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Macroeconomics
Course: Macroeconomics > Unit 3
Lesson 1: Aggregate demand and aggregate supply- Aggregate demand
- Shifts in aggregate demand
- Long-run aggregate supply
- Short run aggregate supply
- Aggregate demand and aggregate supply curves
- Interpreting the aggregate demand and supply
- Shifts in aggregate supply
- Shifts in aggregate demand
- How the AD/AS model incorporates growth, unemployment, and inflation
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Interpreting the aggregate demand and supply
Let's look at some examples of aggregate supply and demand interacting with each other
Key points
- The aggregate demand/aggregate supply model is a model that shows what determines total supply or total demand for the economy and how total demand and total supply interact at the macroeconomic level.
- Aggregate supply is the total quantity of output firms will produce and sell—in other words, the real GDP.
- Aggregate demand is the amount of total spending on domestic goods and services in an economy.
Introduction
In order for a macroeconomic model to be useful, it needs to show what determines total supply or total demand for the economy and how total demand and total supply interact at the macroeconomic level.
We have a model like this! It's called the aggregate demand/aggregate supply model.
Equilibrium in the aggregate demand/aggregate supply model
Let's begin by looking at the point where aggregate supply equals aggregate demand—the equilibrium. We can find this point on the diagram below; it's where the aggregate supply, AS, and aggregate demand, AD, curves intersect, showing the equilibrium level of real GDP and the equilibrium price level in the economy.
At a relatively low price level for output, firms have little incentive to produce, although consumers would be willing to purchase a high quantity. As the price level for outputs rises, aggregate supply rises and aggregate demand falls until the equilibrium point is reached.
In this example, the equilibrium point occurs at point
Are AS and AD macro or micro?
Confusion sometimes arises between the macroeconomic aggregate supply and aggregate demand model and the microeconomic analysis of demand and supply in particular markets for goods, services, labor, and capital.
While they may have superficial resemblance, their underlying differences are much greater.
For example, the vertical and horizontal axes have distinctly different meanings in macroeconomic and microeconomic diagrams. The vertical axis of a microeconomic demand and supply diagram expresses a price—or wage or rate of return—for an individual good or service. This price is implicitly relative; it is intended to be compared with the prices of other products—for example, the price of pizza relative to the price of fried chicken.
In contrast, the vertical axis of an aggregate supply and aggregate demand diagram expresses the level of a price index like the Consumer Price Index or the GDP deflator—combining a wide array of prices from across the economy. The price level is absolute: it is not intended to be compared to any other prices since it is essentially the average price of all products in an economy.
The horizontal axis of a microeconomic supply and demand curve measures the quantity of a particular good or service. In contrast, the horizontal axis of the aggregate demand and aggregate supply diagram measures GDP, which is the sum of all the final goods and services produced in the economy, not the quantity in a specific market.
In addition, the economic reasons for the shapes of the curves in the macroeconomic model are different from the reasons for the shapes of the curves in microeconomic models.
Demand curves for individual goods or services slope down primarily because of the existence of substitute goods, not the wealth effects, interest rate, and foreign price effects associated with aggregate demand curves.
Individual supply and demand curves can have a variety of different slopes, depending on the extent to which quantity demanded and quantity supplied react to price in that specific market, but the slopes of AS and AD curves are much the same in every diagram—short-run and long-run perspectives emphasize different parts of the AS curve.
In short, just because an AD/AS diagram has two lines that cross, do not assume that it is the same as every other diagram where two lines cross. The intuitions and meanings of macro and micro diagrams are only distant cousins in the economics family tree.
Interpreting the AD/AS model
It's time to see what all this means on a practical level! The table below gives information on aggregate supply, aggregate demand, and the price level for the imaginary country of Xurbia.
