Aggregate Demand and Aggregate Supply Model

Foundations of the Aggregate Demand and Aggregate Supply Model

• Aggregate Demand ($AD$) and Aggregate Supply ($AS$) model is used to analyze macroeconomic fluctuations, determining the equilibrium price level and aggregate output.
• Microeconomic concepts of price and quantity are aggregated into economy-wide aggregate variables:
  • Price Level ($P$): Measured using macroeconomic indexes such as the Consumer Price Index ($CPI$) or the $GDP$ deflator.
  • Real GDP ($Y$): Represents the total quantity of real output (goods and services) produced and demanded in the economy.
• Aggregate Demand Curve ($AD$): A curve that illustrates the total quantity of goods and services that households, firms, government entities, and foreign buyers want to buy at each given price level.
• Aggregate Supply Curve ($AS$): A curve that illustrates the total quantity of goods and services that domestic firms choose to produce and sell at each given price level.
• Model Equilibrium: The point where aggregate demand and aggregate supply intersect determines both the equilibrium price level ($P^*$) and the equilibrium real output level ($Y^*$).

The Aggregate Demand (AD) Curve

• The Aggregate Demand equation is expressed as:   $AD = C + I + G + NX$
  • $C$: Consumption spending by households.
  • $I$: Investment spending by businesses and households on capital equipment, structures, and inventories.
  • $G$: Government expenditures on goods and services.
  • $NX$: Net Exports, calculated as total exports minus total imports ($NX = \text{Exports} - \text{Imports}$).
• Graphically, the $AD$ curve plots the price level ($P$) on the vertical axis against real GDP ($Y$) on the horizontal axis and slopes downward from left to right.
• The downward slope indicates an inverse relationship between the price level ($P$) and the total quantity of output demanded ($Y$).
• Government purchases ($G$) are assumed to be fixed by government policy; therefore, the downward slope depends on how price level changes impact Consumption ($C$), Investment ($I$), and Net Exports ($NX$):
  • The Real-Balance Effect (Price and Consumption $C$):
  • An increase in the price level ($P$) reduces the purchasing power of money held by households, lowering real wealth.
  • Lower real wealth makes individuals feel poorer, leading to a decrease in consumer spending ($C$).
  • Consequently, a higher price level reduces the total quantity of goods and services demanded.
  • The Interest-Rate Effect (Price and Investment $I$):
  • A higher price level ($P$) requires consumers and firms to hold more dollars to conduct transaction activities.
  • To obtain additional cash, individuals sell assets or borrow additional funds, which increases the demand for money and drives up nominal interest rates.
  • Higher interest rates raise the cost of borrowing, prompting businesses and households to postpone purchases of new capital equipment and consumer durable goods, thereby cutting back spending ($I$).
  • This reduction in investment leads to a smaller overall quantity of output demanded.
  • The Exchange-Rate Effect (Price and Net Exports $NX$):
  • A rise in the domestic price level ($P$) makes domestic goods (e.g., Malaysian products) relatively more expensive to foreign buyers and foreign imports cheaper to domestic residents.
  • This shift reduces domestic export volume and increases import volume, leading to a decline in net exports ($NX$).
  • The reduction in net exports decreases the aggregate quantity of goods and services demanded.

