Unit 3: Macroeconomics - Economic Output, AD & AS
Understanding Economic Activity, Business Cycles, and Aggregate Demand-Supply Analysis
Introduction: Macroeconomics vs. Microeconomics
Macroeconomics studies the economy as a whole, focusing on aggregate variables and economy-wide phenomena.
Key differences:
| Microeconomics | Macroeconomics |
|---|---|
| Individual markets | Entire economy |
| Individual consumers, firms | All consumers, all firms (aggregates) |
| Supply and demand | Aggregate demand and aggregate supply |
| Prices in specific markets | Average price level (inflation) |
| Employment in one industry | National unemployment rate |
1. Measuring Economic Activity
Gross Domestic Product (GDP)
GDP is the total market value of all final goods and services produced within a country during a specific time period (usually one year).
Key characteristics:
- Market value: Measured in monetary terms
- Final goods: Only final products counted (intermediate goods excluded to avoid double counting)
- Produced: Only current production (not resale of old goods)
- Within a country: Geographic boundary (domestic, not national)
- Time period: Flow concept (per year or quarter)
Methods of Measuring GDP
1. Expenditure Approach
Sum of all spending on final goods and services:
\[ GDP = C + I + G + (X - M) \]Where:
- • \(C\) = Consumption (household spending)
- • \(I\) = Investment (business spending on capital goods)
- • \(G\) = Government spending
- • \(X\) = Exports
- • \(M\) = Imports
- • \((X - M)\) = Net exports (trade balance)
2. Income Approach
Sum of all incomes earned in production:
\[ GDP = \text{Wages} + \text{Rent} + \text{Interest} + \text{Profit} \]Also includes indirect taxes and depreciation
3. Output/Value-Added Approach
Sum of value added at each stage of production:
\[ GDP = \sum \text{Value Added by all industries} \]Value added = Output value - Cost of intermediate inputs
Real vs. Nominal GDP
Nominal GDP:
- Measured at current prices
- Not adjusted for inflation
- Reflects both quantity changes and price changes
Real GDP:
- Adjusted for inflation
- Measured at constant prices (base year prices)
- Reflects only quantity changes
- Better measure of actual economic growth
Real GDP Calculation
\[ \text{Real GDP} = \frac{\text{Nominal GDP}}{\text{GDP Deflator}} \times 100 \]GDP Deflator:
\[ \text{GDP Deflator} = \frac{\text{Nominal GDP}}{\text{Real GDP}} \times 100 \]GDP deflator is a measure of price level (inflation indicator)
Example: Real vs. Nominal GDP
Year 1 (Base Year):
- 100 smartphones × $500 = $50,000
- Nominal GDP = $50,000
- Real GDP = $50,000
Year 2:
- 110 smartphones × $550 = $60,500
- Nominal GDP = $60,500 (21% increase)
- Real GDP = 110 × $500 = $55,000 (10% increase)
Interpretation:
- Nominal GDP rose 21% (quantity + price effect)
- Real GDP rose 10% (actual output increase)
- Remaining 11% due to inflation
Limitations of GDP
What GDP Doesn't Measure
- Non-market activities: Household work, volunteer work, informal economy
- Income distribution: Doesn't show inequality (who gets the income)
- Quality of life: Health, leisure time, environmental quality not reflected
- Sustainability: Resource depletion, environmental degradation not subtracted
- Composition of output: Military goods vs. consumer goods (welfare implications)
- Underground economy: Illegal activities, unreported income
2. The Business Cycle
Definition and Phases
The business cycle (or economic cycle) refers to the fluctuations in economic activity over time, measured by changes in real GDP.
📈 BUSINESS CYCLE DIAGRAM
Vertical Axis: Real GDP
Horizontal Axis: Time
Wavy line showing cyclical fluctuations around upward trend line
Four phases: Expansion → Peak → Contraction (Recession) → Trough → Expansion...
