Aggregate Demand and Aggregate Supply

This is Unit Eight of Principles of Macroeconomics, part one of two: aggregate demand and aggregate supply. This is the course's central model. Every unit after it uses this diagram. Carry one idea through. Output and the price level are decided together, in one intersection, so every event has to be traced through to both of them. And the whole skill is telling a shift of a curve from a movement along it, because getting that wrong reverses the answer rather than blurring it. By the end you will say why aggregate demand slopes down and why the microeconomic reasons do not carry over, find equilibrium from a schedule and place it against potential, tell a shift from a movement along, decide which curve an event moves and which way, and read off what happens to real GDP and the price level.

Two entries to set the frame: the two claims this model reconciles, and what sits on each axis.

The two claims behind the model.

MAC 0701 Say's Law and Keynes' Law

Say's law says supply creates its own demand, because producing generates the income to buy the output. Keynes' law says demand creates its own supply. In the Great Depression the workers, the machines and the knowledge were all still there. Neither man wrote the slogan attached to his name, and each law fits a horizon: Keynes the short run, Say the long run.

What the model measures.

MAC 0702 The Axes of the Model

Real GDP goes on the horizontal axis and the price level on the vertical, and the price level is an index rather than a rate. A price level of one hundred and ten says where prices stand, not how fast they are rising. The inflation rate is the percentage change in that level, so a falling inflation rate still means prices are rising.

Three entries on the demand side: what it is, why it slopes down, and why the reasons from microeconomics do not carry over.

The demand side.

MAC 0703 Aggregate Demand

Aggregate demand is total planned spending on domestically produced output at each price level: consumption, investment, government purchases, and net exports. The same four components as GDP, now read against the price level. It is planned spending, and it is spending on output produced here, which is why the next two entries matter.

Why the curve slopes down.

MAC 0704 Why Aggregate Demand Slopes Down

Three effects. A higher price level erodes the buying power of wealth, so consumption falls. It raises interest rates, so investment falls. And it makes exports dearer, so net exports fall. Wealth acts on consumption, interest rates on investment, and relative prices on net exports. Government purchases contribute nothing to the slope, because they are set politically rather than by the price level.

A comparison that does not work.

MAC 0705 Why Micro Reasoning Does Not Transfer

A single good's demand curve slopes down because buyers substitute toward it and because a lower price leaves them better off. Neither reason survives in the aggregate. When every price falls together there is nothing to substitute toward, and incomes fall with prices, so real income does not change. The three effects of the last entry are the only reasons that remain.

Four entries on the supply side: the short-run curve, the vertical one behind it, what separates the two horizons, and where the slope comes from.

The supply side.

MAC 0706 Short-Run Aggregate Supply

The short-run aggregate supply curve shows the quantity of output firms produce at each price level. It slopes up, because with input prices fixed a higher output price raises profit. Its slope changes along its length: nearly flat far to the left, steeper in the middle, nearly vertical at the right. The curve is drawn holding input prices, capital, resources and technology constant.

The vertical curve behind it.

MAC 0707 Potential GDP and Long-Run Aggregate Supply

Potential GDP is what the economy produces with its labor, capital and technology fully employed. Drawn against the price level it is a vertical line, the long-run aggregate supply curve, and at potential GDP unemployment sits at the natural rate. It is vertical because in the long run wages adjust to any price level, leaving one real wage and one level of employment.

What separates the two horizons.

MAC 0708 The Short Run and the Long Run

In macroeconomics the short run is the period in which wages and some prices are sticky, and the long run is the period in which they have fully adjusted. The definition is about flexibility, not about a number of months. That is why output can sit away from potential in the short run and returns to it in the long run.

What the stickiness does.

MAC 0709 Why the Short-Run Curve Slopes Up

Because nominal wages are fixed for a while, a higher price level lowers the real wage, so firms hire more and produce more, and a lower price level does the reverse. Trace demand shifting either way and the points you get map out the curve. Unit five gave five reasons wages resist falling, and those reasons are what give this curve its slope.

Three entries putting the two curves together, including the distinction every later unit depends on.

Where the two curves meet.

MAC 0710 Macroeconomic Equilibrium

Equilibrium is where aggregate demand crosses short-run aggregate supply, and it sets real GDP and the price level together, in one intersection. Neither curve alone determines output, and neither alone determines prices. This is the model's whole point: output and prices are decided jointly, so any event has to be traced through to both.

Finding it in a table.

MAC 0711 Finding Equilibrium from a Schedule

Given a table of price levels with the quantity demanded and the quantity supplied beside each, work down the rows and compare the two quantities. Where demand exceeds supply, the price level is below equilibrium; where supply exceeds demand, it is above; where they are equal you have the equilibrium price level and the equilibrium real GDP. Then ask where that output sits against potential, because that tells you whether unemployment or inflation is the greater risk. At a price level of one hundred and twenty, demand is seven hundred against supply of six hundred and forty; at one hundred and thirty both are six hundred and eighty, so that is equilibrium; and if potential GDP is eight hundred, this economy is well below it. Equilibrium does not mean healthy: an economy can settle far below potential with high unemployment and stay there.

