Have you ever calculated how much you spend in a year? The amount of money you spend within a particular period constitutes your total demand. Believe it or not, it contributes to national macroeconomics. When we consider the total expenditure by each person in the entire country (including what is spent by the government and businesses), it is called aggregate demand. On the other hand, aggregate supply is the total value of all goods and services producers are willing to supply in an economy over a specified time at different price levels.
If you are having a hard time understanding these two concepts for your AP® Macroeconomics exam, then this article is for you. We will look into the concepts, what shifts aggregate demand and aggregate supply, and why these concepts are important. We will also see how you can be tested on these concepts on the AP® exam.
What is Aggregate Demand and Supply?
Aggregate demand is an economic measurement of the total sum of all final goods and services produced in an economy. It is expressed as the total amount of money paid in exchange for those goods and services and represents different output levels at various prices. It is expressed as the sum of all consumption (C), investments (I), government expenditure (G), and net exports (Xn).
When you take a closer look, aggregate demand is the same as real GDP, especially the long run aggregate demand and is typically depicted by a downward sloping curve. This means that increases in price levels, holding other factors constant (ceteris paribus), results in a reduction in the aggregate demand. The slope is downward because of the following effects:
Consumer wealth responds inversely to changes in price. At higher price levels or higher interest rates, the purchasing power (or real wealth) of consumers reduces, since they have to spend more to acquire each unit of a commodity.
Savings and Interest Rate Effect
Higher prices not only put a strain on your wallet (consumer wealth), but also cause you to save less. This reduces the amount of money available to banks to lend, and the lenders, in turn, raise interest rates to make an appreciable return. The spiral effect of increased interest rates is a reduction in investments (entrepreneurs are less willing to borrow to expand their businesses) and a dip in consumer spending (fewer people take mortgages or car loans and spend less using their credit cards).
Exchange Rates Effect
An increase in price also makes people prefer to purchase foreign products since they are cheaper compared to local goods. This drives the market to demand more foreign currency, causing a weakening of the dollar and a reduction in exports, which drives the real GDP down further.Fig1: Aggregate Demand (AD) Curve
Now that you have a firm picture of aggregate demand, let’s look at the supply side. Aggregate supply refers to the total amount of goods and services that producers are willing to supply within an economy at a given overall price level. An aggregate supply curve indicates the connection between different price levels and the amount of real GDP supplied and it is represented by an upward sloping curve.
To correctly understand the aggregate supply curve, time is an essential factor. In the short run, rising prices (ceteris paribus) or higher demand causes an increase in aggregate supply. Producers do this by increasing the utilization of existing resources to meet a higher level of aggregate demand. The term “short run” indicates a time frame in which prices of some resources remain “sticky” and the real GDP is not necessarily equal to the potential GDP or full employment GDP.
However, long run aggregate supply is not affected by price, but by the number of laborers, capital stock available, and level of technology. In the long run, the prices of resources necessary for production are considered variable, and real GDP is equal to the potential GDP. Thus, the long run aggregate supply curve is almost vertical. This depicts that supply is inelastic to price level changes since all factors of production are considered flexible.Fig 2.1 Short Run Aggregate Supply curve (SRAS) Fig 2.2 Long Run Aggregate Supply
Changes in price levels, holding other things constant (ceteris paribus), causes movements along both aggregate demand and aggregate supply curves. However, other factors can shift aggregate demand and aggregate supply curves—let’s have a look.
What Shifts Aggregate Demand?
Changes in the principal components of aggregate demand (i.e. C+I+G+Xn) primarily constitute what shifts aggregate demand. Below is a graphic illustration of shifts in the Aggregate Demand curve.Fig 3: Shifting Aggregate Demand curve
Let’s dive a little deeper to what shifts aggregate demand.
Expectations of higher inflation, higher future income, or greater profits will typically drive consumer spending and investments up. This causes an increase in the real GDP, which shifts aggregate demand to the right(AD2). The opposite is true when consumers and businesses expect a recession; the GDP reduces and shifts aggregate demand to the left(AD1).
Government Fiscal and Monetary Policy
Fiscal policy is when the government attempts to influence the economy by changing taxation or government spending. Congress supervises this role, and it shifts aggregate demand by manipulating consumer wealth. Here’s how:
A reduction in taxes or an increase in transfer payments causes an increase in consumer wealth and investments, driving the real GDP up and in turn shifting aggregate demand rightward to AD2. The same effect is felt when the government increases its spending on something like healthcare. On the other hand, when the government increases taxes or reduces expenditure, consumer wealth decreases, which contracts the real GDP and shifts the aggregate demand curve to the left to AD1.
