DP Economics SL 3.2 Aggregate Demand and Aggregate Supply

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DP Economics SL | 3.2 Aggregate Demand and Aggregate Supply

DP ECONOMICS · UNIT 3: MACROECONOMICS

3.2

Aggregate Demand and Aggregate Supply

Full notes for SL · IB-style

Contents

1	Aggregate demand
2	The determinants of aggregate demand
3	Short-run aggregate supply
4	Long-run aggregate supply: two views
5	Macroeconomic equilibrium and output gaps
6	Changes in equilibrium: demand-side and supply-side shocks
7	Components of aggregate demand
8	Why AD slopes downwards
9	Shifts in AD: applied
10	Short-run aggregate supply
11	Long-run aggregate supply: two views
12	Shifts in LRAS
13	Macroeconomic equilibrium
14	Demand-pull and cost-push inflation in the model
15	Self-correction in the monetarist model
16	Mixed review: worked problems
17	Additional exam-style practice
18	Real-world AD/AS analysis
19	Common misconceptions and links
20	Exam-style question with markscheme
21	Check your understanding
22	Summary and topic map

These are full teaching notes. Read each section in order, try the Think about it question before you read on, and do every Quick check before moving to the next section.

Before you start

Rate yourself on each statement now, and again after you've worked through the notes. Shade R (not yet), A (getting there) or G (confident).

I can…	R	A	G
define aggregate demand and explain why the AD curve slopes downward
explain the determinants of C, I, G and (X − M) and how they shift AD
explain the determinants of SRAS
explain the neoclassical and Keynesian views of LRAS
show short-run and long-run equilibrium, deflationary and inflationary gaps
analyse the effects of demand and supply shocks on output and the price level

This booklet covers the SL syllabus for 3.2. The HL-only multiplier is not included.

Guiding questions

Why does total spending in an economy rise and fall? Can an economy get stuck in a recession, or does it always recover on its own? What happens to prices and output when oil prices soar?

How this topic is examined

The AD/AS model is the main tool of Unit 3. Almost every macro essay uses it: to explain recessions, inflation and growth, and to analyse fiscal, monetary and supply-side policy. You must be able to draw both the neoclassical and Keynesian versions accurately.

Paper 2 often asks you to show the effect of a shock described in a text (a fall in confidence, a rise in oil prices) on an AD/AS diagram.

Command term	What the examiner wants
Define	the precise meaning, ideally in the IB wording, in one or two sentences
Draw / Sketch	a fully labelled diagram with every axis, curve, equilibrium and change labelled
Explain	a causal chain linked to economic theory, usually supported by a diagram
Analyse	break a situation into its parts and trace the effects of each
Evaluate / Discuss	weigh up arguments, question assumptions and reach a justified conclusion using real-world examples

How to use these notes

Each section teaches one part of the syllabus in full. You'll see these boxes throughout; each has one job:

Box	What it's for
Think about it	a question to get you thinking before a section; the answer comes in the section
Key point	the one idea you must not forget
Common mistake	an error examiners see every year, and how to avoid it
In the real world	where the economics shows up outside the classroom
Try this	something quick you can do yourself to test the idea
Worked example	full solutions with IB-style marks (M1 method, A1 answer, R1 reasoning)
Quick check	short questions to test yourself at the end of each section

1 Aggregate demand

Aggregate demand is total planned spending on an economy's output at each price level.

Think about it

If every price in the economy rose by 10% at once, would people buy more or less in total? Why?

Aggregate demand (AD) is the total planned spending on an economy's goods and services at each possible average price level, in a given period. It is the macroeconomic version of demand: instead of one market, it covers the whole economy.

AD has four components, the same as the expenditure method of measuring GDP:

AD = C + I + G + (X − M)

The AD curve is drawn with the average price level on the vertical axis and real GDP (real output) on the horizontal axis. It slopes downward, but not for the same reasons as a single demand curve: when the general price level rises, all goods become more expensive together, so the substitution effect between goods does not apply. Instead there are three effects.

The wealth effect. A higher price level reduces the real value of people's savings and assets, so they feel poorer and spend less.

The interest rate effect. A higher price level means people need more money to make the same purchases, so demand for money rises, which pushes up interest rates. Higher interest rates reduce borrowing for consumption and investment.

The international trade effect. If domestic prices rise relative to foreign prices, exports become less competitive and imports more attractive, so net exports fall.

Figure 1. The AD curve slopes downward: a higher average price level reduces real output demanded.

Key point

A change in the price level causes a movement along AD. A change in any component of AD for any other reason shifts the curve.

