Have you ever calculated how much you spend in a year? The amount of money you spend in a given period constitutes your total demand. Believe it or not, it contributes to the national macroeconomy. When we consider the total spending of each person across the country (including government and business spending), it is called aggregate demand. On the other hand, aggregate supply is the total value of all the goods and services that producers are willing to offer in an economy during a specified period of time at different price levels.
If you're having trouble understanding these two concepts for the AP® Macroeconomics exam, this article is for you. We'll look at the concepts, what changes aggregate demand and aggregate supply, and why these concepts are important. We'll also look at how you can test these concepts on the AP® exam.
What is aggregate demand and supply?
Aggregate demand is an economic measure of the sum total 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 levels of production at various prices. It is expressed as the sum of all consumption (C), investment (I), public spending (G) and net exports (Xn).
When you take a closer look, aggregate demand equals real GDP, especially long-run aggregate demand, and is usually represented by a downward-sloping curve. This means that increases in price levels, holding other factors constant (All other things being the same), translates into a reduction in aggregate demand. The slope is downward due to the following effects:
wealth effect
Consumer wealth responds inversely to changes in price. At higher price levels or interest rates, the purchasing power (or real wealth) of consumers decreases because they have to spend more to purchase each unit of a good.
Savings and interest rate effect
Higher prices not only burden your wallet (consumer wealth), but also cause you to save less. This reduces the amount of money available for banks to lend, and lenders, in turn, raise interest rates to earn a sizable return. The spiral effect of rising interest rates is a reduction in investment (entrepreneurs are less willing to borrow to expand their businesses) and a drop in consumer spending (fewer people take out mortgages or car loans and spend less using their credit cards). .
Effect of exchange rates
An increase in price also makes people prefer to buy foreign products as they are cheaper compared to local products. This leads the market to demand more foreign currency, causing a weakening of the dollar and a reduction in exports, which further reduces real GDP.
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 provide within an economy at a given general price level. An aggregate supply curve indicates the connection between different price levels and the amount of real GDP supplied and is represented by an upward-sloping curve.
To correctly understand the aggregate supply curve, time is an essential factor. In the short term, the increase in prices (All other things being the same) or higher demand causes an increase in aggregate supply. Producers do this by increasing the use of existing resources to satisfy a higher level of aggregate demand. The term “short run” denotes a period of time in which the prices of some resources remain “fixed” and real GDP is not necessarily equal to potential GDP or full employment GDP.
However, the long-term aggregate supply is not affected by price, but by the number of workers, the available capital stock, and the level of technology. In the long run, it is assumed that the prices of the resources needed for production are variable and that real GDP is equal to potential GDP. Therefore, the long-run aggregate supply curve is nearly vertical. This shows that supply is inelastic to changes in the price level, since all factors of production are assumed to be flexible.
Changes in price levels, other things constant (All other things being the same), causes movements along the aggregate supply and demand curves. However, other factors can change the aggregate demand and aggregate supply curves – let's take a look.
What changes aggregate demand?
Changes in the main components of aggregate demand (ie C+I+G+Xn) are mainly what change aggregate demand. Below is a graphical illustration of changes in the aggregate demand curve.
Let's dig a little deeper into what changes aggregate demand.
Expectations
Expectations of higher inflation, higher future income, or higher profits often increase consumer spending and investment. This causes an increase in real GDP, which shifts aggregate demand to the right (AD2). The opposite is true when consumers and businesses expect a recession; GDP falls and shifts aggregate demand to the left (AD1).
Government Fiscal and Monetary Policy
Fiscal policy is when the government tries to influence the economy by changing taxes or government spending. Congress oversees this role and changes aggregate demand by manipulating consumer wealth. To see how:
A reduction in taxes or an increase in transfer payments causes an increase in consumer wealth and investment, raising real GDP and, in turn, shifting aggregate demand to the right towards AD2. The same effect is felt when the government increases its spending on something like health. On the other hand, when the government raises taxes or cuts spending, consumer wealth falls, which contracts real GDP and shifts the aggregate demand curve to the left for AD.1.