The monetary policy applies when the government attempts to change the level of money circulating in the economy by influencing interest rates. The Federal Reserve Bank usually performs this function. When interest rates rise, the exchange rates are affected, the dollar strengthens against other world currencies, local products increase in price, and investment and consumer spending diminish. Thus, aggregate demand is suppressed and shifts the aggregate demand curve to the left to AD1.
Changes in Foreign Trade
An increase in net exports at any given price level shifts aggregate demand rightward to AD2. The following three main factors influence net exports:
First, if local firms and households purchase more foreign goods than local ones either due to better price or availability, net exports will fall, thus shifting aggregate demand to the left to AD1. If the opposite happens, it shifts aggregate demand to the right to AD2.
Changes in Productivity
When producers employ better organization management strategies or improved technology, it enables more efficient production and enhances the quality of products. This, in turn, encourages investments and boosts exports. Thus, aggregate demand shifts to the right to AD2.
What Shifts Aggregate Supply?
Shifts in the short run aggregate supply curve are caused by changes in inflationary expectations; changes in worker force and capital stock availability; changes in government action (not the same as government expenditure); changes in productivity; and supply shocks.Fig4.1: Shifting Short Run Aggregate Supply Fig4.2: Shifting Long Run Aggregate Supply
Changes in Inflationary Expectations
If firms and workers expect the prices to rise, the short run aggregate supply will shift to the left to SRAS2.
Changes in the Labor Force and Capital Stock
As the labor force and capital stock increase in availability, aggregate supply increases at every price level, shifting aggregate supply to the right to SRAS1.
Changes in Government Action
For example, adopting policies that impose heavy taxes, remove subsidies from local production, or impose restrictive regulations can shift aggregate supply in the short run to the left (SRAS2). The opposite happens when the government adopts policies that reduce the tax burden on producers, subsidizes local production or removes restrictive regulations, shifting aggregate supply to the right (SRAS1).
Positive Institutional and Technological Changes
Such changes enable producers to supply more products at reduced costs. Thus, more output is available at every price level, shifting aggregate supply to the right to SRAS2.
Unexpected hikes in prices of necessary resources or a sudden shortage occasioned by an uncontrollable event, such as natural calamities, can shift aggregate supply to the left in the short run to SRAS1.
A shift in the long run aggregate supply curve is mainly caused by technological innovations and changes in the size and quality of labor. As the economy becomes driven by more efficient technology, and the number and quality of laborers improve, producers are willing to supply more at every given price level. This shifts the long run aggregate supply curve to the right to LRAS1.
Long Run Macroeconomic Equilibrium is the meeting point of the three curves: short run aggregate supply, aggregate demand, and the long run aggregate supply curves. Pe and QY represent the equilibrium price level and full employment GDP.Fig5: Long Run Macroeconomic Equilibrium
Macroeconomics Schools of Thought
The Keynesian theory advances the argument that aggregate demand is influenced by a combination of numerous economic decisions at both public and private levels. According to this theory, changes in aggregate demand influence real output and employment more than prices would affect real output and employment.
Keynes’ theory advances the notion that future economic production is propelled by aggregate demand and that during a depression, an economy must be stimulated by the government in the form of fiscal and monetary policy. In this theory, not only are the cost of resources “sticky,” but prices are also “sticky” in the short run due to firms being caught in fixed price contracts.
Classical theory advances the argument that an economy is self-controlling and is capable of attaining the potential GDP or full employment. It alludes to the opinion that while circumstances exist that would cause an economy not to operate at the potential GDP (full employment), self-adjusting mechanisms will enable the economy to resume the potential GDP. This theory suggests that economic downturns should be mild and brief, and that the economy always operates near full employment based on two principle beliefs: the belief that prices, wages, and interest rates are always flexible and Say’s Law.
Briefly, Say’s law states that when an economy generates a particular level of real GDP, it correspondingly produces an income sufficient to purchase that level of real GDP.
Why are Aggregate Demand and Aggregate Supply Important?
As you can see from our discussions on aggregate demand and supply, their curves, and what shifts aggregate demand and supply, this topic is the bedrock of macroeconomics. From these concepts, economists derive other important macroeconomic topics, such as taxation, international trade, and exchange rates. Governments can take measures to influence investments, interest rates, and consumer spending to ensure that the economy stays on the right path.
