Revise Aggregate demand and aggregate supply for IB Economics (3.2)

Aggregate demand is the total planned spending on an economy's domestically produced goods and services at each average price level in a period. It is made up of four spending flows, and the single most important skill in this section is knowing what shifts each one — because a change in any component shifts the whole AD curve.

AD = C + I + G + (X − M)

Note the sign convention: because imports (M) are spending that leaks abroad rather than onto domestic output, they are subtracted. A rise in incomes abroad raises X and shifts AD right; a domestic boom that sucks in imports raises M and, other things equal, drags AD in the opposite direction.

The AD curve is drawn with the average price level on the vertical axis and real GDP on the horizontal axis, and it slopes downward. It is essential to explain that slope with the correct MACRO reasons, not the micro law of demand — because in AD we are looking at the average price of ALL goods at once, so the substitution ‘to another good’ that explains a single market cannot apply to the whole economy.

Keep two ideas separate. A change in the average PRICE LEVEL causes a MOVEMENT ALONG the AD curve (via the three effects above). A change in any non-price determinant of C, I, G or (X − M) — a confidence swing, a tax cut, a weaker exchange rate — SHIFTS the entire AD curve. Mislabelling a shift as a movement (or vice versa) is a classic exam error.

Short-run aggregate supply shows total planned output at each price level while the prices of factors of production — above all wages — are assumed to be ‘sticky’, i.e. fixed for now. SRAS is upward-sloping: if firms can sell output at higher prices while their input costs stay put, profit margins widen and they have an incentive to produce more.

SRAS SHIFTS when the costs of production change. A rise in wage rates, commodity prices (e.g. an oil-price spike), or business/indirect taxes raises costs and shifts SRAS to the LEFT (higher prices, lower output). A fall in those costs, or a new subsidy, shifts SRAS to the RIGHT. A leftward SRAS shift produces stagflation — rising prices AND falling output at the same time — which demand-side policy alone cannot cure without a trade-off.

The syllabus asks you to know two rival pictures of aggregate supply beyond the short run. They agree that SRAS slopes up but disagree about the economy's long-run behaviour — and the choice of model changes what you predict about demand-side policy.

You do not have to believe one model over the other — good evaluation contrasts them. Faced with a large recessionary gap, the Keynesian model supports demand-side stimulus (output rises, prices barely move); the neoclassical model warns that near full employment the same stimulus mostly feeds inflation. Interdependence is the theme: what AD does to output depends entirely on which part of the AS curve the economy sits on.

Short-run macroeconomic equilibrium is the price level and real output at which the AD curve intersects the SRAS curve: total planned spending equals total planned output, so there is no tendency to change in the short run. From here, a rightward shift of AD (say, a jump in consumer confidence) raises both the price level and real output as the economy moves up along SRAS; a leftward SRAS shift (say, an oil shock) raises the price level but lowers output. The magnitude of each effect depends on the slopes of the curves and on where the economy sits relative to capacity.

When AD shifts, the FINAL change in real GDP is usually larger than the initial change in spending. That is the multiplier. An initial injection — say extra government spending — is received by firms and workers as income; they spend part of it, which becomes someone else's income, part of which is spent again, and so on in successive, shrinking rounds. The total rise in output is a multiple of the first injection. How large depends on how much of each extra pound of income is re-spent within the domestic economy rather than saved, taxed away or spent on imports.

Two of the course's nine key concepts run through this topic. Change is everywhere: shifts in AD and AS are how the model represents economic events, and the whole point of the diagram is to trace how one change ripples into new levels of output and prices. Interdependence is the deeper lesson: output and the price level are determined jointly, and what a demand shift does depends entirely on the supply side it meets — the same rise in AD raises output cheaply on the flat Keynesian range but mostly raises prices near the vertical LRAS. Hold both concepts in mind when you evaluate policy.

AD/AS is the platform for the rest of macroeconomics. Every later topic — demand-side (fiscal and monetary) policy, supply-side policy, inflation, unemployment and economic growth — is analysed by shifting one of these curves and reading off the new equilibrium. Master the shifts, the two AS models and the multiplier intuition here, and those chapters become applications of a single diagram rather than new material.