The distinction the course depends on.

MAC 0712 Movement Along or a Shift?

A change in the price level moves you along a curve. A change in anything else shifts the curve. Getting this wrong reverses the answer, so test every event the same way: ask whether it would change the quantity at a price level that has not moved. If it would, the curve shifts. If the only thing that changed is the price level itself, nothing shifts and you are travelling along a curve that stayed put. The same test applies to both curves. A rise in the price level reducing the quantity of output demanded is a movement along aggregate demand; a rise in consumer confidence raising spending at every price level shifts it right; a rise in oil prices raising costs at every price level shifts short-run supply left. One shift causes a movement along the other curve, never a shift of it, and saying both curves shifted when only one event occurred is the commonest error here.

Four entries on what shifts each curve, including a bookkeeping point that is often misread.

What moves the demand curve.

MAC 0713 What Shifts Aggregate Demand

Anything that changes one of the four components at every price level. Confidence moves consumption and investment; government purchases and taxes move spending directly; foreign incomes and exchange rates move net exports. Rising business confidence shifts the curve right and falling confidence shifts it left. Falling confidence can be self-fulfilling, because spending less is what makes the downturn people feared.

A term that confuses people.

MAC 0714 Why Imports Are Subtracted

Aggregate demand counts spending on output produced here. Imports were already counted inside consumption, investment and government purchases, so subtracting them removes what was produced abroad. The minus sign is bookkeeping, not a judgement about trade. Imports rising does not reduce demand for domestic output: it means some of the spending already counted went abroad and is being taken back out.

What moves the supply curve.

MAC 0715 What Shifts Short-Run Aggregate Supply

Input prices are the main shifter. Higher costs for oil, wages or imported inputs shift the curve left, and lower costs shift it right. A rise in what firms pay for health coverage works like a rise in wages. Input prices move the short-run curve only: they do not change what the economy could produce at full employment.

The shifter that moves both.

MAC 0716 Productivity Shifts Both Curves

Productivity growth shifts short-run supply right and potential GDP right as well, because the same workers and machines now produce more: more output at every price level, and a higher ceiling at full employment. Its effects are slow, a few percentage points a year, which is why growth is a long-run story and shifts in demand are a short-run one.

Three entries on working an event through: sorting it, the case everyone remembers, and reading the result in both directions.

Deciding which curve it touches.

MAC 0717 Which Curve, Which Way?

Sort every event with two questions. Does it change what buyers want to spend at each price level, or what it costs firms to produce at each price level? Spending changes move aggregate demand; cost changes move short-run aggregate supply. Then fix the direction: more spending shifts demand right, less shifts it left, higher costs shift supply left, lower costs shift it right. Productivity is the one shifter that moves supply right and potential GDP with it. A fall in real wages shifts supply right; an oil price rise shifts it left; a tax cut shifts demand right; a slump abroad shifts demand left. A change in the price level appears in none of those lists, because it moves the economy along the curves rather than shifting either, and any answer offering it as a shifter is the distractor.

The case everyone remembers.

MAC 0718 Stagflation

When short-run supply shifts left, the price level rises and real GDP falls at the same time, and rising prices with falling output is called stagflation. The oil shocks of the nineteen seventies are the standard case. It is the combination that makes stagflation hard for policy: anything that raises output raises prices further, and anything that lowers prices lowers output further.

Reading the outcome off the diagram.

MAC 0719 Reading the Result

Once you know which curve moved and which way, the outcome follows a fixed pattern worth memorising. Demand right raises both real GDP and the price level. Demand left lowers both. Supply right raises real GDP and lowers the price level. Supply left lowers real GDP and raises the price level. Notice the pattern: when demand moves, output and prices go the same way, and when supply moves, they go opposite ways. A rise in consumer confidence raises both; a harvest failure lowers output while raising prices; a productivity gain raises output while lowering prices. That pattern is also the diagnosis running backwards: told only that output fell and prices rose, you know supply moved left, because no demand shift produces that pair. This is how unit six's two kinds of inflation are told apart.

Look at what you can now do. You can say why aggregate demand slopes down, through wealth, interest rates and exports, and why the microeconomic reasons do not survive in the aggregate. You can find equilibrium from a schedule by comparing the two quantities row by row, and then place that output against potential. You can tell a shift from a movement along, by asking whether the quantity would change at a price level that has not moved. You can decide which curve an event touches, by asking whether it changed spending or changed the cost of producing. And you can read the result off the diagram, forwards from a shift and backwards from an outcome. Part two takes the model to the three zones of the supply curve, and to what the two schools of thought disagree about.