Aggregate Demand and Aggregate Supply Model

Overview

• The aggregate demand (AD) and aggregate supply (AS) model is a macroeconomic model that looks at the demand and supply of all goods in an economy.
• It helps understand economic fluctuations, causes of recession, and expansions.
• Economic fluctuations are irregular and unpredictable; most macro variables fluctuate together, and as output falls, unemployment rises.

Key Concepts

Economic Fluctuations

• Irregular and Unpredictable: Business cycles are not regular cycles like a sine wave.
• Macro Variables Fluctuate Together: Not necessarily in the same direction or amount but tend to move together.
• Output and Unemployment: As output (GDP) falls, unemployment rises.

Model Characteristics

• Type: Short-run model focusing on price level and real GDP.
• Variables: Divided into nominal and real; short-run interactions differ from the long run.

Aggregate Demand (AD)

• Downward Sloping Curve: Represents the total demand for all goods at different price levels.
  • Lower price levels increase overall demand; higher levels decrease demand.
• Components: Y = C + I + G + NX
  • Consumption (C), Investment (I), Government Spending (G), Net Exports (NX).
• Effects Influencing AD:
  • Wealth Effect: As prices fall, real wealth increases, boosting consumption.
  • Interest Rate Effect: Lower prices reduce money holding, lower interest rates, and increase investment.
  • Net Export Effect: Lower prices weaken the currency, boosting exports.
• Shifts in AD:
  • Consumption: Pessimism or optimism affects consumption.
  • Investment: Tech advancements or pessimism affect firm investments.
  • Government Spending: Directly shifts AD based on fiscal policy.
  • Net Exports: Affected by foreign economic conditions.

Aggregate Supply (AS)

Long-Run Aggregate Supply (LRAS)

• Vertical Curve: Reflects monetary neutrality; unrelated to price level.
• Determined by: Labor, capital, natural resources, technology.
• Shifts: Caused by changes in labor force, capital, resources, technology.

Short-Run Aggregate Supply (SRAS)

• Upward Sloping Curve: Indicates firms' responses to price level changes.
• Theories Explaining SRAS:
  • Sticky Wage Theory: Wages adjust slowly, affecting real wages.
  • Sticky Price Theory: Menu costs and slow price adjustments.
  • Misperceptions Theory: Firms misinterpret overall price changes.
• Shifts in SRAS:
  • Similar factors to LRAS plus changes in expected price levels.

Economic Fluctuations

Shifts in Aggregate Demand

• Decrease in AD: Leads to recession; government may counteract with fiscal/monetary policy.
• Increase in AD: Causes expansions; results in higher price levels.

Shifts in Aggregate Supply

• Adverse Supply Shock: Decreases SRAS, causing stagflation (inflation + stagnation).
• Government Response: Increase G or money supply, though it may cause further inflation.

Case Study: COVID-19 Pandemic

• Concurrent Shifts: Both AD and SRAS shifted left due to government restrictions.
• Outcome: Large decrease in GDP; recovery depends on lifting restrictions.

Conclusion

• The AD-AS model is vital for understanding macroeconomic conditions, recessions, and expansions.
• Future study will focus on the impact of monetary policy on the AD curve.