Aggregate Demand and Aggregate Supply Flashcards
Economic Output
It refers the quantity of goods and services produced in a given time period.
The level of output is determined by both the aggregate supply and aggregate demand within an economy.
Aggregate demand
- The total demand for final goods and services in a given economy at a specific time.
- It is inclusive of all amounts of the product or service purchased at any possible price level.
- AD is the sum of all demand in an economy.
- It is often called the effective demand or aggregate expenditure (AE), and is the demand of all gross domestic product (GDP).
- Aggregate demand curve i.e. the total demand of goods and services in the economy shows the negative relationship between general price level and aggregate income/output (Real GDP)
Demand sources
- Consumption (C):This is the simplest and largest component of aggregate demand (usually 40-60% of all demand), and is often what is intuitively thought of as demand. Consumption is just the amount of consumer spending executed in an economy.
- Investment (I):Investment is a relatively large portion of demand as well, and is referred to as Gross Domestic Fixed Capital Formation. This is the money spent by firms on capital investment (new machinery, factories, stocks, etc.). Investment equates to about 10% of GDP in most economies.
- Government Spending (G):This is referred to as General Government Final Consumption, and is the expenditure by the government. This can include welfare, social services, education, military, etc. Fiscal policy is the way in which governments can alter this spending to drive economic change.
- Net Export (NX):This can be put simply as the sale of goods to foreign countries subtracted by the purchase of goods from other countries (X-M). Trade surpluses and deficits can occur based on whether or not exports or imports are higher.
Shifts in AD curve
Increasing any of these components shifts the AD curve to the right, leading to a greater real GDP and to upward pressure on the price level.
Decreasing any of the components shifts the AD curve to the left, leading to a lower real GDP and a lower price level.
Aggregate Supply
- Theaggregate supply curvedepicts the quantity of real GDP that is supplied by the economy at different price levels.
- The supply curve for an individual good is drawn under the assumption that input prices remain constant
The aggregate supply curve, however, is defined in terms of theprice level. - Increases in the price level will increase the price that producers can get for their products and thus induce more output.
- But an increase in the price will also have a second effect; it will eventually lead to increases in input prices as well, which,ceteris paribus, will cause producers to cut back. So, there is some uncertainty as to whether the economy will supply more real GDP as the price level rises.
Short-run aggregate supply curve
- Theshort‐run aggregate supply (SAS) curveis considered a valid description of the supply schedule of the economyonlyin the short‐run.
- Theshort‐runis the period that begins immediately after an increase in the price level and that ends wheninput priceshave increased in thesame proportionto the increase in the price level.
- The presumption underlying the SAS curve is that input providersdo notorcannottake account of the increase in the general price level right away so that it takes some time–referred to as the short‐run–for input prices to fully reflect changes in the price level for final goods.
- During the short‐run,sellers of final goodsare receiving higher prices for their products, without a proportional increase in the cost of their inputs. The higher the price level, the more these sellers will be willing to supply.
Short run aggregate supply curve
Upward sloping, reflecting the positive relationship that exists between the price level and the quantity of goods supplied in the short‐run.
A shift to therightof theSAScurve fromAS1toSAS3means that at the same price levels the quantity supplied of real GDP hasincreased. A shift to theleftof theSAScurve fromSAS1toSAS2
Long-run aggregate supply curve
- The long‐run aggregate supply (LAS) curvedescribes the economy’s supply schedule in the long‐run.
- Thelong‐runis defined as the period when input prices have completely adjusted to changes in the price level of final goods.
- In the long‐run, the increase in prices that sellers receive for their final goods is completely offset by the proportional increase in the prices that sellers pay for inputs.
- The result is that the quantity of real GDP supplied by all sellers in the economy is independent of changes in the price level. The LAS curve is a vertical line, reflecting the fact that long‐run aggregate supply is not affected by changes in the price level.
- TheLAScurve is vertical at the point labelled as thenatural level of real GDP.
- The natural level of real GDP is defined as the level of real GDP that arises when the economy isfully employing allof its available input
Long-run aggregate supply curve
It is a vertical line, reflecting the fact that long‐run aggregate supply is not affected by changes in the price level.
A shift to therightof the of theLAScurve fromLAS1toLAS2means that at the same price levels the quantity supplied of real GDP hasincreased.
AD-AS Framework
AD-AS model is fundamental in macroeconomic analysis because it explains how macroeconomic indicators affect overall growth.
AD-AS model facilitates analysis of fluctuation of the economy.
