Lecture 11 - Aggregate Demand and Aggregate Supply I Claude

Table of Contents

  1. Economic Fluctuations and Business Cycles
  2. From the Long Run to the Short Run
  3. The AD-AS Framework
  4. The Aggregate Demand Curve
  5. Why the AD Curve Slopes Downward
  6. Shifts in the Aggregate Demand Curve
  7. The Aggregate Supply Curve
  8. The Long-Run Aggregate Supply Curve (LRAS)
  9. Shifts in the LRAS Curve
  10. Long-Run Growth: AD and LRAS Together
  11. The Short-Run Aggregate Supply Curve (SRAS)
  12. Road Ahead
  13. Bibliography

Economic Fluctuations and Business Cycles

Macroeconomic output does not grow smoothly. Instead, it oscillates around a long-run upward trend, producing what economists refer to as the business cycle. These fluctuations are the central subject of short-run macroeconomics, and understanding their causes, patterns, and policy implications is the primary purpose of the AD-AS model.

Three stylised facts characterise economic fluctuations:

  • Economic fluctuations are irregular and unpredictable — unlike the long-run growth trend, short-run deviations cannot be forecast with precision.
  • Most macroeconomic quantities fluctuate together — output, investment, and employment all tend to move in the same direction at the same time.
  • As output falls, unemployment rises — recessions and booms are economy-wide phenomena, not sector-specific events.

ECON1002_IntroToMacroeconomics/ECON1002_images/Week_6_Set2(ADAS_P1)/Slide4.png

This chart plots GDP (in current US dollars) from 1960 to 2014. The red curve represents the long-run trend, while the blue line traces actual GDP. The striking feature is that whilst the long-run trend is smooth and exponential, the actual series exhibits pronounced deviations — visible peaks and troughs that correspond to boom and recession episodes. The business cycle is precisely the study of these deviations around trend, not of the trend itself.

ECON1002_IntroToMacroeconomics/ECON1002_images/Week_6_Set2(ADAS_P1)/Slide7.png

Panel (a) plots US real GDP in billions of 2005 dollars from 1965, with recessions shaded in pink. The chart demonstrates that whilst the long-run trajectory of output is strongly upward, there are repeated episodes during which output falls or stagnates. Crucially, every shaded recession period corresponds to a visible contraction or plateau in real GDP. This confirms the first stylised fact: fluctuations are irregular but observable, and they represent genuine departures from potential output.

ECON1002_IntroToMacroeconomics/ECON1002_images/Week_6_Set2(ADAS_P1)/Slide8.png

Panel (b) shows investment spending over the same period. Investment is notably more volatile than overall GDP — its percentage decline during recessions (the shaded bands) is substantially larger than the corresponding decline in total output. This is consistent with the economic intuition that investment is the most interest-sensitive and expectation-sensitive component of aggregate demand. During a downturn, firms cancel capital projects far more rapidly than households cut consumption.

ECON1002_IntroToMacroeconomics/ECON1002_images/Week_6_Set2(ADAS_P1)/Slide9.png

Panel (c) displays the unemployment rate. In sharp contrast to real GDP and investment, unemployment moves inversely with the cycle: it rises during recessions and falls during expansions. This is the graphical representation of Okun's Law — the empirical regularity linking output gaps to unemployment deviations. The countercyclical nature of unemployment visible in this chart is one of the most robust facts in macroeconomics.

Economic Intuition

Think of the three panels as three faces of the same coin. When firms expect lower demand, they cut investment first (panel b), output subsequently contracts (panel a), and workers are laid off (panel c). The co-movement of all three confirms that recessions are not sector-specific accidents but economy-wide coordination failures.

Key Takeaways: Economic Fluctuations
  • The business cycle describes deviations of actual output around the long-run trend — not movements in the trend itself.
  • Real GDP, investment, and unemployment co-move over the cycle: the first two are procyclical; unemployment is countercyclical.
  • Investment is disproportionately volatile relative to GDP, making it a key transmission channel for aggregate shocks.

From the Long Run to the Short Run

The models examined in earlier weeks — covering economic growth, the financial system, the loanable-funds market, and the quantity theory of money — all belong to the domain of classical economic theory. Two foundational assumptions underpin these long-run models:

  1. The classical dichotomy — economic variables can be cleanly separated into real variables (real GDP, unemployment, real interest rates) and nominal variables (money supply, price level, nominal wages). In the long run, these two sets of variables are determined independently.
  2. Monetary neutrality — changes in the money supply alter nominal variables proportionally but leave real variables unaffected. A doubling of the money supply doubles all prices but does not change the productive capacity of the economy, real output, or real factor returns.

