ECON2000 Chap.9 Aggregate Demand and Supply
Aggregate Demand and Supply
Aggregate demand is derived by repeating IS-MP equilibrium at different inflation rates. Higher inflation triggers a higher policy rate under the monetary rule, which weakens interest-sensitive spending and lowers output. Aggregate supply is connected to labour-market tightness, wage setting, productivity and inflation expectations.
Their intersection determines short-run output and inflation, with an associated interest rate and employment outcome elsewhere in the model. Demand shocks move output and inflation together, while adverse supply shocks lower output and raise inflation.
This chapter traces full-model shock transmission, distinguishes curve shifts from movements along curves and explains why a policy response to a supply shock confronts an output-inflation trade-off.
What this chapter covers
- 01
AD derivation from IS-MP
- 02
AD slope and shifts
- 03
Labour-market supply
- 04
Inflation expectations
- 05
AS slope and shifts
- 06
General equilibrium
- 07
Demand shocks
- 08
Supply shocks
Worked example · free
Tracing a fiscal demand shock
- +1Higher government purchases shift planned expenditure upward.
- +1IS shifts right because goods-market equilibrium output is higher at each interest rate.
- +1AD shifts right because output is higher at each inflation rate.
- +2At unchanged AS, output and inflation rise in the short run.
- +1The policy rule raises the interest rate as inflation and output pressure increase, moderating the expansion.
Key terms
- Aggregate demand
- The inflation-output schedule derived from goods-market equilibrium and the monetary-policy response.
- Aggregate supply
- The short-run inflation-output schedule derived from labour, wage and price setting.
- Demand shock
- A disturbance changing desired expenditure at given supply conditions.
- Supply shock
- A disturbance changing production or price pressure at given demand conditions.
- General equilibrium
- An outcome satisfying the connected goods, policy, labour and price-setting relationships simultaneously.
Aggregate Demand and Supply FAQ
Why does aggregate demand slope downward?
Higher inflation prompts a higher policy rate under the monetary rule. The higher rate reduces interest-sensitive consumption and investment, so IS-MP equilibrium output is lower. Repeating that process across inflation rates gives the downward AD schedule.
What shifts aggregate supply?
Changes in expected inflation, productivity, wage-setting conditions or other production costs can change inflation pressure at a given output level. A movement caused by changing output along an unchanged supply relationship is not a shift.
How do demand and supply shocks differ?
A positive demand shock normally raises output and inflation together. An adverse supply shock lowers output while raising inflation. The opposite comovement creates a policy trade-off because restraining inflation with weaker demand can deepen the output loss.
Which variables define full-model equilibrium?
The AD-AS intersection supplies output and inflation. The corresponding policy rate comes from MP, while employment and wages follow the labour-market block. A complete answer reports every endogenous variable requested rather than stopping at a single diagram.
Exam move
Derive AD verbally from IS-MP before drawing it. For AS, write how output affects labour-market tightness, wages and inflation pressure, then add expected inflation and productivity as shift factors. Practise one demand expansion, one demand contraction, one favourable supply shock and one adverse supply shock.
For each, use a fixed template of logic rather than a fixed sentence: exogenous change, entry equation, first curve, intersection, policy response and adjustment. Mark movements along curves differently from curve shifts. Finish by checking comovement: demand shocks move output and inflation together, while adverse supply shocks move them in opposite directions. Build the full model in layers on separate sheets.
First solve IS-MP at one inflation rate. Then raise inflation, apply the policy response and record the lower output to obtain a second AD point. For supply, begin with labour-market tightness and wage pressure before drawing the inflation-output schedule. Create a shock ledger listing the exogenous variable, the equation it enters, the first curve shifted and the endogenous variables that follow.
Use different colours for shifts and movements along unchanged curves. Add expectations only after the short-run result is clear, then explain how adjustment can erode a temporary output gap. For a supply shock, write the policy trade-off before selecting a stance, because a demand contraction cannot improve inflation and output simultaneously.
End every diagram with a verbal check of output-inflation comovement and the associated interest-rate response. Use a four-panel scratch layout even when the question asks only for AD-AS: planned expenditure, IS-MP, AD-AS and labour outcomes. You need not finish every panel, but locating the shock in its source block prevents unjustified shifts.
After the short-run equilibrium, add one expectation or policy response and state whether it moves along a curve or shifts one. This produces a complete causal chain without losing the derivation behind the final diagram.
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