Aggregate Demand and Aggregate Supply Analysis
1. Definitions
→ Aggregate Demand (AD) → the total planned expenditure on domestically produced goods and services in an economy at different price levels over a given period
→ Aggregate Supply (AS) → the total quantity of goods and services that firms in an economy are willing and able to produce at different price levels over a given period
→ Real output → the quantity of goods and services produced in an economy, measured after removing the effect of changes in prices
→ Price level → the average level of prices of goods and services in an economy
→ Consumption (C) → expenditure by households on goods and services
→ Investment (I) → expenditure by firms on capital goods such as machinery, equipment and buildings
→ Government expenditure (G) → government spending on goods and services
→ Exports (X) → goods and services produced domestically but sold to other countries
→ Imports (M) → goods and services produced abroad and purchased by domestic consumers, firms or the government
→ Net exports (X − M) → the value of exports minus the value of imports
→ Short-run Aggregate Supply (SRAS) → the total quantity of goods and services firms are willing and able to supply at different price levels when some factors of production are fixed
→ Long-run Aggregate Supply (LRAS) → the total productive capacity of an economy when all factors of production can be adjusted
→ Aggregate demand equation → AD = C + I + G + (X − M)
→ Equilibrium → the point where planned aggregate expenditure equals aggregate output → AD = AS
→ Movement along a curve → caused by a change in the price level → movement to a different point on the same AD or AS curve
→ Shift of a curve → caused by a factor other than the price level → the entire AD or AS curve moves
2. Core Concepts
Aggregate Demand
→ AD represents the total spending on domestically produced goods and services
→ AD = C + I + G + (X − M)
→ C = Consumption → household spending
→ I = Investment → spending by firms on capital goods
→ G = Government expenditure → government spending on goods and services
→ X − M = Net exports → spending by foreigners on domestic output minus domestic spending on imports
→ Increase in C → AD increases → firms receive more orders → production increases → real output increases → employment is likely to increase
→ Increase in I → AD increases → firms increase demand for capital goods → production and employment increase → real output rises
→ Increase in G → AD increases → firms receive additional demand → production increases → real output rises
→ Increase in X → AD increases → foreign demand for domestic goods rises → production increases → real output rises
→ Increase in M → net exports fall → AD decreases → domestic demand for output falls → real output decreases
Determinants of AD
→ Consumer confidence → greater confidence → households spend more → C rises →
AD increases
→ Interest rates → lower interest rates → borrowing becomes cheaper → consumption and investment increase → AD increases
→ Income and wealth → higher disposable income or wealth → consumption increases → AD increases
→ Business confidence → greater confidence about future profitability → investment increases → AD increases
→ Government fiscal policy → higher government spending or lower taxation → AD increases
→ Exchange rate → depreciation → exports become relatively cheaper and imports more expensive → net exports may increase → AD increases
→ Overseas economic conditions → stronger economic growth abroad → demand for exports increases → AD increases
→ Inflation expectations → expectations of higher future prices may encourage consumers and firms to spend sooner → AD may increase
Shape of the AD Curve
→ AD curve is downward sloping
→ Movement down the AD curve → lower price level → higher quantity of real output demanded
→ Movement up the AD curve → higher price level → lower quantity of real output demanded
→ Lower price level → purchasing power of money balances increases → consumption may increase → AD rises
→ Lower domestic price level relative to other countries → exports become more competitive → net exports increase → quantity of real output demanded increases
→ Lower price level → reduces demand for money and may reduce interest rates → consumption and investment may increase
Aggregate Supply
→ AS represents the total quantity of goods and services firms are willing and able to produce at different price levels
→ SRAS is affected by the costs of production
→ LRAS represents the productive potential or capacity of the economy
Determinants of AS
→ Costs of raw materials → higher costs → profitability falls → firms reduce supply → AS decreases
→ Wage costs → higher wages → production costs increase → SRAS decreases
→ Productivity → higher productivity → more output can be produced from the same resources → AS increases
→ Technology → improved technology → efficiency and productive capacity increase → AS increases
→ Availability of labour → larger or more skilled workforce → productive capacity increases → LRAS increases
→ Capital stock → greater quantity and quality of capital → productive capacity increases → LRAS increases
→ Education and training → improves human capital → labour productivity increases → LRAS increases
→ Infrastructure → improved transport, communication and energy infrastructure → firms become more productive → LRAS increases
→ Natural resources → greater availability of resources → productive capacity may increase → LRAS increases
→ Government policies → supply-side policies can improve productivity and increase productive capacity → LRAS increases
Shape of SRAS
→ SRAS is upward sloping → alternatively represented as a sweeping curve
→ In the short run → some factors of production are fixed → firms face increasing costs as output expands
→ Increase in demand → firms increase production → greater use of resources → costs may rise → firms require a higher price level to supply additional output
Shape of LRAS
→ Classical LRAS → vertical line at the economy’s potential output
→ At full productive capacity → increases in AD mainly cause inflation rather than increases in real output
→ Three-section LRAS may also be used:
→ Highly elastic section → substantial spare capacity → increases in AD cause relatively large increases in real output with little increase in price level
→ Upward-sloping section → spare capacity is being reduced → increases in AD cause both real output and price level to increase
→ Vertical section → economy reaches full productive capacity → further increases in AD mainly increase the price level rather than real output
3. Diagrams — Explain, do NOT draw
AD/AS Equilibrium Diagram
→ Vertical axis → Price Level
→ Horizontal axis → Real Output
→ AD curve → downward sloping
→ SRAS curve → upward sloping
