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Aggregate Demand & Aggregate Supply Equilibrium

The Aggregate Demand and Aggregate Supply Model



Includes:
Aggregate Demand
Aggregate Supply
Aggregate Demand and Aggregate Supply Equilibrium
Shifts in Aggregate Demand and Aggregate Supply


The aggregate demand (AD) curve and the aggregate supply (AS) curve are used in macroeconomics to help explain changes in the overall condition of an economy. The AD/AS model is a graph that explains the concepts behind the causes of changes in real GDP and the overall level of prices.

This model helps explain the business cycle, cyclical unemployment, and inflation.

The aggregate demand and aggregate supply model in macroeconomics is similar to the supply and demand model in microeconomics. It involves a downward sloping aggregate demand curve similar to a downward sloping demand curve, and an upward sloping aggregate supply curve similar to an upward sloping supply curve.

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The determinants of aggregate demand and aggregate supply are different from the determinants of demand and supply in microeconomics, but the two models are related. For example, the sum of all demand curves in an economy comprises a large portion of the aggregate demand curve.

Changes related to demand and supply for individuals, firms and industries are not considered to be significantly large enough to create changes in the AD/AS model - unless these changes have implications throughout the entire economy.

The aggregate demand & aggregate supply graph plots the overall price level on the vertical axis and real GDP on the horizontal axis.

Changes depicted by this model reflect economic growth as well as the rate of inflation and the unemployment rate. Changes in real GDP represent changes in output, which is economic growth. The unemployment rate is closely tied to changes in output: when output increases, employment tends to increase and unemployment tends to decrease. A negative correlation exists between output and the unemployment rate. The rate of inflation can be considered to be equal to changes in the price level.



Aggregate Demand



Aggregate demand is the total of all expenditures in the economy. Total expenditures in the AD/AS model equal real GDP. Using the expenditures approach, GDP equals the sum of consumption (household sector), investment (business sector), government purchases (government sector), and net exports (international sector). The factors of aggregate demand are the factors that influence spending by each of these sectors:


Household sector


The factors of household consumption are income, wealth, expectations, demographics, and taxes.


Income: An increase in income will increase consumption.
Wealth: An increase in wealth will increase consumption.
Expectations: Consumer confidence influences consumption. If consumers are confident that income and wealth will increase in the future, current consumption will rise. If consumers fear a job loss or a recession, current consumption will fall.
Demographics: Total population and age distribution affect consumption. An increase in the total population will increase consumption. Older and younger households tend to spend more and save less (higher MPC) than households in the middle of the age groups.
Taxes: The amount of taxes helps determine the level of disposable income, and therefore influences the amount of consumption spending.


Business sector


The level of business investment depends on the profitability of investments, which depends on interest rates, technology, the cost of capital goods, and excess capacity.
Interest rates: A large portion of investment is financed through borrowing. Interest is the cost of borrowing. The level of investment is inversely related to the interest rate.
Technology: New technology increases investment. Firms change to new methods in order to remain competitive.
The cost of capital goods: An increase in the cost of production reduces profits. Lower profit potential will reduce investment spending.
Excess capacity: Output can be increased without new investment if excess capacity exists. More excess capacity in the economy means a lower level of investment spending.


Government sector


Government purchases increase aggregate demand by the amount of the purchases. In addition, government purchases add money to the economy which is then subject to a multiplier effect. The multiplier effect for government purchases is greater than the multiplier effect for household income, since households have an MPC that is less than one (they will save a portion of income instead of spend it). The money that the government adds to the economy through government purchases may increase the price level. The level of government spending is often the result of discretionary fiscal policy.


International sector


Exports increase aggregate demand; imports decrease aggregate demand. The level of exports depends on factors in the rest of the world. The level of imports is determined by domestic factors. Factors of aggregate demand in the international sector are income, prices, exchange rates, and government policy.
Income: A portion of consumption will be for goods from the rest of the world. When foreign incomes rise, exports increase. When domestic incomes rise, imports increase.
Prices: When the prices of domestic goods change relative to the prices of foreign goods, net exports will change. Higher domestic prices will increase imports. Higher foreign prices will increase exports.
Exchange rates: When the domestic currency depreciates on the foreign exchange market, domestic goods become cheaper to foreign buyers and exports will increase. Imports will decrease at the same time because the change in the exchange rate will make foreign goods more expensive for domestic buyers.
Government policy: Trade restrictions imposed by governments limit the amount of exports and/or imports.
These factors of aggregate demand include both price factors and non-price factors. Changes in the price factors will cause a cause a movement along the AD curve. Changes in the non-price factors will cause a shift in the entire AD curve. This distinction is due to the fact that the price level is plotted along the vertical axis.


Price factors of aggregate demand


Price factors of aggregate demand are divided into three categories: the wealth effect, the interest rate effect, and the international trade effect. A change in any of these categories will cause a movement along the AD curve.


Wealth effect: Financial assets (money, stocks, and bonds) represent purchasing power. This purchasing power changes inversely with changes in the price level. With any given amount of financial assets, the higher the price level, the lower the purchasing power, and therefore the lower the real wealth.
Interest rate effect: As the price level increases, more money is needed for purchases. This increases the demand for money, and lowers the demand for other financial assets such as bonds. A lower demand for bonds will decrease the price of bonds, increasing interest rates. Higher interest rates will create a decrease in aggregate investment spending.
International trade effect: Changes in the relative prices of foreign and domestic goods will cause changes in net exports. These are changes in the overall price level, creating a movement along the AD curve.


These price factors of aggregate demand give the AD curve its downward slope.


