Build aggregate demand
Use C + I + G + (X − M), explain the determinants of each component and distinguish a shift in AD from a movement along it.
Aggregate demand and aggregate supply analysis
The AD/AS model brings together total planned spending and total output in the economy. It explains how changes in demand or supply can affect real GDP, the overall price level and employment in both the short run and the long run.
Aggregate demandSRAS & LRASFull employmentMacroeconomic equilibriumDemand & supply shocks
What this chapter prepares you to do
Analyse aggregate supply
Explain SRAS and LRAS, identify the factors that shift them, and distinguish the classical and Keynesian views.
Find equilibrium
Identify short-run and long-run macroeconomic equilibrium and relate it to the full-employment level of output.
Trace economic shocks
Use AD/AS diagrams to analyse changes in government spending, costs, technology, exchange rates and other shocks.
High-grade habit: first identify whether the change affects AD or AS, then state the direction of the shift, and only then explain the effect on the equilibrium price level and real output.
Chapter sections
7.1
Aggregate demand
Aggregate demand (AD) is the total amount of effective demand in the economy as a whole. It includes planned spending by households, firms, government and overseas buyers of domestically produced goods and services.
Aggregate demand=C + I + G + (X − M)
Consumption (C)
Household spending on goods and services. The main influence is real disposable income, but consumption can also be affected by interest rates, wealth and expectations about the future.
Investment (I)
Firms' spending on capital goods such as machinery and transport equipment. Investment depends on expectations of future demand, past profits, availability of finance and the rate of interest.
Government expenditure (G)
Government spending on goods and services. It can include current consumption and investment and is largely determined by government decisions.
Net exports (X − M)
Exports add to domestic demand while imports subtract from it. Net exports are influenced by competitiveness, relative inflation, the exchange rate and income at home and abroad.
Trade balanceThe balance between expenditure on exports and expenditure on imports, also called net exports.
Worked example: if C = $75m, I = $30m, G = $25m, X = $50m and M = $55m, then AD = 75 + 30 + 25 + (50 − 55) = $125m. The trade balance is −$5m.
Exam point: do not include profits or saving directly in the AD formula. They may influence spending decisions, but the four components of AD are C, I, G and X − M.
7.2
The aggregate demand curve
Aggregate demand curveA curve showing planned aggregate expenditure at each overall price level.
The AD curve is different from the demand curve for a single product. Its vertical axis is the overall price level and its horizontal axis is real output or real GDP.
Do not confuse aggregate demand with market demand: A market demand curve relates the quantity demanded of one product to its own price. The AD curve relates total planned expenditure across the economy to the overall price level. For AD/AS diagrams, label the axes Price level and Real GDP/output, not simply P and Q.
An aggregate demand curve
The aggregate demand curve shows planned expenditure on domestically produced goods and services at different overall price levels. It slopes downward: a lower price level tends to raise real purchasing power, support lower interest rates and improve the international competitiveness of domestic output.
Adapted from Cambridge International AS & A Level Economics, Second Edition, by Peter Smith (with Adam Wilby and Mila Zasheva).
Why does AD slope downwards?
Real income and wealth
At a lower price level, the purchasing power of income and the real value of fixed-money assets are higher, supporting consumption.
Interest-rate effect
Lower prices tend to be associated with lower interest rates, encouraging consumption and investment because borrowing is cheaper.
International competitiveness
If domestic prices are relatively low, exports become more competitive and consumers may switch away from imports, raising net exports.
Movements along AD and shifts of AD
A change in the overall price level causes a movement along the existing AD curve. A change in any component of AD shifts the whole curve.
Common mistake: a change in the price level does not shift AD. It causes a movement along AD.
7.3
Aggregate supply
Aggregate supply is the total quantity of output that firms in the economy are prepared to supply. It cannot be found simply by adding together individual market supply curves because the macroeconomic relationship is between total output and the overall price level.
Short-run aggregate supply (SRAS)
SRASThe amount of output firms are prepared to supply in the short run at each overall price level.
In the short run, some inputs cannot be changed easily. Money wages may be fixed and firms may be unable to expand capital quickly. At higher price levels, firms have an incentive to produce more, so SRAS is normally upward sloping.