Omonetary policyIt applies when the government tries to change the level of money circulation in the economy by influencing interest rates. The Federal Reserve Bank normally performs this function. When interest rates rise, exchange rates are affected, the dollar appreciates against other world currencies, the prices of local products rise, and investment and consumer spending decline. Therefore, aggregate demand is suppressed and shifts the aggregate demand curve to the left for AD1.
Changes in Foreign Trade
An increase in net exports at any given price level shifts aggregate demand to the right for AD2. The following three main factors influence net exports:
First, if local firms and households buy more foreign than local goods due to better price or availability, net exports will fall, shifting aggregate demand leftward toward AD.1. If the opposite occurs, aggregate demand shifts to the right for AD2.
- Second, if exchange rates significantly favor the dollar against other world currencies, net exports will fall, shifting aggregate demand to the left for AD.1.
- Third, if US real GDP grows much faster than other countries, the dollar will strengthen and net exports will decline, shifting aggregate demand to the left for AD.1.
Changes in productivity
When producers employ better organizational management strategies or improved technology, it allows for more efficient production and improves the quality of products. This, in turn, encourages investment and boosts exports. Therefore, aggregate demand shifts to the right for AD2.
Or what changes to added supply?
Changes in the short-run aggregate supply curve are caused by changes in inflationary expectations; changes in the labor force and availability of social capital; changes in government action (not the same as government spending); changes in productivity; and supply shocks.
Changes in inflation expectations
If firms and workers expect prices to rise, short-run aggregate supply will shift to the left for SARS2.
Changes in the Labor Force and Social Capital
As the availability of the labor force and the capital stock increase, the aggregate supply increases at all price levels, shifting the aggregate supply towards the entitlement to SARS1.
Changes in government action
For example, the adoption of policies that impose heavy taxes, eliminate subsidies for local production, or impose restrictive regulations can shift aggregate supply to the left in the short run (SARS2). The opposite occurs when the government adopts policies that reduce the tax burden on producers, subsidize local production, or eliminate restrictive regulations, shifting aggregate supply to the right (SARS1).
Positive institutional and technological changes
Such changes allow producers to supply more products at reduced costs. Therefore, more production is available at all price levels, shifting aggregate supply to the right for SARS.2.
supply shocks
Unexpected increases in the prices of needed resources or a sudden shortage caused by an uncontrollable event, such as natural disasters, can shift aggregate supply to the left in the short run for SARS.1.
A shift in the aggregate supply curve in the long run is mainly due to technological innovations and changes in the size and quality of the labor force. As the economy becomes driven by more efficient technology and the number and quality of workers improve, producers are willing to offer more at any given price level. This shifts the long-run aggregate supply curve to the right for LRAS.1.
The Long-Term Macroeconomic Equilibrium is the meeting point of the three curves: short-term aggregate supply, aggregate demand, and long-term aggregate supply. Pmimi QYthey represent the equilibrium price level and GDP at full employment.
Macroeconomics schools of thought
A Keynesian theoryadvances the argument that aggregate demand is influenced by a combination of numerous economic decisions at both the 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's theory promotes the notion that future economic output is driven by aggregate demand and that during a depression the government should stimulate the economy in the form of fiscal and economic incentives.monetary policy. In this theory, not only are resource costs "fixed" but also prices are "fixed" in the short run because firms are locked into fixed-price contracts.
classical theoryadvances the argument that an economy is self-controlled and capable of achieving potential GDP or full employment. It alludes to the view that as long as there are circumstances that lead an economy to not operate at potential GDP (full employment), self-adjustment mechanisms will allow the economy to return to 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 main 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 given level of real GDP, it produces enough revenue to purchase that level of real GDP.
Why are aggregate demand and aggregate supply important?
As you can see in our discussions of aggregate supply and demand, its curves, and what changes aggregate supply and demand, this topic is the foundation of macroeconomics. From these concepts, economists derive other important macroeconomic issues such as taxation, international trade, and exchange rates. Governments can take steps to influence investment, interest rates and consumer spending to ensure that the economy stays on track.
