Unit 3: Macroeconomics - Economic Output, AD & AS

Welcome to Macroeconomics! This unit shifts focus from individual markets (microeconomics) to the economy as a whole. You'll learn how to measure economic activity, understand business cycles, and analyze the forces of Aggregate Demand (AD) and Aggregate Supply (AS) that determine national output, employment, and price levels. Mastering the AD-AS model is essential for understanding macroeconomic policy and performance.

1. Measuring Economic Activity

Economic Activity: The production, distribution, and consumption of goods and services in an economy. It represents the total value of economic output and the level of employment and spending within a nation.

Gross Domestic Product (GDP)

Gross Domestic Product (GDP): The total market value of all final goods and services produced within a country's borders during a specific time period (usually one year or quarter). GDP is the primary measure of economic activity and national output.

GDP Components (Expenditure Approach): \[ GDP = C + I + G + (X - M) \]

Where:

• $C$ = Consumption (household spending on goods and services)
• $I$ = Investment (business spending on capital goods)
• $G$ = Government Spending (government expenditure on goods and services)
• $X$ = Exports (foreign spending on domestic goods)
• $M$ = Imports (domestic spending on foreign goods)
• $(X - M)$ = Net Exports (trade balance)

Types of GDP

Nominal GDP vs. Real GDP:

Nominal GDP: GDP measured at current market prices (not adjusted for inflation)

Reflects both changes in output AND changes in prices
Can be misleading when comparing across years

Real GDP: GDP adjusted for inflation using constant base-year prices

Reflects only changes in actual output (volume)
Better measure for comparing economic growth over time
Removes the distortion of changing price levels

Converting Nominal to Real GDP: \[ \text{Real GDP} = \frac{\text{Nominal GDP}}{\text{GDP Deflator}} \times 100 \]

Or: \[ \text{GDP Deflator} = \frac{\text{Nominal GDP}}{\text{Real GDP}} \times 100 \]

Economic Growth

Economic Growth: An increase in the real output (Real GDP) of an economy over time. It represents the expansion of productive capacity and typically improves living standards.

Economic Growth Rate: \[ \text{Growth Rate} = \frac{\text{Real GDP}_{\text{year 2}} - \text{Real GDP}_{\text{year 1}}}{\text{Real GDP}_{\text{year 1}}} \times 100\% \]

Calculation Example:
Year 1 Real GDP = $500 billion
Year 2 Real GDP = $520 billion

\[ \text{Growth Rate} = \frac{520 - 500}{500} \times 100\% = \frac{20}{500} \times 100\% = 4\% \]

Interpretation: The economy grew by 4% in real terms during Year 2.

2. The Business Cycle

Business Cycle (Economic Cycle): The fluctuations in real GDP around its long-term trend, showing alternating periods of expansion (growth) and contraction (decline) in economic activity. These cycles are recurring but irregular in timing and magnitude.

Phases of the Business Cycle

📊 Business Cycle Diagram

Vertical Axis: Real GDP / Output
Horizontal Axis: Time

Line Elements:

• Long-term trend line (upward sloping, representing potential GDP growth)
• Actual GDP line (fluctuates above and below trend in wave pattern)

Four Phases of the Business Cycle:

1. Expansion (Recovery/Boom):

Real GDP is increasing
Rising employment and income
Increasing consumer and business confidence
Rising investment and consumption
Inflation may begin to increase
Government budget improves (higher tax revenues)

2. Peak:

Maximum point of economic activity
Real GDP at its highest
Full employment or beyond (labor shortages)
Inflationary pressures strongest
Economy operating at or above capacity
Turning point before contraction begins

3. Contraction (Recession):

Real GDP is decreasing
Rising unemployment
Falling consumer and business confidence
Declining investment and consumption
Deflationary pressures or falling inflation
Government budget worsens (lower tax revenues, higher welfare spending)
Technical Recession: Two consecutive quarters of negative GDP growth

4. Trough:

Minimum point of economic activity
Real GDP at its lowest
Highest unemployment
Low inflation or deflation
Significant spare capacity (output gap)
Turning point before recovery begins

Output Gap

Output Gap: The difference between actual real GDP and potential GDP (full-employment output). It indicates whether an economy is operating above or below its productive capacity.

