Aggregate Demand and Aggregate Supply: An In-Depth Analysis
- Excel in Economics
- Nov 28, 2024
- 6 min read
Updated: 5 hours ago
Aggregate Demand (AD) and Aggregate Supply (AS) are foundational concepts in macroeconomics, providing a framework for understanding the interplay between total demand and supply in an economy. These models help analyze economic fluctuations, price levels, and employment.
Whether you're studying IB, IGCSE, or A-Level Economics, mastering AD and AS is crucial for explaining macroeconomic phenomena.
This guide offers a comprehensive overview of AD and AS concepts, including their components, determinants, curve shapes, and how shifts impact economic equilibrium.
Aggregate Demand (AD)
1.1 Definition
Aggregate Demand is the total spending on goods and services in an economy at a given price level over a specific period.
1.2 Components of Aggregate Demand
AD is represented by the equation:
AD = C + I + G + (X - M)
C (Consumption): Household spending on goods and services.
I (Investment): Spending by firms on capital goods.
G (Government Spending): Expenditures on public goods and services.
X (Exports): Revenue from selling goods abroad.
M (Imports): Spending on foreign goods (subtracted from AD).
Example:
If an economy has consumption of $500B, investment of $200B, government spending of $300B, exports of $150B, and imports of $100B, then:
AD = $500B + $200B + $300B + ($150B - $100B) = $1,050B.
1.3 Determinants of Aggregate Demand
Income Levels: Higher income boosts consumption and AD.
Interest Rates: Lower rates reduce borrowing costs, increasing consumption and investment.
Government Policies: Fiscal spending raises AD.
Exchange Rates: A weaker currency makes exports cheaper, boosting AD.
Consumer Confidence: Optimistic households spend more, increasing AD.
1.4 Shape of the Aggregate Demand Curve
Downward Sloping: AD decreases as the price level rises due to:
Real Balance Effect: Higher prices erode purchasing power.
Interest Rate Effect: Higher prices increase borrowing costs, reducing spending.
Net Export Effect: Higher prices make domestic goods less competitive internationally.
The graph on the left illustrates the demand for new cars in the United States, while the one on the right represents aggregate demand for all goods and services produced nationwide.
Note that:
The aggregate demand (AD) curve shows the total quantity of goods and services demanded in the U.S., measured in real GDP.
The demand curve for cars represents the quantity demanded in a single industry.
For the AD curve, the quantity of output demanded is measured against the general price level in the U.S., which is typically tracked by a price index (such as the Consumer Price Index or the GDP deflator).
For the car demand curve, the quantity of cars demanded is measured against the price of cars.
Aggregate demand encompasses every industry in the United States.
The demand shown on the left focuses solely on one specific industry—new cars.
1.5 Causes of Shifts in the Aggregate Demand Curve
Rightward Shift: Increase in any AD component (e.g., higher government spending).
Leftward Shift: Decrease in any AD component (e.g., reduced exports due to global recession).
Example:
A government stimulus package increases public spending, shifting AD rightward and boosting economic activity
Assume a nation’s economy begins at AD1:
An increase in household consumption, business investment, government spending, or net exports will cause AD to increase to AD2. More output (Y2) is demanded at the original price level of PL1.
A decrease in any of the four expenditures will cause AD to decrease to AD3. Less output (Y3) is demanded at the original price level of PL1.
Aggregate Supply (AS)
2.1 Definition
Aggregate Supply represents the total output of goods and services that firms in an economy are willing to produce at a given price level over a specific period.
2.2 Determinants of Aggregate Supply
Input Costs: Changes in wages or raw material prices.
Productivity: Technological advancements or workforce efficiency.
Taxes and Subsidies: Impact production costs.
Exchange Rates: Affect import costs of raw materials.
2.3 Shape of the Aggregate Supply Curve
Short-Run AS (SRAS): Upward sloping due to price flexibility.
In the short run, higher prices incentivize firms to increase output.
Long-Run AS (LRAS):
Classical Model: Vertical, representing full employment output
The Keynesian model of aggregate supply
proposed by Depression-era economist John Maynard Keynes, is horizontal (perfectly elastic) below full employment but vertical (perfectly inelastic) beyond full employment.
Keynesian Model: Three segments:
Highly elastic (spare capacity).
Upward sloping (reduced spare capacity).
Vertical (full employment).
