest rates to fall (due to the interest-rate effect). Foreign investors find U.S. assets less attractive, leading to a depreciation of the U.S. dollar, which makes U.S. goods cheaper relative to foreign goods, increasing net exports.

1.3 Shifts in the Aggregate Demand Curve

Changes in any of the components of AD (C, I, G, Nx) unrelated to a change in the price level (i.e., autonomous changes) will shift the entire AD curve.

  • Consumption (C): Changes in consumer confidence, wealth (e.g., stock market boom), taxes, or expectations about future income.

  • Investment (I): Changes in business confidence, interest rates (monetary policy impact), technology, or taxes on businesses.

  • Government Spending (G): Fiscal policy decisions (e.g., increased government spending on infrastructure).

  • Net Exports (Nx): Changes in foreign income, exchange rates, or trade policies.

2. Aggregate Supply (AS)

Aggregate Supply (AS) represents the total quantity of goods and services that firms are willing and able to produce and sell at different price levels in a given period.

It is typically divided into two components: Short-Run Aggregate Supply (SRAS) and Long-Run Aggregate Supply (LRAS).

2.1 Short-Run Aggregate Supply (SRAS)

The SRAS curve shows the positive relationship between the aggregate price level and the quantity of aggregate output supplied in the short run, holding all other factors constant.

  • Upward Slope: The SRAS curve slopes upward because, in the short run, some input prices (like wages) are sticky or slow to adjust. When the overall price level rises, firms can sell their output for more, while their costs (wages) remain relatively fixed. This increases their profit per unit, encouraging them to produce more output.

    • Sticky-Wage Theory: Nominal wages are slow to adjust to changing economic conditions. If the price level falls unexpectedly, real wages rise, making production less profitable, and firms reduce output.

    • Sticky-Price Theory: Prices of some goods and services adjust slowly to changes in economic conditions. If the price level falls unexpectedly, firms with sticky prices may experience reduced demand or be forced to cut output.

    • Misperceptions Theory: Firms might confuse changes in the overall price level with changes in the relative prices of the products they sell. A lower price level can be misinterpreted as a fall in relative prices, leading firms to reduce output.

2.1.1 Shifts in the SRAS Curve

Changes in factors that affect the costs of production, or the quantity of inputs available, will shift the SRAS curve.

  • Changes in Input Prices: Wages, oil prices, raw materials costs. An increase in input prices shifts SRAS to the left (decreases supply).

  • Changes in Productivity/Technology: Advances in technology or improvements in labor productivity shift SRAS to the right (increases supply).

  • Changes in Expectations about Future Prices: If firms expect higher future prices, they may reduce current supply to sell more later, shifting SRAS to the left.

  • Supply Shocks: Unexpected events like natural disasters or changes in government regulations.

  • Changes in the Supply of Labor or Capital: Increases in the labor force or capital stock shift SRAS to the right.

2.2 Long-Run Aggregate Supply (LRAS)

The LRAS curve shows the relationship between the aggregate price level and the quantity of aggregate output supplied in the long run. In the long run, all prices (including input prices like wages) are fully flexible and adjust to economic conditions.

  • Vertical Shape: The LRAS curve is vertical at the economy's potential output or natural rate of output. This output level represents the maximum sustainable output an economy can produce when all resources are fully employed at their natural rates (e.g., natural rate of unemployment). In the long run, output is determined by the economy's resources (labor, capital, natural resources) and technology, not by the price level.

2.2.1 Shifts in the LRAS Curve

The LRAS curve shifts due to changes in the factors that determine an economy's potential output or long-run productive capacity.

  • Changes in Labor: An increase in the labor force or human capital (education/skills).

  • Changes in Capital: An increase in the physical capital stock (e.g., factories, equipment).

  • Changes in Natural Resources: Discovery of new resources or changes in their availability.

  • Changes in Technology: Technological advancements that improve production efficiency.

3. ÅD/AS + inflation

  • Demand pull inflation - more demand of a good in the economy, subsequent rise in price levels

  • Cost - push inflation -

4. The DAD/DAS Model