These assumptions yield powerful tractability: they allow economists to study the real determinants of output (capital, labour, technology) without worrying about the behaviour of prices, and vice versa. However, they are fundamentally assumptions about the long run.

Theoretical Interpretation

The classical dichotomy holds because, in the long run, all prices and wages are fully flexible. If the money supply doubles, firms and workers will eventually renegotiate wages and prices upward, leaving the real wage and thus real output unchanged. The mechanism is one of complete nominal adjustment. In the short run, however, this adjustment is incomplete — prices and wages are sticky — so nominal shocks have real consequences.

In the short run, the assumption of monetary neutrality ceases to be a reasonable approximation. Real and nominal variables become highly intertwined: a change in the money supply can, for instance, temporarily lower interest rates and thereby stimulate real investment, pushing real GDP above its long-run trend. This interaction between nominal and real variables is precisely what the AD-AS model is designed to capture.

Common Mistake

Students sometimes claim that the classical dichotomy is simply "wrong." This is an overstatement. The classical dichotomy is an appropriate description of the long run, where full nominal adjustment occurs. The AD-AS model is a short-run framework — it does not replace classical analysis but complements it by modelling the transition period during which wages and prices have not yet fully adjusted.

The AD-AS Framework

The Aggregate Demand – Aggregate Supply (AD-AS) model is the standard short-run macroeconomic framework. It explains short-run fluctuations in economic activity around the long-run trend by modelling the relationship between the overall price level and the economy's total real output .

  • The Aggregate Demand (AD) curve shows the total quantity of goods and services demanded at each price level. It is derived from the national income identity and slopes downward.
  • The Aggregate Supply (AS) curve shows the total quantity of goods and services supplied at each price level. Its shape depends critically on the time horizon under consideration.

ECON1002_IntroToMacroeconomics/ECON1002_images/Week_6_Set2(ADAS_P1)/Slide16.png

This diagram presents the canonical AD-AS equilibrium. The vertical axis measures the overall price level ; the horizontal axis measures total real output . The equilibrium occurs at the intersection of the two curves, simultaneously determining the equilibrium price level and equilibrium output. This is directly analogous to the microeconomic supply-and-demand diagram, but it operates at the level of the entire economy. The key departure from the classical model is that here, both and are jointly determined — a nominal variable (the price level) and a real variable (output) interact, precisely violating the classical dichotomy.

Exam Insight

If an exam question asks you to "explain macroeconomic equilibrium using the AD-AS model," begin by defining each curve, state their slopes and why, then identify the equilibrium as the intersection. Note explicitly that this violates the classical dichotomy in the short run.

The Aggregate Demand Curve

The AD curve is derived from the aggregate expenditure identity:

where is household consumption, is business investment, is government spending (assumed fixed by policy), and is net exports. The AD curve plots, for each price level , the total quantity of output demanded across all four expenditure components.

Definition

The Aggregate Demand (AD) curve shows the quantity of goods and services that households, firms, the government, and foreign buyers collectively wish to purchase at each price level, holding everything else constant.

The AD curve slopes downward: a higher price level is associated with lower total quantity demanded. This negative relationship operates through three distinct channels, known collectively as the three effects.

Why the AD Curve Slopes Downward

The Wealth Effect (Consumption Channel)

A fall in the price level increases the real value of money holdings. Consumers hold a given stock of nominal wealth (cash, deposits, bonds denominated in nominal terms); when the price level falls, the purchasing power of those nominal holdings rises. Consumers feel wealthier in real terms and therefore increase consumption spending . Since consumption is a component of , aggregate demand rises. Conversely, a rise in the price level erodes real wealth and depresses consumption.

Economic Intuition

Think of someone holding £10,000 in a savings account. If the price level halves, that £10,000 now buys twice as many goods and services. The person feels richer — not because they earned more, but because the real value of their nominal assets has risen. This perceived increase in real wealth stimulates spending.

The Interest Rate Effect (Investment Channel)

A fall in the price level reduces households' demand for money (they need fewer nominal balances for a given volume of transactions). With a fixed nominal money supply, the excess supply of real money balances drives down the nominal interest rate. Lower interest rates reduce the cost of borrowing for firms, stimulating investment expenditure . This channel links the goods market to the money market, and is formally captured by the IS-LM model studied in more advanced courses.

