Aggregate demand and aggregate supply
Key terms
Define each term.
Multiple choice
Circle the correct answer.
Which of the following would cause a movement along the AD curve rather than a shift of it?
An economy is operating on the horizontal section of a Keynesian aggregate supply curve. What is the most likely effect of a rise in government spending?
Worked problems
Show your working.
Finding equilibrium and the effect of a rise in AD from a table. An economy has the following aggregate demand and short-run aggregate supply, with real output in $ billion. Price level 100: AD 900, SRAS 820. Price level 105: AD 880, SRAS 840. Price level 110: AD 860, SRAS 860. Price level 115: AD 840, SRAS 880. Price level 120: AD 820, SRAS 900. Full employment output is $880 billion. Find the equilibrium. Then find the new equilibrium if AD rises by $40 billion at every price level, and describe what happened.
Combining the multiplier with the AD/AS model. In an economy, AD is Y = 2,000 - 10P and SRAS is Y = 10P, where Y is real output in $ billion and P is the price level index. The government raises spending by $20bn and the multiplier is 2.5. Find the initial equilibrium, the shift in AD, and the new equilibrium. Then say what would happen if LRAS were vertical at the initial output.
Chains of reasoning
The steps are in the wrong order. Write the letters in the order that makes a linked chain.
How an oil price shock causes stagflation
- A As the price level rises, the quantity of real output demanded falls, a movement up along the AD curve.
- B The new equilibrium has a higher price level and a lower level of real output.
- C At the old price level there is excess demand, so the price level rises.
- D The world price of oil rises sharply.
- E At every price level firms are now willing to supply less, so SRAS shifts to the left.
- F Lower output means firms need fewer workers, so unemployment rises at the same time as inflation: stagflation.
- G Energy and transport are inputs to almost every good, so firms' costs of production rise across the economy.
The classical route back to full employment, and where it can break
- A Lower wages reduce firms' costs of production, so SRAS shifts right.
- B A fall in business confidence reduces investment, so AD shifts left.
- C In the classical account, the economy returns to full employment output at a lower price level with no intervention.
- D With many workers seeking jobs, money wages begin to fall.
- E Real output falls below full employment output and a negative output gap opens, so unemployment rises.
- F The price level falls and real output rises back towards full employment along the new, lower AD curve.
- G The Keynesian objection is at step 3: if money wages do not fall, SRAS does not shift, and the economy stays below full employment. Even if wages do fall, falling incomes may cut spending further and shift AD left again, so the adjustment may run the wrong way.
Diagrams
Draw two diagrams with the price level on the vertical axis and real output on the horizontal axis. On the first, draw a downward-sloping AD curve, an upward-sloping SRAS curve and a vertical LRAS curve, with all three meeting at full employment output. On the second, draw a Keynesian AS curve in three sections, label the horizontal, intermediate and vertical sections, and draw three AD curves cutting it in each section.
Draw an AD/AS diagram in equilibrium. Show the effect of a sharp rise in import prices on SRAS, and mark the change in the price level and in real output. On a second diagram, show the effect of a large programme of investment in education and training on LRAS, and mark the same two changes.
Draw a classical AD/AS diagram with a vertical LRAS. Show a leftward shift of AD, the short-run fall in output along the original SRAS, and then the rightward shift of SRAS as money wages fall, returning the economy to LRAS at a lower price level. Mark the path of the economy with arrows.
Extended answer
Plan your answer: list the points you would make in each paragraph.
Assess whether an increase in aggregate demand will always lead to inflation. (13 marks)
Answers
Aggregate demand (AD): The total planned spending on an economy's goods and services at each possible price level over a given period.
Aggregate supply (AS): The total output of goods and services that firms in an economy are willing and able to produce at each possible price level over a given period.
B. A change in the price level is the variable on the vertical axis, so it moves the economy along the existing AD curve. Confidence, income tax and foreign incomes all change planned spending at every price level, so each shifts the curve.
B. On the horizontal section there is substantial spare capacity, so firms can produce more without bidding up costs. Extra spending is met by extra output, and the price level barely moves. The same rise in spending on the vertical section would raise only the price level.
Step 1. Find the initial equilibrium. AD equals SRAS at a price level of 110, where both are $860bn. Real output is $860bn, which is $20bn below full employment, so there is a negative output gap and some cyclical unemployment.
Step 2. Write out the new AD schedule. Adding $40bn at each price level: 940 at 100, 920 at 105, 900 at 110, 880 at 115, 860 at 120.
Step 3. Find the new equilibrium. New AD equals SRAS at a price level of 115, where both are $880bn.
Step 4. Split the change into output and prices. Real output rose by $20bn, from 860 to 880, which closes the output gap. The price level rose from 110 to 115, which is (5 / 110) x 100 = 4.5%. Only half of the $40bn rise in spending became extra output; the rest was absorbed by higher prices.
