Unit 3.2 - Variations in Economic Activity: Aggregate Demand and Aggregate Supply

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The graphical representation of the total output purchased at varying price levels over a specific period.

AD curve

The total value of all goods and services sought in an economy over a given time frame, reflecting overall expenditure levels.

Aggregate Demand (AD)

Exchange rate effect (Mundell-Fleming)

This effect describes how a fall in the general price level can lead to a depreciation of the exchange rate, making domestic goods cheaper for foreign buyers. This increase in net exports contributes to a rise in aggregate demand, as outlined by economists Mundell and Fleming.

Interest rate effect (Keynes)

An economic principle stating that a decrease in the general price level leads to lower interest rates, which in turn boosts the demand for money and increases aggregate demand. This effect is associated with economist John Maynard Keynes and highlights the relationship between prices and interest rates.

Keynes's Interest Rate Effect

The relationship where a decrease in the general price level leads to lower interest rates, which increases the demand for money, ultimately resulting in higher aggregate demand through increased consumption, investment, and government spending.

Mundell-Fleming's Exchange Rate Effect

The phenomenon where a decline in the general price level results in lower interest rates, which depreciates the exchange rate, making domestic goods cheaper for foreign buyers and increasing net exports, thus boosting aggregate demand.

Real national output (GDP)

The total value of all goods and services produced in an economy, measured over a specific time period, which reflects the economy's overall economic performance. It is influenced by aggregate demand, which shows the relationship between price levels and the quantity of output demanded.

Wealth effect (Pigou)

A phenomenon where a decrease in the general price level increases the real purchasing power of consumers, leading to higher consumption, investment, and government spending. This effect is named after economist Arthur Pigou and illustrates how price levels influence economic activity.

A perspective showing the long-term supply as a vertical line indicating maximum output achieved at full employment.

Monetarist view of LRAS

A perspective that presents aggregate supply with three sections: horizontal, upward-sloping, and vertical.

Keynesian view

A section indicating abundant unused resources and significant unemployment in the economy.

Horizontal section of the Keynesian AS curve

A section indicating an economy nearing full employment output levels.

Upward-sloping section of the Keynesian AS curve

Indicates a state of maximum employment or the limit of productive capacity.

Vertical section of the Keynesian AS curve

The school of thought holding that long-run aggregate supply is a vertical line at the full employment level of output, so an increase in demand raises only the general price level.

Monetarist view

Monetarist (new classical) view

The economic perspective that argues demand-side policies cannot permanently increase output and may lead to inflation if overused, especially when the economy is near full employment. It contrasts with Keynesian views that support fiscal and monetary policies during recessions.

A government approach that aims to boost economic activity through increased spending and/or reduced taxation.

Expansionary fiscal policy

A policy aimed at promoting borrowing and spending by reducing interest rates.

Expansionary monetary policy

Wages that resist falling even when the demand for labour weakens in a recession.

Sticky downwards

A theoretical framework that posits long-term stability at the potential output level of an economy.

monetarist model

The level of joblessness that exists when an economy is operating at full capacity, often due to frictional and structural factors.

Natural unemployment

Recessionary gap (negative output gap)

A situation where actual output is less than potential output, often due to wage inflexibility leading to prolonged economic downturns. In the Keynesian perspective, this gap necessitates government intervention to stimulate demand and close the gap, as the market alone may not rectify it.

Wage inflexibility / sticky wages

The phenomenon where wages do not adjust downward easily, contributing to persistent recessionary gaps in the Keynesian model. This inflexibility prevents the economy from achieving macroeconomic equilibrium and contrasts with the new classical view of natural unemployment in the long run.

The outcome of taking a nation's total imports and deducting them from its total sales abroad.

Net Exports

The total expenditure on goods and services by households within a domestic economy during a given time frame.

Consumption

The various elements that comprise total demand, including categories of spending.

Components of aggregate demand

State the formula: AD (AD)

AD = C + I + G + (X - M) AD = AS

exports earnings

The revenue generated from selling goods and services to foreign markets, which directly contributes to aggregate demand by adding to the total economic activity through the export component.

An event where a change in a non-price factor influences the supply curve.

A shift of the SRAS curve

The curve that shows the total planned national output at different price levels, while holding productivity and costs of factor inputs constant.

Short Run Aggregate Supply (SRAS)

Labour Costs

Expenses incurred by firms for wages and salaries, which significantly impact production costs, especially in labour-intensive industries. An increase in labour costs can lead to reduced production levels in the short run due to higher overall costs for firms.

Raw Material Costs

The expenses associated with acquiring raw materials or components necessary for production. An increase in these costs raises the overall production costs for firms across an industry or the economy.

SRAS

Short-run aggregate supply represents the total output that firms are willing to produce at various price levels in the short term, with fixed factors of production. The SRAS curve slopes upward, indicating that higher prices incentivize firms to increase output, and shifts occur due to changes in production costs.

A factor affecting one or more elements of total demand, leading to shifts in the overall demand situation.

Determinant of aggregate demand

Items that are not quickly consumed and can be used repeatedly over time, such as appliances and furniture.

Durable goods

The anticipated future changes in prices that can influence consumer behavior and spending patterns.

Expectations

The condition of owing money, particularly for households.

Indebtedness

The cost of borrowing money or the return for saving money.

Interest Rates

The income available to individuals after taxes have been deducted, which can be spent or saved.

