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3.2 Variations in economic activity—aggregate demand and aggregate

supply

❖ Aggregate demand (AD)

Aggregate demand (AD) is the total spending on the economy’s goods and services at different price
levels over a given period of time.

● Aggregate demand curve

The AD curve shows the different quantities of total demand for the economy’s products (goods and
services) at different price levels. A rise in the price level will cause the AD to fall and a fall in price level
causes the AD to rise. Due to this inverse relationship between the price level and AD, the AD curve
slopes downward from left to right.

Fig: The AD curve

● Reasons for an inverse relationship between the price level and AD:

● Real balance effect

An increase in the price level reduces the value of money balance held by the people in the banks and
other financial institutions. This fall in the value of money balance reduces the purchasing power of the
people. Thus, the AD decreases and vice versa.
Example:
Let, money balance=$100
Price level= $5
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$ 100
Maximum quantity of goods that can be bought using the given money balance of $100= = 20
$5
units
Now, money balance being unchanged; price level increases to $10. So, the maximum quantity of
$ 100
goods that can be bought = = 10 units
$ 10
● Interest rate effect
An increase in price level causes the interest rate to increase. This increase in the rate of interest
encourages the people to save more and spend less. In addition, an increase in interest rate raises the
cost of borrowing which, in turn, reduces the consumption spending and investment by borrowing.
Thus, the AD decreases when the price level increases and vice versa.

● Foreign purchase effect

An increase in price level in an economy causes the domestic producers to switch to the cheaper foreign
products as well as the foreign buyers will buy less of the country’s products. Thus, the export earning
decreases and the import spending increases causing the net exports (x-m) to decrease which, in turn,
reduces the AD and vice versa.

● Components of AD:

AD is composed of the following four components:

● Private consumption expenditure (C)

● Private investment expenditure (I)

● Government consumption and investment expenditure (G)

● Net exports (X-M)

So, AD (=AE) = C+ I + G + (X-M)

Note: Net export is the difference between the value of exports of goods and services and
the value of import of goods and services.

Example: 1
Let,
C=$25 I=$40 G=$25 X=$50 M=$25

AD = $25 + $40 + $25 + ($50 - $25)

=$115
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Example: 2
Let, AD= $1000m C =$200m I=$300m G=$400m X=$200m
Find M.

AD = C + I + G + (X-M)
$1000m = $200m + $300m+ $400m+ ($200m - M)

● Determinants of AD components

Determinants of Private consumption expenditure (C)

● consumer confidence

● interest rates

● wealth

● income taxes

● level of household indebtedness

● expectations of future price level

Determinants of private Investment expenditure (I)

● interest rates

● business confidence

● technology

● business taxes

● level of corporate indebtedness

Determinants of Government spending (G)

● Tax Revenue

● Size and composition of population

● political and economic priorities

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Determinants of net exports (X – M)

● income of trading partners

● exchange rates

● trade policies

● Quality of domestic products

● Shifts of the AD curve caused by changes in determinants

Any change in one or all the determinants of AD causes the AD to change. This change in AD
causes the AD curve to shift from its position. An increase in AD causes a rightward shift while a
decrease in AD causes the AD curve to shift leftward.

Fig: Shifts in AD curve

❖ Aggregate Supply (AS)

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Aggregate supply (AS) is the total quantity of goods and services that the firms are able and
willing to produce at different price levels over a period of time (a fiscal year).

Short run aggregate supply (SRAS)

Short Run Aggregate Supply (SRAS) is the total supply of goods and services currently being
achieved in the economy. To put in other words, it is the output that will be supplied in a period
of time when the prices of factors of production (inputs or resources) have no time to adjust to
changes in aggregate demand (AD) and the price level.

There exists a direct relationship between the price level and SRAS. That is, when the price
level rises, SRAS increases and vice versa. Due to this reason the SRAS curve slopes upward
from left to right.

