Macroeconomic Principles: Aggregate Demand, Supply, and Policy

Aggregate Demand Shifters

The following factors cause shifts in aggregate demand:

• C (Consumption): Consumer wealth, consumer expectations, household indebtedness, and taxes.
• I (Investment): Interest rates, expected returns on investment, business taxes, technology, and the degree of excess capacity.
• G (Government Spending)
• Xn (Net Exports): National income abroad and exchange rates.

Aggregate Supply Shifters

The following factors cause shifts in aggregate supply:

• Input Prices: Domestic resource availability (land, labor, capital, entrepreneurial ability), prices of imported resources, and market power.
• Productivity
• Legal/Institutional Environment: Business taxes, subsidies, and government regulation.

AS Curve Ranges

• Horizontal Range: Includes real levels of output substantially less than full-employment output. A change in real output in this range does not affect the price level.
• Vertical Range: The economy has reached its full-capacity real output. Any increase in the price level in this range does not affect real output.
• Intermediate Range: An expansion of real output is accompanied by a rising price level. Full-employment output is found in this range.

Phillips Curve

The Phillips Curve illustrates a stable, inverse relationship between inflation and unemployment. The short-run Phillips curve has a negative slope, while the long-run Phillips curve is vertical.

The Adaptive Expectations Theory predicts a short-run tradeoff between inflation and unemployment but no long-run tradeoff. While the inverse relationship holds in the short run, the graph eventually shifts back to a vertical line in the long run.

Recessionary Policy

In a recession, the government may implement expansionary fiscal policy to increase aggregate demand, shifting the AD curve to the right and increasing real GDP.

The government has two primary tools:

• Increase government spending: Directly increases aggregate demand (AD = C + Ig + G + Xn).
• Decrease taxes: Increases consumption spending (by the tax decrease times the MPC), which also increases aggregate demand.

Spending Multiplier = 1 / MPS = 1 / (1 – MPC)

Classical Economic Theory

Classical economists believe the AS curve is vertical and is the sole factor in determining real output. They view the downsloping AD curve as stable when the money supply is constant. According to Say’s Law, supply creates its own demand, and domestic output remains unchanged when the price level decreases.