Disposable income

Consumer confidence

A measure of how optimistic consumers feel about the overall state of the economy, which directly influences their spending behavior. Higher consumer confidence typically leads to increased consumption, shifting the aggregate demand curve to the right.

Household indebtedness

The total amount of debt that households owe, which can impact their consumption levels. Lower household indebtedness allows for greater spending, shifting the aggregate demand curve to the right, while higher indebtedness can restrict consumption.

The output level when the economy operates at productive capacity.

Full-employment output

The phenomenon where nominal wages are slow to decrease.

Wage rigidity

The condition when short run aggregate supply equals aggregate demand.

Short run macroeconomic equilibrium

The unemployment level present when the economy is at full employment, including frictional, seasonal, and structural types.

natural rate of unemployment (NRU)

State the formula: SRAS

SRAS = AD Condition for short-run macroeconomic equilibrium where the short-run aggregate supply curve intersects the aggregate demand curve, determining the general price level and real GDP.

Demand-side policies

Policies aimed at influencing aggregate demand, which are viewed as ineffective for long-term economic growth by new classical economists. They advocate for supply-side policies to achieve economic objectives instead.

Keynesian model

An economic model that posits the economy may not always maintain equilibrium at full employment, allowing for persistent recessionary gaps. It emphasizes the need for government intervention to address negative output gaps.

Long-run equilibrium

A state in the monetarist/new classical model where the economy operates at full employment output, with automatic adjustments through aggregate demand and supply restoring equilibrium. It assumes flexibility in wages and prices.

Monetarist/new classical model

A model of macroeconomic equilibrium where long-run equilibrium is achieved at full employment output, with automatic adjustments through aggregate demand and supply. It assumes flexible wages and prices to maintain this equilibrium.

Multiplier (negative multiplier effect)

A phenomenon where an initial decrease in income leads to a larger overall decrease in aggregate demand, resulting in a negative impact on real GDP. This effect highlights the importance of government intervention during economic downturns.

Sticky wages (sticky downwards)

The concept that wages do not adjust downward easily, preventing labor markets from clearing. This inflexibility can hinder the economy's ability to restore equilibrium during downturns, especially in recessions.

new classical model

The economic model that posits long-run equilibrium at full employment output, where wages and prices are flexible enough to ensure the economy operates at full capacity, with the long-run aggregate supply curve being vertical.

price level

The average of all prices in an economy, measured up the vertical axis of the AD/AS diagram. Macroeconomic equilibrium is where aggregate demand meets aggregate supply, fixing both this level and real output.

A curve that is vertical at the maximum sustainable output level of an economy.

long-run aggregate supply curve (LRAS)

Monetarism / New classical

An economic theory suggesting that the economy tends toward a long-run full employment output level, with the long-run aggregate supply curve being vertical. It emphasizes that demand-side expansion leads to inflation rather than sustained growth.

new classical

An economic theory that aligns with monetarism, suggesting that the economy tends toward full employment output and emphasizes rational expectations and the importance of long-run productive capacity.

recessionary gap

A situation where actual output falls below potential output, leading to higher unemployment. This gap may occur when aggregate demand decreases, causing a shift in the economy's performance.

A change caused by a variation in the general price level.

Movement along the AD curve

Regulatory actions taken by a government to influence the flow of goods and services across its borders.

Trade Policies

A situation where an economy’s actual real GDP exceeds the potential output at the full employment level.

inflationary gap

A situation where the actual national output is less than the output level associated with full employment.

deflationary gap

A state where short run aggregate supply matches aggregate demand in the economy.

macroeconomic equilibrium

In this section, aggregate supply is perfectly price elastic due to plenty of spare capacity.

Section 1 of the Keynesian AS curve

In this section, the AS curve slopes upward due to resource pressures.

Section 2 of the Keynesian AS curve

Supply that remains unaffected by price levels over a long-term horizon.

LRAS

The optimal use of scarce resources to maximize output.

Efficiency

The state where aggregate supply is perfectly inelastic due to full employment of resources.

Section 3 of the Keynesian AS curve

Institutional Structure

The framework of legal and financial systems that influences economic efficiency and productivity, where improvements in institutions can lead to better resource allocation and increased long-run aggregate supply through enhanced education, training, and healthcare.

Keynesian

The school holding that the AS curve has three distinct sections, reflecting different degrees of spare capacity, so the economy can sit below full employment even in the long run — against the new classical view of a vertical LRAS fixed at full employment.

Technological Progress

The advancements in technology that enhance the productivity of factors of production, leading to an increase in long-run aggregate supply (LRAS) through improved techniques and innovations, which ultimately boosts national output over time.

The curve that illustrates total planned output at various price levels, assuming constant productivity and input costs.

Short run aggregate supply curve (SRAS)

The expenditures incurred by businesses in the creation of goods and services, including materials and labor.

Costs of Production

The total amount of real output firms are willing to produce at various price levels.

Aggregate supply

Unexpected increases in expenses or major interruptions to production that shift supply to a leftward position.

Adverse supply-side shocks

Price level (PL)

The average level of prices in the economy at a given time, which affects the total output of goods and services supplied by firms. The short-run aggregate supply curve illustrates how output changes at different price levels while holding other factors constant.

Real GDP (Y)

The inflation-adjusted measure of the value of all goods and services produced in an economy, reflecting the actual output level. It is used to assess economic performance over time and is influenced by factors such as aggregate supply and demand.