Long-run trend line: Steady upward slope (potential GDP growth)
Four Phases of the Business Cycle
1. Expansion (Recovery/Boom)
- Real GDP increasing
- Production and employment rising
- Consumer and business confidence high
- Increasing consumption and investment
- Rising incomes
- Inflation may start to rise
2. Peak
- Maximum level of economic activity
- GDP at highest point in cycle
- Full employment or beyond (inflationary pressures)
- Economy may overheat
- Turning point before contraction
3. Contraction (Recession)
- Real GDP decreasing
- Production and employment falling
- Consumer and business confidence low
- Decreasing consumption and investment
- Rising unemployment
- Recession: Two consecutive quarters of negative GDP growth
- Depression: Severe, prolonged recession
4. Trough
- Minimum level of economic activity
- GDP at lowest point in cycle
- High unemployment
- Turning point before expansion
Indicators of the Business Cycle
Leading Indicators (predict future economic activity):
- Stock market performance
- Consumer confidence surveys
- Building permits
- New orders for goods
- Money supply changes
Coincident Indicators (change at same time as economy):
- GDP
- Employment levels
- Industrial production
- Retail sales
Lagging Indicators (confirm trends after they occur):
- Unemployment rate
- Corporate profits
- Labor cost per unit of output
- Interest rates
3. Aggregate Demand (AD)
Definition
Aggregate demand (AD) is the total quantity of goods and services demanded in an economy at different price levels during a specific time period.
It represents the total spending in the economy from all sectors.
Components of Aggregate Demand
AD Formula
\[ AD = C + I + G + (X - M) \]1. Consumption (C):
- Household spending on goods and services
- Largest component (typically 60-70% of GDP)
- Durable goods, non-durable goods, services
2. Investment (I):
- Business spending on capital goods
- Fixed investment (machinery, buildings)
- Inventory investment
- Residential investment (new housing)
- Most volatile component
3. Government Spending (G):
- Government purchases of goods and services
- Excludes transfer payments (counted when recipients spend)
4. Net Exports (X - M):
- Exports minus imports
- Positive if trade surplus, negative if trade deficit
The AD Curve
Shape: Downward sloping
Axes:
- Vertical: Average price level (not individual prices)
- Horizontal: Real GDP (total output/income)
Why downward sloping? (inverse relationship between price level and real GDP demanded)
Three Reasons for Downward-Sloping AD
1. Wealth/Real Balance Effect:
- Higher price level → Real value of money falls → People feel poorer → Consumption decreases
- Lower price level → Real value of money rises → People feel wealthier → Consumption increases
2. Interest Rate Effect:
- Higher price level → People need more money for transactions → Demand for money rises → Interest rates rise → Investment and consumption (on credit) decrease
- Lower price level → Lower interest rates → Investment and consumption increase
3. International Trade Effect:
- Higher domestic price level → Domestic goods more expensive relative to foreign goods → Exports decrease, imports increase → Net exports fall
- Lower domestic price level → Net exports rise
📊 AGGREGATE DEMAND CURVE
Vertical Axis: Price Level (PL)
Horizontal Axis: Real GDP (Y)
Downward-sloping AD curve from top-left to bottom-right
Label: AD
Determinants of Aggregate Demand (Shifters)
Changes in components cause the AD curve to shift:
Factors Shifting AD Right (Increase)
Consumption (C) increases:
- Increase in consumer confidence
- Wealth increases (stock market boom, housing prices rise)
- Lower personal taxes
- Lower interest rates (cheaper credit)
- Expectations of higher future income
Investment (I) increases:
- Increase in business confidence
- Lower interest rates (cheaper borrowing)
- Lower corporate taxes
- Technological improvements (new opportunities)
- Expectations of higher future profits
Government Spending (G) increases:
- Expansionary fiscal policy
- Increased infrastructure spending
Net Exports (X - M) increase:
- Strong foreign economic growth (higher demand for exports)
- Domestic currency depreciation (exports cheaper, imports expensive)
- Improved competitiveness
Factors Shifting AD Left (Decrease)
Opposite of the factors above:
- Decreased consumer/business confidence
- Higher interest rates
- Higher taxes
- Wealth decreases
- Contractionary fiscal policy
- Currency appreciation
- Foreign recessions
4. Aggregate Supply (AS)
Definition
Aggregate supply (AS) is the total quantity of goods and services that firms are willing and able to produce at different price levels during a specific time period.
