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DP IB Economics: SL Your notes

3.2 Variations in Economic Activity (AD & AS)

Contents
3.2.1 Aggregate Demand (AD)
3.2.2 Short-Run Aggregate Supply (SRAS)
3.2.3 Alternative Views of Aggregate Supply (AS)
3.2.4 Shifts of the Long-Run Aggregate Supply (LRAS)
3.2.5 Macroeconomic Equilibrium

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3.2.1 Aggregate Demand (AD)

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An Introduction to Aggregate Demand (AD)
Aggregate demand (AD) is the total demand for all goods/services in an economy at any
given average price level
Its value is often calculated using the expenditure approach
AD = Consumption (C) + Investment (I) + Government spending (G) + (Exports-Imports) (X-M)
AD = C + I + G + (X-M)
If AD increases then economic growth has occurred and vice versa
Consumption is the total spending on goods/services by consumers (households) in an economy
Investment is the total spending on capital goods by rms
Government spending is the total spending by the government in the economy:
Includes public sector salaries, payments for the provision of merit and public goods etc.
It does not include transfer payments
Net exports are the di erence between the revenue gained from selling goods/services abroad and
the expenditure on goods/services from abroad
Individuals, rms and governments export/import

The relative importance of the components of AD

Depending on the country, the value of each component and its contribution to AD can vary
signi cantly:
Government spending in Sweden is 53% of AD and in the UK, it is 25% of AD
The % that each component contributes to AD in the UK is approximately
Consumption: 60%
Investment: 14%
Government spending: 25%
Net Exports: 1%
A 1 % increase in consumption or government spending will have a much larger impact on economic
growth than a 1% increase in net exports

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The Aggregate Demand (AD) Curve

The relationship between the average price level and the total output in an economy is shown with an Your notes
aggregate demand (AD) curve

The aggregate demand (AD) curve for an economy with Average Price Level on the Y axis and Real GDP
on the X axis
The AD curve is downward sloping
With lower average price levels there is greater aggregate demand
With higher average price levels there is less aggregate demand

A Movement Along the Aggregate Demand (AD) Curve

Whenever there is a change in the average price level (AP) in an economy, there is a movement along
the aggregate demand (AD) curve

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Your notes

An increase or decrease in the average price level (AP) causes a movement along the aggregate
demand (AD) curve leading to a contraction or expansion of AD
Diagram Analysis
An increase in the AP (ceteris paribus) from AP1 → AP2 leads to a movement along the AD curve from
A→B
There is a contraction of real GDP from Y1 → Y2
Y is the symbol used in macroeconomics to denote national income or real GDP

A decrease in the AP (ceteris paribus) from AP1 → AP3 leads to a movement along the AD curve from A
→C
There is an expansion of real GDP (output) from Y1 → Y3

Shifts of the Entire Aggregate Demand (AD) Curve

Whenever there is a change in any of the non-price determinants of aggregate demand (AD) in an
economy, there is a shift of the entire AD curve

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Your notes

A shift in the entire aggregate demand (AD) curve occurs when there is a change in one of the
determinants of AD
Diagram Analysis
An increase in any one of the non-price determinants of aggregate demand (AD) results in a shift
right of the entire curve from AD1 → AD2
At every price level, real GDP has increased from Y1 → Y2
A decrease in any one of the non-price determinants of AD results in a shift left of the entire curve from
AD1 → AD3
At every price level, real GDP has decreased from Y1 → Y3

Factors that In uence each Component of Aggregate

Demand (AD)
Each component of AD is in uenced by numerous factors
A change to any of these factors will potentially change AD
Consumption is in uenced by changes to consumer con dence, interest rates, wealth, income taxes,
level of household indebtedness, and expectations of future price level
Investment is in uenced by changes to interest rates, business con dence, technology, business
taxes, and the level of corporate indebtedness
Government spending is in uenced by changes to political and economic priorities
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Net exports are in uenced by changes to the income of trading partners, exchange rates, and trade
policies
Your notes
Factors that In uence Consumption