Quick check

1. Write the AD equation.

2. What is on each axis of an AD/AS diagram?

3. Give the three reasons why AD slopes downward.

Answers: 1. AD = C + I + G + (X − M) 2. average price level; real GDP 3. wealth, interest rate and international trade effects

2 The determinants of aggregate demand

Anything that changes C, I, G or (X − M) at a given price level shifts AD.

2.1 Consumption (C)

Consumption is household spending on goods and services and is the largest component of AD, typically 50% to 70% in most economies. It depends on: income (disposable income after taxes); consumer confidence (optimistic households spend more); interest rates (lower rates make borrowing cheaper and saving less attractive); wealth (rising house and share prices make people feel richer); household debt (high debt reduces spending); and expectations of future prices and incomes.

2.2 Investment (I)

Investment is spending by firms on capital goods: machinery, buildings, technology. It is the most volatile component. It depends on: interest rates (the cost of borrowing to invest); business confidence and expected future demand; technology (new technology creates investment opportunities); corporate taxes; the level of debt of firms; and the accelerator: if demand is growing fast, firms invest more to expand capacity.

2.3 Government spending (G)

Government spending on goods and services (health, education, defence, infrastructure) depends on political priorities and the state of the economy. Governments may increase spending in a recession to support demand (fiscal policy, 3.5).

2.4 Net exports (X − M)

Net exports depend on: incomes abroad (rising foreign incomes raise demand for our exports); domestic incomes (rising domestic incomes raise imports); the exchange rate (a depreciation makes exports cheaper and imports dearer, raising net exports); relative inflation; and trade policies such as tariffs.

Change	Component	Effect on AD
consumer confidence falls	C	decrease (shift left)
interest rates are cut	C and I	increase (shift right)
income taxes rise	C	decrease
business expectations improve	I	increase
government builds new roads	G	increase
currency depreciates	X − M	increase
recession in trading partners	X	decrease

Figure 2. A fall in AD: for example, a collapse in consumer and business confidence.

Quick check

1. Name three determinants of consumption.

2. Why is investment the most volatile component of AD?

3. How does a currency depreciation affect AD?

Answers: 1. income, confidence, interest rates, wealth, debt 2. it depends heavily on expectations and confidence 3. net exports rise, so AD shifts right

3 Short-run aggregate supply

In the short run, firms produce more when prices rise, because costs lag behind.

Aggregate supply (AS) is the total quantity of goods and services that firms in an economy plan to produce at each average price level, in a given period.

Short-run aggregate supply (SRAS) slopes upward. In the short run, the prices of factors of production, especially wages, are fixed by contracts and are slow to change. If the average price level rises while wages stay the same, firms' profits rise, so they increase output. That gives a positive relationship between the price level and real output.

SRAS shifts when the costs of production change across the whole economy. A rise in wages, in the price of key raw materials such as oil, or in indirect taxes, or a fall in subsidies, raises costs and shifts SRAS left. Lower costs shift SRAS right. Sudden events that disrupt production, called supply shocks, such as wars, pandemics or natural disasters, also shift SRAS left.

Figure 3. A fall in SRAS (for example a rise in oil prices): the price level rises and real output falls.

Quick check

1. Why does SRAS slope upward?

2. Name three causes of a leftward shift in SRAS.

Answers: 1. wages are fixed in the short run, so higher prices raise profits 2. higher wages, higher raw material prices, higher indirect taxes, supply shocks

4 Long-run aggregate supply: two views

Economists disagree about whether the economy returns to full employment on its own.

4.1 The neoclassical (monetarist / new classical) view

Neoclassical economists argue that in the long run, wages and prices are fully flexible. If the economy is in a recession, unemployed workers eventually accept lower wages, firms' costs fall, SRAS shifts right and output returns to its full-employment level. If output is above full employment, wages are bid up and SRAS shifts left.

So the long-run aggregate supply (LRAS) curve is vertical at the full-employment level of output (Yf), also called potential output. In the long run, output depends only on the quantity and quality of the factors of production and technology, not on the price level. Changes in AD affect only the price level in the long run.

Figure 4. The neoclassical model: SRAS slopes upward, LRAS is vertical at full-employment output Yf.

4.2 The Keynesian view

Keynes argued that wages are sticky downward: workers resist pay cuts, and contracts and minimum wages prevent wages from falling quickly. And even if wages did fall, workers would have less to spend, reducing AD further. So an economy can remain stuck in a recession with high unemployment for a long time.

