Aggregate Demand & Supply

From Micro to Macro

Now, Aggregate Demand and Supply and how the entire economy arrives at its price level and production using AD, SRAS and LRAS. We're moving from individual markets to the entire economy. In the fourth quarter of 2007, the real Gross Domestic Product of the United States was $15.6 trillion, but by the second quarter of 2009 it had fallen to $14.4 trillion; a drop of almost 8%. Unemployment reached 10%. The housing market collapsed first, then problems extended to banks, car makers, stores, and the budgets of state governments. One area of the economy dragged all the others down.

The AD/AS model is designed to analyze widespread economic problems like that. You're now looking at the total amount produced and the overall price level together. The axes on the graph are different from what you're used to in microeconomics. The price level (PL) is on the vertical axis and it's the average of all prices in the economy, measured using something like the Consumer Price Index or the GDP deflator - not the price of a single item. Real GDP (Y) is on the horizontal axis and is the total amount of production with the effects of inflation removed.

You use this to work out what's happening in recessions, explain inflation, and work out if government spending or interest rate changes are helping or actually making things worse.

Aggregate Demand

Aggregate Demand (AD) is the total of all spending. People buy food, businesses buy machinery, the government builds roads and funds schools, and people in other countries buy US soybeans and computer programs. Added together, this is aggregate demand, or C + I + G + (X - M).

The AD curve goes downwards and there are three reasons for this.

The wealth effect says that as the price level rises, the value of people's savings goes down. If a household has $50,000 in the bank, they feel less wealthy when everything is more expensive, and they will spend less.

The interest rate effect: a higher price level means people need more money to buy the same things, so the demand for money goes up and interest rates increase. Higher interest rates discourage investment by businesses and big purchases like homes, cars and appliances.

The exchange rate effect: if prices in the US go up, American goods become more expensive for people in other countries, reducing exports, while imports become relatively cheaper. This lowers net exports.

What causes the entire AD curve to shift? Changes in how confident people are about the future, government spending, taxes, decisions by the Federal Reserve about interest rates, and changes in the economies of other countries. In March 2020, the Federal Reserve lowered interest rates to almost zero, and this strongly moved the AD curve to the right. A tax increase would shift AD to the left. As the European economy improved during 2017, US exports increased and AD shifted to the right.

Short-Run Aggregate Supply

Imagine a factory owner in 2021. Her selling prices are going up, but the pay for her employees is set by agreements made six months before. Because of this, each thing she sells now makes her a bigger profit than she'd planned, so she starts making more. If you think about millions of companies doing the same thing, that's what creates the SRAS (Short-Run Aggregate Supply) curve's slope going upwards.

By "short run" we mean the time when the costs of things that go into production, especially wages, don't change quickly. Workers have current contracts, suppliers gave prices for materials months ago. The delay between output prices rising and those input costs being fixed is what gives the SRAS curve its upward slant.

Anything that alters the cost of production for the entire economy will move the SRAS. In 1973, the OPEC oil embargo caused energy costs to skyrocket and the SRAS curve to move sharply to the left; this is a key reason why we experienced stagflation (a combination of rising prices and slowing economic growth) instead of a typical recession. A major advance in how things are made that lowers the cost per item moves SRAS to the right. Changes in wages, prices of basic goods, business taxes, new rules from the government, and problems with getting goods (like when the Suez Canal was blocked in 2021) all impact the SRAS.

Long-Run Aggregate Supply

The LRAS (Long-Run Aggregate Supply) curve is a straight vertical line. Once both wages and prices have completely adjusted, how much the economy produces depends only on its actual resources: how many people are in the workforce, how much equipment exists (the capital stock), and the level of technology. If every price and every wage suddenly doubled, nothing fundamentally about the economy would change. The same machines would be available, people would come to work on Monday as usual, and the same software would continue to run the same operations.

This vertical line is at potential GDP - the highest amount the economy can produce sustainably.

Your position on the LRAS curve tells you a lot. Being to the left of LRAS means there's a recessionary gap, with factories not working at full speed and unemployment above its normal level. That's where the US was in 1990 and again briefly in the spring of 2020.

Being to the right of LRAS means there's an inflationary gap, and the economy is growing faster than it can handle. There's a lot of overtime, businesses are competing to get the limited number of workers available, and wages are being pushed upwards. Think of the late 1960s, before inflation really took hold.

Self-Correction

Wages are how the economy corrects itself, but it's a slow process. In a recessionary gap, high unemployment slowly lowers wages as people compete for the few jobs available. Lower wages decrease production costs, shifting SRAS to the right, and eventually bringing output back towards potential.

In an inflationary gap, a very tight job market drives wages up, shifting SRAS to the left and slowing things down.

This process does happen, but it can take a long time, and that's why some people think the government should actively use spending and interest rates (fiscal and monetary policy) instead of just waiting.

Worked Example: The Multipliers

Let's look at an example. If MPC (marginal propensity to consume) is 0.8, and the government increases spending by $10 billion, how much will AD (aggregate demand) shift?

The spending multiplier is 1 / (1 - 0.8) = 1 / 0.2 = 5.

The change in AD is 5 x $10B = a $50 billion shift to the right.

Here's how that spending works. The government gives $10B to building companies for road work. Workers get that money and spend 80% of it, $8B, at restaurants, stores, and on rent. Those who receive the $8B then spend 80% of that, $6.4B. This continues with $10B + $8B + $6.4B + $5.12B + ... eventually totaling $50B.

Now, what if instead of spending, the government gave a $10B tax cut? The tax multiplier is -MPC / (1 - MPC) = -0.8 / 0.2 = -4. So, the same $10B would only move AD to the right by $40B.

What makes up the $10B difference? When the government spends, the full $10B goes into the flow of spending immediately and is all spent on goods and services. A tax cut gives people $10B, but they save 20% of it before spending anything. Only $8B enters the first round of spending. The spending multiplier is always one more than the tax multiplier, no matter the marginal propensity to consume - that's the balanced budget multiplier in action. The AP exam frequently tests the difference between these two, so make sure you know when to use each one for different policies.