Determinants and Factors Shifting the Aggregate Demand Curve

• Any exogenous event or policy shift that alters $C$, $I$, $G$, or $NX$ at a given price level—excluding a direct change in the price level ($P$) itself—causes the entire $AD$ curve to shift.
• Shifts in Consumption ($C$):
  • A stock market boom increases household wealth, causing consumers to feel wealthier and spend more ($C$ increases), shifting the $AD$ curve to the right ($AD_1$ to $AD_2$).
  • Increased consumer concern regarding retirement saving leads households to cut current consumption spending, shifting the $AD$ curve to the left.
  • Government tax cuts increase disposable personal income, encouraging households to consume more ($C$ rises) and shifting the $AD$ curve to the right.
• Shifts in Investment ($I$):
  • Technological advancements, such as the introduction of a faster line of computer systems, prompt firms to invest heavily in new computer technology, shifting the $AD$ curve to the right.
  • Pervasive business pessimism regarding future market conditions leads firms to reduce capital spending, shifting the $AD$ curve to the left.
  • An investment tax credit directly increases the quantity of capital investment goods demanded by firms, shifting the $AD$ curve to the right.
  • An expansion of the money supply by monetary authorities lowers short-run interest rates, stimulating investment spending ($I$ rises) and shifting the $AD$ curve to the right.
• Shifts in Government Expenditures ($G$):
  • A decision by Parliament or policy makers to reduce purchases of new medical equipment reduces government spending, shifting the $AD$ curve to the left.
  • Government initiatives to build new highways, infrastructure, or roads increase government purchases, shifting the $AD$ curve to the right.
• Shifts in Net Exports ($NX$):
  • Economic recessions in trading partner nations (e.g., a recession in Europe or Japan leading Japan to purchase fewer Malaysian products) reduce net export demand, shifting the $AD$ curve to the left.
  • An appreciation of the domestic currency exchange rate (e.g., an increase in the exchange rate of the Ringgit) makes domestic goods more expensive relative to foreign goods, decreasing aggregate net exports and shifting the $AD$ curve to the left.

The Aggregate Supply (AS) Curves

• The Aggregate Supply curve represents the total quantity of output that domestic businesses produce and offer for sale at any given price level.
• Aggregate Supply operates across two distinct time horizons:
  • Short-Run Aggregate Supply ($SRAS$): Upward-sloping curve, showing a positive relationship between price level ($P$) and real GDP output supplied ($Y$).
  • Long-Run Aggregate Supply ($LRAS$): Vertical curve positioned at the economy's natural rate of output ($Y_N$).

Determinants and Factors Shifting the Long-Run Aggregate Supply Curve

• The vertical nature of the $LRAS$ curve reflects economic neutrality to nominal price levels in the long run:
  • In the long run, an economy's real aggregate output depends strictly on real economic factors: supplies of labor ($L$), physical capital ($K$), human capital, natural resources, and available technological knowledge.
  • Variations in the overall price level ($P$) do not affect aggregate production in the long run.
• The location of the $LRAS$ curve is fixed at the natural rate of output ($Y_N$), also referred to as potential output or full-employment output.
• $Y_N$ represents the level of output produced when unemployment is at its natural rate.
• Shifts in the $LRAS$ curve occur when changes alter the natural rate of output ($Y_N$):
  • Shifts Arising from Changes in Labor ($L$):
  • The retirement of the Baby Boom generation reduces the available workforce ($L$ falls), shifting $LRAS$ to the left.
  • Government policies that lower the natural rate of unemployment increase the percentage of the labor force active in production, shifting $LRAS$ to the right.
  • Increased immigration expands the labor force ($L$ rises), shifting $LRAS$ to the right.
  • Shifts Arising from Changes in Physical or Human Capital ($K$):
  • Increased physical capital investment in new factories and machinery raises production capacity ($K$ rises), shifting $LRAS$ to the right.
  • Accumulation of human capital, such as an increase in college degree attainments, enhances worker productivity and shifts $LRAS$ to the right.
  • Natural disasters, such as severe earthquakes or hurricanes destroying industrial factories, reduce capital infrastructure ($K$ falls), shifting $LRAS$ to the left.
  • Shifts Arising from Changes in Natural Resources:
  • Adverse changes in weather patterns that make agricultural farming more difficult shift $LRAS$ to the left.
  • The discovery of new mineral deposits increases available resource inputs, shifting $LRAS$ to the right.
  • Reductions in the international supply of imported oil or other essential energy resources shift $LRAS$ to the left.
  • Shifts Arising from Changes in Technology:
  • Technological innovations, such as the development and widespread adoption of computers, enable greater output from existing resource bundles, shifting $LRAS$ to the right.
  • Opening up international trade acts similarly to technological progress by optimizing production efficiency, shifting $LRAS$ to the right.