It represents the total output/production in the economy.
Short-Run vs. Long-Run Aggregate Supply
Short-Run Aggregate Supply (SRAS):
- Period when input prices (especially wages) are sticky/fixed
- Output can vary as firms adjust production
- Upward sloping
Long-Run Aggregate Supply (LRAS):
- Period when all input prices are flexible
- Economy at full employment (potential GDP)
- Shape depends on economic school of thought
Short-Run Aggregate Supply (SRAS)
Shape: Upward sloping (positive relationship between price level and output)
Why upward sloping?
- Sticky wages: Wages don't adjust immediately to price level changes
- Higher price level → Higher profits → Firms increase output
- Lower price level → Lower profits → Firms reduce output
📊 SHORT-RUN AGGREGATE SUPPLY
Upward-sloping SRAS curve from bottom-left to top-right
Label: SRAS
At higher price levels, more output supplied
Determinants of SRAS (Shifters)
Factors Shifting SRAS Right (Increase)
- Lower input prices: Wages, oil, raw materials decrease
- Increased productivity: Better technology, training
- Lower business taxes: More after-tax profit at each price level
- Subsidies: Government support reduces costs
- Favorable supply shocks: Good weather for agriculture, oil discoveries
Factors Shifting SRAS Left (Decrease)
- Higher input prices: Wage increases, oil price shocks
- Decreased productivity:
- Higher business taxes:
- Adverse supply shocks: Natural disasters, wars, pandemics
- Increased regulation: Higher compliance costs
5. Two Views of Long-Run Aggregate Supply
Overview: The Great Debate
Economists disagree about the shape of the long-run aggregate supply curve, reflecting different views about how the economy works.
Two main perspectives:
- Keynesian: Horizontal-to-vertical LRAS (three sections)
- New Classical/Monetarist: Vertical LRAS at potential GDP
A. Keynesian View of AS
Three-Section Aggregate Supply Curve
Keynesians argue the AS curve has three distinct sections reflecting different levels of resource utilization:
Section 1: Horizontal (Keynesian Range)
Situation: Severe recession/depression, high unemployment
- Output: Far below potential GDP
- Unemployment: Very high (e.g., 15-25%)
- Spare capacity: Massive unused resources
Why horizontal?
- Firms can increase output without raising prices
- Abundant unemployed workers available at current wage
- Plenty of idle machinery and factories
- No pressure on prices from increased demand
Policy implication:
- Increase in AD raises output without inflation
- Government intervention highly effective
- Fiscal/monetary stimulus creates jobs and growth with no inflationary cost
Section 2: Upward Sloping (Intermediate Range)
Situation: Normal economic conditions, moderate unemployment
- Output: Below but approaching potential GDP
- Unemployment: Moderate (e.g., 5-10%)
- Some spare capacity: Resources being utilized but not fully
Why upward sloping?
- Some bottlenecks emerge as output increases
- Shortages in specific skills or industries
- Wage pressures in tight labor markets
- Rising input costs
Policy implication:
- Increase in AD raises both output AND price level
- Trade-off between growth and inflation
Section 3: Vertical (Classical Range)
Situation: Full employment, economy at capacity
- Output: At potential GDP (full employment level)
- Unemployment: Only frictional and structural (natural rate)
- No spare capacity: All resources fully employed
Why vertical?