The short-run supply curve (SRAS)
The SRAS curve is upward sloping because, in the short run, some input prices and productive resources cannot adjust fully. A higher overall price level can therefore make increased output more profitable for firms.
Adapted from Cambridge International AS & A Level Economics, Second Edition, by Peter Smith (with Adam Wilby and Mila Zasheva).
What shifts SRAS?
The main short-run influences are factors that change firms' costs. Higher input costs shift SRAS left; lower costs shift it right.
Input prices
Higher wages, oil prices or raw-material costs raise production costs and shift SRAS to the left.
Exchange rate
If an appreciation makes imported inputs cheaper, firms' costs may fall and SRAS can shift right. A depreciation can have the opposite effect where imports are important inputs.
Government measures
Policies or regulations that change firms' costs can shift SRAS. The chapter uses health-and-safety requirements and corporation tax as examples of cost influences.
A shift in the SRAS curve
When firms face higher production costs, they are willing to supply less real output at every price level. SRAS therefore shifts left from SRAS₀ to SRAS₁. Examples from the chapter include higher wage costs, more expensive raw materials and cost-raising regulation.
Adapted from Cambridge International AS & A Level Economics, Second Edition, by Peter Smith (with Adam Wilby and Mila Zasheva).
Easy book example — an oil-price rise: Oil is an important input for transport, energy and many production processes. If oil becomes more expensive, firms’ costs rise across the economy. They are then willing to supply less at each price level, so SRAS shifts left.
An alternative shape for SRAS
Some economists argue that SRAS is relatively flat when the economy has spare capacity, but becomes steeper as resources become scarce and the economy approaches full employment. In that case, additional output creates stronger upward pressure on the price level near capacity.
Long-run aggregate supply (LRAS)
Full-employment level of outputThe level of real output at which the economy is operating at its potential capacity.
LRASThe level of real output when the economy is at full capacity.
In the classical view, the long-run aggregate supply curve is vertical at the full-employment level of output because the economy cannot sustainably produce beyond its productive capacity.
The long-run aggregate supply curve
In the classical view, LRAS is vertical at YFE, the economy’s full-employment or capacity level of real GDP. In the long run, changes in the price level alone do not permanently raise the quantity of real output the economy can produce.
Adapted from Cambridge International AS & A Level Economics, Second Edition, by Peter Smith (with Adam Wilby and Mila Zasheva).
What shifts LRAS?
Quantity of factor inputs
A larger labour force, inward migration or an increase in the capital stock can increase productive capacity. A shrinking working-age population can reduce it.
Effectiveness of factor inputs
Technological progress, education and training can improve productivity and shift LRAS to the right.
A shift in LRAS
An increase in the quantity of factors of production or an improvement in their productivity shifts LRAS right from LRAS₀ to LRAS₁. Full-employment output rises from YFE0 to YFE1.
Adapted from Cambridge International AS & A Level Economics, Second Edition, by Peter Smith (with Adam Wilby and Mila Zasheva).
Classical and Keynesian views
Classical view
LRAS is vertical at full employment. The economy is expected to adjust relatively rapidly back to full employment, so policy intervention is less necessary.
Keynesian view
Aggregate supply may be upward sloping below full employment. Labour-market inflexibilities can make adjustment slow, and the economy may remain below full employment for an extended period.
7.4
Macroeconomic equilibrium
Short-run equilibrium
Short-run macroeconomic equilibrium occurs where AD intersects SRAS. At that point, planned aggregate demand is matched by the amount firms wish to supply, determining the equilibrium price level and real GDP.
Short-run macroeconomic equilibrium
Short-run macroeconomic equilibrium occurs where AD intersects SRAS. Their intersection determines the equilibrium real GDP Y and the overall price level P.
Adapted from Cambridge International AS & A Level Economics, Second Edition, by Peter Smith (with Adam Wilby and Mila Zasheva).
Short-run equilibrium does not have to occur at full employment. If AD is weak, equilibrium can be below the full-employment level, leaving spare capacity. It is also possible to produce temporarily above full-employment output through measures such as overtime, but this is not sustainable in the long run.
Will macroeconomic equilibrium be at full employment in the short run?
