Intermediate Macroeconomic Theory

🥨Intermediate Macroeconomic Theory Unit 7 – Aggregate Demand & Supply Analysis

Aggregate demand and supply analysis forms the backbone of macroeconomic theory. This model examines how total spending and production in an economy interact to determine output and price levels. It provides a framework for understanding economic fluctuations and the impacts of various policies. The AD-AS model consists of aggregate demand, short-run aggregate supply, and long-run aggregate supply curves. By analyzing shifts in these curves, economists can explain changes in GDP, employment, and inflation, as well as evaluate the effectiveness of fiscal and monetary policies.

Key Concepts

  • Aggregate demand (AD) represents the total demand for goods and services in an economy at various price levels
  • Aggregate supply (AS) represents the total supply of goods and services in an economy at various price levels
    • Short-run aggregate supply (SRAS) assumes that some input prices are fixed, while others can vary
    • Long-run aggregate supply (LRAS) assumes that all input prices are flexible and the economy operates at full employment
  • Equilibrium occurs when AD intersects with AS, determining the economy's price level and real GDP
  • Economic fluctuations can be caused by shifts in either the AD or AS curves
  • Fiscal and monetary policies can be used to influence AD and stabilize the economy
  • The AD-AS model helps analyze the effects of various economic shocks and policies on output and prices
  • The model assumes a closed economy, where exports and imports are not considered

Components of Aggregate Demand

  • Consumption (C) includes spending by households on goods and services (food, clothing, entertainment)
  • Investment (I) consists of spending by businesses on capital goods (machinery, equipment, construction)
    • Residential investment includes the construction of new homes and apartments
    • Non-residential investment includes the purchase of new factories, office buildings, and other structures
  • Government spending (G) encompasses expenditures by federal, state, and local governments on goods and services (infrastructure, defense, education)
  • Net exports (NX) represent the difference between exports and imports
    • Exports are goods and services produced domestically but sold abroad
    • Imports are goods and services produced abroad but purchased domestically
  • The AD curve slopes downward due to the wealth effect, interest rate effect, and exchange rate effect

Aggregate Supply: Short-Run vs. Long-Run

  • Short-run aggregate supply (SRAS) is upward sloping due to sticky prices and wages
    • Some input prices are fixed in the short run, while others can vary
    • Firms respond to higher prices by increasing output, as they can earn higher profits
  • Long-run aggregate supply (LRAS) is vertical at the full-employment level of output
    • All input prices are flexible in the long run, and the economy operates at its potential
    • Changes in the price level do not affect real GDP in the long run
  • The SRAS curve shifts due to changes in input prices (wages, raw materials) or productivity
  • The LRAS curve shifts due to changes in factors affecting long-run economic growth (technology, labor force, capital stock)

Equilibrium and Economic Fluctuations

  • Equilibrium occurs when the quantity of goods and services demanded equals the quantity supplied
    • The intersection of the AD and AS curves determines the equilibrium price level and real GDP
  • Short-run equilibrium occurs when the AD curve intersects the SRAS curve
    • This equilibrium may not be at the full-employment level of output
  • Long-run equilibrium occurs when the AD curve intersects both the SRAS and LRAS curves
    • This equilibrium is at the full-employment level of output
  • Economic fluctuations can be caused by shifts in either the AD or AS curves
    • A shift in the AD curve leads to a movement along the AS curve, affecting both output and prices
    • A shift in the AS curve leads to a movement along the AD curve, affecting both output and prices

Shifts in AD and AS Curves

  • The AD curve shifts due to changes in the components of aggregate demand (C, I, G, NX)
    • Factors that can shift AD include changes in consumer confidence, interest rates, government spending, and exchange rates
  • The SRAS curve shifts due to changes in input prices or productivity
    • An increase in input prices (oil prices) shifts the SRAS curve to the left, while a decrease shifts it to the right
    • Improvements in productivity shift the SRAS curve to the right, as more output can be produced at each price level
  • The LRAS curve shifts due to changes in factors affecting long-run economic growth
    • An increase in the labor force, capital stock, or technological progress shifts the LRAS curve to the right
  • Shifts in the AD and AS curves can lead to changes in the equilibrium price level and real GDP

Policy Implications

  • Fiscal policy involves changes in government spending and taxation to influence AD
    • Expansionary fiscal policy (increased spending or reduced taxes) shifts the AD curve to the right, increasing output and prices
    • Contractionary fiscal policy (decreased spending or increased taxes) shifts the AD curve to the left, decreasing output and prices
  • Monetary policy involves changes in the money supply and interest rates to influence AD
    • Expansionary monetary policy (increased money supply or lower interest rates) shifts the AD curve to the right, increasing output and prices
    • Contractionary monetary policy (decreased money supply or higher interest rates) shifts the AD curve to the left, decreasing output and prices
  • Supply-side policies aim to increase LRAS by improving productivity and efficiency
    • Examples include tax reforms, deregulation, and investments in education and infrastructure

Real-World Applications

  • The Great Recession (2007-2009) can be analyzed using the AD-AS model
    • The financial crisis led to a decrease in consumption and investment, shifting the AD curve to the left
    • The resulting decrease in output and employment represented a movement along the SRAS curve
  • The COVID-19 pandemic (2020) caused both demand and supply shocks
    • Lockdowns and reduced consumer spending shifted the AD curve to the left
    • Supply chain disruptions and business closures shifted the SRAS curve to the left
  • The AD-AS model can be used to analyze the effects of oil price shocks
    • An increase in oil prices shifts the SRAS curve to the left, leading to higher prices and lower output
    • The magnitude of the impact depends on the economy's dependence on oil and the response of AD

Common Pitfalls and Misconceptions

  • Confusing the short run and long run
    • In the short run, both output and prices can change due to shifts in AD or SRAS
    • In the long run, only the price level changes, while output remains at the full-employment level
  • Assuming that the economy always operates at full employment
    • The economy can be in equilibrium at any point along the SRAS curve, not just at the intersection with LRAS
  • Ignoring the role of expectations
    • Expectations about future inflation and economic conditions can influence current spending and investment decisions
  • Overlooking the importance of supply-side factors
    • While AD is important, long-run economic growth ultimately depends on factors affecting LRAS (productivity, technology, labor force)
  • Misinterpreting the shape of the LRAS curve
    • The LRAS curve is vertical, not upward sloping, as changes in the price level do not affect real GDP in the long run


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© 2024 Fiveable Inc. All rights reserved.
AP® and SAT® are trademarks registered by the College Board, which is not affiliated with, and does not endorse this website.