Fig: Short run AS curve

● Reasons for a direct relationship between SRAS and price level

● Profit effect
Other factors including the costs of production being unchanged, an increase in price level raises the
firms’ profit. This increased profit encourages the firms to increase production as the price level rises.

● Cost effect
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As the firms increase production, the cost of producing additional output increases. The increased costs
of production can be covered up only if the price level rises. Hence, the firms produce more output only
if the price level rises.

● Misinterpretation effect
The producers/ firms often confuse the increase in price level with an increase in the relative prices. The
prices of their goods may increase because of inflation occurring in the economy but they may think that
the prices their goods have increased as they have become more popular among the consumers. This
may encourage them to produce more when the price level rises.

Factors affecting SRAS

Productivity - the level of labour, capital and Multi-Factor productivity:
Higher level of productivity means goods and services are being produced more efficiently, decreasing
unit costs of production, increasing aggregate supply.

Labour Wage Costs

Higher wage costs means that an economy produces less goods and services due to higher costs of
production

Government policy
Imposition of regulation and taxation can place a burden on the unit costs of production, lowering the
aggregate supply of an economy. On the other hand, provision of subsidies to private producers reduces
the unit costs of production, increasing the aggregate supply in an economy.

Fig: Shifts in SRAS curve

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❖ Long-run aggregate supply (LRAS)

Long Run Aggregate Supply (LRAS) is the maximum supply of goods and services that can be achieved
with full employment of resources.

Alternative views of aggregate supply (AS)

• Keynesian view of the AS curve

The LRAS curve illustrated by the Keynesians has three segments on it. It is perfectly elastic
(horizontal) at low level of output, upward sloping over a range of output and perfectly inelastic
(vertical) at the full employment/ potential level of output.
Fig: Keynesian LRAS curve
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The diagram above shows the long-run aggregate supply curve that was created by John
Maynard Keynes. Keynes believed that the long-run aggregate supply curve (LRAS) has three
main segments through which a market will go through over a period of time. Keynes believed
that at the beginning, the market will start out with an increased level of output with no
increase in prices since there is lots of spare capacity in the economy. Once the market moves
through the early parts of the LRAS, the spare capacity will then be used up and output will go
up at the same time. As a consequence, the costs of the factors of production will rise. After the
middle section in the LRAS, employment will be full since output cannot be increased since all
the factors of production are being utilized.

• Monetarist/new classical view of the long-run aggregate supply (LRAS) curve

Monetarists believe that the LRAS is completely vertical as there is no spare capacity in an
economy. The maximum output is already being produced; this means that any shifts in the AD
curve will only cause increases in the price level (inflation) and will have no effect on output
levels.

Fig: Vertical LRAS curve illustrated by the monetarists

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However both the Keynesians and monetarists agree on that the LRAS curve shifts rightward if
there is an increase in the economy’s production possibility (increase in the potential or full
employment level of output). An economy’s production possibility may increase due to the
following reasons:

• Changes in the quantity and/or quality of factors of production

• Improvements in technology
• Increases in efficiency
• Changes in institutions (competitive markets, banking system, property rights etc.)

Fig: Rightward shift in LRAS

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● Macroeconomic equilibrium

• Short-run equilibrium

Short-run macroeconomic equilibrium is achieved when aggregate demand (AD) and the short-
run aggregate supply (SRAS) are equal in the short term. In graphical form, this is the point
where the aggregate demand curve meets (or intersects) the short-run aggregate supply curve.

Fig: Short run macroeconomic equilibrium

Short-run macroeconomic equilibrium occurs (geometrically) at the intersection of the short-

run aggregate supply curve (SRAS) and the aggregate demand curve (AD). This intersection
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indicates the price level at which the aggregate quantity of final goods and services supplied in
the economy is equal to the aggregate quantity demanded, and indicates as well the
corresponding level of real GDP (equilibrium real GDP). In the above diagram, the equilibrium
price level is P* and the short-run equilibrium real GDP is Y*. This short-run equilibrium real
GDP may be less than or greater than (or equal to) potential GDP.

