Chapter 21 - Aggregate Demand and Aggregate Supply
Builds on Chapter 17 - Tracking the Business Cycle by providing a framework to forecast where the economy is headed. The AD-AS model is the macroeconomic analogue of the microeconomic supply-and-demand model.
Key Concepts
- The AD-AS framework determines two macroeconomic outcomes: real GDP and the average price level (GDP deflator)
- Equilibrium occurs where the AD and AS curves intersect
- Changes in the price level = movement along a curve; all other changes = shift of the curve
- AD shocks move output and prices in the same direction; AS shocks move them in opposite directions
- The shape of the AS curve depends on the time horizon (from horizontal to vertical)
1. The AD-AS Framework
From Micro to Macro
In microeconomics, demand and supply determine outcomes in individual markets (e.g., quantity and price of gasoline). The AD-AS framework “supersizes” this:
- Aggregate demand (AD): total purchasing plans of all buyers in the entire economy
- Aggregate supply (AS): total production plans of all suppliers in the entire economy
- Explores aggregate outcomes: total output and average prices across the whole economy
The Two Axes
| Axis | Variable | Measured by |
|---|---|---|
| Horizontal | Quantity of output | Real GDP |
| Vertical | Price of output | GDP deflator |
Macroeconomic Equilibrium
Equilibrium occurs where AD and AS intersect — the only point where quantity demanded equals quantity supplied. Equilibrium determines:
- Equilibrium GDP (e.g., $20 trillion)
- Average price level
Macro vs. Micro Trade-offs
| Microeconomics | Macroeconomics | |
|---|---|---|
| Trade-off | Across products | Across time |
| Opportunity cost | Buying gasoline instead of other goods | Buying output today instead of saving for the future |
2. Aggregate Demand
Definition
Aggregate Demand Curve
Shows the relationship between the price level and the total quantity of output that buyers plan to purchase. Includes all buyers: consumers, businesses, government, overseas customers.
The AD curve is downward-sloping: a lower price level leads buyers to demand a larger quantity of output.
Aggregate Expenditure
The AD curve illustrates the level of aggregate expenditure (AE) associated with different price levels.
| Component | Meaning |
|---|---|
| Consumption | |
| Planned Investment | |
| Government Purchases | |
| Net Exports |
Why AD is Downward-Sloping: The Central Bank Channel
- Higher price level → higher inflation → Bank of Canada raises real interest rates → higher opportunity cost of spending → less aggregate expenditure
- Sometimes called the central bank channel (primary mechanism)
Other forces (smaller effects):
- International trade effect: higher domestic prices make Canadian goods less competitive
- Wealth effect: higher prices reduce the real value of savings (partially offset by debt effect)
Exam Alert
The main reason AD slopes downward is the central bank channel — NOT the substitution effect (that’s microeconomics).
Movement Along vs. Shift
| Cause | Effect |
|---|---|
| Change in price level | Movement along the AD curve |
| Any other change in spending | Shift of the AD curve |
AD shifts right (increased spending → expansion + inflation):
- Rise in output, rise in prices
AD shifts left (decreased spending → recession + deflation):
- Fall in output, fall in prices
Aggregate Demand Shifters
| Component | Rises when… | Examples |
|---|---|---|
| Consumption (C) | People feel more prosperous | ↑ Wealth, ↑ Consumer confidence, ↑ Gov’t assistance, ↓ Taxes, ↓ Inequality |
| Investment (I) | Profitable to expand production | ↑ GDP growth, ↑ Business confidence, ↑ Investment tax credits, ↓ Corporate taxes, ↓ Uncertainty |
| Government purchases (G) | Expansionary fiscal policy | Spending bills, automatic stabilizers (NOT transfer payments directly) |
| Net exports (NX) | Global factors improve | ↑ Global GDP growth, ↓ Canadian dollar, ↓ Trade barriers in foreign markets |
Common Mistake
Interest rate changes do not always shift the AD curve.