The Keynesian AS curve has three sections. At low output, with lots of spare capacity, it is horizontal: firms can increase output without raising prices, because unemployed resources are readily available. As the economy approaches full employment, it slopes upward, as bottlenecks and shortages of some resources push up costs. At full employment (Yf) it becomes vertical: output cannot rise further, so extra demand only raises prices.

Figure 5. The Keynesian AS curve: horizontal with spare capacity, upward-sloping near capacity, vertical at Yf.

	Neoclassical	Keynesian
LRAS shape	vertical at Yf	horizontal, then upward, then vertical
Wages and prices	flexible in the long run	sticky, especially downward
Recessions	self-correcting	can persist
Policy implication	limited role for demand management	government should manage AD

4.3 Shifts of LRAS

In both models, the economy's productive capacity grows when the quantity or quality of factors of production increases, or technology improves. This shifts LRAS (or the vertical part of the Keynesian AS) to the right. Causes include investment in capital, improvements in education and health (human capital), population growth and immigration, new technology, and institutional changes that improve efficiency. A rightward shift of LRAS is long-term economic growth and corresponds to an outward shift of the PPC.

Figure 6. An increase in LRAS: potential output rises.

Quick check

1. Why is the neoclassical LRAS vertical?

2. Describe the three sections of the Keynesian AS curve.

3. Name two causes of a rightward shift in LRAS.

Answers: 1. in the long run output depends on resources, not the price level 2. horizontal (spare capacity), upward, vertical at Yf 3. investment, education, technology, more labour

5 Macroeconomic equilibrium and output gaps

Equilibrium is where AD meets AS; it need not be at full employment.

Short-run equilibrium occurs where AD intersects SRAS, determining the average price level and real output. Long-run equilibrium in the neoclassical model occurs where AD, SRAS and LRAS all intersect at Yf.

If short-run equilibrium output is below Yf, there is a deflationary (recessionary) gap: a negative output gap with unemployment. In the neoclassical model, wages fall, SRAS shifts right and the gap closes over time. In the Keynesian model, the economy may stay in the gap unless AD increases.

If short-run equilibrium output is above Yf, there is an inflationary gap: a positive output gap. Workers demand higher wages, SRAS shifts left, and output returns to Yf at a higher price level.

Figure 7. An increase in AD in the neoclassical model: short-run output rises above Yf (inflationary gap); in the long run SRAS shifts left and only prices are higher.

Quick check

1. Define a deflationary gap.

2. How does the neoclassical economy close an inflationary gap?

Answers: 1. equilibrium output below full employment 2. wages rise, SRAS shifts left, output returns to Yf

6 Changes in equilibrium: demand-side and supply-side shocks

Shifts of AD move prices and output in the same direction; shifts of SRAS move them in opposite directions.

Demand-side shocks. An increase in AD (for example, a boom in confidence or a rise in exports) raises both real output and the price level in the short run. A decrease in AD (a collapse in confidence, a recession abroad) lowers both. In the Keynesian model, if the economy has lots of spare capacity, a rise in AD increases output with little effect on prices.

Supply-side shocks. A decrease in SRAS (a rise in oil prices, a natural disaster) raises the price level and lowers output at the same time: stagflation. This creates a policy dilemma, because boosting output would worsen inflation, and fighting inflation would deepen the fall in output. An increase in SRAS (cheaper energy, higher productivity) lowers prices and raises output.

Shock	Price level	Real output	Example
AD increases	rises	rises	boom in consumer confidence
AD decreases	falls	falls	global financial crisis 2008
SRAS decreases	rises	falls	oil price shocks of the 1970s and 2022
SRAS increases	falls	rises	falling energy costs

In the real world

In 2022 the sharp rise in energy and food prices after the war in Ukraine shifted SRAS left in many economies. Inflation rose to its highest level in 40 years in the US, UK and eurozone, while growth slowed: a classic supply-side shock.

Quick check

1. What is stagflation?

2. Why does a fall in SRAS create a policy dilemma?

Answers: 1. rising inflation with falling output 2. boosting output worsens inflation; fighting inflation worsens output

7 Components of aggregate demand

C + I + G + (X − M).

Aggregate demand is total planned spending on domestic output at each price level. Consumption is usually the largest component (about 60% in many economies), followed by government spending and investment; net exports may be positive or negative.

Component	Main determinants
consumption (C)	income, wealth, confidence, interest rates, household debt, taxes
investment (I)	interest rates, business confidence, technology, corporate taxes
government spending (G)	political priorities, economic conditions
net exports (X − M)	foreign incomes, exchange rates, relative prices, trade policy

8 Why AD slopes downwards

Wealth, interest rate, trade effects.