Component In uence on the Explanation

component

Consumption Consumer The stronger the economy, the higher consumer

con dence con dence
Consumers feel secure in their jobs and are con dent
of receiving regular salary payments
Consumption increases and saving decreases
In a weakening or recessionary economy, consumer
con dence falls
Consumers feel less secure in their jobs
Consumption decreases and saving increases

Interest rates A change in the base interest rates will change the level of
consumer spending and savings
If interest rates increase there is a greater incentive to
save
More saving = less consumption
If interest rates increase, the monthly repayment on any
loan or mortgage increases
Higher loan repayments = less consumption

Wealth If consumer wealth increases, then consumption usually

increases
Rising property prices or share prices give consumers
con dence to borrow more money
Increased borrowing = increased consumption

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Income taxes Disposable income is the money that households have

left from their salary/wages after they have paid their
Your notes
taxes and have received any transfer payments/bene ts
If taxes increase, then disposable income decreases -
and vice versa

Level of household Debt is usually repaid with monthly payments

indebtedness
The higher the level of debt, the higher the monthly
repayment and the less money available for new
consumption

Expectations of If consumers believe prices will rise in the future, they are
future price level incentivised to consume now - and vice versa

Factors that In uence Investment

Component In uence on the Explanation

component

Investment Interest rates Most investment by rms is nanced through business

loans
Decreasing interest rates encourage investment
There is a mostly inverse relationship between
investment and interest rates

Business con dence Firms will choose to invest if they feel con dent that
they will make a good return on their investment
The decision to invest is linked to the business
objective of pro t maximisation
The longer a period of economic growth, the higher the
business con dence will be
If growth slows, future expectations of pro ts will
decrease and investment decisions become harder

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Technology When a rm identi es new technology which will reduce

costs and raise output, they are incentivised to invest
Your notes
Business taxes When governments raise business taxes it reduces the
pro ts of rms
Lower pro ts mean there is less money available for
investment

Level of corporate Corporate debt is usually repaid with monthly payments

indebtedness
The higher the level of debt, the higher the monthly
repayment and the less money available for new
investment

Factors that In uence Government Spending

Component In uence on the Explanation

component

Government Political Governing parties have di erent political priorities

spending priorities which in uence spending
Some parties believe the state should provide more
goods/services and spending increases
Other parties believe the role of government in society
should be smaller and spending decreases

Economic Fiscal Policy is set once a year and announced during

priorities the presentation of the Government's budget
Expenditure is directly related to the Government's
objectives and policy aims
E.g., A policy aimed at upgrading a country's rail
network requires increased expenditure

Factors that In uence Net Exports

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Component In uence on the Explanation

Your notes
component

(Exports - Income of When the household income of trading partners increases,

Imports) trading foreigners purchase more products - exports increase
partners
When the household income of trading partners decreases,
foreigners purchase fewer products - exports decrease

Exchange rates When the domestic currency appreciates, consumers'

money goes further abroad - imports increase
When the domestic currency appreciates, exports are more
expensive for foreigners - exports decrease
When the domestic currency depreciates, consumers'
money goes less far abroad - imports decrease
When the domestic currency depreciates, exports are less
expensive for foreigners - exports increase

Trade policies If protectionism increases there is decreased demand for

imports as they are more expensive
If protectionism decreases there is increased demand for
imports as they are less expensive - and exports usually
increase due to free trade

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3.2.2 Short-Run Aggregate Supply (SRAS)

Your notes
The SRAS Curve
Aggregate supply is the total supply of goods/services produced within an economy at a speci c
price level at a given time
The short run is a period in which wages and other factor prices are in exible
The long run is a period in which there is full wage and factor price exibility

A diagram showing the upward sloping short run aggregate supply (SRAS) curve for an economy
The AS curve is upward sloping due to two reasons
The aggregate supply is the combined supply of all individual supply curves in an economy which
are also upward sloping
As real output increases, rms have to spend more to increase production e.g. wage bills will
increase
Increased costs result in higher average prices

A Movement Along the SRAS Curve

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Whenever there is a change in the average price level (AP) in an economy, there is a movement along
the short run aggregate supply (SRAS) curve
Your notes

