Aggregate Demand & Supply

📉 Aggregate Demand & Aggregate Supply

Part 1 of 7 — The AD–AS Model & the Aggregate Demand Curve

Topics in This Part

🔑 Key Concept: The AD–AS model is the master diagram of macroeconomics. It puts the price level (not the price of one good) on the vertical axis and real GDP (total output) on the horizontal axis, and uses two curves — aggregate demand and aggregate supply — to explain recessions, inflation, and the effects of every policy you'll study.

A New Pair of Axes

In microeconomics, a demand curve plots the price of one good against the quantity of that good. The AD–AS model zooms all the way out to the whole economy:

Aggregate demand (AD) shows the total quantity of real GDP that households, firms, government, and foreigners want to buy at each price level.

⚠️ Don't confuse the curves. A micro demand curve slopes down because of substitution and income effects within a market. AD slopes down for three completely different macro reasons — coming up next.

Why Aggregate Demand Slopes Downward

A lower price level raises the total quantity of real GDP demanded for three reasons. Memorize these — they are tested directly.

💡 All three describe a movement along a fixed AD curve caused by a change in the price level — not a shift of the curve.

Concept Check 🎯

What's Inside Aggregate Demand?

Aggregate demand is the spending side of GDP. It is built from the same four components as the expenditure approach to GDP:

$AD = C + I + G + NX$

🔑 Key Idea: Anything that changes $C$, $I$, $G$, or $NX$ at a given price level shifts the entire AD curve. That is the engine behind fiscal policy, monetary policy, and the multiplier — all of which you'll meet later.

Sort the Spending 🔽

Match each item to the AD component it belongs to.

A Quick Look at Net Exports

Net exports is one piece of AD worth computing directly:

$NX = \text{Exports} - \text{Imports}$

If a country exports $700 billion of goods and imports $900 billion, then $NX = 700 - 900 = -200$, i.e. -$200 billion — a trade deficit, which subtracts from aggregate demand.

Compute Net Exports 🧮

Use $NX = \text{Exports} - \text{Imports}$ (in billions). Enter signed numbers.

1) Exports $= 500$, Imports $= 300$. $NX = \,?$ 2) Exports $= 250$, Imports $= 400$. $NX = \,?$ 3) Exports $= 600$, Imports $= 600$. $NX = \,?$

Part 1 Recap

• The AD–AS model plots the price level vs. real GDP for the whole economy.
• AD slopes downward because of the wealth, interest-rate, and net-export effects.
• AD is the sum $C + I + G + NX$; changing any component at a given price level shifts AD.

Next up: what makes the AD curve shift left or right — the heart of macro policy. 📈

📉 Aggregate Demand & Aggregate Supply

Part 2 of 7 — Shifts in Aggregate Demand

🔑 The Big Distinction: A change in the price level moves you along a fixed AD curve. A change in anything else that affects spending shifts the whole curve. Mixing these up is the #1 AD–AS error on the AP exam.

What Shifts Aggregate Demand?

Anything that raises spending at a given price level shifts AD right ($\rightarrow$); anything that lowers it shifts AD left ($\leftarrow$).

⚠️ A rightward shift increases real GDP demanded at every price level (more total spending). A leftward shift decreases it. Get the direction right before you worry about the price level.

Concept Check 🎯

Movement Along vs. Shift — the Decisive Test

Ask one question: "Did the price level change first, or did something else?"

Example: A tax cut raises disposable income → households spend more at every price level → AD shifts right.

Example: A higher price level triggers the interest-rate effect → we slide up and to the left along the existing AD curve. No shift.

💡 Memory hook: price level → along; everything else → shift.

Along or Shift — and Which Way? 🔽

For each event, choose what happens to AD.

A Closer Look: the Dollar's Strength

The exchange rate quietly moves AD through net exports:

• A stronger dollar makes U.S. goods more expensive abroad and imports cheaper → exports fall, imports rise → $NX$ ↓ → AD shifts left.
• A weaker dollar does the reverse → $NX$ ↑ → AD shifts right.