This topic has also been a focal point for AP® Macroeconomic examinations. In fact, going by previous examinations, there’s over a 90% chance that you will be examined on it.
To prepare for the AP® Macroeconomics Exam, first, you need to be familiar with AP-level material, have a good understanding of the exam structure, and refer to multiple sources of information, as well as what has transpired on previous examinations. A look at our previous post on the Ultimate List of AP® Macroeconomics Tips as well as the CollegeBoard’s Essential Macroeconomics Exam Tips will catapult you to a whole new level of preparation.
It is important that you get a firm grip on this concept and the curves involved. To help you with this, let’s take a look at an FRQ from the 2015 exam.
Assuming that the U.S. economy is running at below potential GDP (below full employment):
(a) Sketch a graph with clear labels showing the following curves:
i) Long run aggregate supply (LRAS).
ii) Short run aggregate supply(SRAS).
iii) Aggregate demand (AD).
On the graph, identify the present equilibrium output (label it as Y1) and price level (label it as PL1), and the point of full-employment GDP (label as Yf).
A correctly drawn graph showing Aggregate Demand (AD), Short run Aggregate Supply (SRAS), Equilibrium output (Y1), and Equilibrium price level (PL1), as shown below, would earn you two marks. You will be awarded one extra mark for drawing an upright Long Run Aggregate Supply (LRAS) at the point of full employment GDP (Yf), which is to the right of Equilibrium output (Y1).Fig 6: AD, SRAS and LRAS curves showing PL1, Y1, and Yf
(b) The Federal Reserve has sought your advice on setting a new federal funds rate to get the economy on track to reach full employment. Should the Federal Reserve aim at a higher or lower federal funds rate?
A simple response stating that the Federal Reserve should target a lower federal funds rate earns you one mark.
(c) Justify your advice in (b) above, and sketch a money market graph which shows the impact of your recommendations on the nominal interest rate.
A correctly drawn and labeled money market graph would earn you one mark (see Figure 7).
On the money market graph, showing a shift to the right in the money supply curve (MS2) caused by the decrease in the nominal interest rate earns you another mark.Fig 7: Money market curve
(d) If the Government officers pursue fiscal policy, in part (b) above, rather than monetary policy, assuming that the recessionary gap stands at $300 billion and the marginal propensity to consume (mpc) is 0.8, then:
i) Calculate the least required change in government spending to eliminate the recessionary gap without changing taxes.
The minimum required adjustment in government spending is calculated by dividing the recessionary gap by the government spending multiplier.
In this case, $300 billion/5 = $ 60 billion, earning you one mark.
(ii) Explain the effect of changing taxes without altering government spending to eradicate the recessionary gap. Will the least required adjustment in taxes be larger than, slighter than, or equal to the minimum necessary adjustment in government spending in part (d)?
The minimum change in taxes will be greater than the minimum change required in government spending. Here’s the explanation: the tax multiplier is much lower than the government spending multiplier i.e. (mpc/mps = 0.8/0.2 = 4) < (1/mps = 1/0.2 = 5). This is because a portion of the increased available income caused by the reduced taxes will be put into savings and not spent. This will earn you two marks.
(e) Explain the effect on the aggregate demand and aggregate supply assuming the government eases income tax rates to remove the recessionary gap.
(i) Aggregate demand will increase due to an increase in disposable income, which in turn causes an increase in consumption and investment. (One mark)
(ii) aggregate supply can respond in three different ways, each depending on the approach you take.
First, the long run aggregate supply can remain the same because lowering taxes increases consumption and investment or there is no change in inputs.
Second, long run aggregate supply can increase because low taxes increase savings and investment in physical capital or improve productivity due to the enhanced incentive.
Third, the long run aggregate supply can diminish because reduced taxes can lead to crowding out of more investment.
Each correct response gains you one mark and another mark for a correct explanation.
Did you notice that the final answers are supported by well-articulated points that we had mentioned earlier, especially in part (a) and (e)? We defined aggregate demand and explained what shifts aggregate demand and aggregate supply. It is always crucial that you remember to draw large, clear, and well-labelled graphs.
To wrap up on the subject of aggregate demand and supply, keep in mind that these concepts are important in formulating economic policy, and you are highly likely to be examined on it. A good understanding of what shifts aggregate demand and aggregate supply, as well as the curves, different economic theories around them, and how they are practically applied will boost your confidence as you approach the exam.
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