Aggregate demand and aggregate supply model

2.it’s used to illustrate
Assuming no other changes affect aggregate demand, the increase in government purchases shifts the aggregate demand curve by a multiplied amount of the initial increase in government purchases to AD2 in Figure 22.9 "An Increase in Government Purchases". Real GDP rises from Y1 to Y2, while the price level rises from P1 to P2. Notice that the increase in real GDP is less than it would have been if the price level had not risen.
Figure 22.9 An Increase in Government Purchases
An increase in government purchases boosts aggregate demand from AD1 to AD2. Short-run equilibrium is at the intersection of AD2 and the short-run aggregate supply curve SRAS1. The price level rises to P2 and real GDP rises to Y2.
In contrast, a reduction in government purchases would reduce aggregate demand. The aggregate demand curve shifts to the left, putting pressure on both the price level and real GDP to fall.
In the short run, real GDP and the price level are determined by the intersection of the aggregate demand and short-run aggregate supply curves. Recall, however, that the short run is a period in which sticky prices may prevent the economy from reaching its natural level of employment and potential output. In the next section, we will see how the model adjusts to move the economy to long-run equilibrium and what, if anything, can be done to steer the economy toward the natural level of employment and potential output.
KEY TAKEAWAYS
The short run in macroeconomics is a period in which wages and some other prices are sticky. The long run is a period in which full wage and price flexibility, and market adjustment, has been achieved, so that the economy is at the natural level of employment and potential output.
The long-run aggregate supply curve is a vertical line at the potential level of output. The intersection of the economy’s aggregate demand and long-run aggregate supply curves determines its equilibrium real GDP and price level in the long run.
The short-run aggregate supply curve is an upward-sloping curve that shows the quantity of total output that will be produced at each price level in the short run. Wage and price stickiness account for the short-run aggregate supply curve’s upward slope.
Changes in prices of factors of production shift the short-run aggregate supply curve. In addition, changes in the capital stock, the stock of natural resources, and the level of technology can also cause the short-run aggregate supply curve to shift.
In the short run, the equilibrium price level and the equilibrium level of total output are determined by the intersection of the aggregate demand and the short-run aggregate supply curves. In the short run, output can be either below or above potential output.
TRY IT!
The tools we have covered in this section can be used to understand the Great Depression of the 1930s. We know that investment and consumption began falling in late 1929. The reductions were reinforced by plunges in net exports and government purchases over the next four years. In addition, nominal wages plunged 26% between 1929 and 1933. We also know that real GDP in 1933 was 30% below real GDP in 1929. Use the tools of aggregate demand and short-run aggregate supply to graph and explain what happened to the economy between 1929 and 1933.
Case in Point: The U.S. Recession of 2001
What were the causes of the U.S. recession of 2001? Economist Kevin Kliesen of the Federal Reserve Bank of St. Louis points to four factors that, taken together, shifted the aggregate demand curve to the left and kept it there for a long enough period to keep real GDP falling for about nine months. They were the fall in stock market prices, the decrease in business investment both for computers and software and in structures, the decline in the real value of exports, and the aftermath of 9/11. Notable exceptions to this list of culprits were the behavior of consumer spending during the period and new residential housing, which falls into the investment category.
During the expansion in the late 1990s, a surging stock market probably made it easier for firms to raise funding for investment in both structures and information technology. Even though the stock market bubble burst well before the actual recession, the continuation of projects already underway delayed the decline in the investment component of GDP. Also, spending for information technology was probably prolonged as firms dealt with Y2K computing issues, that is, computer problems associated with the change in the date from 1999 to 2000. Most computers used only two digits to indicate the year, and when the year changed from ’99 to ’00, computers did not know how to interpret the change, and extensive reprogramming of computers was required.
Real exports fell during the recession because (1) the dollar was strong during the period and (2) real GDP growth in the rest of the world fell almost 5% from 2000 to 2001.
Then, the terrorist attacks of 9/11, which literally shut down transportation and financial markets for several days, may have prolonged these negative tendencies just long enough to turn what might otherwise have been a mild decline into enough of a downtown to qualify the period as a recession.
During this period the measured price level was essentially stable—with the implicit price deflator rising by less than 1%. Thus, while the aggregate demand curve shifted left as a result of all the reasons given above, there was also a leftward shift in the short-run aggregate supply curve.