💡 Same logic applies to foreign income: when our trading partners boom, they buy more of our exports → $NX$ ↑ → AD shifts right.

Concept Check 🎯

Part 2 Recap

• A change in the price level = movement along AD.
• A change in $C$, $I$, $G$, or $NX$ for any other reason = shift of AD.
• More spending shifts AD right; less spending shifts AD left.

Now that AD is solid, we turn to the other curve — aggregate supply — which behaves very differently in the short run vs. the long run. 🏭

📉 Aggregate Demand & Aggregate Supply

Part 3 of 7 — Short-Run & Long-Run Aggregate Supply

🔑 The Core Insight: In the short run, some input prices (especially nominal wages) are "sticky" and can't adjust quickly, so output responds to the price level → SRAS slopes upward. In the long run, all prices and wages adjust, so output settles at potential GDP regardless of the price level → LRAS is vertical.

Short-Run Aggregate Supply (SRAS)

SRAS slopes upward. A higher price level, with input costs (like wages) temporarily fixed, makes production more profitable, so firms expand output.

The reason output can respond at all is sticky prices/wages: contracts, menu costs, and slow expectations mean costs lag behind the price level in the short run.

💡 Think of it from a firm's view: if the price of what you sell rises but the wage you pay hasn't changed yet, your profit margin widens, so you hire and produce more.

What shifts SRAS?

⚠️ A negative supply shock (e.g. an oil-price spike) shifts SRAS left, raising the price level and lowering output at the same time — that's stagflation.

Concept Check 🎯

Long-Run Aggregate Supply (LRAS)

In the long run, wages and all input prices fully adjust. Once they catch up, the temporary profit incentive disappears and the economy produces at potential (full-employment) output, $Y_f$ — no matter the price level.

$\text{LRAS is a vertical line at } Y = Y_f$

LRAS represents the economy's productive capacity at full employment (where the only unemployment is natural). It does not depend on the price level.

What shifts LRAS (i.e., changes potential GDP)?

Only things that change the economy's real capacity to produce:

• More/better resources — labor force growth, more capital, new natural resources
• Technological progress / higher productivity
• Better institutions — stronger property rights, education, infrastructure

🔑 A rightward shift of LRAS is economic growth: the entire long-run capacity of the economy expands. Demand-side changes (AD shifts) do not move LRAS.

Which Curve Moves? 🔽

Decide whether each event shifts SRAS only, LRAS (and SRAS), or neither.

SRAS-Only vs. Both Curves

A useful rule of thumb:

• A temporary cost change (a one-off oil spike, a bad harvest) moves SRAS only.
• A permanent change in productive capacity (new technology, more capital or labor, better institutions) moves LRAS — and SRAS shifts with it.

⚠️ Watch out: a change in the expected price level or in nominal wages shifts SRAS but leaves LRAS untouched, because it doesn't change the economy's real capacity.

Concept Check 🎯

Part 3 Recap

💡 Short run: output can differ from potential. Long run: output returns to potential. That tension is what drives the business cycle — and our next topic, equilibrium.

📉 Aggregate Demand & Aggregate Supply

Part 4 of 7 — Equilibrium & Output Gaps

🔑 Where it all meets: The economy's short-run equilibrium is where AD crosses SRAS — that point gives the equilibrium price level and equilibrium real GDP. Comparing that GDP to potential output ($Y_f$, the LRAS line) tells you whether the economy is in a boom, a recession, or right on target.

Short-Run Macroeconomic Equilibrium

Short-run equilibrium occurs where AD = SRAS. At that intersection:

• The equilibrium price level ($PL$) is read off the vertical axis.
• The equilibrium real GDP ($Y$) is read off the horizontal axis.