This topic has also been a focal point for the AP® Macroeconomics exams. In fact, by going through previous exams, there is more than a 90% chance that you will be tested.
To prepare for the AP® Macroeconomics exam, you must first be familiar with AP-level material, have a good understanding of the exam's structure, and consult various sources of information, as well as what happened on previous exams. Check out our previous post onThe Ultimate List of Macroeconomic Tips from AP®just like himEssential Tips for the CollegeBoard Macroeconomics Testit will catapult you to a whole new level of readiness.
It is important that you have a good understanding of this concept and the curves involved. To help you with that, let's take a look at an FRQ from the 2015 exam.
Assuming the US economy is below potential GDP (below full employment):
(a) Draw a clearly labeled graph showing the following curves:
i) Long-term aggregate supply (LRAS).
ii) Short-Term Aggregate Supply (SARS).
iii) Aggregate demand (AD).
On the graph, identify the current equilibrium output (label it Y1) and the price level (label it PL1) and the full employment GDP point (labeled YF).
A correctly drawn graph showing aggregate demand (AD), short-run aggregate supply (SARS), equilibrium output (Y1) and the equilibrium price level (PL1), as shown below, would earn two points. You will receive an additional grade for drawing a vertical Long-Run Aggregate Supply (LRAS) at the GDP point of full employment (YF), which is to the right of the equilibrium output (Y1).
(b) The Federal Reserve sought your advice on setting a new federal funds rate to move the economy toward full employment. Should the Federal Reserve target a higher or lower fed funds rate?
A simple answer that the Federal Reserve should target a lower fed funds rate earns you a score.
(c) Justify your advice in (b) above and draw a money market graph showing the impact of your recommendations on the nominal interest rate.
A correctly drawn and labeled money market chart would earn you a tick (see Figure 7).
On the money market graph, which shows a rightward shift in the money supply curve (MS2) caused by the fall in the nominal interest rate, earns another mark.
(d) If government officials follow the fiscal policy of part (b) above, instead ofmonetary policy, assuming that the recessionary gap is $300 billion and the marginal propensity to consume (mpc) is 0.8, then:
i) Calculate the minimum change in public spending necessary to close the recessive gap without changing taxes.
The minimum adjustment required in public spending is calculated by dividing the recessionary gap by the public spending multiplier.
In this case, $300 billion/5 = $60 billion, earning a milestone.
(ii) Explain the effect of changing taxes without changing public spending to eradicate the recessive gap. Will the required minimum adjustment to taxes be greater than, less than, or equal to the required minimum adjustment to public spending in part (d)?
The minimum change in taxes will be greater than the minimum required change in government spending. Here is the explanation: the tax multiplier is much smaller than the government spending multiplier, that is, (mpc/mps = 0.8/0.2 = 4) < (1/mps = 1/0.2 = 5). This is because a part of the increase in disposable income caused by the tax cut will go into saving and not be spent. This will give you two marks.
(e) Explain the effect on aggregate demand and aggregate supply assuming that the government reduces income tax rates to close 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. (A mark)
(ii) the aggregate supply can respond in three different ways, each one depending on the approach adopted.
First, aggregate supply in the long run may remain the same because the tax cut increases consumption and investment or there is no change in inputs.
Second, aggregate supply in the long run may increase because low taxes increase saving and investment in physical capital or improve productivity because of the higher incentive.
Third, aggregate supply in the long run may decline because lower taxes may lead to more investment being evaded.
Each correct answer gives you one point and another point for a correct explanation.
Did you notice that the final answers are supported by the well-articulated points we made above, especially in parts (a) and (e)? We define aggregate demand and explain what changes aggregate demand and aggregate supply. It is always crucial that you remember to draw large, clear, and well-labeled graphics.
To conclude the topic of aggregate supply and demand, remember that these concepts are important for economic policy making and it is very likely that you will be examined. A good understanding of what changes aggregate demand and aggregate supply, as well as the curves, the different economic theories surrounding them, and how they are applied in practice, will build your confidence as you approach the exam.
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