Step 5. Say what a further rise in AD would do. The economy is now at full employment output of $880bn. If LRAS is vertical there, a further rise in AD cannot raise real output in the long run, so it would raise only the price level.
The split in step 4 is the whole point. The same rise in AD can be mostly output or mostly inflation depending on how close the economy is to capacity, and the numbers let you show that rather than assert it.
Step 1. Initial equilibrium. Set AD = SRAS: 2,000 - 10P = 10P, so 20P = 2,000 and P = 100. Real output Y = 10 x 100 = $1,000bn.
Step 2. Size of the AD shift. The multiplier turns a $20bn injection into a $20bn x 2.5 = $50bn increase in spending at every price level, so the new AD is Y = 2,050 - 10P.
Step 3. New equilibrium with an upward-sloping SRAS. 2,050 - 10P = 10P, so P = 102.5 and Y = $1,025bn. Real output rose by $25bn, only half of the $50bn shift, and the price level rose by 2.5%.
Step 4. If LRAS is vertical at $1,000bn. In the long run output cannot exceed $1,000bn. Substituting Y = 1,000 into the new AD: 1,000 = 2,050 - 10P, so P = 105. The whole increase in spending ends up as a 5% rise in the price level and none of it as extra output.
Step 5. Interpret. The multiplier measures how far AD shifts, not how much output rises. How much of that shift becomes real output depends on the slope of AS, which depends on how much spare capacity exists.
Candidates who apply the multiplier and report a $50bn rise in GDP have assumed a horizontal AS curve without saying so. At A Level you are expected to see that the multiplier and the AS curve answer different questions.
D, G, E, C, A, B, F
- The world price of oil rises sharply.
- Energy and transport are inputs to almost every good, so firms' costs of production rise across the economy.
- At every price level firms are now willing to supply less, so SRAS shifts to the left.
- At the old price level there is excess demand, so the price level rises.
- As the price level rises, the quantity of real output demanded falls, a movement up along the AD curve.
- The new equilibrium has a higher price level and a lower level of real output.
- Lower output means firms need fewer workers, so unemployment rises at the same time as inflation: stagflation.
This is why a supply shock is so hard for policymakers. Raising AD to fight the unemployment makes the inflation worse; cutting AD to fight the inflation makes the unemployment worse. No demand-side policy fixes both.
B, E, D, A, F, C, G
- A fall in business confidence reduces investment, so AD shifts left.
- Real output falls below full employment output and a negative output gap opens, so unemployment rises.
- With many workers seeking jobs, money wages begin to fall.
- Lower wages reduce firms' costs of production, so SRAS shifts right.
- The price level falls and real output rises back towards full employment along the new, lower AD curve.
- In the classical account, the economy returns to full employment output at a lower price level with no intervention.
- The Keynesian objection is at step 3: if money wages do not fall, SRAS does not shift, and the economy stays below full employment. Even if wages do fall, falling incomes may cut spending further and shift AD left again, so the adjustment may run the wrong way.
Being able to state exactly which step the Keynesian view rejects is worth more than describing either school in general. It turns a list of opinions into an argument about a mechanism.
Label the full employment level of output, usually Yfe, on both. The second diagram is the one you will use most, because it lets you say that the effect of any change in AD depends on where the economy starts.
The contrast is the lesson. Both are supply-side changes, but one raises prices and cuts output while the other lowers prices and raises output. Candidates who can show both on diagrams can answer almost any question about growth or inflation.
Draw the short-run and long-run positions as separate points. The diagram is the classical argument in one picture, and a Keynesian critique is simply an argument that the second shift is slow or missing.
Define and frame: Define aggregate demand, its components and inflation. Identify 'always' as the claim under test. State that the answer depends on how much spare capacity the economy has, which determines the shape of AS at the point where AD shifts.
Analysis: when it does: Near full capacity, on the steep or vertical section of AS, a rightward AD shift is absorbed almost entirely by the price level: demand-pull inflation. Explain the mechanism: firms compete for scarce labour and materials, costs rise and are passed on. Use a diagram with the shift on the vertical section and, on a classical view, the long-run result that extra demand raises only prices.
Analysis: when it does not: With a large negative output gap, on the horizontal section, the same shift raises real output and employment with little effect on the price level. Add that if the rise in AD is driven by investment, it also shifts LRAS right over time, so capacity grows with demand and inflationary pressure can be offset.
Evaluation: Weigh the conditions rather than listing them. The size of the output gap is decisive but hard to measure, since potential output is estimated. The speed of the increase matters: a rapid rise creates bottlenecks even with spare capacity. Expectations matter: if firms and workers expect inflation they raise prices and wages ahead of it. And the cause matters: a rise in AD alongside a favourable supply shock need not raise prices at all.
Judgement: Reject 'always'. An increase in AD leads to inflation when the economy is close to capacity, when the increase is rapid or when inflation expectations are rising; it leads mainly to higher output when there is substantial spare capacity. State which conditions you judge most likely in the case given, because a conclusion that says only 'it depends' without saying on what will not reach the top band.