We then compare equilibrium $Y$ to potential output $Y_f$ (the vertical LRAS line):

🔑 Long-run equilibrium is the special case where AD, SRAS, and LRAS all intersect at the same point — output equals potential.

Concept Check 🎯

Measuring the Output Gap

The output gap is simply the distance between actual equilibrium output and potential output:

$\text{Output gap} = Y - Y_f$

• A negative gap ($Y < Y_f$) is a recessionary gap.
• A positive gap ($Y > Y_f$) is an inflationary gap.

Worked example. Suppose short-run equilibrium GDP is $9.4 trillion and potential GDP is $10.0 trillion:

$\text{gap} = 9.4 - 10.0 = -0.6 \text{ trillion}$

The economy is $0.6 trillion below potential — a recessionary gap of $0.6 trillion. (Later you'll see policy must raise AD by less than $0.6T because of the multiplier.)

⚠️ The output gap measures the spending hole or excess, but the AD shift needed to close it is smaller than the gap — the multiplier does the rest. That's Part 5.

Compute the Gap 🧮

Use $\text{Output gap} = Y - Y_f$ (in trillions of dollars). Enter signed numbers (e.g. -0.5).

1) $Y = 8.5$, $Y_f = 9.0$. Output gap $= \,?$ 2) $Y = 12.4$, $Y_f = 12.0$. Output gap $= \,?$ 3) $Y = 15.0$, $Y_f = 15.0$. Output gap $= \,?$

Name That Gap 🔽

For each pairing of equilibrium output ($Y$) and potential output ($Y_f$), choose the economy's condition.

Part 4 Recap

• Short-run equilibrium: AD = SRAS → gives equilibrium $PL$ and $Y$.
• Compare $Y$ to $Y_f$: below = recessionary gap, above = inflationary gap, equal = long-run equilibrium.
• Output gap $= Y - Y_f$.

Next: how a single dollar of spending ripples into a larger change in GDP — the multiplier. 🔁

📉 Aggregate Demand & Aggregate Supply

Part 5 of 7 — The Spending Multiplier & AD Shifts

🔑 Why a small push moves AD a lot: When one person spends, that becomes another person's income, which they partly spend again, and so on. This chain means an initial change in spending shifts AD by a multiple of itself — the spending (expenditure) multiplier.

MPC, MPS, and the Multiplier

Out of each extra dollar of income, households spend a fraction and save the rest:

• MPC = marginal propensity to consume = fraction of extra income spent.
• MPS = marginal propensity to save = fraction saved.

$MPC + MPS = 1$

The spending multiplier is:

$\text{Multiplier} = \frac{1}{1 - MPC} = \frac{1}{MPS}$

💡 A higher MPC means more of each dollar gets re-spent, so the multiplier is larger. A higher MPS shrinks it.

Compute the Multiplier 🧮

Use $\text{Multiplier} = \dfrac{1}{1 - MPC} = \dfrac{1}{MPS}$.

1) $MPC = 0.8 \Rightarrow$ multiplier $= \,?$ 2) $MPS = 0.25 \Rightarrow$ multiplier $= \,?$ 3) $MPC = 0.6 \Rightarrow$ multiplier $= \,?$ (decimal is fine)

From Initial Spending to Total AD Shift

The full change in real GDP (the size of the AD shift) is:

$\Delta Y = \text{Multiplier} \times \Delta \text{(initial spending)}$

Worked example. The government spends an extra $50 billion and $MPC = 0.8$.

$\text{Multiplier} = \frac{1}{1 - 0.8} = 5$

$\Delta Y = 5 \times \$50\text{B} = \$250\text{ billion}$

So AD shifts right by $250 billion, not just the original $50 billion.

🔑 Closing a gap. To erase a $250B recessionary gap with $MPC = 0.8$ (multiplier $5$), the government needs an initial spending increase of only $\frac{\$250\text{B}}{5} = \$50\text{ billion.}$ Always divide the gap by the multiplier to find the required spending change.