Output Gap Formula: \[ \text{Output Gap} = \text{Actual GDP} - \text{Potential GDP} \]

Or as percentage: \[ \text{Output Gap (\%)} = \frac{\text{Actual GDP} - \text{Potential GDP}}{\text{Potential GDP}} \times 100\% \]

Types of Output Gaps:

Negative Output Gap (Recessionary Gap):

Actual GDP < Potential GDP
Economy producing below capacity
Unemployment above natural rate
Deflationary pressure
Spare capacity and underutilized resources

Positive Output Gap (Inflationary Gap):

Actual GDP > Potential GDP
Economy operating above sustainable capacity
Unemployment below natural rate
Inflationary pressure
Resources stretched beyond normal capacity

Zero Output Gap:

Actual GDP = Potential GDP
Full employment equilibrium
Economy at optimal sustainable output

3. Aggregate Demand (AD)

Aggregate Demand (AD): The total quantity of goods and services that all buyers in an economy (households, firms, government, and foreign sector) are willing and able to purchase at different price levels, during a specific time period, ceteris paribus.

Aggregate Demand Formula: \[ AD = C + I + G + (X - M) \]

This is the same as the GDP expenditure formula, showing that AD represents total planned spending in the economy.

The AD Curve

📊 AD Curve Diagram

Vertical Axis: Price Level (PL)
Horizontal Axis: Real GDP (Y)

AD Curve: Downward sloping from left to right
Shows inverse relationship between price level and real GDP demanded

Why AD Slopes Downward

Three Reasons for Downward-Sloping AD:

1. Wealth Effect (Real Balances Effect):

When price level rises, real value of money holdings decreases
People feel poorer with reduced purchasing power
Consumption decreases → AD decreases
Example: If prices double but your bank balance stays same, you can buy half as much

2. Interest Rate Effect:

When price level rises, people need more money for transactions
Increased demand for money → interest rates rise
Higher interest rates discourage borrowing
Investment and consumption (especially big-ticket items) decrease → AD decreases
Example: Higher prices → higher interest rates → fewer car/house purchases

3. International Trade Effect (Net Exports Effect):

When domestic price level rises (relative to foreign prices)
Domestic goods become relatively more expensive
Exports decrease (foreigners buy less) and imports increase (domestic consumers buy more foreign goods)
Net exports (X - M) decrease → AD decreases
Example: If US prices rise, Americans buy more Japanese cars, Japanese buy fewer American cars

Components of Aggregate Demand

1. Consumption (C)

Consumption: Household spending on goods and services. Typically the largest component of AD (around 60-70% in most developed economies).

Determinants of Consumption:

Disposable Income: Income after taxes; higher income → higher consumption
Consumer Confidence: Optimism about future → higher consumption
Interest Rates: Lower rates → cheaper borrowing → higher consumption
Wealth: Stock market gains, property values → higher consumption
Household Debt: High debt → lower consumption (debt repayment)
Expectations: Expected future income/prices affect current consumption

2. Investment (I)

Investment: Business spending on capital goods (machinery, buildings, equipment) and changes in inventories. Most volatile component of AD.

Determinants of Investment:

Interest Rates: Lower rates → cheaper borrowing → higher investment (MOST IMPORTANT)
Business Confidence: Optimism about future profits → higher investment
Profit Levels: Higher profits → more funds available for investment
Technology: New technology → investment in new capital
Capacity Utilization: Operating near full capacity → need for expansion
Corporate Taxes: Lower taxes → higher after-tax profits → higher investment
Expectations: Expected future demand affects investment decisions

3. Government Spending (G)

Government Spending: Government expenditure on goods and services (does NOT include transfer payments like pensions or unemployment benefits, as these are not direct purchases).

Determinants of Government Spending:

Political Priorities: Defense, education, healthcare, infrastructure
Economic Conditions: Countercyclical fiscal policy (spend more in recessions)
Budget Position: Deficits may limit spending capacity
Demographics: Aging population → higher healthcare spending

4. Net Exports (X - M)

Net Exports: The difference between exports and imports. Can be positive (trade surplus) or negative (trade deficit).