To see that this point of intersection is an equilibrium point, consider first a situation where the
price level is below that corresponding to the short-run equilibrium. At this price level, the
quantity of real GDP that will be supplied by firms will be less than the quantity of real GDP that
will be demanded by households, business firms, government, and net foreign demand. With
firms unable to meet demand, inventories decline and back orders become the rule. In order to
meet the strong demand, firms will begin to increase production; and in so doing will incur
additional resource costs that will result in price increases (i.e., there will be a movement up
along the SAS curve). As prices increase, this will lead to a moderating of demand (movement
up along the AD curve). These movements will continue until quantity supplied equals quantity
demanded -- at the point of intersection of the SAS and AD curves.

Similarly, if the price level is greater than the equilibrium level, the quantity of real GDP
supplied will exceed the quantity demanded. In this case, inventories will accumulate, goods
and services will go unsold, and eventually firms will lay off workers, cut production, and reduce
prices in order to sell their output. This will cause a movement down along the SAS curve, and
as prices fall there will be a corresponding movement down along the AD curve. These
movements will continue until equilibrium is reached.

● Changes in short –run macroeconomic equilibrium

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Any change in the AD and/or SRAS causes the short-run macroeconomic equilibrium to change.
For instance, SRAS being unchanged, an increase in AD causes the price level as well as the real
GDP to increase.

Fig: Effect of change in AD on short-run equilibrium

Fig: Effect of change in SRAS on short-run equilibrium

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❖ Long – run macroeconomic equilibrium

● Equilibrium in the monetarist/new classical model

● Determination of long-run equilibrium at full employment level of output

(potential output)
According to the monetarists / new classical mode, Long-run macroeconomic equilibrium
requires that real GDP is equal to potential GDP, and corresponds to a situation of full
employment. That is, long-run macroeconomic equilibrium requires the economy being on its
vertical long-run supply curve. This is full-employment equilibrium, and is the only case where
we have long-run equilibrium as well as short-run equilibrium. This contrasts with the short-run
equilibrium situation, in which real GDP may be less than or greater than (or equal to) potential
GDP.

Fig: Full employment equilibrium

The above diagram shows the full employment equilibrium of an economy. The point of full
employment equilibrium is ELR on the LRAS curve. The equilibrium price level is PE and the
equilibrium real GDP is YE which is also the potential GDP. That is, when an economy is in a state
of full employment equilibrium Real GDP = potential GDP or full employment GDP.
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● Automatic adjustment to full employment equilibrium

In the long-run the economy is self-correcting. The shocks to AD do not affect aggregate
output / AS in the long run.

Let us consider first the case where there is a short-run equilibrium at a real GDP below the
level of potential GDP. This is called a below full-employment equilibrium, and the difference
between potential GDP and real GDP is called a recessionary gap (also referred to as negative
output gap or deflationary gap). A recessionary gap is associated with a business cycle
contraction. A recessionary gap manifests the presence of high unemployment.

Fig: Short-run recessionary/deflationary gap

If real GDP < Potential real GDP (full employment GDP), then a recessionary gap exist. At the
same time: Unemployment rate > natural rate of unemployment. Since more job seekers are in
the market, they tend to settle with a lower wage. Lower wage will lower the AS curve (increase
AS) and causing the price to decrease. Lower price will increase consumption. This process will
continue until the economy reaches the long run equilibrium where real GDP=potential real
GDP.

On the other side, if the short-run equilibrium real GDP is in excess of potential GDP is called an
above full-employment equilibrium. The excess of real GDP over potential GDP is called an
inflationary gap (also referred to positive output gap). That is, this gap creates inflationary
pressure in an economy.
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Fig: Short-run inflationary gap

If real GDP > Potential real GDP (full employment GDP), then an inflationary gap exist. At the
same time: Unemployment rate < natural rate of unemployment. Since job seekers are less
than job openings in the market, employers are forced to raise the wage to attract new
workers. High wage will decrease the AS (upward shift), and raise the price. Higher price will
lower consumption. This process will repeat until the long run equilibrium is reached.

