Revise Aggregate Demand and Aggregate Supply for Cambridge 9708 (4.3)

Aggregate Demand (AD) represents the total demand for all goods and services produced within an economy at a given overall price level over a period of time. It is calculated as the sum of its components: Consumption (C), Investment (I), Government Spending (G), and Net Exports (X-M). The AD curve is downward sloping, indicating an inverse relationship between the general price level and the quantity of real GDP demanded. This slope is not due to the substitution effect found in microeconomics, but rather three macroeconomic effects. The wealth effect suggests that a lower price level increases the real value of households' financial assets, boosting consumption. The interest rate effect posits that a lower price level reduces demand for money, lowering interest rates and stimulating investment. Finally, the international trade effect means a lower domestic price level makes exports cheaper and imports more expensive, increasing net exports.

A shift in the AD curve occurs when any non-price-level factor changes one of its components (C, I, G, or X-M). A rightward shift signifies an increase in aggregate demand at every price level, while a leftward shift signifies a decrease. For example, an increase in consumer confidence or a cut in income tax would boost Consumption (C), shifting AD to the right. A fall in interest rates set by the central bank would make borrowing cheaper, encouraging firms to increase Investment (I). An increase in government expenditure on infrastructure represents a rise in G. Externally, a boom in a major trading partner's economy would increase demand for exports (X), also shifting AD to the right. These shifts are central to understanding business cycles and the impact of fiscal and monetary policy.

The Short-Run Aggregate Supply (SRAS) curve illustrates the total quantity of real output that firms are willing and able to produce at different price levels, assuming the costs of factors of production remain constant. The primary assumption is that wage rates and other input prices are 'sticky' in the short run. The SRAS curve is upward sloping because as the general price level rises, firms' revenues increase while their main costs (like wages) do not. This widens their profit margins, creating a powerful incentive to increase production by utilising existing capacity more intensively, for example by asking workers to do overtime. This relationship holds until factor costs, especially wages, eventually adjust to the new, higher price level.

Short-run macroeconomic equilibrium is established at the intersection of the AD and SRAS curves. This point determines the economy's equilibrium price level and level of real GDP. Any shifts in AD or SRAS will disrupt this equilibrium and move the economy to a new one. For instance, expansionary fiscal policy (e.g., increased government spending) shifts AD to the right, leading to higher real GDP and demand-pull inflation. Conversely, a sudden increase in the global price of oil would raise production costs, shifting the SRAS curve to the left. This results in a highly undesirable outcome known as stagflation: a combination of lower real GDP (stagnation) and a higher price level (cost-push inflation). The AD-AS framework is therefore an essential tool for analysing the consequences of economic policies and external shocks.

Aggregate demand is total planned spending on domestically produced goods and services at each price level. It slopes downward because of the wealth, interest rate, and exchange rate effects.

AD = C + I + G + (X − M)

Equilibrium: AD = AS

Inflationary gap: Y > Yf

Recessionary gap: Y < Yf