Determinants of Net Exports:

Exchange Rates: Depreciation → cheaper exports, expensive imports → higher net exports
Foreign Income: Higher foreign income → more exports
Domestic Income: Higher domestic income → more imports → lower net exports
Relative Inflation: Higher domestic inflation → less competitive → lower net exports
Trade Policy: Tariffs, quotas affect trade volumes
Competitiveness: Quality, technology, productivity affect exports

Shifts in the AD Curve

Movement ALONG AD vs. SHIFT of AD:

Movement Along AD:

Caused by change in PRICE LEVEL only
Represents change in quantity of real GDP demanded
Curve stays in same position

Shift of AD:

Caused by changes in NON-PRICE DETERMINANTS
Changes in C, I, G, or (X-M) at every price level
Entire curve moves right (increase) or left (decrease)

Factor Change	Effect on AD Component	AD Shift
Consumer confidence increases	C increases	Right (AD increases)
Interest rates decrease	C and I increase	Right (AD increases)
Government spending increases	G increases	Right (AD increases)
Currency depreciates	(X-M) increases	Right (AD increases)
Income taxes increase	C decreases	Left (AD decreases)
Business confidence falls	I decreases	Left (AD decreases)

4. Aggregate Supply (AS)

Aggregate Supply (AS): The total quantity of goods and services that all producers in an economy are willing and able to supply at different price levels, during a specific time period, ceteris paribus.

Short-Run vs. Long-Run Aggregate Supply

Short-Run Aggregate Supply (SRAS):

Period where some input prices (especially wages) are fixed or sticky
Firms can increase output by using existing capacity more intensively
Positive relationship between price level and output
Upward sloping curve

Long-Run Aggregate Supply (LRAS):

Period where all input prices are flexible and adjust fully
Economy produces at full employment (potential GDP)
Output determined by factors of production and technology
Position of curve shows productive capacity

Why SRAS Slopes Upward

Reasons for Upward-Sloping SRAS:

1. Sticky Wages (Nominal Wage Rigidity):

Wages don't adjust immediately to price level changes
When prices rise but wages stay constant, real wages fall
Firms' profit margins increase → incentive to produce more
Employment increases, output increases

2. Sticky Prices (Menu Costs):

Some firms slow to adjust prices (contracts, catalogs, menus)
Creates temporary price discrepancies
Profitable production opportunities arise

3. Misperceptions Theory:

Firms may confuse changes in overall price level with changes in relative prices
Perceive higher prices as increased demand for their product specifically
Respond by increasing output

Determinants of SRAS (Shifts)

Factors that Shift SRAS:

Leftward Shift (SRAS Decreases - Cost Push):

Increased input costs (wages, raw materials, energy)
Higher business taxes or regulations
Natural disasters damaging production capacity
Currency depreciation (more expensive imports)
Supply shocks (oil price spikes)

Rightward Shift (SRAS Increases):

Decreased input costs
Lower business taxes or reduced regulations
Currency appreciation (cheaper imports)
Positive supply developments (good harvests, new resource discoveries)
Improved productivity (better technology, training)

Determinants of LRAS (Shifts)

Factors that Shift LRAS (Changes in Productive Capacity):

Rightward Shift (LRAS Increases - Economic Growth):

Quantity of Resources:
- Population growth (more labor)
- Capital accumulation (more machinery, infrastructure)
- Discovery of natural resources
Quality of Resources:
- Improved education and training (human capital)
- Better health (more productive workforce)
- More efficient capital (newer technology)
Technology:
- Technological innovations and improvements
- Better production methods
- Increased efficiency
Institutional Factors:
- Improved property rights
- Better infrastructure
- Reduced regulations/red tape
- More competitive markets

Leftward Shift (LRAS Decreases - Rare):

Major natural disasters
Wars destroying productive capacity
Severe economic sanctions
Mass emigration of skilled workers
Depletion of natural resources

5. Comparing AS Models: Keynesian vs. New Classical/Monetarist

There are two main perspectives on how aggregate supply behaves, particularly in the long run. These different views have profound implications for economic policy.

