Aggregate Demand & Supply: Determinants, Shifts & Business Impact

TAKEAWAYS

• AD = C + I + G + (X – M): The four components of aggregate demand and how changes in consumer confidence, government spending, or exchange rates shift the entire curve.
• AS has two regimes: Short-run (sticky prices, upward-sloping) vs. long-run (vertical at full employment), explained via Nepal’s labor market rigidities.
• Multiplier effect: A ₹100 increase in government infrastructure spending (e.g., NTC’s fiber expansion) can boost GDP by ₹300+ due to repeated spending cycles.
• Real-world shifts: Daraz’s Black Friday sales (demand-pull inflation) vs. Ncell’s tariff hikes (cost-push inflation) show how businesses experience AD/AS changes.
• Policy tools: How the Nepal Rastra Bank (NRB) uses repo rates (monetary policy) or fiscal deficits (fiscal policy) to correct AD/AS imbalances.
• Business applications: Pricing strategies (e.g., Khalti’s dynamic fees during Diwali), hiring decisions (unemployment vs. labor shortages), and investment risks (interest rates, inflation).

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1. Aggregate Demand (AD): The Engine of Economic Activity

AD measures total spending in an economy at different price levels. It is the sum of:

• Consumption (C): Household spending on goods/services (e.g., Pathao rides, Daraz orders).
• Investment (I): Business spending on capital (e.g., NTC’s 4G towers, banks’ loans to SMEs).
• Government spending (G): Public expenditure (e.g., NRB’s infrastructure projects, NEPSE’s market regulations).
• Net exports (X – M): Exports minus imports (e.g., Nepal’s remittance-driven imports vs. tourism revenue).

How AD Works: The 45° Line Diagram

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Worked Example: Daraz’s Black Friday and AD Shifts

Scenario: During Black Friday 2023, Daraz offered 50% discounts on electronics. Assume:

• Initial equilibrium: GDP = ₹4.5 trillion, P = 100.
• Discounts increase consumption (C) by ₹500 billion.

Trace the AD Shift:

1. Initial AD: ₹4.5 trillion at P=100.
2. New AD: Shifts right by ₹500 billion (new AD = ₹5.0 trillion at P=100).
3. Short-run effect: GDP rises to ₹5.0 trillion, but prices may also rise if supply is constrained (e.g., limited stock of iPhones).
4. Long-run effect: If Daraz restocks quickly, prices stabilize, but higher demand may signal firms to increase production (AS shifts right).

Visual:

Real-World Tie-In:

• Pathao’s surge pricing during Dashain/Tihar is another AD shift: higher demand (C↑) → higher prices (P↑) until supply (drivers) adjusts.
• NEPSE stock market: When global oil prices rise (cost-push inflation), AD for fuel imports (M↑) falls, shifting AD left.

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2. Determinants of AD: What Moves the Curve?

AD shifts occur due to changes in non-price factors for any of its components. Use this table to compare:

Key Insight:

• Procyclical policies: If the government increases G during a boom (e.g., NTC’s fiber expansion in 2022), it may worsen inflation.
• Countercyclical policies: Cutting taxes during a recession (e.g., NRB’s stimulus in 2020) can stabilize AD.

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3. Aggregate Supply (AS): The Economy’s Production Capacity

AS shows the total output firms are willing to produce at different price levels. It has two regimes:

A. Short-Run AS (SRAS): Upward-Sloping

• Why upward-sloping?: Sticky wages/prices (e.g., minimum wage laws, union contracts).
• Determinants:
  • Input costs: Oil prices (affects transport costs for Daraz).
  • Productivity: Tech adoption (e.g., Ncell’s 5G rollout).
  • Taxes/subsidies: VAT hikes (cost↑) vs. agricultural subsidies (cost↓).
  • Regulations: Labor laws (e.g., Nepal’s 8-hour workday rule).

B. Long-Run AS (LRAS): Vertical at Full Employment

• Why vertical?: All resources (labor, capital) are fully employed.
• Determinants:
  • Labor force: Population growth, immigration.
  • Capital stock: Infrastructure (e.g., Prithvi Highway expansion).
  • Technology: AI in banking (e.g., Khalti’s chatbot support).
  • Institutions: Property rights, corruption levels.

Comparison Table: SRAS vs. LRAS

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Worked Example: NTC’s Tariff Hike and AS Shifts

Scenario: NTC increases internet tariffs by 20% due to higher fiber costs.

1. Initial equilibrium: GDP = ₹4.5 trillion, P = 100.
2. Effect: Higher costs for Daraz, Pathao, and banks → SRAS shifts left.
3. Short-run: GDP falls to ₹4.0 trillion, P rises to 110 (stagflation: high prices + low growth).
4. Long-run: If NTC invests in cheaper solar-powered infrastructure, LRAS shifts right over 5 years.

Visual:

Real-World Tie-In:

• Global oil prices: When Brent crude rises (e.g., 2022), Nepal’s transport costs (SRAS) rise → higher prices for Khalti’s delivery partners.
• Minimum wage laws: Nepal’s 2023 wage hike for formal sector workers (₹25,000 → ₹30,000) shifts SRAS left for labor-intensive firms (e.g., garment factories).

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4. Equilibrium: Where AD Meets AS

The intersection of AD and AS determines:

• Real GDP (output).
• Price level (inflation/deflation).

