Aggregate Demand and Aggregate Supply

TL;DR

Aggregate Demand (AD) represents the total spending on goods and services in an economy at different price levels, while Aggregate Supply (AS) shows the total output firms are willing to produce. Their intersection determines an economy's equilibrium price level and real GDP. Shifts in either curve cause changes in economic output, employment, and inflation.

1. The Mental Model

Think of AD and AS as the "whole economy" versions of supply and demand curves you've seen for individual products. Instead of just apples, we're talking about everything produced and consumed in a country.

2. The Core Material

Aggregate Demand (AD) and Aggregate Supply (AS) are fundamental concepts in macroeconomics. They help us understand how an economy determines its overall price level and the total quantity of goods and services produced (real GDP).

2.1 Aggregate Demand (AD)

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Aggregate Demand is the total quantity of goods and services demanded by households, firms, the government, and foreign buyers at different price levels. It's an inverse relationship: as the overall price level rises, the quantity of goods and services demanded generally falls. This isn't just because individual items cost more, but due to three main effects:

• Wealth Effect: A higher price level reduces the real value (purchasing power) of your money. If your money buys less, you feel poorer and tend to spend less.
• Interest Rate Effect: A higher price level means you need more money to buy the same things. This increases the demand for money, pushing up interest rates. Higher interest rates make borrowing more expensive, which reduces investment (by firms) and consumption (by households for big purchases like cars or houses).
• Exchange Rate Effect: If domestic prices rise, domestic goods become relatively more expensive than foreign goods. This discourages exports and encourages imports, reducing net exports (a component of AD).

The AD curve slopes downward.

Shifters of AD: Changes in any of the components of GDP (Consumption, Investment, Government Spending, Net Exports) not caused by a change in the price level will shift the AD curve.
* Consumption (C): Consumer confidence, taxes, wealth (e.g., stock market boom).
* Investment (I): Business confidence, interest rates (excluding those caused by price level changes), technology, corporate taxes.
* Government Spending (G): Government policies (e.g., new infrastructure projects).
* Net Exports (NX): Foreign income, exchange rates (excluding those caused by price level changes), trade policies.

2.2 Aggregate Supply (AS)

Photo by Volker Braun on Pexels

Aggregate Supply is the total quantity of goods and services that firms are willing and able to produce at different price levels. It's usually depicted with two main segments:

• Short-Run Aggregate Supply (SRAS): This curve shows a positive relationship between the price level and the quantity of output supplied. In the short run, some input prices (like wages) are "sticky" or don't adjust immediately to changes in the price level. So, if output prices rise but input costs stay the same, firms' profits increase, incentivizing them to produce more.
• Long-Run Aggregate Supply (LRAS): This curve is vertical at the economy's potential output or full-employment output. In the long run, all input prices are flexible and will adjust to the overall price level. This means the total amount an economy can produce depends on its resources (labor, capital, technology), not on the price level. At full employment, the economy is producing all it can with its existing resources, regardless of prices.

Shifters of AS:
* Changes in Input Prices: Wages, raw materials (e.g., oil prices), imported resources. An increase in input prices shifts SRAS left; a decrease shifts it right.
* Productivity: Technology, education/training of workers. Increased productivity shifts both SRAS and LRAS right.
* Government Policies: Taxes on businesses, regulations, subsidies. These can affect firms' costs and incentives.
* Quantity/Quality of Resources: Labor force size, capital stock, natural resources. These primarily shift LRAS (and thus SRAS).

graph TD
    A["Factors Shifting AD/AS"] --> B{Aggregate Demand (AD)};
    A --> C{Aggregate Supply (AS)};

    B -- Shifts Right --> D["Increase in C, I, G, or NX"];
    B -- Shifts Left --> E["Decrease in C, I, G, or NX"];

    C -- SRAS Shifts Right --> F["Decrease in Input Costs, Increase in Productivity"];
    C -- SRAS Shifts Left --> G["Increase in Input Costs, Decrease in Productivity"];
    C -- LRAS Shifts Right --> H["Increase in Resources (Labor, Capital), Technology"];
    C -- LRAS Shifts Left --> I["Decrease in Resources, Technology (rare)"];

