Aggregate Demand and Supply

The aggregate demand and supply model IS the main one for macroeconomics in the course. It will be used at AS and A2, understanding this is you’re major weapon.

Whats Aggregate Demand and Aggregate Supply….?

Remember market supply, sloping upwards, for a single market. Aggregate supply is the same, but for a WHOLE economy. There are two types. Short Run and Long Run Aggregate Supply…….

Short Run Aggregate Supply is the sum of how all markets respond to changes in inflation(how their goods prices change). It is like a normal supply curve, but if aggregate demand(total demand) is equal to SRAS, the economy may not be in a stable equilibrium. Any changing conditions along SRAS may cause changes in factor markets and changes in incentives, causing SRAS to shift, just like a market curve with similar scenarios.

Keynesian Economists believe it to shift because of the profit incentive before we near full capacity(like a competitive market), profit incentive/money wages nearing capacity and money wage rises at capacity.

New Classicals believe it to shift up and down due to money wage adjustments….

Long Run Aggregate Supply

The stable levels of output with respect to prices an economy can produce. The economy can be in happy equilibrium in all markets supplying at any point along this curve. It also signifies the productive capacity of an economy aswell as the natural rate of unemployment. LRAS has strong links with the Phillips Curve(see Unemployment chapter).

An everlasting debate…Keynesians v New Classicals

A debate which has been lasting for the best part of the last 100 years is how the long run aggregate supply curve is modelled………In the exam, choosing either one is okay. If Frederick Hayek, Milton Friedman agree with one and Paul Samuelson, Paul Krugman agree with the other than you cant go much wrong with either.

Keynesian LRAS…..(Factor Markets are ‘sticky downwards’)

Output going up…..John Maynard and his successors explained that an economy can settle into an equilibrium well below it’s potential output, and only an increase in aggregate demand for domestic producers will make the profit incentive to supply more. As unemployment in factor markets is high, there is little inflationary pressure on getting more factors to supply more. It is only when we get towards full capacity that factor scarcity makes cost push inflation.

 Output going down…. When demand falls, there is greater ease on capital markets and OTE pay/bonuses fall back to basic pay, less profit too. Prices hence fall, to a point. As they explain during economic downturns wage cuts face very fierce opposition, and this means that pay falling below basic rates will see a massive rise in unemployment, due to strikes/poor morale etc(the animal spirits money illusion, people hate a pay cut, and fairness, same work less pay!!??). Wages for the output we have bottom out at this basic rate, meaning we have a minimum price level for various outputs, well below full employment. Keynesian criticisms of classical labour markets is expalined in ‘Labour Markets’.

Classical LRAS Model…….(Factor Markets adjust quickly)

A victory was with the classical model with the finding of the natural rate of unemployment. For if an economy is to tend towards a certain %, then it must tend towards a certain output, whatever demand has been, due to adaptive expectations of wages with respect to inflation. Economic cycles are around this rate. The vertical NAIRU works well with vertical LRAS.

Rising Output Pressure…..will cause a positive output gap past LRAS, with a bit of inflation on the demand pull side. People increase their wage expectations due to this and ‘money wages’ increase. Market supply SRAS shifts backwards, as rising wages means a cost push price rise(same output needs higher prices for equilibrium). We cut back on market output and are back on LRAS again.

Falling Output Pressure….Less demand for domestic goods sees a lower pressure on prices. Rising unemployment and classical labour market assumptions means people what workers expect to earn fall. Costs of production fall, meaning prices can fall. SRAS shifts down(same supply can be made with lower prices). We are back at LRAS natural rate again!!

Aggregate Demand

Each economy has several obvious goods markets. There are capital markets where firms demand and firms supply, goods markets where consumers demand firms supply. The public sector buys materials for infrastructure etc………..

Aggregate Demand is the total demand for all output produced within the economy.


  1. C is Consumption. The largest part of demand usually is by domestic citizens for domestic goods.
  2. I is Investment (for the ins and outs, see ‘The Capital Market’), for capital goods made at home by domestic firms.
  3. G is Government Spending. What confused me at first was that it doesnt account for taxes(I used to think and read somewhere ‘net spending’). But taxes are accounted for in C and I, causing them to be lower. The output demanded by the public sector made at home.
  4. X-M is the balance of trade. If X-M is positive, there is net demand for our goods from overseas. X-M<0 means some of our demand is reduced as it is switched overseas…..

Why Does it Slope Down?? Explain!!!!….We know in any market a lower price means more demand, but this is a bit more complex. Thing methodically in all the components and you will be fine…..

