Aggregate demand and aggregate supply

Every lesson so far assumed firms supply whatever is demanded at a fixed price. That is a fair picture of a slump with idle machines and workers, but not of an economy near capacity, where more demand shows up as higher prices. We need two curves in the (Y, P) plane:

• Aggregate demand (AD): for each price level, the output at which the goods and money markets are both in equilibrium. It summarises IS–LM.
• Aggregate supply (AS): for each price level, the output firms produce given how wages are set. It summarises the labour market.

Their crossing is where planned spending, money and the labour market are all consistent. Keynes’s “effective demand” is the point where aggregate demand equals aggregate supply (CUET 2021).

Fix the nominal money supply M and raise the price level. Real balances M/P fall, so LM shifts left, the interest rate rises, investment falls, and equilibrium income falls. Each price level gives one IS–LM equilibrium, and so one point of AD. A decline in the price level raises the real money supply because each rupee buys more goods (JNU 2014); the higher real balances raise income (Hyderabad 2010).

AD shifts right with anything that shifts IS or LM right at a given price level: more government spending or investment, higher net exports, more money (UGC NET 2023; Hyderabad 2011). A higher price level is a movement along AD, not a shift, which is the false statement in UGC NET 2023. Its slope comes from IS and LM: the steeper IS, the steeper AD (JNU 2014, 2019), because output then responds little to the interest rate.

Two channels run from a lower price level to more spending:

• The Keynes effect: lower P → higher real balances → lower interest rate → more investment. It is the channel above.
• The Pigou (real balance) effect: lower P raises the real value of people’s money and bonds, so they feel wealthier and consume more (JNU 2016). Pigou used it to argue that wage and price flexibility restores full employment on its own (CUET 2021): falling wages and prices raise the real value of assets until spending recovers.

Both stabilise the economy when prices fall (JNU 2014; Hyderabad 2012). The difference matters in a liquidity trap. There, higher real balances cannot lower the interest rate, so the Keynes effect fails and, on its own, AD would be vertical (JNU 2017, 2020). The Pigou effect still works through consumption, which is why it can make AD slope down even in a trap (JNU 2018, 2019). AD is also vertical if investment ignores the interest rate.

Output depends on employment, and employment on the labour market. Firms hire until the marginal product of labour equals the real wage W/P. What happens when the price level rises depends on the money wage W.

The short-run AS slopes up because money wages do not change straight away when the price level changes (DSE 2012, 2013). With a rigid nominal wage the AS is upward sloping (DSE 2009, 2011). GATE 2023 listed the models that give the same shape: sticky wages, worker misperception and imperfect information. In the sticky-price model, the more firms that cannot change their prices, the flatter the curve; if none can, it is horizontal (GATE 2024).

AS shifts right with more capital or better technology (DSE 2017; JNU 2012), and left with a higher minimum money wage (DSE 2017) or an adverse supply shock, which lowers the marginal product of labour (CUET 2022).

The left panel is IS–LM at the equilibrium price level, with the dashed LM at the starting price level: watch LM move as P changes. That is the Keynes effect drawing AD. Try the three supply shapes, then raise the money supply with sticky wages and press “Next year” until output is back at Y_f.

A demand shock shifts AD. With a Keynesian AS below full employment, output rises and prices don’t (JNU 2012, 2013; Hyderabad 2017). With a vertical AS, only prices rise (Hyderabad 2011), and a tax rise lowers prices and leaves output alone. With sticky wages, both rise in the short run; then wage-setters notice the higher prices, raise wages, the short-run AS shifts up, and output returns to Y_f at a higher price level. In the long run, money is neutral: more money raises all prices in the same proportion (CUET 2020), and it shifts even the classical AD right (Hyderabad 2015; CUET 2025).

A negative demand shock that causes a recession tells you one thing for sure: prices did not absorb the whole shock, since otherwise output would not have fallen (JNU 2021). Short-run fluctuations in GDP come mainly from shifts in AD (Hyderabad 2020).

A supply shock, such as an oil price rise, shifts short-run AS up: prices rise and output falls, which is stagflation (Lesson 7). A technological advance with a classical AS raises output and lowers prices (JNU 2012).