New Classical/Monetarist View of LRAS

New Classical/Monetarist LRAS: Vertical Curve

Key Assumption: Markets clear quickly; wages and prices are flexible

Shape: Vertical line at potential GDP (Y_f or Y*)

Logic:

In the long run, all input prices adjust fully to changes in output prices
Real wages return to equilibrium level
Economy always returns to full employment output
Output determined solely by supply-side factors (resources, technology)
Changes in aggregate demand only affect price level, not real output

Policy Implication:

Demand-side policies (fiscal, monetary) cannot permanently increase output
Only supply-side policies can increase long-run output
Focus on controlling inflation rather than managing demand
Markets are self-correcting; minimal government intervention needed

📊 New Classical/Monetarist AS Diagram

SRAS: Upward sloping (short-run relationship)
LRAS: Vertical line at Y_f (full employment GDP)

If AD increases:

• Short run: Both output and price level increase (move along SRAS)
• Long run: Only price level increases, output returns to Y_f (SRAS shifts left)
• Result: No permanent output gain, only inflation

Keynesian View of AS

Keynesian AS: Three-Section Curve

Key Assumption: Wages and prices are sticky, especially downward; markets don't clear quickly

Shape: Horizontal → Upward sloping → Vertical (three distinct sections)

Three Sections:

1. Horizontal Section (Deep Recession/Depression):

Occurs when economy has significant spare capacity
High unemployment, idle factories
Output well below potential
Firms can increase output without raising prices (use idle resources)
Price level remains constant as output increases
Large negative output gap

2. Upward-Sloping Section (Normal Times):

Economy approaching but not at full capacity
Some spare capacity remains but diminishing
As output increases, bottlenecks emerge
Some prices and wages begin rising
Both output and price level increase
Moderate output gap (positive or negative)

3. Vertical Section (Full Employment):

Economy at full capacity
All resources fully employed
Cannot increase output further (at least in short run)
Any additional demand only increases price level (demand-pull inflation)
Similar to Classical LRAS at this point
Zero or positive output gap

📊 Keynesian AS Diagram

AS Curve Shape: Three sections forming an "inverted L with a curve"

• Horizontal from Y = 0 to some point
• Upward sloping from that point to Y_f
• Vertical at Y_f (full employment)

If AD increases in different sections:

• Horizontal section: Only output increases (no inflation)
• Upward section: Both output and price level increase
• Vertical section: Only price level increases (pure inflation)

Keynesian Policy Implications:

Recessions: Active demand-management policies highly effective
- Increase government spending or cut taxes
- Stimulate AD without causing inflation (when in horizontal section)
- Can increase output and employment substantially
Government Role: Markets don't self-correct quickly
- Economies can remain in recession for long periods
- Active fiscal and monetary policy needed
- Government intervention justified and necessary
Inflation vs. Unemployment Trade-off:
- In upward-sloping section, trade-off exists
- Policymakers must balance inflation and unemployment objectives

Comparing the Two Views

Aspect	Keynesian View	New Classical/Monetarist View
LRAS Shape	Three sections: horizontal → upward → vertical	Vertical at full employment
Wage/Price Flexibility	Sticky, especially downward; slow to adjust	Flexible; adjust quickly to equilibrium
Market Self-Correction	Slow or may not occur; economies can stay in recession	Quick; markets automatically return to full employment
Effectiveness of AD Policies	Highly effective, especially in recession (horizontal section)	Ineffective in long run; only affect price level
Government Role	Active intervention necessary to stabilize economy	Minimal intervention; let markets work
Unemployment	Can persist due to insufficient demand	Always returns to natural rate
Main Policy Focus	Manage aggregate demand to achieve full employment	Control money supply to control inflation; supply-side for growth
Time Horizon	Short run very important; long run may never arrive	Long run is what matters; short run disturbances temporary

Synthesis: Modern Mainstream View

Contemporary Consensus:

Modern macroeconomics incorporates elements from both views:

Short Run: Keynesian insights largely accepted
- Prices and wages can be sticky
- Demand shocks can affect real output
- Active policy may be beneficial in severe recessions
Long Run: Classical insights dominate
- Output ultimately determined by supply side
- Economy tends toward full employment over time
- Persistent demand stimulus only causes inflation
Policy Approach:
- Use demand-side policies for short-run stabilization
- Use supply-side policies for long-run growth
- Central banks focus on inflation targeting
- Automatic stabilizers help smooth business cycles

6. The AD-AS Model: Equilibrium and Changes

Macroeconomic Equilibrium

Macroeconomic Equilibrium: The point where aggregate demand equals aggregate supply. At this point, the quantity of real GDP demanded equals the quantity supplied, determining both the equilibrium price level and real GDP.

