ECO 372 Week 3 Aggregate Demand and Aggregate Supply Example

Tariffs as a Supply Shock: Using Aggregate Demand and Aggregate Supply to Explain Why 2025 Raised the Risk of Higher Prices and Slower Growth Together

[Student Name]

University of Phoenix

ECO/372: Principles of Macroeconomics

Week 3 Assignment

[Instructor Name]

[Date]

Lakeview Precision Components is a composite written for a model paper; tariff actions and research findings come from the sources listed and are stated generally.

In 2025, the United States imposed new tariffs on a wide range of imports, including a baseline tariff on most goods, much higher rates on some countries for periods during the year and tariffs of 25 percent and later 50 percent on steel and aluminum. Lakeview Precision Components, the composite Grand Rapids parts supplier, buys specialty steel bar and some cast components from abroad. Its costs rose, and so did the prices of its domestic steel suppliers, who faced less import competition. Its finance chief asked what the tariffs would do to the economy as a whole. The model of aggregate demand and aggregate supply answers that question by asking which curve a shock moves and in what direction. This paper applies it.

Aggregate Demand

Aggregate demand shows the total quantity of goods and services demanded at each price level. It slopes downward for three reasons: when the overall price level drops, the money and wealth people hold buy more, encouraging spending; it lowers interest rates, encouraging investment; and it improves the price of U.S. products against imports, lifting net exports (Mankiw, 2021). Changes in consumer confidence, government spending, taxes, the money supply and foreign incomes shift the whole curve.

Short-Run Aggregate Supply

In the short run, the aggregate supply curve slopes upward: when the price level rises unexpectedly, firms with sticky wages and contracts find it profitable to produce more. Changes in production costs, such as wages, energy prices or imported inputs, shift the curve. A rise in costs shifts it left, meaning less output at each price level.

Long-Run Aggregate Supply

In the long run, output depends on labor, capital, natural resources and technology, not on the price level, so long-run aggregate supply is vertical at potential output. Wages and prices eventually adjust, returning the economy toward potential after a shock. Long-run supply itself can shift if a shock permanently changes productivity or capacity.

The Tariffs as a Supply Shock

A broad tariff raises the cost of imported inputs and finished goods. Firms like Lakeview pay more for steel and components, and domestic suppliers facing less competition raise their prices too. Across the economy, higher costs shift short-run aggregate supply to the left. The model predicts a higher price level and lower output than otherwise, the signature of an adverse supply shock.

Who Paid the 2018 Tariffs

Evidence from the tariffs imposed in 2018 and 2019 helps gauge the effect. Amiti et al. (2019) found that the tariffs were passed almost entirely into the prices U.S. importers paid, so the burden fell mainly on U.S. buyers rather than foreign sellers. Fajgelbaum et al. (2020) estimated that the tariffs raised costs for U.S. consumers and importers and, after accounting for tariff revenue and gains to protected producers, produced a modest net loss to the economy. Those findings suggest the 2025 tariffs would also raise prices paid by U.S. firms and households.

Demand Effects

Tariffs can also shift aggregate demand. Retaliatory tariffs on U.S. exports, such as agricultural products, reduce net exports. Uncertainty about trade policy can lead firms to delay investment, as some of Lakeview's customers postponed new tooling orders in spring 2025. Higher prices reduce real incomes and consumer spending. These effects shift aggregate demand left, further reducing output while partly offsetting the price increase.

The Combined Effect

Combining a leftward shift in supply with a smaller leftward shift in demand, the model predicts lower output and a price level that rises, though by less than from the supply shift alone. The size of each shift was uncertain in 2025, which is why forecasters' projections varied widely.

The Risk of Stagflation

An adverse supply shock creates stagflation risk: rising prices with weak growth. The 1970s oil shocks are the classic case. In 2025, the tariffs raised that risk, though their scale was smaller relative to the economy. Stagflation creates a dilemma: policies that stimulate demand to support output worsen inflation, while policies that restrain demand to fight inflation deepen the slowdown.

Long-Run Adjustment

If the tariffs remained in place, the economy would gradually adjust. Wages and prices would settle at a higher level, and output would return toward potential, though potential itself might be slightly lower if tariffs reduced efficiency by shifting production to higher-cost domestic suppliers. If tariffs were reduced, short-run supply would shift back to the right.

What It Means for Lakeview

For Lakeview, the analysis pointed to higher input costs, possible weakness in vehicle demand as car prices rose and uncertainty about how long tariffs would last. The company sought domestic steel suppliers under longer contracts, added tariff pass-through clauses to customer contracts where possible and built a plan for a slowdown in orders.

Comparing With the 1970s

The oil shocks of 1973 and 1979 are the textbook supply shocks: oil prices quadrupled and then more than doubled, shifting aggregate supply sharply left, and the economy suffered both recession and high inflation. The 2025 tariffs differ in scale and in kind. Oil is an input to nearly every industry, while tariffs affect imported goods unevenly, and the U.S. economy uses less energy per dollar of output than it did in the 1970s. Inflation expectations were also better anchored in 2025 than in the 1970s, when years of rising prices had already shaped behavior. The comparison suggests a smaller, though real, risk of stagflation.

Limits of the Model

The aggregate model compresses many markets into one, so it cannot show which industries gain or lose. Steel producers may benefit from protection while steel buyers like Lakeview pay more. A full assessment requires industry detail as well as the aggregate view.

Conclusion

The 2025 tariffs fit the model of an adverse supply shock: higher costs shift short-run aggregate supply left, raising prices and reducing output, while uncertainty and retaliation weaken demand. Evidence from earlier tariffs shows most of the cost falls on U.S. buyers. The resulting stagflation risk creates a policy dilemma, and in the long run the economy adjusts to a higher price level and possibly lower potential output.

References

Amiti, M., Redding, S. J., & Weinstein, D. E. (2019). The impact of the 2018 tariffs on prices and welfare. Journal of Economic Perspectives, 33(4), 187-210. https://doi.org/10.1257/jep.33.4.187

Fajgelbaum, P. D., Goldberg, P. K., Kennedy, P. J., & Khandelwal, A. K. (2020). The return to protectionism. The Quarterly Journal of Economics, 135(1), 1-55. https://doi.org/10.1093/qje/qjz036

Mankiw, N. G. (2021). Principles of macroeconomics (9th ed.). Cengage.