As the price level falls: real wealth rises (wealth effect), interest rates tend to fall, encouraging borrowing (interest rate effect), and domestic goods become more competitive (international trade effect). All increase real output demanded.

WORKED EXAMPLE 1 Explaining (standard)

Explain the international trade effect.

Solution

A lower domestic price level makes exports cheaper and imports relatively dearerR1

Net exports rise, increasing real output demandedR1

9 Shifts in AD: applied

Real-world causes.

Event	Component	Effect on AD
fall in interest rates	C and I	increase
stock market crash	C (wealth)	decrease
recession in trading partners	X	decrease
depreciation of currency	X − M	increase
cut in income tax	C	increase
rise in business confidence	I	increase

WORKED EXAMPLE 2 Shift (exam level)

Explain the effect of a fall in consumer confidence on AD.

Solution

Households save more and spend lessR1

Consumption falls; AD shifts leftR1

10 Short-run aggregate supply

Costs and output.

SRAS slopes upward because wages and some costs are fixed in the short run; higher prices raise profits, so firms increase output. SRAS shifts with changes in costs: wages, raw material prices, indirect taxes, subsidies, supply shocks.

WORKED EXAMPLE 3 Supply shock (standard)

Explain the effect of a rise in oil prices on SRAS.

Solution

Higher costs of production for most firmsR1

SRAS shifts leftR1

11 Long-run aggregate supply: two views

Monetarist and Keynesian.

The monetarist/new classical LRAS is vertical at potential output: in the long run, output is determined by the quantity and quality of resources, not the price level. The Keynesian AS has three sections: horizontal (spare capacity), upward-sloping (bottlenecks), vertical (full employment).

Figure 8. The Keynesian aggregate supply curve.

WORKED EXAMPLE 4 Comparing (exam level)

Compare the effect of an increase in AD in the Keynesian horizontal section and in the vertical section.

Solution

Horizontal: output rises with no price level increase (spare capacity)R1

Vertical: only the price level rises (full capacity)R1

12 Shifts in LRAS

Increasing potential output.

LRAS shifts right when the quantity or quality of factors increases: more labour (migration), better education and training, investment in capital, new technology, improved institutions. These are the sources of long-term growth.

Quick check

1. Give three causes of an increase in LRAS.

Answers: 1. more capital investment; better education; new technology

13 Macroeconomic equilibrium

Where AD meets AS.

Short-run equilibrium occurs where AD = SRAS. Long-run equilibrium occurs where AD = SRAS = LRAS (at full employment output). Recessionary and inflationary gaps exist when short-run equilibrium is below or above potential output.

Figure 9. Long-run equilibrium at the full employment level of output.

WORKED EXAMPLE 5 Gap (standard)

Identify the type of gap when short-run equilibrium output is below potential output.

Solution

Recessionary (deflationary) gapA1

14 Demand-pull and cost-push inflation in the model

Two causes.

Demand-pull inflation: AD increases near full capacity, raising the price level. Cost-push inflation: SRAS shifts left due to rising costs, raising the price level and reducing output (stagflation).

WORKED EXAMPLE 6 Stagflation (exam level)

Using AD/AS analysis, explain how an oil price shock can cause stagflation.

Solution

Higher costs shift SRAS leftR1

Price level rises and real output falls: inflation with unemploymentR1

15 Self-correction in the monetarist model

Wages adjust.

In the monetarist view, a recessionary gap closes on its own: unemployment pushes wages down, SRAS shifts right, and the economy returns to potential output. Keynesians argue this may take a long time because wages are sticky downwards.

Quick check

1. Why might wages not fall quickly in a recession?

Answers: 1. contracts, minimum wages, unions, worker resistance

16 Mixed review: worked problems

Bringing the ideas together.

WORKED EXAMPLE 7 Mixed problem (exam level)

Explain the effect of large investment in education on AD and LRAS.

Solution

Short run: government spending increases ADR1

Long run: better-skilled workforce increases LRASR1

Potential output rises with limited inflationR1

17 Additional exam-style practice

Paper 1 and Paper 2.

WORKED EXAMPLE 8 Paper 1 part (a) (exam level)

Using an AD/AS diagram, explain two causes of a recession. [10]

Solution

Diagram with leftward AD shift showing lower real outputA1

Cause 1: fall in consumer confidence/wealthR1 R1

Cause 2: fall in exports or rise in interest ratesR1 R1

18 Real-world AD/AS analysis

The COVID-19 shock.

The COVID-19 pandemic caused both a fall in AD (lockdowns, lower confidence) and a fall in SRAS (supply-chain disruptions). Later, recovering demand with constrained supply contributed to high inflation in 2021–2023.