    D --> J["Higher Price Level, Higher Real GDP"];
    E --> K["Lower Price Level, Lower Real GDP"];
    F --> L["Lower Price Level, Higher Real GDP"];
    G --> M["Higher Price Level, Lower Real GDP"];
    H --> N["Lower Price Level (long run), Higher Real GDP (long run)"];
    I --> O["Higher Price Level (long run), Lower Real GDP (long run)"];

2.3 Equilibrium

The intersection of the AD and AS curves determines the economy's equilibrium price level and equilibrium real GDP.
* Short-Run Equilibrium: Where AD intersects SRAS. This is where the quantity of output demanded equals the quantity of output supplied at a specific price level.
* Long-Run Equilibrium: Where AD, SRAS, and LRAS all intersect at the same point. This means the economy is operating at its potential output with full employment.

What happens when AD or AS shifts?
* AD Increases: Price level rises, real GDP rises (in the short run).
* AD Decreases: Price level falls, real GDP falls (in the short run).
* SRAS Increases: Price level falls, real GDP rises.
* SRAS Decreases: Price level rises, real GDP falls (stagflation).

3. Worked Example

Imagine an economy is in long-run equilibrium. Now, let's say there's a significant increase in consumer confidence due to positive news about job growth and incomes.

1. Initial State: Economy is at long-run equilibrium, where AD1, SRAS1, and LRAS all intersect at P1 (price level) and Yp (potential GDP).
2. The Change: Increased consumer confidence leads to an increase in consumption (C). Since C is a component of Aggregate Demand and the change isn't due to the price level, the AD curve shifts to the right, from AD1 to AD2.
3. Short-Run Impact: The new short-run equilibrium is where AD2 intersects SRAS1. At this point, the price level (P2) is higher than P1, and real GDP (Y2) is higher than Yp. The economy is now operating above its potential output, likely leading to lower unemployment and upward pressure on wages and other input costs.
4. Long-Run Adjustment: Because real GDP (Y2) is above potential (Yp), there's an inflationary gap. Wages and other input costs will eventually rise to reflect the higher price level. As input costs increase, firms' profits decrease at any given price level, causing the SRAS curve to shift left, from SRAS1 to SRAS2.
5. New Long-Run Equilibrium: The economy eventually settles at a new long-run equilibrium where AD2 intersects SRAS2 and LRAS. At this point, the price level (P3) is even higher than P2, but real GDP has returned to Yp (potential output).

Outcome: In the short run, increased consumer confidence leads to higher prices and higher output. In the long run, the economy returns to its potential output, but at a permanently higher price level.

4. Key Takeaways

• Aggregate Demand (AD) shows total spending at different price levels, mainly influenced by consumer, business, government, and foreign spending.
• Aggregate Supply (AS) shows total output produced, with SRAS showing a positive relationship and LRAS being vertical at potential output.
• Changes in wealth, interest rates, and exchange rates explain the downward slope of the AD curve.
• Shifts in AD or AS cause changes in the equilibrium price level and real GDP.
• Increases in input prices shift SRAS left, while technological advances shift both SRAS and LRAS right.
• In the long run, an economy always tends to return to its potential output, primarily through adjustments in the SRAS curve.
• Demand-side policies (like fiscal or monetary policy) primarily affect AD, while supply-side policies focus on AS.

Common Mistakes to Avoid:
- Confusing a movement along the AD/AS curve (due to price level changes) with a shift of the curve (due to other factors).
- Forgetting the difference between short-run (sticky wages/prices) and long-run (flexible wages/prices) aggregate supply.
- Assuming that changes in real GDP from AD/AS shifts are permanent; the long-run always tends back to potential output.
- Not understanding that a shift in AD affects output in the short run but mainly the price level in the long run.
- Mixing up microeconomic supply/demand shifters with macroeconomic AD/AS shifters.

5. Now Try It

Think about a scenario where there's a widespread increase in global oil prices. Using the AD-AS model, draw the initial long-run equilibrium, then show the short-run impact of the oil price increase, and finally, illustrate how the economy would adjust in the long run (assuming no government intervention). What happens to the price level and real GDP in the short run and the long run? What would unemployment look like in the short run?