Short-run equilibrium does not have to be at full employment. With weaker aggregate demand, equilibrium can occur at Y₁, below YFE, leaving unemployed resources and spare productive capacity.
Adapted from Cambridge International AS & A Level Economics, Second Edition, by Peter Smith (with Adam Wilby and Mila Zasheva).
Long-run equilibrium
With a vertical classical LRAS, long-run equilibrium is at the full-employment level of output. The price level is determined by the position of AD where it meets LRAS.
Long-run macroeconomic equilibrium
With a vertical classical LRAS curve, long-run equilibrium is at the full-employment output YFE. Aggregate demand determines the long-run price level where it crosses LRAS.
Adapted from Cambridge International AS & A Level Economics, Second Edition, by Peter Smith (with Adam Wilby and Mila Zasheva).
An increase in aggregate demand
If government spending or another component of AD increases, AD shifts to the right. In the short run this normally raises both real GDP and the price level. The size of each effect depends on the shape of SRAS: a flatter SRAS gives a larger output effect, while a steeper SRAS gives a larger price effect.
A shift in aggregate demand in the short run
A rightward shift in aggregate demand from AD₀ to AD₁ moves the economy along SRAS. In the short run, both real GDP and the price level rise; the relative size of these changes depends on the slope of SRAS.
Adapted from Cambridge International AS & A Level Economics, Second Edition, by Peter Smith (with Adam Wilby and Mila Zasheva).
Easy book example — higher government spending: Suppose the government increases expenditure while other influences are unchanged. Because G is a component of AD, the AD curve shifts right. In the short run, the new equilibrium normally has higher real GDP and a higher price level. If the economy is already at full employment, the increase in output cannot be sustained in the long run.
Adjustment from full employment
If the economy begins at full employment, a short-run increase in AD can push output temporarily above capacity. As firms' costs, including wages and raw-material prices, rise, SRAS shifts left and real output returns toward the full-employment level. The economy is then left with a higher overall price level.
Adjustment following an increase in aggregate demand
Starting from full employment, an increase in AD can push real GDP temporarily above capacity. As wage and raw-material costs rise, SRAS shifts left from SRAS₀ to SRAS₁, returning output to YFE but leaving the economy with a higher price level.
Adapted from Cambridge International AS & A Level Economics, Second Edition, by Peter Smith (with Adam Wilby and Mila Zasheva).
A short-run supply shock
A negative supply shock such as a rise in oil prices increases firms' costs and shifts SRAS to the left. With AD unchanged, the new short-run equilibrium has lower real GDP and a higher price level. If the shock is temporary, SRAS may later move back. If it permanently reduces productive capacity, LRAS can also shift left.
A supply shock
A negative supply shock, such as a sharp increase in oil prices, shifts SRAS left from SRAS₀ to SRAS₁. The new short-run equilibrium combines lower real GDP with a higher price level.
Adapted from Cambridge International AS & A Level Economics, Second Edition, by Peter Smith (with Adam Wilby and Mila Zasheva).
Shifts versus movements along AD and AS
A shock that shifts one curve normally causes a movement along the other. For example, a supply shock shifts SRAS and creates a movement along AD; an aggregate-demand shock shifts AD and creates a movement along SRAS.
Exam method: identify the initial equilibrium, draw the shift, mark the new equilibrium, and then state separately what happens to real GDP, the price level and, where relevant, employment.
Chapter 7 revision checklist
Define aggregate demand.
Use AD = C + I + G + (X − M).
Explain determinants of consumption.
Explain determinants of investment.
Explain how net exports affect AD.
Explain why the AD curve slopes downwards.
Distinguish a movement along AD from a shift of AD.
Define short-run aggregate supply.
Explain why SRAS slopes upwards.
Identify cost factors that shift SRAS.
Explain the effect of an exchange-rate change on imported input costs.
Define full-employment output.
Explain the classical vertical LRAS curve.
Identify factors that shift LRAS.
Explain how technology and training affect productive capacity.
Distinguish classical and Keynesian views of long-run aggregate supply.
Identify short-run macroeconomic equilibrium.
Analyse an increase in AD.
Analyse a negative supply shock.
Distinguish curve shifts from movements along the other curve.
20 questions. Each answer is marked immediately with a short explanation of why it is correct or incorrect.