The Exchange Rate Effect (Net Exports Channel)

The interest rate effect has an additional open-economy dimension. A fall in the domestic interest rate makes UK assets less attractive relative to foreign assets, causing a net capital outflow (NCO increases). The increased supply of pounds on foreign exchange markets causes the pound to depreciate. A depreciated pound makes UK exports cheaper for foreign buyers and imports more expensive for domestic consumers, thus stimulating and suppressing . Net exports rise, adding to aggregate demand.

Theoretical Interpretation

The three effects are not independent: the interest rate and exchange rate effects are connected through the money market and the foreign exchange market. The wealth effect operates independently via the balance sheet channel. Together they ensure that the AD curve is downward-sloping in space, though the precise slope depends on the quantitative magnitudes of each effect.

ECON1002_IntroToMacroeconomics/ECON1002_images/Week_6_Set2(ADAS_P1)/Slide22.png

This diagram illustrates a movement along the AD curve. Starting at price level and output , a fall in the price level to increases the quantity of goods and services demanded to . This is a movement along the existing curve, not a shift of the curve. The diagram makes explicit that it is changes in the price level that trace out the AD schedule; all other determinants are held constant. Students must distinguish this clearly from a shift of the AD curve, which is caused by changes in those other determinants.

Common Mistake

A change in the price level causes a movement along the AD curve. A change in any exogenous expenditure component (e.g., a tax cut, a rise in business confidence, a foreign boom) causes a shift of the AD curve. Confusing these two is one of the most common errors in macroeconomics examinations.

Shifts in the Aggregate Demand Curve

The AD curve shifts whenever there is a change in the desired level of spending at any given price level. Since , any exogenous change in one of these four components will shift the curve.

Changes in consumption ():

  • Shifts in consumer confidence or patience (e.g., rising pessimism during a financial crisis reduces at every price level, shifting AD left).
  • Changes in household wealth not caused by price level movements (e.g., a stock market crash reduces wealth and thus ).

Changes in investment ():

  • Technological improvements that raise the expected return on capital, increasing firms' desired investment at each interest rate and price level.
  • Changes in the money supply: an increase in lowers the interest rate for any given price level, stimulating and shifting AD right.

Changes in government purchases ():

  • Discretionary fiscal policy: government decides to build new hospitals or infrastructure, raising directly and shifting AD right.
  • Note that tax changes affect indirectly — a tax cut raises household disposable income and thus shifts AD right through the consumption channel.

Changes in net exports ():

  • A sudden appreciation or depreciation of the nominal exchange rate alters the competitiveness of exports and imports for a given price level.
  • Foreign income shocks: if the UK's major trading partners experience a boom, they demand more UK exports, raising and shifting AD right.
Exam Insight

For any AD/AS question involving a policy or shock, always identify: (1) which component of is directly affected; (2) whether this is a shift or a movement; (3) in which direction the curve shifts; and (4) what happens to equilibrium and . This four-step framework scores marks reliably.

Key Takeaways: AD Curve
  • The AD curve slopes downward via the wealth effect (), interest rate effect (), and exchange rate effect ().
  • Changes in cause movements along the AD curve; exogenous expenditure shocks cause shifts.
  • Rightward shifts occur from increases in , , , or at a given price level; leftward shifts from decreases.
  • Government spending is assumed fixed by policy and does not respond to changes in — it shifts the AD curve when policymakers actively change it.

The Aggregate Supply Curve

The Aggregate Supply (AS) curve shows the quantity of goods and services that firms are willing to produce and sell at each price level. Unlike the AD curve, the shape of the AS curve depends critically on the time horizon under consideration.

Definition

The Long-Run Aggregate Supply (LRAS) curve is vertical: output is determined solely by real factors (capital, labour, technology) and is independent of the price level.
The Short-Run Aggregate Supply (SRAS) curve is upward-sloping: higher price levels are associated with greater output supplied, at least temporarily.

This distinction between short-run and long-run aggregate supply is one of the most conceptually important in all of macroeconomics. It reflects the difference between an economy in which all wages and prices have fully adjusted and one in which nominal rigidities still exist.

The Long-Run Aggregate Supply Curve (LRAS)

In the long run, the productive capacity of an economy is determined entirely by its real endowments:

  • Physical capital — the stock of machinery, structures, and equipment.
  • Human capital — the skills, education, and knowledge of the workforce.
  • Labour — the size and participation rate of the working population.
  • Natural resources — land, minerals, and other natural inputs.
  • Technology — the available methods for combining inputs into output.

None of these determinants depends on the overall price level. A doubling of the price level does not change the stock of machines, the education level of workers, or the available technology. Consequently, the quantity of output supplied in the long run is the same at any price level — the LRAS curve is a vertical line positioned at the economy's natural rate of output .

