3.2 Variations in economic activity - aggregate demand and aggregate supply

Aggregate demand (AD) is the total planned spending on an economy’s domestic output at a given average price level: C + I + G + (X − M).

Consumption is household spending, investment is firms’ capital spending, government spending is public expenditure, and net exports are exports minus imports. AD is a flow of spending, not simply the quantity of money.

If C = 600, I = 150, G = 200, X = 100 and M = 50, then AD = 600 + 150 + 200 + (100 − 50) = 1,000. The result is spending on domestic output, so imports are subtracted.

When a question gives a component change, identify that component first; only then decide whether AD shifts. A change in the average price level itself is a movement along the AD curve.

Higher AD does not automatically mean higher wellbeing: output, prices, distribution and environmental effects may move differently.

A non-price determinant shifts AD only by changing one of its spending components.

Consumption responds to confidence, interest rates, wealth, taxes, household debt and expected prices; investment responds to rates, business confidence, technology, business taxes and corporate debt; government spending follows political and economic priorities; net exports respond to trading-partner income, exchange rates and trade policy.

A rise in interest rates can reduce mortgage-linked consumption and firms’ borrowing for investment. If both fall, AD shifts left, although the size of the shift depends on the context.

Trace three links: determinant → component → AD direction. Keep other determinants constant while making the model prediction.

Do not shift AD just because the economy’s average price level changes; that is a movement along the existing curve.

Short-run aggregate supply (SRAS) shows the real output firms will supply at different average price levels while some wages and factor prices are slow to adjust.

Higher input, energy or wage costs leave firms able to produce less at each price level, shifting SRAS left. Lower costs, higher productivity or lower indirect taxes shift it right.

If an energy shock raises the cost of every unit, firms reduce planned output at the same price level: SRAS shifts left. A higher price level alone would instead move along SRAS.

Ask whether the change is a price-level change or a non-price cost/productivity change, then choose movement or shift.

‘Short run’ is a model horizon, not a fixed number of days; it means at least some factor prices remain inflexible.

Alternative AS models differ in how output responds when the economy has spare capacity or is close to full employment.

The monetarist/new-classical view uses a vertical LRAS at potential output and expects temporary gaps to self-correct. The Keynesian view uses an elastic-to-vertical AS: demand can raise output when resources are idle, but mainly raises prices near capacity.

A stimulus in a recession with unused factories can increase real output with limited price pressure in the Keynesian model. The same stimulus near full employment mainly produces an inflationary gap.

Compare spare capacity, wage flexibility and the time horizon before predicting whether a demand change affects output, prices or both.

An inflationary output gap means output is above estimated potential; it is not the same definition as the inflation rate.

A rightward LRAS (or Keynesian AS) shift means the economy can produce more at full potential.

Capacity can expand through more or better labour and capital, technology, process efficiency, natural resources or institutions that improve finance and competition. A loss of these capacities shifts it left.

Training that raises worker productivity can move potential output right. A new competition rule may also expand capacity by making entry and investment easier.

Name the capacity channel before drawing the shift, then ask whether the change affects potential output or only current production costs.

A temporary energy-cost change shifts SRAS; it does not automatically change the economy’s long-run productive capacity.

Short-run macroeconomic equilibrium is the AD–AS intersection; compare its output with potential output to identify a recessionary or inflationary gap.

In the monetarist/new-classical model, a recessionary gap lowers employment and wages, reducing costs and shifting SRAS right until output returns to potential. In the Keynesian model, wages may be sticky downwards, so weak confidence and demand can leave the gap persistent.

If a fall in consumption shifts AD left, output can move below potential. The classical prediction is eventual full-employment output at a lower price level; the Keynesian prediction allows a long period of low output and unemployment.

Read the intersection first, measure the gap against potential output, then state which model assumptions justify the adjustment story.

Equilibrium means plans are mutually consistent; it does not guarantee full employment, zero unemployment or a fair outcome.

A useful model comparison starts with assumptions, not with memorised curve shapes.

Classical models assume flexible wages and self-correction toward potential output. Keynesian models allow sticky wages, idle capacity and demand-led persistence. Their policy conclusions therefore differ for the same shock.

After a fall in AD, the classical model predicts a temporary recessionary gap that closes through lower costs; the Keynesian model predicts that weak confidence can keep output below potential and may justify demand support.

State the assumption, trace the predicted adjustment and name the evidence or context that would make that prediction more plausible.

Neither model is a universal law. A prediction is conditional on its time horizon, institutions, spare capacity and wage behaviour.