An increase or decrease in the average price level (AP) causes a movement along the short run
aggregate supply (SRAS) curve leading to a contraction or expansion of the quantity supplied

Diagram Analysis
An increase in the AP (ceteris paribus) from AP1 → AP2 leads to a movement along the SRAS curve
from A → B
There is an expansion of real GDP from Y1 → Y2
Y is the symbol used in macroeconomics to denote national income or real GDP
A decrease in the AP (ceteris paribus) from AP1 → AP3 leads to a movement along the SRAS curve from
A→C
There is a contraction of real GDP (output) from Y1→Y3

Shifts of the Entire SRAS Curve

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Whenever there is a change in the non-price determinants of supply in an economy (e.g. costs of
production or productivity changes), there is a shift of the entire SRAS curve
Your notes

A shift in the entire short run aggregate supply (SRAS) curve occurs due to a change in one of the non-
price determinants of supply
Diagram Analysis
A decrease in costs or increase in productivity results in a shift right of the entire curve from SRAS1 →
SRAS2
At every price level, output and real GDP have increased from Y1 → Y2
An increase in costs or decrease in productivity results in a shift left of the entire curve from SRAS1 →
SRAS3
At every price level, output and real GDP have decreased from Y1 → Y3

The Non-price Determinants of the SRAS Curve

There are two main factors that can in uence the short-run aggregate supply (SRAS). They are
Changes in costs of raw materials and energy
Changes in indirect taxes
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Explaining the In uences on Short-run Aggregate Supply (SRAS)

Change in Condition Explanation Impact on SRAS Your notes

Changes to the costs of As the price of input costs rise, fewer SRAS decreases
raw materials/energy goods/services can be produced with the same - shifts left
amount of money

As the price of input costs decrease, more SRAS increases

goods/services can be produced with the same - shifts right
amount of money
Factors which in uence the input costs include
wage rates, interest rates, government regulation
and exchange rates

Changes in indirect taxes Indirect taxes represent an additional cost for SRAS increases
rms - shifts right
Decreasing taxes = decrease in costs
Lower costs = more output

Increasing taxes = increase in costs SRAS decreases

Higher costs = less output - shifts left

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3.2.3 Alternative Views of Aggregate Supply (AS)

Your notes
Monetarist/New Classical View of the Long-run
Aggregate Supply (LRAS) Curve
Classical and Keynesian economists have di erent views on the long-run aggregate supply
Classical economists believe that the LRAS is perfectly inelastic (vertical) at a point of full
employment (YFE) of all available resources
This point corresponds to the maximum possible output on a production possibilities curve (PPC)
The classical view believes that in the long-run an economy will always return to this full employment
level of output (YFE), and all that will change in the long run will be the average price level
During extreme periods of economic growth there can be an in ationary gap that develops
In the long run this will self-correct and return to the long-run level of output, but at a higher
average price level
During slowdowns or recessions there can be a recessionary gap that develops
In the long-run this will self-correct and return to the long-run level of output, but at a lower
average price level

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The Classical View of long-run aggregate supply (LRAS) with a vertical aggregate supply curve at the
full employment level of output (YFE) Your notes

Diagram Analysis
Using all available factors of production, the long-term output of this economy (LRAS) occurs at YFE
The economy is initially in equilibrium at the intersection of AD1 and LRAS (P1, YFE)
A slowdown reduces output from AD1→AD2 and creates a short term recessionary gap
This self corrects in the long term and returns the economy to the long-run equilibrium at the
intersection of AD2 and LRAS (P2, YFE) - a lower price and back to the full employment level of output

Keynesian View of the AS Curve

Keynes believed that the long-run aggregate supply curve (LRAS) was more L shaped, having 3
distinct sections
. An elastic section in which supply is elastic at lower levels of output as there is a lot of spare production
capacity in the economy. Struggling rms will increase output without raising prices
. A relatively price elastic section in which rms are starting to bid with each other for available
resources. Price levels begin to rise
. A perfectly inelastic (vertical) section at a point of full employment (YFE) of all available resources. The
closer the economy gets to this point the more price in ation will occur as rms compete for scarce
resources