  1. Trade Effect……Say general prices fall. The most simple thing is the balance of trade. Our exports become more demanded as they are cheaper, and many switch from importing that Nestle bar as Cadbury is tasty and worth less X-M becomes higher and hence more demand..
  2. Interest rate Effects…..Prices falling means less money is demanded for transactions(‘more for speculation’, we assume former outweighs), and with the same supply, average interest rates fall. More income is devoted to consumption, credit is cheaper spurring consumption again, also investment. More investment is carried out as more assets yield higher than the interest rate.
  3. Wealth Effect…Talking aggregate demand, we are talking goods needed for manufacture and consumer goods, not assets and wealth. So falling prices in goods for the former two mean you’re house or savings can buy more than before. Consumption/ Investment rises as there is a motive to release equity.
  4. Fiscal Stance….usually left out as government spending decisions depend on the government, political stance. However, the government may spend more with lower prices as it can get more with it’s accumulated budget, making up for it with taxes when prices are higher.

Surely if prices fall, people delay consumption, businesses become scared??? This is a simplification, to go into it like this will bring you into debates professional economists/experts have had ever since the beginning. We assume factors causing AD to rise outweighs what causes it to fall….

It all works vice versa aswell, via the same mechanics…………

Hysterises: Extreme Demand Affects Capacity

It has been assumed that, when aggregate demand swings causing economic cycles, it does so around a relatively fixed productive capacity. However, this is not true if AD is extreme for a sustained period.

What it Proposes: If demand is down for a sustained period, aggregate supply can follow after a time lag. Likewise, if we have a sustained economic boom in activity with excess AD, productive capacity will evenutally rise with it provided it has held.

Empricism: Natural Rate of Unemployment is a reliable indicator of LRAS, and actual unemployment of the output gap. The two seem to follow see below.

Why Does LRAS Follow Suit?

Consider a fall into economic depression, where AD is down for a long period. Unemployment of labour and capital will rise and stay high, with people out of work for long periods.

With this, unemployed labour encounters a depreciation in skills, meaning less productivity upon return to work, and a rise in the NAIRU. Factories, offices and infrastructure can depreciate, meaning less capacity of capital and greater factor immobilities. There can also be a net emigration of labour.

Looking at the supply side, capacity to produce contracts. Vice versa applies with immigration of skilled workers and consistent use of skills.

Trend Rates of growth over time can be altered due to hysterises, due to the changes on the supply side.

Inflationary Spirals…..

Keynesians and Classicals believe there can be inflationary spirals due to constant militancy of labour and wgae demands. Say we have a huge rise in aggregate demand, causing money wages to rise. Firms increase their prices due to cost push inflation. The higher wages means more AD again, causing price pressures on goods, increasing money wages again…..Cycle can continue. The rate of interest can keep this in check, controlling AD shifts.

Keynesian Cross Diagrams

This shows that there is a natural rate of unemployment and reinforces the fact that there is a long run limit of capacity the economy cannot remain beyond for long.

Key Assumptions: investment and government spending of AD is constant throughout ‘autonomous’. When income rises, it is only consumption that rises, creating a shallow gradient as the marginal propensity to consume is less than 1. The assumption of I and G to be constant has lead to the criticism of it being unrealistic(the accelerator??)

It looks at the relation between different levels of income which is made from supplying, and how much demand is gained to buy back what has been supplied. We consider what happens to stocked goods, or ‘inventories’ and the effect this has on scaling up/down production.

How it Works…..We have the income=value made 45 degree diagonal. People earn an income equal to what is supplied. That income get’s converted into aggregate demand, which, due to a marginal propensity to consume of less than 1, rises more slowly(look at the assumptions of the AD). If the supply value is greater than the later AD, inventories build up, and firms cut back on employment, moving us down the supplied/income curve to the point of intersection. If the AD is greater than the income/supply than inventories will fall and employment of factors will rise to the point.

We are at equilibrium when the income earnt from supply creates enough demand to buy back production again. Aggregate Supply = Aggregate Demand. It enforces the idea of a natural rate of unemployment and limited aggregate supply.

Says Law of supply creates it’s own demand seems to be partially satisfied here. There are points where mere supply will not create the demand needed to buy back exactly what was made(as the classical school suggested). But we do tend towards that.

The Paradox of Thrift

If everyone were to save a greater amount of their income, surely total saving will rise over time. The paradox suggests otherwise.

Say we decide to save more of what we earn. Following from the circular flow model, this amounts to more withdrawals of income, for less revenue is being earnt by firms causing lower incomes in total.

Lower incomes mean that less can be saved, and this may offset the higher marginal propensity to save, thus reducing total savings over a period of time.

Disputes: Classical Interest Rates. If the extra saving is deposits in a bank, then the fall in incomes causes a fall in demand for borrowed funds for investment. This, along with more bought forward for saving means the market rate of interest will fall until the demand=supply of loanable funds.

Falls in market rates should restore incomes through extra investment.


One Response to Aggregate Demand and Supply

  1. Pingback: Thinktank « Zahablog's Economic Page

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