Definition

The natural rate of output is the level of real GDP produced when all factors of production are fully and efficiently utilised. Unemployment at this point equals the natural rate — frictional and structural unemployment are present, but there is no cyclical unemployment.

ECON1002_IntroToMacroeconomics/ECON1002_images/Week_6_Set2(ADAS_P1)/Slide29.png

This diagram shows the LRAS as a vertical line at the natural rate of output . When the price level moves from down to , the quantity of output supplied remains unchanged at . The two orange callout boxes make the logic explicit: a change in the price level (step 1) does not affect the quantity supplied in the long run (step 2). This is a direct graphical representation of monetary neutrality and the classical dichotomy — in the long run, real output is entirely insulated from nominal disturbances.

Theoretical Interpretation

The verticality of the LRAS reflects full nominal flexibility. In the long run, if the price level rises by 10%, nominal wages will also rise by 10%, leaving the real wage unchanged. Since firms' supply decisions depend on real wages (real costs of production), their output decisions are unaffected. The real economy is thus insulated from nominal changes, validating the classical dichotomy in the long run.

Shifts in the LRAS Curve

Because the LRAS is anchored to the natural rate of output , any factor that changes will shift the LRAS curve. These are the same factors that drive long-run economic growth, analysed in the growth theory weeks of this course:

  • Changes in labour supply — population growth, immigration, or changes in the natural rate of unemployment (e.g., improved job-matching technology) alter the equilibrium labour input and thus .
  • Changes in physical capital — investment in new machinery or infrastructure raises productive capacity. Conversely, capital depreciation or destruction reduces it.
  • Changes in human capital — investment in education and training raises the effective quality of the labour force, expanding .
  • Changes in natural resources — discovery of new resources (e.g., North Sea oil) or depletion of existing ones shifts LRAS right or left respectively.
  • Technological progress — the most sustained driver of LRAS rightward shifts, as improvements in production methods raise output per unit of input.
Exam Insight

When asked to analyse the effects of a supply-side policy (e.g., increased spending on education, deregulation of labour markets), the correct approach is to identify how the policy changes one of the LRAS determinants, show LRAS shifting right, and then note that long-run output rises whilst the price level falls (assuming AD is held constant).

Long-Run Growth: AD and LRAS Together

The AD-AS framework can reproduce the classical analysis of long-run growth and inflation when both curves are allowed to shift over time.

Over the long run, two processes occur simultaneously:

  1. Technological progress continuously shifts the LRAS curve to the right, expanding the economy's productive capacity.
  2. Monetary expansion by the central bank continuously shifts the AD curve to the right.

The result is a combination of:

  • Ongoing output growth — driven by rightward shifts in LRAS as technology improves.
  • Ongoing inflation — driven by AD shifting rightward faster than or alongside LRAS; as the money supply grows, the price level rises over time.

ECON1002_IntroToMacroeconomics/ECON1002_images/Week_6_Set2(ADAS_P1)/Slide33.png

This diagram traces three equilibrium points across decades: 1990, 2000, and 2010. The LRAS shifts rightward each decade (), reflecting sustained technological progress. Simultaneously, the AD curves shift rightward (), driven by monetary expansion. The combined result is that output grows from to (steps 3 and 4 in the figure), whilst the price level rises from to (step 4). This diagram is highly instructive because it reconciles the AD-AS model with the long-run classical analysis: growth is driven by supply-side improvements, whilst monetary expansion explains the trend inflation observed in the data.

Economic Intuition

Why does ongoing money supply growth cause inflation rather than output growth in the long run? Because the LRAS is vertical — once the economy is at , there is no extra productive capacity. Additional demand from monetary expansion simply bids up prices rather than pulling more output from firms. This is the graphical expression of the quantity theory of money in the long run.

Key Takeaways: LRAS and Long-Run Equilibrium
  • LRAS is vertical at , determined by capital, labour, natural resources, and technology.
  • Any change in these real factors shifts LRAS; price level changes do not.
  • Long-run growth is explained by LRAS shifting right (technology) plus AD shifting right (money supply), producing both output growth and trend inflation.

The Short-Run Aggregate Supply Curve (SRAS)

In the short run, the relationship between the price level and output supplied is fundamentally different from the long run. The SRAS curve is upward-sloping: a higher price level induces firms to supply a greater quantity of output.