Source: Kevin L. Kliesen, “The 2001 Recession: How Was It Different and What Developments May Have Caused It?,” The Federal Reserve Bank of St. Louis Review, September/October 2003, 23–37.
ANSWER TO TRY IT! PROBLEM
All components of aggregate demand (consumption, investment, government purchases, and net exports) declined between 1929 and 1933. Thus the aggregate demand curve shifted markedly to the left, moving from AD1929 to AD1933. The reduction in nominal wages corresponds to an increase in short-run aggregate supply from SRAS1929 to SRAS1933. Since real GDP in 1933 was less than real GDP in 1929, we know that the movement in the aggregate demand curve was greater than that of the short-run aggregate supply curve.
Previous Section
Aggregate Demand and Supply: This graph demonstrates the basic relationship between aggregate demand and aggregate supply. The aggregate demand curve is derived via the consumption, investment, government spending, and net export.
The Role of Debt
Many societies have increasingly adopted debt and credit as an integral part of their economic system. This has justified the incorporation of debt (also called the credit impulse) into the larger framework of aggregate demand. From a quantitative perspective this is simply expressed as: Spending = Income + Net Increase in Debt. Spending capital prior to the receipt of capital is an important consideration at both the consumer level and the government level (deficit spending).
The Aggregation Problem
There are some limitations to the aggregation perspective, generally summarized as the aggregation problem. The difficulty arises in treating all consumer preferences (and thus their respective demands) as homogeneous and continuous. As the numbers of consumers, the tastes of consumers and the distribution levels of incomes will alter, so too will the demand curve. This can create inaccurate assumptions in AD inputs. Simply, there is some loss of accuracy in combining such a diverse array of economic inputs.
The Slope of the Aggregate Demand Curve
Due to Pigou's Wealth Effect, the Keynes' Interest Rate Effect, and the Mundell-Fleming Exchange Rate Effect, the AD curve slopes downward.
Learning Objectives
Explain the factors that influence the slope of the aggregate demand curve
Key Takeaways
Key Points
Pigou's Wealth Effect, the Keynes' Interest Rate Effect, and the Mundell-Fleming Exchange Rate Effect are all theoretical inputs that reaffirm a downwards slope for aggregate demand (AD).
The critical takeaway from Keynes's perspective on the slope of the aggregate demand curve is that interest rates affect expenditures more than they affect savings. As a result, insufficient AD is not sustainable in a given system.
The simplest way to put to wealth effect is that an increase in spending will denote an increase in wealth.
Robert Mundell and Marcus Fleming noted that incorporating the nominal exchange rate into the mix makes it impossible to maintain free capital movement, a fixed exchange rate and independent monetary policy.
While these varying effects make the concept of aggregate demand slopes seem somewhat complicated, the most important thing to keep in mind is that people will be demanding more goods when they are cheaper.
Aggregate demand is a pivotal idea of macroeconomics that simply represents the total demand for all goods and services in an economy. To unpack this concept, we will delve into its definition, dissect the formula that calculates it, and reveal the components that collectively form aggregate demand. Prepare to see economics in action as we explore this cornerstone of macroeconomic theory, which offers a robust framework to understand market dynamics at a national level.
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What is the aggregate demand?
Aggregate demand represents the total amount of goods and services that households, businesses, and the government are willing and able to purchase at different price levels. It reflects the overall demand in the economy and influences the level of economic activity. When aggregate demand is high, it stimulates production and economic growth, while a decrease in aggregate demand can lead to a contraction in output and economic slowdown.
Aggregate Demand Definition
Aggregate demand is defined as follows:
Aggregate demand is the total expenditure on goods and services within an economy encompassing consumption by households, investment by businesses, government spending, and net exports (exports minus imports).
Suppose there is an economic downturn, and households become cautious about spending due to concerns about the future. As a result, consumer confidence decreases, leading to a decline in consumer spending on goods and services. Simultaneously, businesses become hesitant to invest in new projects due to the uncertain economic environment. With lower consumer spending and reduced investment, aggregate demand decreases. As a consequence, businesses may experience a decline in sales, leading to reduced production, layoffs, and an overall slowdown in the economy.
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What is the aggregate demand formula?
The four main sources of spending in aggregate demand originate from different sectors of the economy. These are households, firms, the government, and exports and imports. We represent these sectors in an equation known as the aggregate demand (AD) equation:
What are the components of aggregate demand.