Explain the components of aggregate demand and aggregate supply, the AD/AS model, the business cycle and the multiplier

What this dot point is asking

SCSA wants you to define the components of AD and AS, use the AD/AS model to explain changes in output and prices, describe the business cycle, and apply the multiplier. Expect an AD/AS diagram and an extended response.

Aggregate demand

Aggregate demand (AD) is the total planned spending on goods and services in an economy at a given price level over a period. It has four components:

$AD = C + I + G + (X - M)$

• C (consumption): household spending, the largest component (around 55 to 60 percent of AD). Driven by disposable income, interest rates, wealth and confidence.
• I (investment): business spending on capital. Driven by interest rates, expected profits and business confidence; the most volatile component.
• G (government spending): spending by federal, state and local government.
• (X - M) (net exports): exports minus imports. Driven by the exchange rate, world income and the terms of trade.

The AD curve slopes downward: a lower price level raises real spending power, the real money supply and net export competitiveness.

Aggregate supply

Aggregate supply (AS) is the total output producers are willing and able to supply at each price level.

• The short-run aggregate supply (SRAS) curve slopes upward: higher prices, with input costs sticky, raise profit margins and output.
• The long-run aggregate supply (LRAS) curve is vertical at the economy's productive capacity (potential output), determined by the quantity and quality of resources, technology and productivity, not the price level.

Factors that shift AS include input costs (wages, energy, raw materials), productivity, technology, the exchange rate (affecting imported input costs), and supply-side policy.

AD/AS equilibrium

Macroeconomic equilibrium occurs where AD intersects AS, determining the equilibrium real GDP and price level. On the diagram, the vertical axis is the general price level and the horizontal axis is real GDP.

• A rightward shift in AD (for example a tax cut or rate cut) raises both real GDP and the price level, with the inflation effect stronger as the economy nears capacity.
• A leftward shift in AS (for example an oil price shock) raises the price level while lowering real GDP, producing stagflation.

The business cycle

The business cycle is the recurring fluctuation of real GDP around its long-run trend. Its phases are:

• Expansion: rising output, falling unemployment, rising confidence.
• Peak (boom): the economy near or above capacity, inflation pressure building.
• Contraction (downturn): falling output and rising unemployment. Two consecutive quarters of negative growth is the common definition of a recession.
• Trough: the low point before recovery.

Counter-cyclical macroeconomic policy aims to smooth the cycle: stimulating AD in downturns and restraining it in booms.

The multiplier

The multiplier measures how an initial change in spending leads to a larger total change in real GDP, because one person's spending becomes another's income, which is partly spent again.

$\text{Multiplier} = \frac{1}{1 - MPC} = \frac{1}{MPS + MRT + MPM}$

where MPC is the marginal propensity to consume, MPS is the marginal propensity to save, MRT is the marginal rate of taxation, and MPM is the marginal propensity to import. Higher leakages (saving, tax, imports) reduce the multiplier.