Chapter 31 — Aggregate Demand and Aggregate Supply

The Macroeconomic Model

This is the central macro model. Just as supply and demand (Chapter 5) is the central micro model, the AS-AD model is the central macro model. It lets you analyze what happens to the overall economy — total output, the price level, and employment — when conditions change.

31.1 Aggregate demand (AD)

The aggregate demand curve shows the relationship between the overall price level and the total quantity of goods and services demanded. It slopes downward for three reasons (different from micro demand):

1. The wealth effect. When the price level falls, the real value of money increases (your dollars buy more). Consumers feel wealthier and spend more. When the price level rises, money buys less, consumers feel poorer and spend less.

2. The interest rate effect. When the price level falls, people need less money for transactions. They deposit more in banks. Banks have more funds to lend. Interest rates fall. Lower rates → more borrowing → more investment and consumption.

3. The exchange rate effect. When the U.S. price level falls (relative to other countries), U.S. goods become cheaper for foreign buyers. Exports rise. And foreign goods become relatively more expensive for U.S. buyers. Imports fall. Both increase aggregate demand (net exports rise).

Shifters of AD: anything that changes C, I, G, or NX at a given price level shifts AD. - Consumer confidence → C → AD right - Business investment → I → AD right - Government spending or tax cuts → G or C → AD right - Foreign demand for U.S. goods → NX → AD right - Monetary policy: Fed cuts rates → I and C rise → AD right

31.2 Aggregate supply (AS)

Long-run aggregate supply (LRAS) is vertical at potential output — the level of output the economy produces when all resources are fully employed and operating at normal capacity. LRAS doesn't depend on the price level; it depends on the economy's resources (labor, capital, technology, institutions). LRAS shifts when resources or technology change.

Short-run aggregate supply (SRAS) slopes upward: when the price level rises, firms produce more (because some input costs — particularly wages — are sticky and don't adjust immediately, so higher output prices raise profit margins temporarily). When the price level falls, firms produce less.

Why SRAS slopes up (sticky-wage theory): wages are set by contracts or norms and don't adjust instantly. When the price level rises unexpectedly, output prices rise but wages don't (yet), so production becomes more profitable and firms expand output. Over time, wages adjust, and the economy returns to LRAS.

31.3 Equilibrium and the output gap

Short-run equilibrium: where AD crosses SRAS. The intersection determines the price level and real GDP.

• If GDP < potential (LRAS): recessionary gap — unemployment above natural rate, resources underutilized
• If GDP > potential: inflationary gap — economy overheating, inflation rising
• If GDP = potential: full employment, stable inflation

31.4 Analyzing shocks

Demand shock (AD shifts)

AD shifts right (fiscal stimulus, consumer confidence surge, rate cuts): price level rises, GDP rises. In the short run: both output and inflation increase. In the long run: wages adjust upward, SRAS shifts left, and the economy returns to potential output at a higher price level. The demand stimulus is temporary — it boosts output in the short run but only raises prices in the long run.

AD shifts left (financial crisis, consumer pessimism, rate hikes): price level falls, GDP falls. Recession. The classic demand-deficiency recession (2008).

Supply shock (SRAS shifts)

SRAS shifts left (oil price spike, supply-chain disruption): price level rises AND GDP falls simultaneously. This is stagflation — the worst macro outcome. The 1970s oil shocks were SRAS-left events.

SRAS shifts right (technology improvement, oil price fall, productivity boom): price level falls AND GDP rises. The best macro outcome. The late 1990s tech boom was partly an SRAS-right event.

COVID as a simultaneous shock

COVID 2020 was a simultaneous AD-left (consumers stayed home) AND SRAS-left (factories closed, supply chains broke). Standard models struggle with simultaneous shocks because the effect on the price level is ambiguous (AD-left pushes prices down; SRAS-left pushes prices up). In practice: GDP fell sharply (both curves shifted left) and the price level was initially uncertain, then rose once demand recovered faster than supply (the 2021–23 inflation).

31.5 The Keynesian vs. classical debate

Classical view: the economy self-corrects. If GDP falls below potential (recessionary gap), wages and prices eventually fall, SRAS shifts right, and the economy returns to full employment. Government intervention is unnecessary and potentially harmful. "In the long run, the economy returns to potential."

Keynesian view: self-correction is too slow. Wages and prices are sticky downward (workers resist pay cuts; firms resist price cuts). The adjustment can take years — and during those years, millions of people are unemployed. Government intervention (fiscal and monetary stimulus) can speed the adjustment and reduce the human cost. As Keynes said: "In the long run, we are all dead."

The honest synthesis: both views have merit. Classical self-correction does eventually work — but "eventually" can be very long (the 2008 recovery took 6+ years). Keynesian intervention can speed recovery — but it can also cause inflation if applied when the economy is already at potential (the 2021 overshoot). The right policy depends on conditions: aggressive intervention during deep recessions (2008, COVID); restraint when the economy is near potential.

31.6 Where this is going

Chapter 32 applies the AS-AD framework to fiscal policy (government spending and taxes). Chapter 33 extends it to the open economy (trade, exchange rates, capital flows).

Key terms recap: AD — the relationship between the price level and total quantity demanded; slopes down for three reasons SRAS — upward-sloping because of sticky wages; output responds to the price level in the short run LRAS — vertical at potential output; determined by resources, technology, institutions output gap — the difference between actual and potential GDP recessionary gap — GDP < potential inflationary gap — GDP > potential stagflation — simultaneous high inflation and high unemployment (SRAS shifts left) self-correcting mechanism — the classical view that wages/prices adjust to restore full employment

Themes touched: Disagreement (Keynesian vs. classical — the most consequential macro debate), Tradeoffs (intervention vs. self-correction), Affects daily life (recession vs. expansion determines your job prospects).