Short-Run Aggregate Supply (SRAS) Slope and Microfoundations

• In the short run, an increase in the general price level ($P$) tends to raise the quantity of goods and services supplied, while a decrease in $P$ reduces the quantity supplied.
• This positive relationship is driven by short-run market imperfections, specifically wage and price rigidities:
  • The Sticky-Wage Theory:
  • Nominal wages adjust slowly over time due to formal long-term labor contracts between firms and workers, informal social norms, and standard notions of fairness.
  • Nominal wages are established based on expected price levels and do not react immediately when the actual price level ($P$) deviates from expectations.
  • Specific Numerical Example: A firm enters into a contract to pay workers an hourly wage of $RM20$ based on an expected price level of $100$. If the actual price level falls unexpectedly to $95$, the firm receives $5\%$ less revenue for its output, while labor costs remain fixed at $RM20$ per hour. Production becomes less profitable, prompting the firm to reduce employment and decrease the output quantity supplied.
  • The Sticky-Price Theory:
  • Prices of certain goods and services are slow to adjust immediately to macroeconomic changes due to menu costs (costs associated with reprinting catalogs, changing price tags, or updating price lists).
  • When the overall price level falls unexpectedly, a firm that does not immediately lower its prices experiences a relative price increase compared to competitors, depressing sales volume.
  • Reduced sales prompt the firm to cut back production, lowering the overall quantity of output supplied in the short run.

Short-Run Aggregate Supply Shifts and Expected Price Levels

• Factors that shift the $LRAS$ curve will automatically shift the $SRAS$ curve in the same direction.
• In addition, expectations of the price level uniquely influence the location of the $SRAS$ curve without shifting the $LRAS$ curve:
  • A higher expected price level increases input costs (such as nominal wage demands), reducing firm profitability at any given actual price level and shifting the $SRAS$ curve to the left.
  • A lower expected price level reduces nominal labor and production costs, shifting the $SRAS$ curve to the right.

Macroeconomic Equilibrium and Economic Fluctuations

• Long-run macroeconomic equilibrium occurs at the intersection of the $AD$ curve, the $LRAS$ curve, and the $SRAS$ curve:
  • Output is positioned at the natural rate of output ($Y_N$).
  • Price perceptions, nominal wages, and market prices have fully adjusted such that expected price level equals actual price level, causing $SRAS$ to pass through this exact intersection.
• Economic Fluctuations Caused by Shifts in Aggregate Demand ($AD$):
  • Short-Run Dynamics:
  • A wave of pessimism causes consumer and investment confidence to drop, shifting the $AD$ curve to the left from $AD_1$ to $AD_2$
  • The economy moves from initial long-run equilibrium point $A$ to short-run equilibrium point $B$
  • At point $B$, real output falls from $Y_1$ to $Y_2$ (below natural rate $Y_N$) and the price level falls from $P_1$ to $P_2$
  • Long-Run Dynamics:
  • Lower output and higher unemployment gradually put downward pressure on wages and input prices over time.
  • As price level expectations adjust downward, nominal production costs fall, shifting the $SRAS$ curve to the right from $AS_1$ to $AS_2$
  • The economy transitions to point $C$, where $AD_2$ intersects $LRAS$
  • In the long run, aggregate output recovers back to the natural rate $Y_1$, while the price level falls further to $P_3$
• Economic Fluctuations Caused by Adverse Shifts in Aggregate Supply ($SRAS$):
  • Short-Run Impact (Supply Shock):
  • An adverse event increases production costs (e.g., a sharp increase in firm production costs), shifting the $SRAS$ curve to the left from $AS_1$ to $AS_2$
  • The economy moves from initial point $A$ to short-run point $B$
  • This movement results in stagflation: real aggregate output falls from $Y_1$ to $Y_2$ (economic stagnation) while the price level rises from $P_1$ to $P_2$ (inflation).