Equilibrium Condition: \[ AD = AS \]

At equilibrium:

• Equilibrium Price Level: PL*
• Equilibrium Real GDP: Y*
• No unplanned inventory changes
• No pressure for price level or output to change

Types of Equilibrium

1. Full Employment Equilibrium:

AD intersects AS at potential GDP (Y_f)
Actual GDP = Potential GDP
No output gap
Unemployment at natural rate
Ideal situation

2. Recessionary Equilibrium (Deflationary Gap):

AD intersects AS to the left of potential GDP
Actual GDP < Potential GDP
Negative output gap
Cyclical unemployment exists
Deflationary pressure
Resources underutilized

3. Inflationary Equilibrium (Inflationary Gap):

AD intersects AS to the right of potential GDP
Actual GDP > Potential GDP (temporarily)
Positive output gap
Unemployment below natural rate
Inflationary pressure
Unsustainable in long run

Effects of AD Changes

Scenario 1: AD Increases (AD shifts right)
Causes: Increased consumer confidence, lower interest rates, government stimulus, currency depreciation

Short-Run Effects (Classical Model):

Both price level and real GDP increase
Movement up along SRAS
Unemployment decreases
Inflationary pressure emerges

Long-Run Effects (Classical Model):

Wages and input prices adjust upward
SRAS shifts left
Output returns to potential GDP
Only price level permanently higher
No long-run output gain

Keynesian Perspective:

Effects depend on which section of AS curve
In recession (horizontal): mostly output increase, little inflation
Near full employment (upward): both output and inflation increase
At full employment (vertical): only inflation increases

Scenario 2: AD Decreases (AD shifts left)
Causes: Decreased confidence, higher interest rates, government austerity, currency appreciation, financial crisis

Short-Run Effects:

Both price level and real GDP decrease
Unemployment increases
Recession occurs
Deflationary pressure

Long-Run (Classical): Wages eventually fall, SRAS shifts right, returns to full employment
Long-Run (Keynesian): May remain in recession without intervention (wages sticky downward)

Effects of AS Changes

Scenario 3: SRAS Decreases (SRAS shifts left) - NEGATIVE SUPPLY SHOCK
Causes: Higher oil prices, natural disasters, increased wages/regulations, currency depreciation

Effects:

Price level increases (inflation)
Real GDP decreases
Unemployment increases
Stagflation: Combination of stagnant output and inflation
Creates policy dilemma (fighting inflation worsens recession; fighting recession worsens inflation)

Example: 1973 Oil Crisis - oil prices quadrupled, causing stagflation in many countries

Scenario 4: LRAS Increases (LRAS shifts right) - ECONOMIC GROWTH
Causes: Technology improvements, increased capital, better education, population growth, institutional improvements

Effects:

Potential GDP increases
Can produce more without inflation
Real GDP increases (if AD also shifts or is adequate)
Price level may decrease (if AD constant)
Living standards improve
Sustainable long-term growth

Example: China's rapid growth (1980s-2010s) due to capital accumulation, technology adoption, and institutional reforms

7. IB Economics Exam Skills

Diagram Drawing Essentials

AD-AS Diagram Checklist:

Label axes: Price Level (PL) vertical, Real GDP (Y) horizontal
Draw curves:
- AD: Downward sloping
- SRAS: Upward sloping
- LRAS: Vertical at Y_f (Classical) or three-section (Keynesian)
Mark equilibrium: Label where AD intersects AS as E₁, with PL₁ and Y₁
Show full employment: Mark Y_f (potential GDP) on horizontal axis
Show shifts: Use AD₁→AD₂ or AS₁→AS₂ with arrows
New equilibrium: Mark E₂ with new PL₂ and Y₂
Indicate changes: Use arrows to show ↑ or ↓ in PL and Y

Key Exam Question Types

Question Type 1: Explain with Diagram [6 marks]
Example: "Using an AD-AS diagram, explain how a decrease in consumer confidence affects the economy."

