Question 1

Is the Aggregate Demand curve just the sum of all individual demand curves in an economy?

Accepted Answer

No, this is a common misconception. A microeconomic demand curve relates the price of a single good to quantity demanded, based on substitution and income effects. The AD curve relates the general price level of all goods to total real output. Its downward slope is explained by economy-wide phenomena: the wealth effect, interest rate effect, and international trade effect, not by substituting between goods.

Question 2

If the price level rises, won't firms just pass on higher costs, meaning the SRAS curve should be vertical?

Accepted Answer

Not in the short run. The core assumption of the SRAS curve is that factor costs, especially wages, are 'sticky'. When the general price level (output prices) rises, firms' wage costs do not immediately increase. This increases their profit margins per unit, incentivising them to supply more output. In the long run, wages and other costs do adjust, which is why the Long-Run Aggregate Supply (LRAS) curve is vertical.

Question 3

Does an increase in government spending always cause significant inflation?

Accepted Answer

Not necessarily. The impact depends on the initial state of the economy. If the economy has substantial spare capacity (is on the flat, Keynesian section of the AS curve), an increase in government spending shifts AD right, leading to a large increase in real GDP with little to no inflation. However, if the economy is already operating near full capacity (on the steep section of the AS curve), the same AD shift will primarily cause demand-pull inflation with minimal increase in real GDP.

Aggregate demand and aggregate supply

What you need to know

Aggregate demand and aggregate supply