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Your notes

The Keynesian View of long-run aggregate supply (LRAS) with a vertical aggregate supply curve at the
full employment level of output (YFE) becoming more elastic at lower levels of output

Diagram Analysis
The vertical portion of the LRAS curve corresponds to the classical view of LRAS
The Keynesian view believes there is a maximum level of possible output
The LRAS curve becomes elastic at a certain price level as prices cannot fall further
Possibly due to minimum wage laws, the existence of trade unions, or long-term employment
contracts preventing wage decreases
Real output national equilibrium can occur at any level of output
The Keynesian view believes that an economy will not always self-correct and return to the full
employment level of output (YFE)
It can get stuck at an equilibrium well below the full employment level of output e.g. Great
Depression
The Keynesian view believes that there is a role for the government to increase its expenditure so as
to shift aggregate demand and change the con dence (animal spirits) in the economy

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In ationary & De ationary Output Gaps

An output gap is the di erence between the actual level of output (real GDP) and the maximum Your notes
potential level of output

An in ationary output gap occurs when the real GDP is greater than the potential real GDP
A de ationary (recessionary) output gap occurs when the real GDP is less than the potential real GDP
There is spare capacity in the economy to produce more goods/services that are being produced

It is di cult to measure output gaps accurately

This is because it is hard to know exactly what the maximum productive potential of an economy
is
Rapidly rising prices can indicate a positive gap is developing
Rising unemployment and slowdown in economic growth can indicate that a negative gap is
increasing
A de ationary (recessionary) output gap
A de ationary gap can be illustrated using either a Classical or Keynesian diagram

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Your notes

Keynesian (top) and Classical (bottom) diagrams illustrating an economy that has a de ationary output
gap (Y1- YFE) and is currently producing less than its potential output

Diagram Analysis
The potential output of this economy is at YFE
The economy is in a short-run equilibrium at AP1Y1
A negative output gap exists at YFE - Y1
This e ectively gives the economy additional spare capacity in the short-term
One cause of this may be that AD has recently decreased due to a fall in consumption
The Classical view is that the output will return to YFE in the long-run, but at a lower average price
level
The Keynesian view is that an economy may be stuck in a negative output gap for a long period of
time

An in ationary output gap

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An in ationary gap can be illustrated using either a Classical or Keynesian diagram

Your notes

A Classical illustration of an in ationary output gap (Y1 - YFE) where the economy is currently producing
more than its potential output

Diagram Analysis
The potential output of this economy is at YFE
The economy is in a short-run equilibrium at AP1Y1
A positive output gap exists at Y1 - YFE
This economy is producing beyond its capacity in the short-term
One cause of this may be that workers are willing to work overtime once full capacity is reached
It is not sustainable and the Classical view is that the output will return to YFE, but at a higher
price level

Examiner Tips and Tricks

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When writing about an in ationary output gap, students often confuse it with the concept of
in ation (an increase in the average price level). Output gaps focus on output, not price levels. An
in ationary output gap means that the economy is producing beyond its full employment level of Your notes
output.

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3.2.4 Shifts of the Long-Run Aggregate Supply (LRAS)

Your notes
Factors that Shift the LRAS
Classical economists believe that the long-run aggregate supply (LRAS) can increase in the long-run
Keynesian economists believe that aggregate supply can increase in the long-term

The following factors will shift the entire Classical LRAS curve, or the Keynesian AS curve outwards, thus
increasing the potential output of the economy. This corresponds to an outward or inward shift on the
production possibilities curve for an economy
. Changes in the quality or quantity of the factors of production: Any factor that increases the quantity
or quality of a factor of production will increase the productive potential of an economy e.g. improving
the skills of workers or changing the migration policies so that there is an increase the quantity of
labour
. Technological advances: these often improve the quality of the factors of production e.g.
development of metal alloys
. E ciency improvements: process innovation often results in productivity improvement e.g. moving
from labour intensive car production to automated car production
. Changes in institutions: increasing nancial institutions can result in more access to nance and help
to increase the potential supply. Creating and implementing new legislation (laws) can make it easier
for new rms to enter markets thus increasing supply e.g. implementation of competition policy

Examiner Tips and Tricks

You will frequently be examined on your understanding of factors that shift the short-run aggregate
supply (SRAS) curve and long-run aggregate supply (LRAS) curve.
Make sure you know the di erence and remember that LRAS factors will shift the entire LRAS curve
to the right, representing an increase in the potential output of the economy. Changes to SRAS do
not change the potential output of the economy.