Note:

Fluctuations in the short-run aggregate supply cause short-run stagflation. A fall in aggregate
supply leads to stagflation, characterized by high unemployment (“stagnation”) and a high
inflation rate.

Fig: Short-run stagflation

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As seen in the above diagram, a fall in SRAS (AS to AS1) raises the price level from PLe to PL1 and
reduces the real GDP from QY to Q1 resulting in increased unemployment in an economy. This
situation of increase in both price level and unemployment is referred to as stagflation.

● Unemployment at full employment equilibrium is equal to the

natural rate of unemployment
Full employment is considered to be the highest possible level of employment. It is often
considered to be achieved when the unemployment rate falls to 3%, although the rate may vary
between countries. The rate of unemployment cannot fall to 0 % because at any particular time
some people may be experiencing a period of unemployment as they move from one job to
another job.

The unemployment that exists when the economy is in full employment equilibrium with real
GDP = potential GDP is called natural rate of unemployment. It also referred to as the non-
accelerating inflation rate of unemployment (nairu). At the state of full- employment
equilibrium, aggregate demand for labour equals the aggregate supply of labour at the current
wage rate and price level. So, the inflation rate remains constant, with the actual inflation rate
equaling the expected one at this rate of unemployment.

● Equilibrium in the Keynesian model

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Persistence of deflationary/recessionary gaps: equilibrium level of output

might not equal the full employment level of output
According to the Keynesians, if an economy is left free from any form of government
intervention, there is no guarantee that the economy will achieve a full employment/ potential
level of GDP. Indeed, they think that the GDP may deviate from the full employment level by a
large amount and for long periods. Due to this reason there is a persistence of
deflationary/recessionary gaps in an economy. In such cases, they favor government
intervention to influence the level of economic activity. They argue that if there is high
unemployment and the GDP is below the full employment/potential level by a larger amount,
the government should increase its spending to achieve the full employment / potential level of
GDP.

Fig: Equilibrium in the Keynesian model

The above diagram shows the long run macroeconomic equilibrium in the Keynesian model.
The equilibrium Real GDP is ‘Y’ which is below the potential GDP Yf. Since the equilibrium GDP
is below the potential level, recessionary gap (also referred to as deflationary gap or negative
output gap) of Y- Yf occurs in an economy.

Because deflationary/recessionary gaps can occur in the LR, there is a key role for AD in
Keynesian macroeconomic policies. Governments may need to stimulate AD by using Fiscal and
Monetary policies (Policies influencing AD).

Here expansionary Fiscal and Monetary policies can create economic growth and reduce
unemployment, but at the expense of higher inflation.
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❖ Assumptions and implications of the monetarist/new classical

and Keynesian models
The three key assumptions underlying the monetarists/ new classical study of macroeconomics
are flexible prices, Say's law, and saving-investment equality. These three assumptions ensure
that the macro economy would continue to produce the quantity of aggregate output that fully
employs available resources. While a few resources might be temporarily unemployed, they
would be quickly reemployed as resource prices (especially wages) adjust to equilibrium
balance.

● Flexible Prices

The first assumption of monetarist/new classical economics is that prices are flexible. Price
flexibility means that markets are able to adjust quickly and efficiently to equilibrium. While this
assumption does not mean that every market in the economy is in equilibrium at all times, any
imbalance (shortage or surplus) is short lived. Moreover, the adjustment to equilibrium is
accomplished automatically through the market forces of demand and supply without the need
for government action.

The most important macroeconomic dimension of this assumption applies to resource markets,
especially labor markets. The unemployment of labor, particularly involuntary unemployment,
arises if a surplus exists in labor markets. With a surplus, the quantity of labor supplied exceeds
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the quantity of labor demanded--at the exist price of labor (wages). With flexible prices, any
surplus is temporary. Wages fall to eliminate the surplus imbalance and restore equilibrium--
and achieve full employment.