- Cannot produce more in the short run (physical limit)
- All workers employed, all machines running
- Any attempt to increase output just raises prices
Policy implication:
- Increase in AD only causes inflation (no output increase)
- Demand management ineffective at increasing real GDP
- Supply-side policies needed to shift LRAS right
📊 KEYNESIAN AGGREGATE SUPPLY
Three-section AS curve:
Section 1 (left): Horizontal at low output (depression)
Section 2 (middle): Upward sloping (normal times)
Section 3 (right): Vertical at Yf (full employment)
Yf = Full employment/potential GDP level
Keynesian Policy Implications
Key Keynesian Beliefs
- Markets don't self-correct: Can remain in recession indefinitely
- Demand deficiency: Recessions caused by insufficient AD
- Government should intervene: Active fiscal and monetary policy
- Short run matters: "In the long run we are all dead"
- Sticky wages/prices: Don't adjust quickly to clear markets
Policy prescriptions:
- Recession: Increase government spending, cut taxes, lower interest rates
- Inflation: Reduce government spending, raise taxes, raise interest rates
- Focus: Managing aggregate demand
B. New Classical/Monetarist View of AS
Vertical Long-Run Aggregate Supply
New Classical economists and Monetarists argue that LRAS is vertical at potential GDP (full employment output).
Key concept: Economy naturally tends toward full employment in the long run.
Why LRAS is Vertical
Flexibility of wages and prices:
- In long run, wages and prices fully adjust
- Markets clear—no persistent unemployment or excess supply
- Economy returns to natural rate of unemployment
Real factors determine output:
- Output determined by quantity and quality of resources
- Labor force size and skills
- Capital stock
- Technology
- NOT by price level or aggregate demand
Natural rate of unemployment (NRU):
- Long-run equilibrium unemployment rate
- Consists of frictional + structural unemployment
- Cannot be reduced below this by increasing AD
📊 NEW CLASSICAL/MONETARIST AS
Vertical LRAS at potential GDP (Yf)
Upward-sloping SRAS curves (short run)
In long run, economy always at Yf
Label: LRAS (vertical line at full employment)
Self-Correcting Mechanism
How Economy Returns to Potential GDP
Scenario: Recession (below full employment)
- Unemployment high → Downward pressure on wages
- Wages fall → Production costs decrease
- SRAS shifts right
- Output increases, price level falls
- Continues until full employment restored
Scenario: Overheating (above full employment)
- Labor shortages → Upward pressure on wages
- Wages rise → Production costs increase
- SRAS shifts left
- Output decreases, price level rises
- Continues until full employment restored
New Classical/Monetarist Policy Implications
Key Beliefs
- Markets self-correct: Economy naturally moves to full employment
- Money matters: Inflation always caused by excessive money supply growth
- Government intervention harmful: Causes instability and inflation
- Long run focus: Short-run demand management ineffective or counterproductive
- Flexible prices: Markets clear efficiently if not interfered with
Policy prescriptions:
- Monetary policy: Stable, predictable money supply growth
- Fiscal policy: Balanced budgets, low taxes, minimal spending
- Supply-side policies: Improve productivity, remove market rigidities
- Avoid fine-tuning: Don't try to manage short-run fluctuations
6. AD-AS Model: Equilibrium and Analysis
Macroeconomic Equilibrium
Short-run macroeconomic equilibrium occurs where AD intersects SRAS.