Diagrammatic Illustration of Long-run Shifts

1. Changes to LRAS in the Classical Model
Changes to any of the determinants of LRAS will change the long-run productive potential of the
economy

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Your notes

The Classical view of an increase in the long-run aggregate supply (LRAS) of an economy leading to
lower average price levels

Diagram Analysis
The initial potential output of this economy is seen at YFE
The economy is in equilibrium at AP1YFE
A change to the education level in the economy can increase the quality of labour and shift the LRAS
to the right from LRAS1→LRAS2
There is now an increased level of potential output in the economy at YFE1
The extra supply in the economy allows prices to fall and output to increase resulting in a new
equilibrium at AP2YFE1

2. Changes to AS in the Keynesian Model

As with the Classical model, changes to any of the determinants of AS will change the long term
productive potential of the economy

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Your notes

The Keynesian view of an increase in the long-term aggregate supply (LRAS) of an economy
Diagram Analysis
The initial potential output of this economy is seen at YFE
A change to the immigration policy can increase the quantity of labour and shift the AS to the right
from AS1→AS2
There is now an increased level of possible output in the economy YFE1

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3.2.5 Macroeconomic Equilibrium

Your notes
Short-run Equilibrium
Real national output equilibrium occurs where aggregate demand (AD) intersects with short-run
aggregate supply (SRAS)

A diagram showing the Classical short-run equilibrium in an economy resulting in an equilibrium price of
AP1 and real output of Y1
According to classical theory, this economy is in short run equilibrium at AP1Y1
Any changes to the components of AD will cause the AD curve to shift left or right creating a new
short-run equilibrium
Any changes to the non-price determinants of SRAS will shift the SRAS curve left or right creating a
new short-run equilibrium

Long-run Equilibrium in the Monetarist/New Classical

Model

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Classical and Keynesian economists have di erent views on the long-run equilibrium of real national
output
Your notes
Classical economists believe that the economy will always return to its full potential level of output
and all that will change in the long-run, is the average price level
YFE is considered to be equal to the natural rate of unemployment in an economy

A diagram that shows the Classical view of long-run equilibrium which occurs at the intersection of
long-run aggregate supply (LRAS), short-run aggregate supply (SRAS) and aggregate demand (AD)
Diagram Analysis
The LRAS curve demonstrates the maximum possible output of an economy using all of its scarce
resources
The SRAS intersects with AD at the LRAS curve
This economy is producing at the full employment level of output (YFE)
The average price level at YFE is AP1

The Classical Adjustment Process (Self-correcting)

Classical economists believe that in the long run the economy will always return to its full potential
level of output and all that will change is the average price level

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This is the also referred to as the self-correcting mechanism

Automatic adjustment from a de ationary output gap Your notes

A de ationary (recessionary) output gap occurs when the real GDP is less than the potential real GDP

Aggregate demand (AD) has shifted left causing a de ationary gap, which in the long-run will self-
correct to YFE but at a lower average price level (AP2)

Correction Process
. Initial long-run equilibrium is at AP YFE
. AD shifts left from AD → AD1, possibly due to the onset of a recession
. Output falls from YFE → Y1 and price levels fall from AP → AP1
. Due to the fall in output, rms lay o workers
. Unemployed workers are now willing to work for lower wages and this reduces the costs of
production which causes the SRAS curve to shift right from SRAS1 → SRAS2
. A new long-run equilibrium is formed at AP2 YFE

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. The economy is back to the full employment level of output (YFE), but at a lower average price

Automatic adjustment from an in ationary output gap Your notes

An in ationary output gap occurs when real GDP is greater than the potential real GDP