Answer Structure:

Define consumer confidence and its role in consumption
Draw AD-AS diagram with initial equilibrium
Explain: decreased confidence → reduced consumption → AD decreases
Show AD shifting left from AD₁ to AD₂
New equilibrium at lower price level and lower real GDP
Consequences: recession, unemployment increases, deflationary pressure
Could show output gap between Y₂ and Y_f

Question Type 2: Compare Keynesian and Classical Views [8 marks]
Example: "Compare Keynesian and New Classical views of long-run aggregate supply."

Answer Structure:

Classical View:
- LRAS is vertical at full employment
- Wages and prices flexible
- Markets self-correct quickly
- Diagram showing vertical LRAS
- AD increases only cause inflation, no output change
Keynesian View:
- AS has three sections
- Wages and prices sticky
- Markets don't self-correct
- Diagram showing horizontal-upward-vertical AS
- AD increases can raise output without inflation (in recession)
Policy Implications: Keynesian supports active intervention; Classical opposes
Evaluation: Which is more realistic depends on time frame and economic conditions

Question Type 3: Analyze Supply Shock [8 marks]
Example: "Using an AD-AS diagram, analyze the effects of a significant increase in oil prices on an economy."

Answer Structure:

Define supply shock and explain oil as key input
Draw AD-AS diagram
Show SRAS shifting left (higher production costs)
New equilibrium: higher price level (cost-push inflation), lower output
Unemployment rises as output falls
Stagflation: Simultaneous inflation and recession
Policy Dilemma:
- Expansionary policy to boost output → worsens inflation
- Contractionary policy to reduce inflation → worsens recession
Long run: May need supply-side policies, or if temporary shock, SRAS may eventually shift back
Real example: 1973 or 1979 oil crises

8. Real-World Applications

Case Study: COVID-19 Pandemic (2020-2021)

AD-AS Analysis:

Supply Shock:

Lockdowns → SRAS shifts left (workers can't work, supply chains disrupted)
LRAS may shift left (business closures reduce capacity)

Demand Shock:

Decreased confidence, uncertainty → consumption and investment fall
AD shifts left significantly

Net Effect:

Both AD and AS decreased
Real GDP fell sharply (deep recession, Q2 2020)
Price level effects varied by country
Unemployment spiked

Policy Response:

Massive fiscal stimulus (government spending, transfers)
Extremely low interest rates, quantitative easing
→ AD shifted back right
Recovery began, but inflation emerged later (2021-2022)

Case Study: 2008 Financial Crisis

AD-AS Analysis:

Demand Shock:

Financial crisis → credit crunch → investment collapsed
Wealth effect (falling house/stock prices) → consumption fell
Confidence plummeted
AD shifted left sharply

Effects:

Deep recession (Great Recession)
Price level fell or growth slowed (deflation fears)
Unemployment rose from ~5% to 10% (US)
Large negative output gap

Policy Response:

Fiscal: stimulus packages, bank bailouts
Monetary: near-zero interest rates, quantitative easing
Gradually shifted AD back right
Recovery took several years

Debate: Keynesians argued intervention prevented depression; Classical critics worried about debt and inflation (which didn't materialize)

9. Summary Tables

AD Components Summary

Component	What It Includes	Main Determinants	Typical % of AD
C (Consumption)	Household spending on goods/services	Income, confidence, interest rates, wealth	60-70%
I (Investment)	Business spending on capital	Interest rates, confidence, profits, technology	15-20%
G (Gov't Spending)	Government purchases	Political priorities, fiscal policy	15-25%
(X-M) Net Exports	Exports minus imports	Exchange rates, foreign income, competitiveness	-5% to +5%

Effects Summary

Change	Effect on Price Level	Effect on Real GDP	Effect on Unemployment
AD increases	Increases	Increases (short run)	Decreases
AD decreases	Decreases	Decreases	Increases
SRAS decreases	Increases	Decreases	Increases
SRAS increases	Decreases	Increases	Decreases
LRAS increases	Decreases (if AD constant)	Increases (potential)	Decreases (natural rate)

Conclusion

The AD-AS model is the fundamental framework for analyzing macroeconomic performance and policy. Understanding how aggregate demand and aggregate supply interact to determine output, employment, and price levels is essential for explaining business cycles, evaluating economic policies, and comparing different schools of macroeconomic thought. The debate between Keynesian and Classical/Monetarist views continues to shape policy discussions about the appropriate role of government in managing the economy.

Key Takeaways for IB Success: