4.3 Aggregate Demand and Aggregate Supply analysis

Aggregate demand (AD) is the total planned expenditure on domestically produced goods and services at a given price level: consumption + investment + government spending + (exports − imports).

Consumption depends on households, investment on firms, government spending on public decisions and net exports on foreign and domestic demand. AD is a flow over a period, not a stock of wealth.

If C=500, I=120, G=180, exports=90 and imports=110, AD = 780 in the same units.

Imports are subtracted because they are spending on foreign output; adding them would double-count expenditure that is not domestic production.

Aggregate demand is AD = C + I + G + (X − M): consumption, investment, government spending and exports minus imports.

Each component is planned spending on current domestic output. Imports are subtracted because they are spending on foreign production, while exports add foreign spending on domestic production.

If C=500, I=120, G=180, X=90 and M=110, AD is 780.

Adding imports would count foreign output as domestic output; AD is not simply all spending by residents.

Consumption, investment, government spending and net exports are the components of AD. Income, interest rates, expectations, taxes, wealth, exchange rates and foreign income can change those components.

A determinant that increases planned spending shifts AD right; one that reduces it shifts AD left. Trace the component before drawing the curve.

A lower interest rate may raise consumption and investment, shifting AD right; a fall in foreign income can reduce exports and shift AD left.

A change in the price level is movement along AD, while a change in a component determinant shifts AD.

The AD curve shows the total real output demanded at different average price levels, holding other determinants constant. It slopes downward in the standard model.

A lower price level can increase real purchasing power, reduce interest rates and improve net exports, so planned real expenditure rises. These are mechanisms, not movements of the curve’s determinants.

A fall in the domestic price level can make exports more competitive and reduce the money needed for transactions, increasing real output demanded along AD.

AD is not the household demand curve for one good and its vertical axis is the price level, not one product’s price.

AD shifts when planned spending changes at every price level. Expansionary fiscal policy, lower interest rates, stronger confidence, higher wealth or greater foreign income can shift AD right; contractionary changes shift it left.

Check the channel and direction: a tax cut may raise consumption, while an exchange-rate appreciation may reduce exports and shift AD left.

Higher consumer confidence increases consumption at each price level, shifting AD right; a fall in export demand shifts it left.

Do not call every rise in output an AD shift; a movement along AD follows a change in the price level itself.

Aggregate supply (AS) is the total real output firms are willing and able to produce at different average price levels over a period, given production conditions.

The supply side includes wages, input prices, productivity, technology, taxes, infrastructure and the available labour and capital. Distinguish a movement along AS from a shift of AS.

A rise in firms’ costs can reduce real output supplied at each price level, while productivity improvement can increase it.

AS is not the sum of one firm’s short-run supply curve without considering the economy-wide price level and costs.

Aggregate supply shifts when firms’ cost conditions or productive capacity change. Wage and raw-material costs, taxes, subsidies, productivity, technology, labour force, capital stock and supply shocks are key determinants.

Lower unit costs or greater capacity shift AS right; higher costs or a destructive shock shift it left. State whether the change affects output, the price level or both through the model.

A fall in energy prices can shift AS right, while a supply-chain disruption can shift it left and create cost-push inflation pressure.

A higher price level alone is movement along AS; a cost change shifts the curve.

Short-run aggregate supply (SRAS) is generally upward sloping because firms may face rising marginal costs as output approaches capacity. Long-run aggregate supply (LRAS) represents the economy’s sustainable productive capacity and is drawn according to the model used.

The short run contains fixed factors or sticky costs; the long run allows capital, labour and technology to adjust. Keep the chosen classical or Keynesian LRAS convention explicit.

An economy can raise output along SRAS when spare capacity exists, but a lasting expansion of productive capacity requires an outward LRAS shift.

LRAS is not simply SRAS made steeper, and the curve’s shape is a model assumption with an economic interpretation.

SRAS shifts when firms’ current costs change, such as wages, raw materials, taxes or energy prices. LRAS shifts when sustainable capacity changes through labour, capital, technology, skills or institutions.

A supply shock can move SRAS left without permanently reducing capacity; investment or productivity can shift LRAS right and may also shift SRAS.

A sudden oil-price rise shifts SRAS left; improved infrastructure and worker skills can shift LRAS right over time.

Not every short-run cost change changes long-run capacity, and an LRAS shift is not a movement along SRAS.

A movement along AD or AS follows a change in the average price level, holding other determinants constant. A shift changes the whole curve because spending, costs or productive capacity change.

Identify the changed variable first, then decide whether the new equilibrium lies on the old curve or requires a new curve.

A higher price level moves the economy along AD; a tax change that alters consumption shifts AD. A wage shock shifts SRAS; a higher price level alone does not.

A new equilibrium point is not automatically a curve shift; compare the original and new determinants.

In the AD/AS model, equilibrium occurs where planned aggregate expenditure equals firms’ aggregate supply at a given price level. The intersection determines real output and the average price level; employment is related through production.

If AD exceeds AS at the current price, firms see unintended stock falls and may increase output; if AS exceeds AD, inventories rise and output pressure weakens.

The intersection of AD and SRAS gives short-run output and price level; compare it with LRAS to judge whether output is above or below sustainable capacity.

Equilibrium output is not automatically full-employment output or a socially optimal price level.

A rightward AD shift usually raises real output, the price level and employment in the short run. A leftward SRAS shift tends to lower output and employment while raising prices; an LRAS increase permits higher sustainable output with less inflation pressure.

The final effect depends on the curve’s slope, spare capacity, expectations and whether the shift is temporary or structural.

Higher consumer confidence can create demand-pull inflation and more employment; a supply shock can create stagflation—higher prices with lower output.

Demand expansion is not always inflation-only, and supply contraction is not simply “lower prices because less is produced”.