AP Macroeconomics Notes on Aggregate Supply and Aggregate Demand

Vocabulary List

1. Aggregate Demand (AD): The total demand for goods and services in an economy at a given price level and time.
2. Aggregate Supply (AS): The total supply of goods and services produced within an economy at a given price level and time.
3. Short-Run Aggregate Supply (SRAS): Reflects production in the short run, where some input costs (e.g., wages) are fixed.
4. Long-Run Aggregate Supply (LRAS): Reflects the economy’s full productive capacity when all resources are used efficiently.
5. Price Level: A measure of the average prices of goods and services in an economy.
6. Real GDP: The total value of goods and services produced in an economy, adjusted for inflation.
7. Wealth Effect: The tendency for consumption to change when the real value of wealth changes due to a change in the price level.
8. Interest Rate Effect: The impact of price level changes on borrowing costs, influencing investment and consumption.
9. Net Export Effect: The tendency for higher price levels to reduce net exports (X – M) due to reduced competitiveness abroad.
10. Supply Shock: An unexpected event that changes production costs, shifting the SRAS curve.
11. Stagflation: A combination of high inflation and stagnant economic growth, often caused by a negative supply shock.
12. Full Employment Output: The level of output when all resources are fully utilized (on the LRAS curve).
13. Demand Shock: An unexpected event that changes aggregate demand (e.g., a change in consumer confidence).
14. Sticky Wages: Wages that are slow to adjust to changes in economic conditions.
15. Macroeconomic Equilibrium: The point where AD intersects AS, determining the economy’s output and price level.

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To practice this topic further, you might want to check out our database of AP Macro Free Response Questions on Aggregate Supply and Demand.

1. What is Aggregate Demand (AD)?

Aggregate Demand represents the total demand for all goods and services in an economy at various price levels. The AD curve slopes downward due to three key effects:

• Wealth Effect:
  As price levels fall, the real value of wealth increases, boosting consumption. Conversely, higher price levels reduce purchasing power.
• Interest Rate Effect:
  Lower price levels reduce interest rates, encouraging borrowing and investment. Higher price levels increase interest rates, discouraging borrowing.
• Net Export Effect:
  Lower domestic price levels make exports more competitive internationally and reduce imports, increasing net exports (X – M).

Formula for AD:AD=C+I+G+(X−M)\text{AD} = C + I + G + (X – M)AD=C+I+G+(X−M)

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2. What is Aggregate Supply (AS)?

Aggregate Supply is the total output of goods and services that firms in an economy are willing and able to produce at a given price level.

Short-Run Aggregate Supply (SRAS):

• The SRAS curve is upward sloping because wages and other input costs are “sticky” in the short run, meaning they do not immediately adjust to changes in price levels.
• Factors that shift SRAS include:
  • Changes in input prices (e.g., wages, raw materials).
  • Productivity changes (e.g., technology improvements).
  • Government policies (e.g., taxes, subsidies).

Long-Run Aggregate Supply (LRAS):

• The LRAS curve is vertical, reflecting that in the long run, output is determined by the economy’s productive capacity (not price level).
• Factors that shift LRAS include:
  • Changes in the quantity or quality of resources (e.g., more capital, better education).
  • Technological advancements.
  • Institutional changes (e.g., improved property rights or reduced trade barriers).

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3. Macroeconomic Equilibrium

The equilibrium in an economy occurs where AD intersects AS.

• Short-Run Equilibrium: Determines the current price level and Real GDP.
• Long-Run Equilibrium: Occurs when the economy operates at its full employment output (on the LRAS curve). At this point:
  • No cyclical unemployment exists.
  • The economy is producing at its natural rate of output.

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4. Shifts in Aggregate Demand

Factors that shift the AD curve include:

• Changes in Consumer Spending (C): Due to changes in income, wealth, or consumer confidence.
• Changes in Investment Spending (I): Driven by interest rates, expectations, or government policies (e.g., tax incentives).
• Changes in Government Spending (G): Increases in government expenditure shift AD right, while decreases shift it left.
• Changes in Net Exports (X – M): A rise in exports or a fall in imports shifts AD right.

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5. Shifts in Aggregate Supply

SRAS shifts occur due to:

• Input Prices: A rise in wages or oil prices shifts SRAS left (higher production costs).
• Supply Shocks: Natural disasters, war, or pandemics can reduce supply.
• Productivity Changes: Technological improvements shift SRAS right.

LRAS shifts occur due to:

• Resource Availability: More workers, better infrastructure, or access to resources increase LRAS.
• Technological Advancements: Innovation raises the economy’s productive capacity.
• Institutional Reforms: Policies that improve efficiency or reduce barriers to production.

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6. Stagflation and Economic Fluctuations

• Stagflation: Occurs when the SRAS curve shifts left due to a negative supply shock, leading to higher prices (inflation) and lower output (stagnation).
• Demand Shock: A sudden increase or decrease in AD, such as during a financial crisis or a government stimulus package.

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7. Policy Responses

• Fiscal Policy:
  Governments use spending and taxation to influence AD. For example, increasing government spending shifts AD right, boosting GDP and reducing unemployment.
• Monetary Policy:
  Central banks use tools like interest rate changes or quantitative easing to adjust AD. Lowering interest rates stimulates investment and consumption, increasing AD.