Concept Check 🎯

Match the Multiplier 🔽

Pick the correct value for each scenario.

Part 5 Recap

• $MPC + MPS = 1$; multiplier $= \dfrac{1}{1-MPC} = \dfrac{1}{MPS}$.
• Total AD shift $= \text{multiplier} \times \text{initial spending}$.
• Required spending to close a gap $=$ gap $\div$ multiplier.

💡 The multiplier is why small policy changes can move the whole AD curve. Now let's watch AD and AS shifts play out as the business cycle. 🔄

📉 Aggregate Demand & Aggregate Supply

Part 6 of 7 — Shocks, Self-Correction & Policy

🔑 Putting the model to work: Every recession, boom, and inflation episode is a story about AD or AS shifting. This part traces those shifts, shows how the economy self-corrects in the long run, and previews how policy can close gaps faster.

Demand-Side Shocks

Start from long-run equilibrium, then shift AD:

Key fact: a pure AD shift moves the price level and output in the same direction (both up, or both down).

💡 This is the signature of a demand shock: prices and output rise together (inflationary boom) or fall together (demand-driven recession).

Supply-Side Shocks

Now shift SRAS instead:

Key fact: a SRAS shift moves the price level and output in opposite directions.

⚠️ Stagflation — rising prices and falling output at once — can only come from a leftward SRAS shift, never from an AD shift. The AP exam loves this distinction.

Diagnose the Shock 🔽

Read the symptoms; identify the curve and direction.

Long-Run Self-Correction

Even with no policy, the economy drifts back to potential as wages adjust:

• Recessionary gap ($Y < Y_f$): high unemployment puts downward pressure on wages. As nominal wages fall, SRAS shifts right, lowering the price level and raising output back to $Y_f$.
• Inflationary gap ($Y > Y_f$): tight labor markets push wages up. As nominal wages rise, SRAS shifts left, raising the price level and pulling output back down to $Y_f$.

🔑 Self-correction works through SRAS moving along the fixed LRAS until $Y = Y_f$ again. It is slow — which is the case for active fiscal/monetary policy to speed things up.

Policy preview

Concept Check 🎯

Size the Policy 🧮

Required spending change $=$ gap $\div$ multiplier. Recall multiplier $= \dfrac{1}{1 - MPC}$. Enter numbers in billions.

1) A $400B recessionary gap, $MPC = 0.75$ (multiplier $= 4$). Required increase in $G$ $= \,?$ 2) A $200B inflationary gap, $MPC = 0.8$ (multiplier $= 5$). Required cut in $G$ $= \,?$ 3) $MPC = 0.5$, so the multiplier $= \,?$

Part 6 Recap

• Demand shocks: PL and output move the same direction.
• Supply shocks: PL and output move in opposite directions (left SRAS = stagflation).
• Self-correction works through SRAS sliding along LRAS back to $Y_f$ — slowly.
• Policy can shift AD to close gaps faster: expansionary for recessions, contractionary for inflation.

Time to bring it all together in the mastery check. ✅

📉 Aggregate Demand & Aggregate Supply

Part 7 of 7 — Mixed Practice & Mastery Check

You can now (1) explain why AD slopes down and what shifts it, (2) distinguish SRAS from LRAS, (3) find equilibrium and identify output gaps, (4) apply the multiplier, and (5) diagnose demand vs. supply shocks. Let's put it together. 🧩

Quick Reference

⚠️ Remember: price level → movement along AD; everything else → shift. And only SRAS-left causes stagflation.

Mixed Practice 🔽

One question from each major idea.

Mixed Numerical Practice 🧮

1) $MPC = 0.9$. Multiplier $= \,?$ 2) With that multiplier, an initial $20B rise in $G$ shifts AD right by how many billions? (enter the number) $= \,?$ 3) Equilibrium GDP $9.7T, potential $10.0T. Output gap in trillions (signed) $= \,?$

Exit Quiz ✅

Answer all three to finish the lesson.