In the Keynesian model, the three sections (1, 2, and 3) can be described as follows:Â
Section 1:Â The economy has significant spare capacity. Unemployment is high, and there is plenty of unused land, capital, and labor. Output increases (from Y1 to Y2) occur with minimal inflation (P1 to P2).Â
Section 2:Â The economy is nearing full capacity. Unemployment is low, and land and capital are becoming scarce. Further output increases (from Y2 to Yfe) lead to rising prices as demand for resources exceeds supply, resulting in higher inflation (from P2 to Pfe).Â
Section 3: The economy surpasses its full employment output level. Unemployment is very low, and there is little to no spare capacity in the economy. All factories and productive land are in use. Further output increases (Yfe to Y3) lead only to runaway inflation (Pfe to P3).
In our upcoming units, we will primarily analyze national output and price determination using the SRAS and LRASÂ models. However, much of the analysis and theory can also be explored and applied using the Keynesian model of aggregate supply.
2.4 Causes of Shifts in the Aggregate Supply Curve
Short-Run (SRAS):
Rightward shift: Reduced input costs (e.g., falling oil prices).
Leftward shift: Increased input costs (e.g., wage inflation).
Long-Run (LRAS):
Rightward shift: Technological improvements, better education, or increased labor force.
Leftward shift: Natural disasters, loss of resources.
Example:
A technological breakthrough improves productivity, shifting LRAS rightward and increasing potential output.
A nation’s LRAS curve corresponds with its production possibilities curve (PPC). Both show the potential level of output a country can sustain in the long run, assuming resources are fully employed in the economy.
The PPC on the right corresponds with the LRAS on the left.Â
At Y1 the economy has a negative output gap. It is producing below full employment and inside its PPC.Â
At Y2 the economy has a positive output gap. It is producing beyond full employment and outside its PPC.Â
In the long run, the economy is producing at full employment output and on its PPC. Output always returns to full employment (and to the PPC) in the long run because wages and other input costs adjust to the price level until resources are fully employed.
A change in the factors of production of a nation will shift its LRAS, causing either economic growth or contraction in the nation. Shifts in the LRAS correspond with shifts in the PPC.
Factors that can cause a shift in a nation’s LRAS include (quantity and quality of FOP/resources):Â
Changes in population (more workers lead to greater potential output, fewer workers lead to less potential output)Â
Changes in technology (new technologies increase potential output)Â
Increased trade (more imported resources increase potential output)Â
Improvements in human capital (better educated or skilled workers increase potential output)
In the Keynesian AS model, a change in any of the factors above will likewise cause an outward shift in aggregate supply and an increase in a country’s actual and potential output.
Interaction Between Aggregate Demand and Aggregate Supply
3.1 Movement vs. Shift
Movement Along: Caused by changes in price level.
Example: A price drop increases quantity demanded along the AD curve.
Shift: Caused by changes in non-price factors.
Example: Higher government spending shifts AD outward.
3.2 Equilibrium in the AD/AS Model
Equilibrium occurs where the AD and AS curves intersect, determining:
Real Output: Total economic output.
Price Level: Overall price of goods and services.
Employment: Level of labor utilization.
3.3 Effects of Shifts in AD and AS
AD Shift:
Rightward shift increases output, price level, and employment (demand-pull inflation).
Leftward shift decreases output, price level, and employment (recession).
AS Shift:
Rightward shift increases output and reduces price level (economic growth).
Leftward shift reduces output and raises price level (cost-push inflation).
Example:
A supply chain disruption increases production costs, shifting SRAS leftward, raising prices, and reducing output.
Applications of AD/AS Analysis
Policy Formulation:
Governments use AD/AS models to design fiscal and monetary policies for economic stabilization.
Inflation Control:
Central banks adjust interest rates to influence AD.
Economic Growth:
Long-term policies target LRAS shifts through investments in infrastructure and education.
Exam Tip
Always include well-labeled diagrams for AD and AS shifts, showing effects on price levels and output.
Clearly differentiate between short-run and long-run AS impacts.
Use real-world examples for policy applications.
Conclusion
Aggregate Demand and Aggregate Supply analysis is critical for understanding economic performance, price stability, and employment levels. By mastering the components, determinants, and interactions of AD and AS, you’ll be well-equipped to evaluate macroeconomic dynamics and policy outcomes.
Practice Questions: Aggregate Demand and Supply
Define Aggregate Demand and explain its components with examples.
Describe the difference between short-run and long-run Aggregate Supply curves.
Illustrate and explain the effects of a rightward shift in Aggregate Demand on the price level and output.
Evaluate the impact of a supply shock, such as rising oil prices, on the SRAS curve.
Discuss the role of AD/AS analysis in designing government fiscal policies during a recession.