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Aggregate Demand and Supply

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Among cities that have changed dramatically over the past two decades is Dubai, a large city in the Middle East that thrived on oil production. But unlike many other oil-rich cities, at the start of the new millennium, Dubai undertook a strategy of transforming its economy to one less dependent on oil, as it foresaw (correctly) a future when oil is no longer an endless source of money. What did Dubai do?

Investors and the government in Dubai invested heavily in infrastructure, building massive skyscrapers that became home to multinational corporations, luxury homes and condos (including thousands on artificial islands in the Persian Gulf) to attract wealthy foreigners seeking a vacation home, and some of the most lavish shopping malls and attractions to make Dubai a world travel destination.

By diversifying its economy, Dubai ensured that its capacity to produce goods and services that consumers desired extended beyond energy resources. The takeaway from Dubai’s strategy is that the state of an economy cannot be assessed solely based on the performance of a single market, region, or time period. Likewise, government policies are often designed to meet the needs of an entire nation. It would be dangerous to look at just one region or one industry and come to conclusions or make policy recommendations for the nation as a whole.

British economist John Maynard Keynes recognized the need to develop tools to analyze the macroeconomy as a whole. He focused on aggregate expenditures by consumers, businesses, and governments as the key drivers for the economy that determined employment and output. But the model he developed during the Great Depression did not fully consider the effect that changes in the economy would have on prices. Why?

Keynes focused on the problem at hand, when resources were underutilized. For this reason, an expansion of consumption or production did not create much upward pressure on prices. For example, in times of high unemployment, more labor can be hired without raising wages because firms with job openings often are inundated with applicants.

Therefore, the initial Keynesian model was a fixed price model, one that essentially ignored the supply side because increasing production would occur without a rise in prices. The lessons from Keynes, with their focus on spending, formed the foundation of the demand side of the modern macroeconomic model. In this chapter, we add the supply side and move from a fixed price model to a flexible price model, where prices and wages adjust to macroeconomic conditions. We call this model the aggregate demand–aggregate supply (AD/AS) model. This model looks a lot like the supply and demand model for a market, but it has several important differences: It measures real output of the aggregate (overall) economy, it uses the average price level for an economy, and it focuses on short-run fluctuations around a long-run equilibrium output.

The response of prices and wages does not always change in a consistent manner. As we will see, sometimes prices and wages can be sticky in the short run, a condition that allows an economy to respond positively to economic stimulus policies. But in the long run, prices and wages tend to be very responsive to changing macroeconomic conditions.

This flexible price model expands the analysis that began with Keynes to many more modern problems facing economies. The AD/AS model builds on skills you already have: defining demand and supply curves, assessing changes in economic facts, and determining a new equilibrium. These techniques provide policymakers with a way of looking at the overall economy when many factors and differences in economic performance prevail across regions and industries.

This chapter begins with an analysis of aggregate demand and its determinants. We then turn to aggregate supply, studying the differences between a long-run aggregate supply curve and a short-run aggregate supply curve, and the determinants of each. Finally, we put the aggregate demand and aggregate supply curves together to analyze macroeconomic equilibrium. The AD/AS model gives you the tools to analyze tradeoffs between economic output and inflation. It will allow you to understand the causes of recessions and inflation, and how government policy is sometimes used to correct these problems.