- Inflation-induced interest rate changes (Bank of Canada responding to price level) → movement along AD (already built in)
- Output-induced interest rate changes (Bank cutting rates to combat recession) → shift of AD
3. Aggregate Supply
Definition
Aggregate Supply Curve
Shows the relationship between the price level and the total quantity of output that suppliers collectively produce.
The AS curve is upward-sloping: higher output leads to higher prices.
Why AS is Upward-Sloping
A business’ pricing decision depends on the state of the economy:
- Excess demand → Higher output → Higher prices
- Insufficient demand → Lower output → Lower prices
Movement Along vs. Shift
| Cause | Effect |
|---|---|
| Change in price level | Movement along the AS curve |
| Change in production costs | Shift of the AS curve |
AS shifts right (↓ production costs → expansion + lower prices):
- Fall in production costs → AS shifts down to the right → GDP rises, prices fall
AS shifts left (↑ production costs → recession + higher prices):
- Rise in production costs → AS shifts up to the left → GDP falls, prices rise → stagflation
Stagflation
The combination of declining GDP (economic stagnation) and rising prices (inflation). Caused by a leftward shift in AS.
Aggregate Supply Shifters (Production Cost Changes)
1. Input Prices
- ↑ Input prices → ↑ marginal costs → firms raise prices → AS shifts left
- Key input prices: labour and oil prices
2. Productivity
- ↓ Productivity → must buy more inputs for same output → ↑ production costs → AS shifts left
- ↑ Productivity → do more with less → AS shifts right
- Example: Productivity growth slowed dramatically in the mid-1970s
3. Exchange Rate
- Depreciation of Canadian dollar → foreign goods more expensive → domestic prices rise → AS shifts left
- Appreciation of Canadian dollar → foreign competition rises → AS shifts right
- Example: BC floods in 2021 washed out rail/highway links to Vancouver → skyrocketing transport costs → temporary leftward AS shift
4. Macroeconomic Shocks and Countercyclical Policy
Monetary Policy
Monetary Policy
The process of setting interest rates to influence economic conditions.
The Bank of Canada cuts interest rates in response to both low inflation and weak output:
- Inflation-induced response: Bank cuts rate if inflation is too low → movement along AD (not a shift)
- Output-induced response: Bank cuts rate to combat declining GDP → shifts AD to the right
Fiscal Policy
Fiscal Policy
The government’s use of spending and tax policies to influence economic conditions.
Expansionary fiscal policy examples: buildings, roads, bridges; tax cuts
- Increased government purchases shift AD to the right
The Multiplier:
Multiplier
A measure of how much GDP changes as a result of both the direct and indirect effects flowing from each extra dollar of spending.
Multiplier Example
Multiplier = 2, Initial government spending = 40 billion $$\Delta GDP = \40b \times 2 = $80b$$ Direct effect: construction workers and materials companies receive income directly Ripple effects: workers spend income at daycare → daycare workers spend at restaurants → etc. Crowding out: some private spending is dampened, reducing the overall multiplied effect
Expansionary Policy in a Recession
An output-induced interest rate cut OR boost to government purchases:
- Shifts AD right → new equilibrium: rise in output + rise in prices
Forecasting Macroeconomic Outcomes (3-Step Framework)
Exam Alert — 3-Step Process
- Is this a shift in aggregate demand or aggregate supply?
- AD shifts in response to changes in
- AS shifts in response to changes in production costs
- Is the shift an increase (right) or decrease (left)?
- How will price level and quantity of output change at the new equilibrium?