● Say's Law: Supply creates its own demand

The second assumption of monetarists/new classical economics is that the aggregate

production of good and services in the economy generates enough income to exactly purchase
all output. That is, the production of goods is ensured to be purchased by waiting buyers. This
notion commonly summarized by the phrase "supply creates its own demand" is attributed to
the Jean-Baptiste Say, a French economist who helped to popularize the work of Adam Smith in
the early 1800s.

● Saving-Investment Equality

The last assumption of monetarists/new classical economics is that saving by the household
sector exactly matches investment expenditures on capital goods by the business sector.

Keynesian Critique of the assumptions of the monetarists/new classical

economics
Keynesian economics was developed by John Maynard Keynes in 1936 during the depths of the
Great Depression. Keynes promoted his new theory of macroeconomics by showing where the
existing monetarists / new classical economics went wrong, especially why it was unable to
explain the length and severity of the Great Depression. A discussion of each of the three
assumptions of monetarists /new classical economics provides a bit of insight.

Flexible Prices:

Whereas new classical economists assumes that prices are flexible and quickly adjust to
equilibrium, Keynesian economics assumes that prices are inflexible and do not quickly adjust
to equilibrium. Keynes argued that prices are really inflexible, especially in the downward
direct. This inflexibility or rigidity of prices results because sellers, both output producers and
resource owners, are unwilling or unable to accept lower prices. Inflexible prices thus prevent
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markets from eliminating shortages and surpluses. In particular, rigid wages allow a surplus of
labor (that is, involuntary unemployment) to persist.

Say's Law:

Keynes was perhaps most critical of Say's law that supply creates its own demand. Keynes
questioned whether or not supply does in fact create demand. While, in principle, revenue
generated by production ultimately ends up as household income, this does not happen
instantaneously. In the meantime, households can only spend the income that they actually
have (disposable income). If they have less income, then they spend less, less are sold, less are
produced, and less revenue are generated.

Saving-Investment Equality:

The assumed equality between saving and investment was also criticized by Keynes. According
to the Keynesians saving and investment are influenced by factors other than the interest rate.
These other factors can prevent the equality between saving and investment. The lack of
equality between saving and investment can lead to a cumulatively reinforcing downward spiral
of declining production and income.

The most important non-interest-rate determinant of household saving is disposable income.

As the disposable income changes, not only does the household sector change consumption
expenditures, it also changes saving. Keynesian economics assumes that the relation between
saving and income is a great deal more important than that between saving and the interest
rate.

Note:

Keynesian and the monetarist theoretical approach

Keynesians are the economists whose ideas are based on the work of the British economist
John Maynard Keynes. The terminology of demand-side economics is synonymous with
Keynesian economics. They believe the economy is best controlled by manipulating the
demand for goods and services. They believe that if left to free market forces there is no
guarantee that the economy will achieve a full employment level of GDP. Indeed they think
that the level of GDP can deviate from the full employment level by a large amount and for
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long periods. In such cases, they favor government intervention to influence the level of
economic activities. They argue that if there is high unemployment, the government should
use a deficit budget to increase the aggregate demand (AD). They believe that a government
can assesses the appropriate amount of extra spending to inject into the economy in such a
situation. For most Keynesians, the avoidance of unemployment is a key priority. They
believe in consumption, government expenditures and net exports to change the state of the
economy.

However, these economists do not completely disregard the role the money supply has in the
economy and on affecting the gross domestic product, or GDP. Yet, they do believe it takes a
great amount of time for the economic market to adjust to any monetary influence.

Monetarists are the economists whose ideas are based on the work of the American
economist Milton Friedman. They are certain that the money supply is what controls the
economy, as their name implies.

In contrast to the Keynesians, for monetarists, the control of inflation should be the top
priority of a government. They argue that inflation is the result of excessive growth of money
supply. So, they believe that the main role of a government is to control inflation. They also
maintain that attempts to reduce unemployment by increasing government spending will
only succeed in raising inflation in the long run (conflicts between policy objectives). They
believe that the economy is inherently stable unless disturbed by erratic changes in the
growth of money supply.

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