This positive relationship arises because, in the short run, not all prices and wages adjust instantaneously. Three major theories explain the upward slope of the SRAS:

  1. Sticky-wage theory — nominal wages are set in advance through contracts or social convention and do not instantly respond to changes in the price level. If the price level rises unexpectedly, firms receive higher revenues for their goods, but their wage costs are temporarily fixed. Real wages fall, making labour cheaper in real terms and inducing firms to hire more workers and expand output.

  2. Sticky-price theory — some firms face menu costs or contractual obligations that prevent them from immediately adjusting their prices. When the overall price level rises, firms with stuck prices find their relative prices have fallen, stimulating demand for their products and inducing them to produce more.

  3. Misperceptions theory — firms may confuse a general rise in the price level with an increase in the relative price of their own product. Believing that their specific product has become more valuable relative to other goods, firms temporarily expand production before eventually recognising that all prices have risen proportionally.

In all three cases, the short-run positive relationship between and is a temporary one. Over time, wages adjust, price-setters update their menus, and misperceptions are corrected. Once all nominal adjustments are complete, the economy returns to the LRAS.

ECON1002_IntroToMacroeconomics/ECON1002_images/Week_6_Set2(ADAS_P1)/Slide35.png

This diagram shows the SRAS as an upward-sloping curve. Beginning at price level and output , a fall in the price level to reduces the quantity of output supplied to . This is the reverse of what occurs with the AD curve: lower prices reduce the incentive (or ability, given nominal wage stickiness) of firms to produce. The slide caption notes that the positive slope could arise from sticky wages, sticky prices, or misperceptions — any or all of these mechanisms is consistent with an upward-sloping SRAS. Critically, the positive relationship is explicitly described as temporary, dissolving once nominal rigidities are resolved.

Theoretical Interpretation

The upward slope of the SRAS reflects the failure of the classical dichotomy in the short run. Nominal prices and wages are temporarily rigid, so a change in the overall price level does affect real variables — specifically, it alters real wages and thus firms' marginal cost of production. Higher nominal prices, with wages stuck, compress unit labour costs in real terms, making it profitable to expand production. This channel disappears once wage contracts are renegotiated, restoring the classical dichotomy.

Common Mistake

Do not confuse the SRAS and LRAS curves. The LRAS is vertical because price level changes have no long-run effect on output. The SRAS is upward-sloping because of short-run nominal rigidities. The key question in any dynamic AD-AS analysis is: are we in the short run (SRAS relevant) or has sufficient time passed for adjustment to the long run (LRAS relevant)?

Exam Insight

When a question asks "why does the SRAS slope upward?" always name at least two of the three theories (sticky wages, sticky prices, misperceptions) and briefly explain the mechanism of each. Then note that the positive relationship is temporary — this signals to the examiner that you understand the distinction between short-run and long-run supply.

Key Takeaways: SRAS
  • The SRAS slopes upward because of short-run nominal rigidities: sticky wages, sticky prices, or misperceptions about relative prices.
  • Higher price levels temporarily reduce firms' real costs, encouraging more output; lower price levels have the opposite effect.
  • The positive slope of SRAS is a transient phenomenon: as nominal variables adjust, the economy returns to the LRAS.

Road Ahead

The next part of the AD-AS analysis will:

  1. Explain in greater depth why the SRAS slopes upward — focusing on the role of expectations in the wage-setting process and how expectational errors generate short-run output fluctuations.
  2. Combine AD and SRAS to analyse business cycles — examining how demand and supply shocks displace the economy from its long-run equilibrium, and how the economy returns to over time.
  3. Examine stabilisation policy — whether and how monetary and fiscal policy can be used to counteract business cycles and speed the return to long-run equilibrium.

Bibliography

Mankiw, N.G. (2020) Principles of Economics. 9th edn. Mason, OH: South-Western Cengage Learning.

Mankiw, N.G. (2019) Macroeconomics. 10th edn. New York: Worth Publishers.

Blanchard, O. (2021) Macroeconomics. 8th edn. Harlow: Pearson Education.

Keynes, J.M. (1936) The General Theory of Employment, Interest and Money. London: Macmillan.

Hicks, J.R. (1937) 'Mr. Keynes and the "Classics": A Suggested Interpretation', Econometrica, 5(2), pp. 147–159.

Friedman, M. (1968) 'The Role of Monetary Policy', American Economic Review, 58(1), pp. 1–17.

Lucas, R.E. (1973) 'Some International Evidence on Output-Inflation Tradeoffs', American Economic Review, 63(3), pp. 326–334.

Okun, A.M. (1962) 'Potential GNP: Its Measurement and Significance', in Proceedings of the Business and Economic Statistics Section of the American Statistical Association. Washington, DC: American Statistical Association, pp. 98–104.