What does this information tell you about the state of the Xurbia’s economy? Where is the equilibrium price level and output level—the short-run macroequilibrium? Is Xurbia risking inflationary pressures or facing high unemployment? How can you tell?
| Price level | Aggregate demand | Aggregate supply |
|---|---|---|
| 110 | $700 | $600 |
| 120 | $690 | $640 |
| 130 | $680 | $680 |
| 140 | $670 | $720 |
| 150 | $660 | $740 |
| 160 | $650 | $760 |
| 170 | $640 | $770 |
We need to build an AD/AS diagram to better understand this data! We'll start by plotting the AS and AD curves from the data provided.
Step 1. Draw your x axis and y axis. Label the x axis "Real GDP" and the y axis "Price level".
Step 2. Plot AD on your graph using the values for price level and aggregate demand on the chart.
Step 3. Plot AS on your graph using the values for price level and aggregate supply on the chart.
You should now have a diagram that looks like the one below!
Step 4. Find the equilibrium by determining where AD and AS intersect—in this case, our equilibrium is at a price level of 130 and real GDP of $680.
Step 5. Draw conclusions from the given information.
If equilibrium occurs in the flat range of AS, then economy is not close to potential GDP and will be experiencing unemployment but stable price level. If equilibrium occurs in the steep range of AS, then the economy is close to or at potential GDP and will be experiencing rising price levels or inflationary pressures, but will have a low unemployment rate.
In our example, we can see that the equilibrium is fairly far from where the AS curve becomes steep. This implies that the economy is not close to potential GDP. Thus, unemployment will be high, and changes in the price level are likely to be small.
Self-check question
In the AD/AS model, what can prevent the economy from achieving equilibrium at potential GDP?
Review questions
- What is on the horizontal axis of an AD/AS diagram? What is on the vertical axis?
Critical thinking question
On a microeconomic demand curve, a decrease in price causes an increase in quantity demanded because the product in question is now relatively less expensive than substitute products.
Explain why aggregate demand increases in response to a decrease in the aggregate price level—it's not for the same reason! In other words, what causes total spending to increase if it is not because goods are now cheaper?
Problems
Xurbia
Scroll back up and review the example problem discussed in the Interpreting the AD/AS model section. You'll find a table similar to the one in our example problem below. It gives information on aggregate supply, aggregate demand, and the price level for the imaginary country of Xurbia.
| Price level | AD | AS |
|---|---|---|
| 110 | 700 | 600 |
| 120 | 690 | 640 |
| 130 | 680 | 680 |
| 140 | 670 | 720 |
| 150 | 660 | 740 |
| 160 | 650 | 760 |
| 170 | 640 | 770 |
Plot an AD/AS diagram from the data above. Identify the equilibrium.
Then, Imagine that as a result of a government tax cut, aggregate demand becomes higher by 50 at every price level.
Identify the new equilibrium. How will the new equilibrium alter output? How will it alter the price level? What do you think will happen to employment?
Harris
The imaginary country of Harris Island has the aggregate supply and aggregate demand curves given in the table below.
| Price level | AD | AS |
|---|---|---|
| 100 | 700 | 200 |
| 120 | 600 | 325 |
| 140 | 500 | 500 |
| 160 | 400 | 570 |
| 180 | 300 | 620 |
Plot an AD/AS diagram from the data above. Identify the equilibrium.
Would you expect unemployment in this economy to be relatively high or low? Would you expect concern about inflation in this economy to be relatively high or low?
Imagine that consumers begin to lose confidence about the state of the economy, so AD becomes lower by 275 at every price level.
Identify the new aggregate equilibrium. How will the shift in AD affect the original output, price level, and employment?
Santher
Santher's economy is described in the table below.
| Price level | AD | AS |
|---|---|---|
| 50 | 1,000 | 250 |
| 60 | 950 | 580 |
| 70 | 900 | 750 |
| 80 | 850 | 850 |
| 90 | 800 | 900 |
Plot an AD/AS diagram from the data above. Identify the equilibrium.
Would you expect unemployment in this economy to be relatively high or low? Would you expect prices to be a relatively large or small concern for this economy? Imagine that input prices fall, so AS shifts to the right by 150 units.
Identify the new equilibrium. How will the shift in AS affect the original output, price level, and employment?
Want to join the conversation?