Non-price determinants of aggregate demand
The price factors of aggregate demand (wealth effect, interest rate effect, and international trade effect) show different real GDP levels at different price levels. Changes in all of the factors that affect consumption, investment, government purchases, and net exports can also cause real GDP to change at every price level. All factors of aggregate demand, then, are also non-price factors of aggregate demand. Changes in the non-price factors of aggregate demand will cause the entire AD curve to shift.



Aggregate Supply



The aggregate supply (AS) curve is a graph of the level of real GDP that firms will be willing to produce at various price levels. The aggregate supply curve is different in the short run than in the long run.

Firms are willing to supply more output whenever profitability increases. An increase in the prices of output, holding all other factors constant, will increase profitability and the level of real output. This means that a positive relationship exists between the price level and the real GDP supplied. The AS curve slopes upward.

The aggregate supply curve becomes steeper as the price level rises. This is because at higher levels of output, more firms reach capacity and cannot respond to higher prices with an increase in output, at least in the short run.

The upward slope of the AS curve generally holds true in the short run. Holding all other factors constant is at least partially realistic in the short run. Profits increase with a higher price level in the short run because input prices tend to be less flexible than output prices. For example, wage rates may be set by contract and are based on historical or expected price levels, not actual price levels. A time lag may also exist before suppliers raise their prices.

In the long run, however, input prices have time to adjust to changes in the price level. Real profits will not necessarily increase with a higher price level. With no increase in long run profits, the aggregate supply curve loses its upward slope. As a result, in the long run real GDP will not change with a price level change. The long run aggregate supply curve becomes a vertical line.

Many economists agree that this vertical line is at the level of real GDP that coincides with the natural rate of unemployment. This means that long run real GDP would be equal to potential GDP.
The vertical long run aggregate supply curve, at the natural rate of unemployment level of output, does not mean that long run real GDP is fixed. Both the long run and the short run aggregate supply curves shift as changes occur in the non-price determinants of aggregate supply. Technological advances and increases in resources allow for economic growth in the long run.


Non-price determinants of aggregate supply


The non-price determinants of aggregate supply are resource prices, technology, and expectations.


Resource prices: As stated above, resource prices do not fully adjust to changes in the overall price level in the short run. When resource prices do change, profitability and the level of aggregate supply also change. An increase in resource prices will shift the AS curve to the left. Only changes in the prices of resources, and not changes in the overall price level, will create this shift in the aggregate supply curve.
Technology: Technological advances increase efficiency. New technology allows more output to be produced with the same level of resource inputs. This lowers the costs of production. As a result, firms are willing to supply more output, and the AS curve shifts to the right.
Expectations: Expectations of the future price level will cause shifts in the current aggregate supply curve. When wage contracts are renewed, an expected increase in the price level can cause an increase in current input prices, reducing aggregate supply. Expectations of higher prices shift the AS curve to the left. Since a leftward shift in the aggregate supply curve creates a higher price level, this means that anticipated higher prices can cause higher prices. In effect, the expectation of inflation becomes a self-fulfilling prophesy.



Aggregate Demand & Aggregate Supply Equilibrium



The aggregate demand curve slopes downward. The short run aggregate supply curve slopes upward. The point where these two curves intersect indicates the short run equilibrium price level and real GDP.

If this is also long run equilibrium, then it would indicate a level of real GDP that is equal to potential GDP. The long run aggregate supply curve would be a vertical line that runs through this point.

What happens to the equilibrium price level and equilibrium real GDP when changes in the economy cause the positions of these curves to shift?

Consider two scenarios. First, one in which the change in the economy is created by a change in aggregate demand. Second, one in which the change in the economy is created by a change in aggregate supply.
These scenarios assume an initial position of short run and long run equilibrium.



Shift in aggregate demand



If aggregate demand increases due to changes in any of the non-price determinants of aggregate demand, the aggregate demand curve shifts to the right. This intersects the short run aggregate supply curve at a different point, creating a new short run equilibrium situation with a higher price level and a higher real GDP than the original equilibrium.

In this case, equilibrium real GDP will be above potential GDP. But this is not long run equilibrium. This point is away from the long run aggregate supply curve.

In the long run, as input prices adjust to the new (higher) price level, the short run aggregate supply curve will shift leftward, until it intersects the new aggregate demand curve along the long run aggregate supply curve.
At this point, the initial increase in real GDP has not been sustained. The new long run equilibrium is at the original level of real GDP. The only change in long run equilibrium is a higher price level. This higher price level represents inflation.

Since the initial cause of the change in equilibrium is an increase in aggregate demand, this type of inflation is called demand-pull inflation.


Shift in aggregate supply



If the initial change in equilibrium is a sudden increase in the price of a key input, the short run aggregate supply curve shifts to the left. This intersects the aggregate demand curve at a different point, creating a new equilibrium with a higher price level and a lower real GDP than the original equilibrium. In this case, the result is both higher prices and lower output. This situation is called stagflation. The type of inflation caused by a decrease in aggregate supply is called cost-push inflation.

Stagflation caused by a sudden leftward shift in the aggregate supply curve is called supply shock.

In the long run, this leftward shift in the aggregate supply curve may or may not be permanent. It is unlikely that such a supply shock will continue to push the aggregate supply curve further to the left. Events that create supply shock tend to be independent, one-time events.

If the initial cause of the supply shock is a weather event or a natural disaster, the aggregate supply curve will eventually shift back to the original equilibrium position.

If the cause of the supply shock is man-made, such as a decision by oil producers to decrease global supplies, the shift in the short run aggregate supply curve could shift the long run aggregate supply curve to the left as well. This would mean that the price level increase could be permanent, long run equilibrium real GDP could be lower, and the natural rate of unemployment could increase.