Aggregate demand (AD) has shifted right causing an in ationary gap, which in the long-run will self-
correct to YFE but at a higher average price level (AP2)

Correction Process
. Initial long-run equilibrium is at AP YFE
. AD shifts right from AD1 → AD2, possibly due to raid expansion of the money supply
. Output rises from YFE → Y1 and price levels rise from AP → AP1
. Due to the increase in average prices (in ation), workers demand higher wages
. Higher wages increase the costs of production which causes the SRAS curve to shift left from SRAS1
→ SRAS2

. A new long-run equilibrium is formed at AP2 YFE

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. The economy is back to the full employment level of output (YFE), but at a higher average price
Equilibrium in the Keynesian Model Your notes
Keynesian economists believe that the economy can be in long term equilibrium at any level of
output

The Keynesian view believes that an economy will not always self-correct and return to the full
employment level of output (YFE)
It can get stuck at an equilibrium well below the full employment level of output e.g. Great
Depression

The Keynesian view believes that there is role for the government to increase its expenditure so as to
shift aggregate demand and change the negative 'animal spirits' in the economy

A diagram that shows the Keynesian View of aggregate supply (AS) with a vertical aggregate supply
curve at the full employment level of output (YFE) becoming more elastic at lower levels of output
Diagram Analysis
Using all available factors of production, the long-term output of this economy occurs at YFE
The economy is initially in equilibrium at the intersection of AD1 and AS (AP1YFE)

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A slowdown reduces aggregate demand from AD1→AD2 and creates a recessionary gap equal to
YFE - Y1
Your notes
The economy may reach a point where average prices stop falling (AP2), but output continues to fall
Prices may be blocked from falling further due to minimum wage laws, the existence of trade
unions, or long-term employment contracts preventing wage decreases
This economy may not self-correct to YFE for years
The low output leads to high unemployment and low con dence in the economy
This stops further investment and further reduces consumption
Keynes argued that this was where governments needed to intervene with signi cant expenditure
e.g. Roosevelt's New Deal; response to nancial crisis of 2008
Assumptions & Implications of the two Models
Each model has strengths and weaknesses
It has been said that free market fans like Classical thinking when an economy is doing well but very
quickly switch to a Keynesian way of thought during severe recessions as they seek government bail
outs
The Economist Mariana Mazzucato sums it up with the phrase, 'Capitalists like to privatise their pro ts
and socialise their losses'

The Assumptions & Implications of Classical Thinking

Assumptions Implications

Wages are exible Markets self-correct to YFE in the long run due to the fact that
wages can easily rise or fall so as to change costs of
production
The self-correction is based on automatic short-run supply
side changes and there is no need for government
intervention

Any deviation from YFE is There may be short periods of unemployment when a
temporary recessionary gap occurs, however markets will return to YFE
which corresponds to the natural rate of unemployment
(NRU) for an economy

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Demand-side policies are less Economic growth is generated by increasing the productive
e ective than supply-side capacity of the economy
Your notes
policies in generating economic
growth This thinking follows Says' Law
Government intervention should focus on increasing the
supply-side of an economy

The Assumptions & Implications of Keynesian Thinking

Assumptions Implications

'In the long-run we are all Keynes explained that the idea of markets self-correcting in the
dead' long-run was awed in that the long-run could be a very long period
of time indeed
The consequences of severe recessionary gaps and the
unemployment they cause can be signi cant, lasting for generations

Wages can be in exible Markets will reach a point where self-correction as a result of falling
'sticky' downwards wages is no longer viable
Workers will reach a point where they are no longer willing to accept
lower wages
Wages may be blocked from falling further due to minimum wage
laws, the existence of trade unions, or long-term employment
contracts preventing wage decreases

Governments have to Animal spirits refers to the human emotions which drive nancial
intervene to break the decisions during times of uncertainty or market volatility
'negative animal spirits'
If the emotions are gloomy about the economic outlook, then
gloominess will continue
This was the situation in the Great Depression and Keynes advocated
that Government spending was required to change the mood in the
economy and to help rebuild business and consumer con dence
Once governments had intervened, the self-correcting mechanism
would begin to function again

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