Macroeconomics

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Aggregate Demand and Aggregate Supply

The Aggregate Demand Curve

The downward–sloping aggregate demand (AD) curve shows how changes in the price level lead to changes in the economy’s aggregate expenditures. AD = aggregate expenditures = C + I + G + (X–M)
Reasons that a decrease in the price level leads to an increase in aggregate expenditures:
1. Wealth effect: As the price level falls, the real wealth people hold increases and they can consume more.
2. Interest rate effect: A decrease in the price level leads to decreased interest rates, which increases investment expenditures (because it increases the real money supply).
3. International effect: A decrease in the price level leads domestic goods to be cheaper relative to foreign goods, which leads exports to rise and imports to fall, which increases net exports.
4. Multiplier effect: A multiplier effect amplifies the initial changes in expenditures caused by the above effects, which further flattens the AD curve.
The AD curve can be shifted by anything that affects aggregate expenditures, except for changes in the price level.

The Aggregate Supply Curve

The aggregate supply (AS) curve specifies how shifts in aggregate demand affect the price level and real output.
It is upward sloping, as higher price levels prompt businesses to produce more goods.
The AS curve shifts up (down) when firms begin adjusting their prices upward (downward) over a longer horizon; this can be due to changes in input prices (including wages) and changes in productivity.

The Potential Output Curve

The potential output curve shows the amount of goods that can be produced when both capital and labor are employed at their target levels.
It is vertical because changes in the price level are not thought to cause changes to the available economic resources.

Long-Run Equilibrium in the Macroeconomy

In the long run, output is fixed to the potential output level, and the price level is flexible to obtain the equilibrium at potential output.
Increases (decreases) in AD lead to lower (higher) price levels.

Aggregate Supply and Aggregate Demand

FIGURE 5 The long-run equilibrium in the aggregate supply (AS) and aggregate demand (AD) model occurs where the AS and AD curves intersect with the potential output curve.

Short-Run Equilibrium in the Macroeconomy

Inflationary Gap in the AS/AD Model

FIGURE 6 An inflationary gap occurs in the AS/AD model when AD intersects with AS to the right of the potential output curve. At this short-run equilibrium between AS and AD, there is upward pressure on the price level as the economy is producing above its potential and unemployment is low. If AD does not shift, then in the long run the AS curve will shift upward to achieve the long-run equilibrium in which AD, AS, and potential output all intersect.

The short-run equilibrium is where the AS and AD curves intersect.
Increases (decreases) in AD lead to a higher (lower) output; if AS shifts upward, the increases (decreases) in AD lead to higher (lower) price levels, otherwise prices do not change in the short run.
Inflationary (recessionary) gaps occur when this short-run equilibrium has output above (below) the potential output level. If AD does not change, then over the long run the AS curve will shift upward (downward) to eliminate the gap.
1. Economies can operate at above-potential output for brief periods of time if resources are over-utilized (employees are forced to work extra overtime, for example).