Aggregate Demand and Supply, GDP, and Market Dynamics
Aggregate Demand and Supply
Aggregate Demand (AD): Definition & Components
AD: The total demand for goods and services in an economy at a given price level. It’s the sum of:
- Consumption (C): Household spending on goods and services. Advanced Note: This is influenced by factors like disposable income, consumer confidence, and interest rates.
- Investment (I): Business spending on capital goods (machinery, equipment, etc.) and changes in inventories. Advanced Note: Investment is sensitive to interest rates, business expectations, and technological advancements.
- Government Spending (G): Spending by all levels of government on goods and services. Advanced Note: This is a component of fiscal policy and can be used to stimulate or restrain the economy.
- Net Exports (NX): Exports (goods and services sold to other countries) minus imports (goods and services bought from other countries). Advanced Note: The exchange rate and global economic conditions significantly impact net exports.
Aggregate Supply (AS): Short-Run & Long-Run
AS: The total quantity of goods and services firms are willing and able to supply at a given price level.
- Short-Run Aggregate Supply (SRAS): Upward-sloping. An increase in the price level leads to higher production in the short run because firms can increase output by using existing resources more intensively. Advanced Note: Input prices are assumed to be fixed in the short run.
- Long-Run Aggregate Supply (LRAS): Vertical at potential GDP. Represents the economy’s potential output when all resources are fully employed. Advanced Note: Shifts in LRAS are driven by factors like technological progress, increases in the labor force, and capital accumulation.
Equilibrium in the AD/AS Model
The intersection of AD and AS determines the equilibrium price level and real GDP. Advanced Note: This equilibrium can be at, above, or below potential GDP, indicating different macroeconomic situations (e.g., recession, inflation).
Shifts in AD & AS
Shifts in AD: Caused by changes in consumption, investment, government spending, or net exports. A rightward shift increases both the price level and real GDP; a leftward shift decreases both.
Shifts in AS: Caused by changes in productivity, input prices, or supply shocks. A rightward shift increases real GDP and decreases the price level; a leftward shift decreases real GDP and increases the price level. Advanced Note: Stagflation occurs when AS shifts left, leading to both higher prices and lower output.
Keynes’ Law vs. Say’s Law
Keynes’ Law: “Demand creates its own supply.” Relevant in the short run, suggesting that insufficient demand can lead to recessions.
Say’s Law: “Supply creates its own demand.” Relevant in the long run, suggesting that the economy’s productive capacity drives demand. Advanced Note: The AD/AS model can be used to illustrate both laws depending on which zone of the SRAS curve the equilibrium lies in (Keynesian, Intermediate, or Neoclassical).
Measuring the Economy: GDP
Gross Domestic Product (GDP): Definition & Calculation
GDP: The total market value of all final goods and services produced within a country’s borders in a given period.
GDP Calculation (Expenditure Approach): GDP = C + I + G + NX (Consumption + Investment + Government Spending + Net Exports)
GDP Calculation (Income Approach): GDP is also calculated by summing all incomes earned in the production of goods and services.
Nominal vs. Real GDP
Nominal GDP: GDP measured in current prices. Advanced Note: The nominal GDP can increase due to either higher output or higher prices.
Real GDP: GDP adjusted for inflation. Advanced Note: Real GDP provides a more accurate measure of changes in the economy’s output over time.
Real GDP Calculation: Real GDP = (Nominal GDP / Price Index) * 100
GDP Per Capita
GDP per capita: GDP divided by the population. Provides a measure of the average income per person in a country. Advanced Note: GDP per capita is a useful indicator of a country’s standard of living, but it doesn’t capture income inequality or non-market activities.
Limitations of GDP
GDP doesn’t fully capture a nation’s well-being. It excludes:
- Non-market activities (e.g., household production)
- The informal economy
- Environmental quality
- Income distribution
- Leisure time
Demand & Supply: Microeconomic Foundations
Demand: Definition & Law of Demand
Demand: The quantity of a good or service consumers are willing and able to buy at various prices.
Law of Demand: As price increases, quantity demanded decreases (inverse relationship), ceteris paribus.
Supply: Definition & Law of Supply
Supply: The quantity of a good or service producers are willing and able to sell at various prices.
Law of Supply: As price increases, quantity supplied increases (direct relationship), ceteris paribus.
Market Equilibrium
Equilibrium: The point where quantity demanded equals quantity supplied. Determines the equilibrium price and quantity.
Shifts in Demand & Supply
Shifts in Demand: Caused by changes in factors other than price (e.g., consumer income, tastes, prices of related goods). A rightward shift increases demand; a leftward shift decreases demand.
Shifts in Supply: Caused by changes in factors other than price (e.g., input costs, technology, government regulations). A rightward shift increases supply; a leftward shift decreases supply.
Price Ceilings & Price Floors
Price Ceiling: A maximum legal price. Can lead to shortages if set below the equilibrium price.
Price Floor: A minimum legal price. Can lead to surpluses if set above the equilibrium price.
Consumer & Producer Surplus
Consumer surplus: the difference between what consumers are willing to pay and what they actually pay.
Producer surplus: the difference between what producers receive and their willingness to accept.
Social Surplus (Total Surplus): Consumer surplus + Producer surplus. Represents the overall economic benefit from a market. Advanced Note: Deadweight loss occurs when the market is not producing at the efficient quantity (equilibrium).
Analyzing Market Changes: 4-Step Process
- Draw the initial demand and supply curves.
- Identify whether the change affects demand or supply.
- Determine the direction of the curve shift (right or left).
- Identify the new equilibrium and compare it to the original.
Key Economic Facts to Memorize
- Aggregate Demand (AD): Total spending in an economy at a given price level; AD = C + I + G + NX.
- Aggregate Supply (AS): Total quantity of goods and services supplied at a given price level; SRAS is upward sloping, LRAS is vertical.
- Equilibrium (AD/AS): The intersection of AD and AS determines equilibrium price level and real GDP.
- Shifts in AD: Caused by changes in C, I, G, or NX; rightward shift increases price and output, leftward shift decreases both.
- Shifts in AS: Caused by changes in productivity, input prices, or supply shocks; rightward shift increases output and decreases price; leftward shift decreases output and increases price.
- Keynes’ Law: Demand drives supply in the short run.
- Say’s Law: Supply drives demand in the long run.
- GDP (Expenditure Approach): GDP = C + I + G + NX.
- GDP (Income Approach): Sum of all incomes earned in production.
- Nominal GDP: GDP in current prices.
- Real GDP: GDP adjusted for inflation; real GDP = (nominal GDP / price index) * 100.
- GDP per capita: GDP per person; a measure of average income.
- Law of Demand: Inverse relationship between price and quantity demanded.
- Law of Supply: Direct relationship between price and quantity supplied.
- Market Equilibrium: Quantity demanded equals quantity supplied.
- Price Ceiling: Maximum legal price; can cause shortages.
- Price Floor: Minimum legal price; can cause surpluses.
- Consumer surplus: Difference between willingness to pay and actual price.
- Producer surplus: Difference between price received and willingness to accept.
- Social surplus: Consumer surplus + producer surplus; maximized at market equilibrium.