Forecasting Examples
2020 GST Credit: ↑ consumption → AD shifts right → output ↑, prices ↑
2008 Financial Crisis: frozen credit → ↑ real interest rates → ↓ consumption → AD shifts left → output ↓, prices ↓
Gulf War (oil prices rise): ↑ production costs → AS shifts left → output ↓, prices ↑ (stagflation)
Tech advances (productivity ↑): ↓ production costs → AS shifts right → output ↑, prices ↓
Diagnosing the Shock
Exam Alert — Diagnostic Tip
- Output and prices move the SAME direction → AD shock
- Output and prices move OPPOSITE directions → AS shock
COVID example: Output fell AND prices fell → AD decrease (decline in spending) Stagflation example: Output fell AND prices rose → AS decrease (production costs rose)
5. Aggregate Supply in the Short Run and the Long Run
Why Time Horizons Matter
- Changes in AD → fairly immediate effect
- Changes in AS → can take a while to play out (businesses slowly adjust prices and wages)
- Initial impact of a shock may differ from longer-term effects
- Four time horizons to analyze: (1) long run, (2) very short run, (3) short run, (4) medium run
The Four Time Horizons
| Time Horizon | Duration | Price Behaviour | AS Curve Shape |
|---|---|---|---|
| Very short run | A few weeks | Prices fixed | Horizontal |
| Short run | A few months | Prices sticky (partial adjustment) | Gently upward-sloping |
| Medium run | A year or two | Prices less sticky (more adjustment) | Steeply upward-sloping |
| Long run | Several years+ | Prices fully flexible | Vertical |
Long Run: Flexible Prices (Vertical AS)
Long Run
A period long enough that all businesses have adjusted their prices, wages, and input costs.
- Classical dichotomy: if all prices rise 10× (including wages), nothing real changes → price level has no effect on real output
- Long-run AS is vertical at potential output
- Changes in AD have no effect on long-run output — only the price level changes
Very Short Run: Fixed Prices (Horizontal AS)
- Prices are stuck at their pre-existing level
- All adjustment falls on quantities
- Strong AD → high output; weak AD → low output
- Shifts in AD have a big effect on output
Short Run: Sticky Prices (Upward-Sloping AS)
Sticky Prices
Prices that adjust sporadically and sluggishly to changes in market conditions.
- Very short run: price level stuck
- As time passes: some sellers adjust
- Insufficient demand → some sellers cut prices
- Excess demand → some sellers raise prices
- Result: upward-sloping short-run AS curve
Medium Run
- More sellers have adjusted prices than in the short run
- AS curve is steeper than the short-run curve
- Quantity adjustment further dissipates
The Full Transition (Following an AD Decrease)
| Time Horizon | Price Adjustment | Effect on GDP |
|---|---|---|
| Very short run | None (prices fixed) | Large fall in GDP |
| Short run | Small price fall | Moderate fall in GDP |
| Medium run | Moderate price fall | Small fall in GDP |
| Long run | Full price adjustment | No change in GDP |
Exam Alert
As the economy moves from the very short run to the long run following an AD shock:
- The AS curve rotates from horizontal → upward-sloping → steeper → vertical
- More and more of the adjustment is absorbed by prices rather than quantities
- The output effect shrinks to zero in the long run; the economy returns to potential output
Definitions
Aggregate demand curve Shows the relationship between the price level and the total quantity of output that buyers plan to purchase; downward-sloping.
Aggregate supply curve Shows the relationship between the price level and the total quantity of output that suppliers collectively produce; upward-sloping in the short/medium run.
Aggregate expenditure (AE) The total amount of goods and services that people want to buy across the whole economy: .
Macroeconomic equilibrium The price level and output level at which the AD and AS curves intersect.
Monetary policy The process of setting interest rates to influence economic conditions (conducted by the Bank of Canada).
Fiscal policy The government’s use of spending and tax policies to influence economic conditions.
Multiplier A measure of how much GDP changes per dollar of spending, capturing both direct and indirect (ripple) effects: .
Stagflation The combination of stagnant output (recession) and rising inflation; caused by a leftward AS shift.
Sticky prices Prices that adjust sporadically and sluggishly to changing market conditions.
Potential output The long-run equilibrium level of real GDP; the vertical position of the long-run AS curve.
Classical dichotomy The idea that in the long run, changes in the price level have no effect on real variables — price level and real output are independent.