Three Possible Scenarios:

1. Below Full Employment (Recessionary Gap):

   • AD intersects SRAS to the left of LRAS.
   • Policy: Expansionary fiscal/monetary policy (e.g., NRB cuts repo rate).
   • Example: Nepal’s GDP growth slowed to 3.2% in 2020 (COVID-19) → AD fell.

2. Above Full Employment (Inflationary Gap):

   • AD intersects SRAS to the right of LRAS.
   • Policy: Contractionary policy (e.g., higher taxes, NRB sells bonds).
   • Example: 2015 fuel price hike → AD shifted right, but AS couldn’t keep up → inflation hit 8.2%.

3. Full Employment (Potential GDP):

   • AD intersects SRAS at LRAS.
   • Policy: Neutral policy (maintain stability).
   • Example: Nepal’s pre-2020 growth (6-7%) when labor markets were tight.

4. Recessionary gap (AD left of LRAS),

5. Full employment (AD at LRAS),

6. Inflationary gap (AD right of LRAS).**

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5. Real-World Applications: How Businesses Use AD/AS

A. Pricing Strategies (Demand-Pull Inflation)

• Example: During Dashain, Pathao raises surge prices by 3x.
  • AD shifts right (more demand for rides).
  • AS is inelastic (limited drivers).
  • Result: Higher prices (P↑) until supply adjusts (more drivers join).

B. Investment Decisions (Interest Rates)

• Example: Ncell plans to expand 5G but hesitates due to high interest rates (8%).
  • If NRB cuts rates to 6%, I↑ → AD shifts right → Ncell borrows and invests.

C. Hiring and Unemployment (LRAS Constraints)

• Example: Nepal’s unemployment is 12% (2023), but firms like Daraz struggle to hire skilled workers.
  • LRAS is constrained by education gaps.
  • Policy: Government vocational training programs shift LRAS right.

D. Exchange Rates and Net Exports

• Example: Indian rupee depreciates → Nepal’s exports to India (X↑) rise.
  • AD shifts right (more demand for Nepalese goods like textiles).
  • Example: Garment factories in Kathmandu see higher orders.

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6. Policy Responses to AD/AS Shocks

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## In the Real World

1. eSewa and Khalti: Demand-Pull Inflation

   • During festivals, eSewa/Khalti users get cashback (wealth↑) → C↑ → AD shifts right.
   • Result: Higher demand for electronics (Daraz), travel (Pathao), and dining → temporary inflation spikes.
   • Policy: NRB monitors liquidity and may raise reserve requirements to curb excessive lending.

2. NEPSE Stock Market: AS Constraints

   • Nepal’s stock market (NEPSE) is small (market cap: ~₹2.5 trillion) due to:
     • Low LRAS: Limited corporate savings and weak institutions.
     • SRAS shocks: Political instability (e.g., 2020 lockdowns) → lower corporate profits → SRAS shifts left.
   • Business impact: Firms like NMB Bank face higher borrowing costs when AS is constrained.

3. Daraz’s Supply Chain: AS Elasticity

   • Daraz’s ability to handle Black Friday depends on AS elasticity:
     • Inelastic AS: Limited warehouse space → prices rise sharply.
     • Elastic AS: More suppliers join → prices stabilize.
   • Real data: In 2022, Daraz’s sales grew 40%, but only 20% translated to GDP growth due to supply bottlenecks.

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## Exam Tip

1. Diagrams are mandatory: Always draw AD/AS shifts with:

   • Clear labels (e.g., "AD↑ due to G↑").
   • Equilibrium points marked (E1, E2).
   • LRAS vertical line with "Full Employment" label.

2. Link to Nepal’s economy:

   • Use real data: "Nepal’s GDP growth was 3.2% in 2020 due to AD↓ from COVID-19."
   • Mention institutions: NRB, NTC, NEPSE, or government policies.

3. Common mistakes to avoid:

   • ❌ Confusing AD shifts (movements along SRAS) with AS shifts (changes in SRAS/LRAS).
   • ❌ Ignoring the long-run: Always ask, "Is this a short-run or long-run effect?"
   • ❌ Forgetting net exports: Many questions test how exchange rates (e.g., ₹/USD) affect AD.

4. Worked example formula: For any AD/AS question:

   1. Identify the shock (e.g., "NTC raises tariffs").
   2. Determine which curve shifts (SRAS left).
   3. Trace the effect on GDP and P.
   4. Suggest a policy response (e.g., "NRB should cut repo rate").

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## Practice Questions (Exam-Style)

1. Short Answer:

   • "Explain how a 20% depreciation of the Nepalese rupee against the USD affects AD. Use a diagram."
   • Answer: AD shifts right due to X↑ (exports like textiles become cheaper for buyers). Draw AD shifting right, showing higher GDP and P.

2. Long Answer:

   • "Nepal experienced stagflation in 2015 due to fuel price hikes. Analyze the AD/AS changes and suggest two policy measures to correct it."
   • Answer:
     • AD/AS: SRAS shifted left (cost-push inflation) + AD shifted right (government spending on protests).
     • Policies:
       1. Supply-side: Subsidize fuel to shift SRAS right.
       2. Demand-side: Increase taxes to shift AD left.

3. Data Interpretation:

   • Given: Nepal’s inflation = 8.2% (2015), GDP growth = 0.7%.
   • "Identify the type of inflation and explain using AD/AS."
   • Answer: Cost-push inflation (SRAS shifted left due to fuel price hikes), leading to stagflation (high P, low GDP).