Regarding the problems in the end of the chapter i have some questions to make , mostly about employment:
A)At Xurbia , how can we predict what will happen with unemployement in that case?
B)At Harris , how can we imagine about the employements rate or unemployements? I have learned how to predict about U when we have potential GDP given in a problem , but in this case we don't. And also at Harris , when the AD changes and ofc even the Equilibrum changes , what will happen with U?
*(U=Unemployement)
Thanks everyone(3 votes)
I think that at Xurbia, the unemployment rate decreases. Before the the tax cut, the equilibrium was at a price level of 130, and an output level of 680. After the tax cut, the equilibrium is at a price level of 140 and an output level of 720. So, as you see, people are demanding more and firms have to supply more output to satisfy that demand. That means that firms need more people to increase their productivity, so they employ more people and unemployment rate decreases. I hope I'm right and that this helped :)(3 votes)
Explain why aggregate demand increases in response to a decrease in the aggregate price level.
We have 2 factors, wealth effect, substitution effect (interest rate and export goods)
Wealth effect:
As the price level decreases, the real purchasing power of the people increases, so they tends to consume more for today. This increase 'C' in AD for economy leading to rise in AD.
Substitution effect
1. Interest rate
As the price level decreases, the demand for the loan decreases. The banks and borrowers can unlikely to increase the interest rate of loan. This causes less in saving, increase in C and also I(for investment) due to low interest rate; leading to increase in AD
2. Net export effect
Increase in price level of domestic goods decreases the competitiveness of the countries' product, leading to increase in import and decrease in export.
This results in fall in AD!
Is it right?(3 votes)
I thought that as price level decreases, people save more, so money supply for lending increases, decreasing the cost of borrowing or in other words the interest rate, therefore increasing investments by firms, and consumption (as household now are taking more loans to buy cars and houses).
But as the interest rate decreases because demand for loans decreases, shouldn't there be less saving as well?
So which effect dominates? Does one effect happen before the other?(3 votes)
i live on the isle of harris weird to see harris island as a example of a imaginary country lol(3 votes)- Yes unemployment increased because more supplies(1 vote)
- On y-axis on ADAS model as per my understanding we take only general/average price of all final goods and services while constructing AD . The prices of input like wages, rent, interest and profit are taken on y axis while constructing As or LRAS curve. When combine AD&AS to reach equilibrium point , does this mean that we r taking price of all final goods and services including rewards of factor of production (rent, wages, interest, profit)? Also is this model based on Keynesian approach?
Pl correct me.(2 votes)- That does mean we are taking prices of all final goods and services including rewards of factor of production. The model is based on Keynesian approach.(1 vote)
- Is equilibrium always the 3rd point of the graph(1 vote)
- I believe equilibrium isn't always the 3rd point of the graph.(2 votes)
Demand for loans increases due to lower interest rates as people have started saving more because of low prices and banks have more cash to give out. At one point loans will become costlier as everyone will be willing to take up a loan. What happens to the AD then does it decrease??(1 vote)- If prices decrease and banks have more cash, then the demand for loans will decrease and the supply of loans will increase. As a result interest rates will go down, and we cannot be sure whether the quantity of loans will increase or decrease. AD will not change either way.(2 votes)
The equilibrium for the AS/AD curve is (80:850). Unemployment would be low. Prices would be small. If the AS curve shifted to the right the new equilibrium would be (70:900), price would decrease, output would increase, and unemployment would still decrease.(1 vote)
So, for the Santher's question, The original equilibrium was at (GDP=850,PL=80), and the new equilibrium occurred at (GDP=900,PL=70). That makes sense as the decrease in input prices motivated the firms to produce more and sell for a lower price, but if we looked at the position of the equilibrium point on the new AS curve, it is obvious that it is now farther from the steep part and thus the potential GDP, which means that unemployment rate is now higher.
How can we link the increase in production to the increase in unemployment rate?(1 vote)- Can you evaluate the view that an increase in aggregate demand will always lead to an inflationary gap please?(1 vote)
Unemployment at Harris will decrease and employment will increase because more supplies are being made which means there are more people working than there is unemployed(1 vote)