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.
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.
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.
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.
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.
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.