At equilibrium:
- Quantity demanded = Quantity supplied
- Determines equilibrium price level and real GDP
- May or may not be at full employment
Three Possible Short-Run Equilibria
1. Recessionary Gap (Deflationary Gap)
Situation: Equilibrium output < Potential GDP
- Economy in recession
- High unemployment (above natural rate)
- Spare capacity
- Low inflation or deflation
Policy response:
- Expansionary policies to shift AD right
- Increase government spending, cut taxes, lower interest rates
2. Full Employment Equilibrium
Situation: Equilibrium output = Potential GDP
- Economy at full employment
- Unemployment at natural rate
- Ideal situation
3. Inflationary Gap
Situation: Equilibrium output > Potential GDP
- Economy overheating
- Unsustainably low unemployment (below natural rate)
- High inflation pressure
- Cannot be maintained long-run
Policy response:
- Contractionary policies to shift AD left
- Reduce government spending, raise taxes, raise interest rates
Shifts in AD and AS: Economic Shocks
Example 1: Positive Demand Shock
Cause: Increase in consumer confidence, government spending surge
Effect: AD shifts right
- Short run: Higher output, higher price level
- Unemployment: Falls
- Long run (Monetarist view): Only inflation, no permanent output increase
Example 2: Negative Supply Shock
Cause: Oil price spike, natural disaster, pandemic
Effect: SRAS shifts left
- Stagflation: Lower output + higher price level
- Unemployment: Rises
- Policy dilemma: Can't address both problems simultaneously with demand management
Long-Run Growth: Shifting LRAS
Increasing Potential GDP
To shift LRAS right (sustainable long-run growth):
- Increase quantity of resources:
- Population growth, immigration
- Capital accumulation (investment)
- Natural resource discoveries
- Increase quality of resources:
- Education and training
- Research and development
- Technological innovation
- Institutional improvements:
- Better property rights
- Reduced regulations
- Efficient legal system
Result: Higher potential GDP, higher living standards, non-inflationary growth
Comparison: Keynesian vs. New Classical/Monetarist
| Aspect | Keynesian | New Classical/Monetarist |
|---|---|---|
| LRAS Shape | Horizontal-upward-vertical (3 sections) | Vertical at potential GDP |
| Market Self-Correction | No—can remain in disequilibrium | Yes—automatically returns to full employment |
| Wage/Price Flexibility | Sticky (especially downward) | Flexible (adjust quickly) |
| Main Problem | Insufficient aggregate demand | Excessive money supply growth |
| Government Role | Active intervention needed | Minimal intervention, stable rules |
| Fiscal Policy | Highly effective | Ineffective or harmful (crowding out) |
| Monetary Policy | Can stimulate economy | Should target stable money growth only |
| Focus | Short-run stabilization | Long-run growth, price stability |
| Inflation Cause | Demand-pull or cost-push | Always monetary (too much money) |
IB Economics Exam Tips
AD-AS Diagram Essentials
- Always label axes: Price Level (PL) on Y-axis, Real GDP (Y) on X-axis
- AD curve: Downward sloping, label "AD"
- AS curves: Label clearly (SRAS, LRAS, Keynesian AS)
- Mark equilibrium: Intersection point, with equilibrium PL and Y
- Show Yf: Mark full employment/potential GDP level
- Shifts: Use arrows and new labels (AD1 → AD2)
- Explain effects: Changes in output, price level, employment
Key Points to Remember
- AD components: C + I + G + (X - M)
- Movement vs. shift: Along curve = price level change; shift = non-price factor
- SRAS shifters: Input costs, productivity, supply shocks
- AD shifters: Anything affecting C, I, G, or (X - M)
- Keynesian vs. Monetarist: Know key differences in AS shape and policy views
- Recessionary gap: Y < Yf, expansionary policy needed
- Inflationary gap: Y > Yf, contractionary policy needed
Common Mistakes to Avoid
- Confusing micro and macro: AD/AS is NOT same as supply/demand
- Wrong axis labels: Use "Price Level" not "Price," "Real GDP" not "Quantity"
- Forgetting multiplier: AD shifts may be larger than initial spending change
- Ignoring time frame: Specify short-run vs. long-run effects
- Mixing up gaps: Recessionary gap = below potential; Inflationary gap = above potential
- Not explaining transmission: Show HOW policy affects AD/AS components
Evaluation Points
- Time lags: Policies take time to implement and have effects
- Magnitude uncertainty: Hard to know optimal policy size
- Conflicting objectives: Can't always achieve low inflation AND low unemployment simultaneously
- External factors: Global economy affects domestic AD and AS
- Supply-side constraints: Demand stimulus ineffective if at full capacity
- Theoretical disagreement: Economists debate which model is correct
✓ Macroeconomics AD-AS Checkpoint
You should now understand how to measure economic activity using GDP; the phases of the business cycle; the components and determinants of aggregate demand; the determinants of aggregate supply in the short and long run; the fundamental differences between Keynesian and New Classical/Monetarist views of the economy; how to use AD-AS analysis to explain macroeconomic equilibrium, gaps, and policy responses; and how shifts in AD and AS affect output, price levels, and employment. These concepts form the foundation for understanding macroeconomic policy, inflation, and unemployment in IB Economics SL.