Output gaps caused by shocks to AD & AS can help us evaluate recession and expansion cycles in the economy
AD-AS model assists in evaluating long run and short run equilibrium dynamics and accommodates both Keynesian and classical approach to the macroeconomic analysis
AD-AS Equilibrium
When the aggregate demand andSAS(short-run aggregate supply) curves are combined, the intersection of the two curves determines both theequilibrium price level, denoted byP, and theequilibrium level of real GDP, denoted byY
If it is further assumed that the economy is fully employing all of its resources, the equilibrium level of real GDP,Y*, will correspond to thenatural level of real GDP, and theLAScurve may be drawn as a vertical line atY
AD-AS Equilibrium
The immediate, short‐run effect is that the equilibrium price level increases fromP1, toP2, and real GDP increasesaboveits natural level, fromY1, toY2.
The increase in real GDP is due to the fact that input prices have not yet risen in response to the increase in the price level for final goods; the economy is still operating along the oldSAScurve,SAS1.
Eventually, however, input providers will demand higher prices to reflect the increase in the general price level. Production costs will therefore increase, and the supply of real GDP will be reduced.
This is represented by the shift to theleftof theSAScurve fromSAS1toSAS2.
The end result is a higher price level,P3, at the same, natural level of real GDP,Y1.
AD-AS equilibrium when economy is not at fully employment;
The graphical analysis applies only to the case where there is zero economic growth, and the economy is already at the natural level of real GDP when aggregate demand increases.
In the case where the economy is not fully employing all of its input resources and has therefore not yet attained its natural level of real GDP, an increase in aggregated demand—depictedas a shift fromAD1toAD2—causes both an increase in the equilibrium price level fromP1toP2, and an increase in the equilibrium level of real GDP fromY1toY2
In this case, the increase in the equilibrium price level does not necessarily lead to an increase in input prices because the economy is not fully employing all of its input resources.
When unemployed inputs are available, input prices do not tend to rise.
The result, in this case, is that theSAScurvedoes notshift left and cancel out the increase in real GDP brought about by the increase in aggregate demand.
The immediate, short‐run effect is that the A change in in aggregate demand when the economy is below natural level of GDP
The AD–AS and Inflationary pressure
The AD–AS framework implies two ways that inflationary pressures may arise.
One possible trigger is if aggregate demand continues to shift to the right when the economy is already at or near potential GDP and full employment, thus pushing the macroeconomic equilibrium into the steep portion of the AS curve.
A shift of aggregate demand to the right; the new equilibrium E1is clearly at a higher price level than the original equilibrium E0.
In this situation, the aggregate demand in the economy has soared so high that firms in the economy are not capable of producing additional goods, because labor and physical capital are fully employed, and so additional increases in aggregate demand can only result in a rise in the price level.
A shift in aggregate demand, from AD0to AD1, when it happens in the area of the AS curve that is near potential GDP, will lead to a higher price level and to pressure for a higher price level and inflation.
The new equilibrium (E1) is at a higher price level (P1) than the original equilibrium.
A shift in aggregate supply, from AS0to AS1, will lead to a lower real GDP and to pressure for a higher price level and inflation.
The new equilibrium (E1) is at a higher price level (P1), while the original equilibrium (E0) is at the lower price level (P0).
An alternative source of inflationary pressures can occur due to a rise in input prices that affects many or most firms across the economy—perhaps an important input to production like oil or labor—and causes the aggregate supply curve to shift back to the left.
The shift of the AS curve to the left also increases the price level from P0at the original equilibrium (E0) to a higher price level of P1at the new equilibrium (E1).
In effect, the rise in input prices ends up, after the final output is produced and sold, being passed along in the form of a higher price level for outputs.
Classical theory was developed according to specific economic assumptions:
Self-regulating markets:classical theorists believed that free markets regulate themselves when they are free of any intervention. Adam Smith referred to the market’s ability to self-regulate as the “invisible hand” because markets move towards their natural equilibrium without outside intervention.
Flexible prices:classical economics assumes that prices are flexible for goods and wages. They also assumed that money only affects price and wage levels.
Supply creates its own demand:based on Say’s Law, classical theorists believed that supply creates its own demand. Production will generate an income enough to purchase all of the output produced. Classical economics assumes that there will be a net saving or spending of cash or financial instruments.
Equality of savings and investment:classical theory assumes that flexible interest rates will always maintain equilibrium.
Calculating real GDP:classical theorists determined that the real GDP can be calculated without knowing the money supply or inflation rate.
Real and Nominal Variables:classical economists stated that real and nominal variables can be analyzed separately
