Aggregate Demand & Aggregate Supply

Aggregate Demand & Aggregate Supply

The AD/AS model is the central macroeconomic framework for analysing changes in output, employment, and the price level. It brings together the behaviour of all consumers, firms, the government, and the international sector.

Aggregate Demand (AD)

Aggregate demand is the total planned spending on goods and services in an economy at a given price level over a given period.

AD = C + I + G + (X - M)

Component	Description	Approx. UK Share
C (Consumption)	Household spending on goods and services	~60%
I (Investment)	Spending by firms on capital goods (machinery, technology, buildings)	~17%
G (Government spending)	Public expenditure on goods and services (not transfers)	~20%
X - M (Net exports)	Exports minus imports	Typically negative (deficit)

Why AD Slopes Downwards

The AD curve is downward-sloping (higher price level → lower real output demanded):

1. Wealth effect (Pigou effect): higher prices reduce the real value of savings → consumers feel poorer → C falls

2. Interest rate effect: higher prices increase demand for money → interest rates rise → I and C fall (more expensive to borrow)

3. International competitiveness effect: higher domestic prices → exports less competitive, imports relatively cheaper → (X - M) falls

Shifts in AD

AD shifts when any component changes at a given price level:

Consumption (C) affected by:

• Consumer confidence and expectations
• Interest rates (lower rates → cheaper borrowing → more spending)
• Wealth effects (rising house/share prices → higher consumption via equity withdrawal)
• Income tax changes
• Credit availability
• Distribution of income (higher MPC among lower earners)

Investment (I) affected by:

• Interest rates (cost of borrowing)
• Business confidence and expectations (animal spirits — Keynes)
• Corporation tax
• Technological change
• Spare capacity
• Accelerator effect: investment depends on the rate of change of national income

Government spending (G) is a policy variable — determined by fiscal policy decisions.

Net exports (X - M) affected by:

• Exchange rates (depreciation → exports cheaper, imports dearer → (X-M) improves)
• Relative inflation rates
• Income levels abroad (higher foreign income → more demand for UK exports)
• Trade policies (tariffs, quotas)
• Non-price factors (quality, branding, reliability)

Aggregate Supply (AS)

Aggregate supply is the total output that producers are willing and able to supply at a given price level.

Short-Run Aggregate Supply (SRAS)

The SRAS curve is upward-sloping: higher prices incentivise firms to produce more (higher prices increase profit margins in the short run, assuming some costs are sticky).

Shifts in SRAS (changes in costs of production):

• Raw material/commodity prices (oil price shocks)
• Wages: higher wages shift SRAS left (cost-push)
• Exchange rate: depreciation raises import costs → SRAS left
• Indirect taxes: increase shifts SRAS left; subsidies shift right
• Productivity: higher productivity shifts SRAS right

Long-Run Aggregate Supply (LRAS)

There are two competing views of LRAS:

Classical/Monetarist View

• LRAS is vertical at the economy's potential output (full employment GDP)
• In the long run, all markets clear, wages and prices are fully flexible
• The economy always returns to full employment
• Changes in AD only affect the price level, not real output, in the long run
• LRAS shifts with changes in the quantity or quality of factors of production: labour force growth, capital investment, technological progress, institutional improvements

Keynesian View

• The AS curve has three sections:

1. Horizontal (spare capacity): economy well below full employment — firms can increase output without raising prices (unemployed resources)

2. Upward-sloping (approaching full employment): bottlenecks emerge in some sectors — prices begin to rise as output increases

3. Vertical (full employment): all resources fully employed — further increases in AD only raise prices (pure inflation)

• The Keynesian view implies that demand management (fiscal/monetary policy) can increase real output when there is spare capacity, without causing inflation

Macroeconomic Equilibrium

Short-Run Equilibrium

Where AD intersects SRAS — determines the actual price level and real output.

Long-Run Equilibrium

• Classical: where AD intersects LRAS at potential output. If AD shifts, the economy adjusts through wage/price flexibility back to LRAS.
• Keynesian: if equilibrium is on the horizontal section, the economy can be in long-run equilibrium below full employment (a deflationary gap). Government intervention is needed.

Using the AD/AS Model

Demand-Pull Inflation

• AD shifts right (e.g., consumer confidence rises, government increases spending)
• If economy is near full capacity → prices rise (demand-pull inflation)
• Output increases in the short run but may be limited by capacity

Cost-Push Inflation

• SRAS shifts left (e.g., oil price rise, wage push)
• Prices rise AND output falls → stagflation (inflation + recession)
• This is a supply-side shock

Economic Growth

• Short-run growth: AD increases along an upward-sloping SRAS
• Long-run (sustained) growth: LRAS shifts right (investment, technology, education, labour force)
• Only LRAS shifts can increase potential output permanently without inflationary pressure

Recession

• AD shifts left (falling confidence, credit crunch, austerity)
• Output falls, unemployment rises
• If severe and prolonged: deflationary spiral (falling prices → delayed spending → further falls)

Output Gap

• Positive output gap: actual GDP > potential GDP → inflationary pressure
• Negative output gap: actual GDP < potential GDP → spare capacity, unemployment above natural rate

The Multiplier

An initial change in AD leads to a larger final change in national income.

Multiplier (k) = 1 / (1 - MPC) = 1 / MPW

Where:

• MPC = marginal propensity to consume
• MPW = marginal propensity to withdraw (MPS + MPT + MPM)
• MPS = save, MPT = tax, MPM = import

Example: if MPC = 0.8, k = 1 / 0.2 = 5. A £10bn increase in government spending → £50bn increase in national income.

Evaluation of the Multiplier

• Size depends on MPC/MPW — in open economies with high taxes, the multiplier may be small (UK multiplier estimated at 1.0–1.5)
• Time lags: the full multiplier effect takes time to work through
• Crowding out: government spending financed by borrowing may raise interest rates, reducing private investment (reducing the multiplier)
• Negative multiplier: works in reverse too (spending cuts have multiplied contractionary effects)
• At or near full employment, the multiplier mainly raises prices rather than output

Exam Technique

• Always draw the AD/AS diagram — label axes (price level on Y, real GDP on X), curves, and shifts clearly
• Show the before and after equilibrium with arrows
• State the cause of the shift before describing the effect
• In 25-mark essays, compare classical and Keynesian interpretations of the same shock
• Use the multiplier to explain why small initial changes have larger effects
• Evaluate by considering time lags, crowding out, and the position of the economy relative to full capacity