→ Equilibrium occurs where AD intersects SRAS
→ Equilibrium determines the economy’s price level and real output
→ The equilibrium level of real output also determines the level of employment → higher output generally requires more labour
Shift in AD
→ Increase in AD → AD curve shifts right
→ New equilibrium → higher real output and higher price level, assuming an upward-sloping SRAS
→ Decrease in AD → AD curve shifts left
→ New equilibrium → lower real output and lower price level
Shift in SRAS
→ Increase in SRAS → SRAS shifts right
→ Production becomes possible at lower costs → equilibrium real output increases → price level decreases
→ Decrease in SRAS → SRAS shifts left
→ Production costs increase → equilibrium real output decreases → price level increases
→ This combination of falling output and rising prices is known as stagflation
Shift in LRAS
→ Increase in LRAS → productive capacity increases → economy can produce more without generating the same inflationary pressure
→ LRAS shifts right → potential output increases
→ Decrease in LRAS → productive capacity falls → potential output decreases
4. Examples
→ Increase in government spending → G increases → AD increases → AD shifts right → real output and employment increase → price level may rise
→ Fall in interest rates → borrowing becomes cheaper → consumption and investment increase → AD increases → output and employment increase
→ Increase in oil prices → firms face higher production costs → SRAS decreases → price level rises while real output falls
→ Improved technology → productivity increases → firms can produce more efficiently → SRAS and potentially LRAS increase → output increases and inflationary pressure falls
→ Improved education and training → human capital increases → labour productivity increases → productive capacity increases → LRAS shifts right
→ Economic recession abroad → foreign demand falls → exports decrease → AD falls → domestic output and employment may decrease
5. Analysis
Effects of an Increase in AD
→ Increase in AD → firms experience higher demand for goods and services → inventories fall → firms increase production → real GDP increases
→ Higher production → firms require more workers → employment increases → unemployment decreases
→ Higher employment → household incomes increase → consumption may increase further → further increase in AD → multiplier effect
→ Increase in AD → greater demand for scarce resources → factor prices may rise → firms’ costs increase → price level rises
→ Therefore → an increase in AD can cause economic growth and inflation simultaneously
Effects of a Decrease in AD
→ Decrease in AD → firms receive fewer orders → production falls → real output decreases
→ Lower production → firms require fewer workers → employment falls → unemployment increases
→ Lower household incomes → consumption falls → AD may fall further → multiplier effect operates in reverse
→ Lower demand for resources → pressure on wages and other costs may decrease → price level may fall
Effects of an Increase in SRAS
→ Increase in SRAS → firms can produce at lower costs → greater quantity supplied at each price level
→ SRAS shifts right → equilibrium real output increases → employment increases
→ Greater supply → downward pressure on the price level → inflationary pressure decreases
→ Therefore → an increase in SRAS can produce economic growth with lower inflation
Effects of a Decrease in SRAS
→ Increase in production costs → firms reduce supply → SRAS shifts left
→ SRAS shifts left → equilibrium real output decreases → employment decreases
→ Reduced supply combined with unchanged AD → price level increases
→ Higher prices + lower output → stagflation
Employment
→ Increase in AD → higher output → firms need more workers → employment increases
→ Decrease in AD → lower output → firms need fewer workers → employment decreases
→ Increase in LRAS → greater productive capacity → sustainable output and employment can increase
→ However → an increase in output does not always produce proportional increases in employment → firms may use automation or increase productivity instead
6. Evaluation
→ Size of the spare capacity → when an economy has significant spare capacity → increase in AD is more likely to increase real output and employment → inflationary effect is relatively small
→ Near full employment → increase in AD is more likely to create inflationary pressure → real output may increase only slightly
→ Elasticity of SRAS → highly elastic SRAS → large increase in output with relatively small increase in price level → inelastic SRAS → greater inflationary pressure
→ Time period → short run → firms may increase output using existing resources → long run → constraints on labour and capital become more important
→ Size of the multiplier → larger multiplier → initial increase in AD produces a larger final increase in real output → depends on leakages such as saving, taxation and imports
→ Nature of the AD increase → if AD increases because of investment → long-run productive capacity may also increase → if caused mainly by consumption → long-run supply capacity may not increase
→ Supply-side conditions → strong productivity growth → economy can accommodate higher AD with less inflation → weak productivity growth → greater inflationary pressure
→ Government policy → expansionary fiscal or monetary policy may increase AD → but excessive demand stimulus can create inflation and external deficits
→ Level of economic development → developing economies may have greater unused resources → increases in AD may generate substantial increases in output → economies close to full capacity face greater inflationary pressure
→ Exchange rate effects → depreciation may increase AD through higher net exports → but imported raw materials become more expensive → SRAS may decrease → inflationary pressure may increase
→ Judgement → the effect of an AD or AS shift depends mainly on the economy’s spare capacity, the elasticity of SRAS, the size of the shift and the time period being considered → an increase in AD is more beneficial when there is substantial spare capacity, while increases in AS are generally more sustainable because they can raise real output without creating the same inflationary pressure
7. Exam Tip
→ For AD shifts, always identify the component changing → C, I, G or (X − M) → then build the chain → component changes → AD changes → output changes → employment changes → price level changes
→ For AS shifts, identify whether the change is caused by production costs (SRAS) or productive capacity (LRAS)
→ In evaluation questions → never simply state “it depends” → specify what it depends on and explain why → e.g. “The impact on inflation depends on spare capacity because an economy operating close to full employment has less scope to increase output.”