Variations in economic activity—aggregate demand and aggregate supply

· Purpose of the model: explains changes in real output (real GDP) and the price level in the whole economy.
· Use it to analyse short-run fluctuations, output gaps, inflationary pressure, recessionary/deflationary pressure, and the difference between Keynesian and monetarist/new classical views.
· In essays, always link changes in AD, SRAS, or LRAS/AS to both real GDP and the price level.

Aggregate demand (AD)

· Aggregate demand (AD) = total planned spending on domestically produced goods and services at different price levels.
· Formula: AD = C + I + G + (X − M)
· C = consumption, I = investment, G = government spending, X − M = net exports.
· The AD curve slopes downward.
· A lower price level causes a movement along AD to a higher level of real output demanded; a higher price level causes a movement to lower real output demanded.
· In exams, distinguish clearly between movement along the curve and shift of the curve.

This diagram shows the basic AD/AS framework: a downward-sloping AD curve crossing an upward-sloping AS/SRAS curve. Use it to identify equilibrium price level and equilibrium real GDP before analysing any shifts. Source

Components and determinants of AD

· Consumption (C) depends on consumer confidence, interest rates, wealth, income taxes, household indebtedness, and expectations of future price level.
· Investment (I) depends on interest rates, business confidence, technology, business taxes, and corporate indebtedness.
· Government spending (G) depends on political priorities and economic priorities.
· Net exports (X − M) depend on income of trading partners, exchange rates, and trade policies.
· Strong exam technique: when asked why AD changed, identify the component first, then the determinant, then the direction of the shift.

Shifts of the AD curve

· A rise in any determinant that increases total spending causes a rightward shift of AD.
· A fall in any determinant that reduces total spending causes a leftward shift of AD.
· Examples of AD right shift: higher consumer confidence, lower interest rates, higher government spending, stronger export demand.
· Examples of AD left shift: higher income taxes, weak business confidence, lower government spending, falling trading partner income.
· Right shift of AD tends to cause higher real GDP and higher price level in the short run.
· Left shift of AD tends to cause lower real GDP and lower price level in the short run.

This diagram shows an AD rightward shift from expansionary policy. It is useful for showing how stronger aggregate demand raises real output and often the price level in the short run. Source

Short-run aggregate supply (SRAS)

· Short-run aggregate supply (SRAS) shows the total output firms are willing to produce at different price levels in the short run.
· The SRAS curve slopes upward.
· Main determinants of SRAS in the syllabus: costs of factors of production and indirect taxes.
· If costs of production fall or indirect taxes fall, SRAS shifts right.
· If costs of production rise or indirect taxes rise, SRAS shifts left.
· A rightward SRAS shift causes higher real GDP and lower price level.
· A leftward SRAS shift causes lower real GDP and higher price level.
· This is the key basis for explaining cost-push inflation and stagflation.

Alternative views of aggregate supply

· The syllabus requires the monetarist/new classical view of LRAS and the Keynesian view of AS.
· In the monetarist/new classical model, LRAS is vertical at full employment output/potential output.
· This means in the long run the economy returns to full employment equilibrium.
· In the Keynesian model, the AS curve has a horizontal section, then an upward-sloping section, then a vertical section.
· This means when there is spare capacity, increases in AD can raise real GDP with little or no inflation.
· Near full employment, extra AD mainly increases the price level.
· In essays, compare the models directly: classical = self-correcting economy; Keynesian = gaps can persist.

This diagram shows the Keynesian AS/LRAS shape with spare capacity, an intermediate range, and full employment. It helps explain why an increase in AD may raise mostly real GDP at low output levels but mostly the price level near capacity. Source

Shifts of LRAS / Keynesian AS over the long run

· A rightward shift of LRAS or Keynesian AS means higher potential output and improved productive capacity.
· Causes: better quantity and/or quality of factors of production, improved technology, increased efficiency, and better institutions.
· A leftward shift means lower productive capacity.
· These are long-run supply-side changes, not short-run cost changes.
· In exam answers, say this increases the economy’s productive capacity and supports non-inflationary growth.

Macroeconomic equilibrium

· Short-run equilibrium occurs where AD = SRAS.
· This determines the current equilibrium real GDP and equilibrium price level.
· In the monetarist/new classical model, long-run equilibrium occurs where AD, SRAS, and LRAS intersect at full employment output.
· In this model, the economy is assumed to automatically adjust back to full employment after a shock.
· At full employment equilibrium, unemployment equals the natural rate of unemployment.
· In the Keynesian model, equilibrium output may remain below full employment for a prolonged period.
· Therefore, deflationary/recessionary gaps can persist without policy intervention.

Inflationary and deflationary/recessionary gaps

· A deflationary/recessionary gap exists when equilibrium real GDP is below full employment output.
· Effects: cyclical unemployment, unused resources, weak growth, downward pressure on prices/inflation.
· An inflationary gap exists when equilibrium real GDP is above full employment output.
· Effects: upward pressure on the price level, resource bottlenecks, inflationary pressure.
· In the classical view, these gaps are temporary because the economy self-corrects.
· In the Keynesian view, a deflationary gap may persist because wages/prices are sticky and AD may remain too low.

This diagram shows an economy operating below full employment output, with actual output to the left of Ye. Use it to explain a deflationary/recessionary gap, cyclical unemployment, and why policy may be used to shift AD rightward. Source

Monetarist/new classical vs Keynesian: assumptions and implications

· Monetarist/new classical assumptions: prices and wages are relatively flexible; markets tend to clear; the economy is self-correcting.
· Implication: policy may be less necessary in the long run because output returns to potential output automatically.
· Keynesian assumptions: wages/prices can be sticky; demand may be insufficient; economies can settle below full employment.
· Implication: demand management policies may be needed to close recessionary gaps.
· Strong evaluation point: the choice between models changes whether economists support active policy intervention.

Exam skills and diagram moves

· If AD shifts right: mention higher real GDP and higher price level in the short run.
· If AD shifts left: mention lower real GDP and lower price level in the short run.
· If SRAS shifts right: mention higher real GDP and lower price level.
· If SRAS shifts left: mention lower real GDP and higher price level.
· If LRAS/Keynesian AS shifts right: mention higher potential output and long-run growth.
· Always label axes correctly: price level on the vertical axis, real GDP/output on the horizontal axis.
· Always state whether the change is movement along a curve or a shift of the curve.

Common exam traps

· Do not confuse AD with demand in microeconomics.
· Do not say a change in price level shifts AD or SRAS; it usually causes a movement along the relevant curve.
· Do not confuse SRAS determinants with LRAS determinants.
· Do not assume all increases in AD are good; near full employment they may mainly cause inflation.
· Do not forget to mention both real GDP and price level whenever a curve shifts.