In the real world

Many economies experienced inflation above 8% in 2022 as recovering demand met supply-chain bottlenecks and energy price shocks.

Quick check

1. Use AD/AS to explain why inflation rose in 2022.

Answers: 1. AD recovered while SRAS fell due to energy and supply shocks

19 Common misconceptions and links

Students often think…	Actually…
AD slopes down for the same reasons as market demand	it slopes down because of wealth, interest rate and trade effects
SRAS and LRAS shift for the same reasons	SRAS shifts with costs; LRAS with the quantity and quality of resources
Keynesians and neoclassicals use the same LRAS	neoclassical LRAS is vertical; Keynesian AS has three sections
a rise in AD always raises output	near full employment it mainly raises prices

How 3.2 connects to the rest of the course

Topic	Connection
3.1 Measuring economic activity	AD uses the GDP components
3.3 Macroeconomic objectives	unemployment and inflation through AD/AS
3.5 and 3.6 Demand management	fiscal and monetary policy shift AD
3.7 Supply-side policies	policies that shift LRAS
1.2 Schools of thought	Keynesian vs classical views

20 Exam-style question with markscheme

Try this under exam conditions (about 18 minutes) before reading the markscheme.

Figure 10. Quarterly changes in consumption and investment.

Text A. In the second quarter of 2020, lockdowns closed shops and factories. Firms postponed investment plans because they were unsure when demand would recover. The government introduced wage-support schemes and the central bank cut interest rates to near zero.

(a) Identify the quarter with the largest fall in investment. [1]

(b) Explain why investment fell more than consumption. [3]

(d) Explain why the recovery in 2020 Q3 was strong. [2]

Markscheme

Part	Answer	Marks
(a)	2020 Q2 (−18%)	A1
(b)	investment depends on confidence and expected demand	R1
	high uncertainty during lockdowns	R1
	spending on necessities continued	R1
(c)	diagram: AD shifts left	A1
	lower C and I	R1
	real GDP falls	R1
	price level falls / inflation lower	R1
(d)	lockdowns lifted; pent-up demand	R1
	government support / low interest rates	R1

Examiner's comments. In (c), weaker answers shifted SRAS. The text describes falling spending, so AD must shift.

21 Check your understanding

Section A: multiple choice

1. Aggregate demand is

A. total planned spending on output at each price level B. total supply C. consumer spending only D. government spending only

2. The AD curve slopes downward partly because of

A. rising costs B. diminishing returns C. the wealth effect D. technological change

3. An increase in consumer confidence shifts AD

A. to the left B. to the right C. not at all D. along the curve

4. SRAS shifts left when

A. AD rises B. productivity rises C. taxes fall D. costs of production rise

5. In the neoclassical model, LRAS is

A. horizontal B. vertical at full employment output C. upward sloping D. downward sloping

6. In the Keynesian model, a rise in AD with spare capacity

A. raises output without raising prices B. only raises prices C. reduces output D. has no effect

7. Stagflation is

A. rising output and falling prices B. zero inflation C. high growth D. rising inflation with falling output

8. A deflationary gap exists when

A. output is above full employment B. inflation is high C. equilibrium output is below full employment D. the budget is in surplus

Section B: structured

9. Explain the determinants of investment. [4]

10. Distinguish between the neoclassical and Keynesian views of LRAS. [4]

11. Using a diagram, explain the effects of a large rise in oil prices. [6]

Answers

1. A 2. C 3. B 4. D 5. B 6. A 7. D 8. C

9. Interest rates, business confidence, technology, corporate taxes, the accelerator.

10. Neoclassical: vertical LRAS, flexible wages, self-correction; Keynesian: three-section AS, sticky wages, can stay in recession.

11. SRAS shifts left; price level rises; output falls; stagflation; policy dilemma.

22 Summary and topic map

Idea	Remember
AD	C + I + G + (X − M); slopes down
Shifts of AD	confidence, interest rates, taxes, G, exchange rate, incomes abroad
SRAS	slopes up; shifts with costs and supply shocks
Neoclassical LRAS	vertical at Yf; self-correction
Keynesian AS	horizontal, rising, vertical; sticky wages
Gaps	deflationary below Yf; inflationary above
Shocks	AD: P and Y same direction; SRAS: opposite directions

Before the exam, make sure you…

•label axes: average price level and real GDP
•state which model you are using
•separate AD shifts from SRAS shifts
•explain the mechanism behind each shift

AD and AS on one page

Cover this page with a sheet of paper and try to rebuild it from memory. Whatever you can't recall is what to revise next.

Figure 11. Topic map for AD and AS.

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