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Aggregate demand is the relationship between the total quantity of goods and services demanded (from all the four sources of demand) and the price level, all other determinants of spending unchanged. The aggregate demand curve is a graphical representation of aggregate demand.
- Overview
- Key points
- Introduction
- The aggregate supply curve
- Potential GDP
- Why does AS cross potential GDP?
- The Aggregate Demand Curve
- Summary
- Self-check question
- Review questions
The concepts of supply and demand can be applied to the economy as a whole.
•Aggregate supply is the total quantity of output firms will produce and sell—in other words, the real GDP.
•The upward-sloping aggregate supply curve—also known as the short run aggregate supply curve—shows the positive relationship between price level and real GDP in the short run.
•The aggregate supply curve slopes up because when the price level for outputs increases while the price level of inputs remains fixed, the opportunity for additional profits encourages more production.
•Potential GDP, or full-employment GDP, is the maximum quantity that an economy can produce given full employment of its existing levels of labor, physical capital, technology, and institutions.
•Aggregate demand is the amount of total spending on domestic goods and services in an economy.
•The downward-sloping aggregate demand curve shows the relationship between the price level for outputs and the quantity of total spending in the economy.
To understand and use a macroeconomic model, we first need to understand how the average price of all goods and services produced in an economy affects the total quantity of output and the total amount of spending on goods and services in that economy.
Firms make decisions about what quantity to supply based on the profits they expect to earn. Profits, in turn, are also determined by the price of the outputs the firm sells and by the price of the inputs—like labor or raw materials—the firm needs to buy. Aggregate supply, or AS, refers to the total quantity of output—in other words, real GDP—firms will produce and sell. The aggregate supply curve shows the total quantity of output—real GDP—that firms will produce and sell at each price level.
The graph below shows an aggregate supply curve. Let's begin by walking through the elements of the diagram one at a time: the horizontal and vertical axes, the aggregate supply curve itself, and the meaning of the potential GDP vertical line.
The graph shows an upward sloping aggregate supply curve. The slope is gradual between 6,500 and 9,000 before become steeper, especially between 9,500 and 9,900.
Image credit: Figure 1 in "Building a Model of Aggregate Demand and Aggregate Supply" by OpenStaxCollege, CC BY 4.0
The horizontal axis of the diagram shows real GDP—that is, the level of GDP adjusted for inflation. The vertical axis shows the price level. Price level is the average price of all goods and services produced in the economy. It's an index number, like the GDP deflator.
[Wait, what's a GDP deflator again?]
If you look at our example graph above, you'll see that the slope of the AS curve changes from nearly flat at its far left to nearly vertical at its far right. At the far left of the aggregate supply curve, the level of output in the economy is far below potential GDP—the quantity that an economy can produce by fully employing its existing levels of labor, physical capital, and technology, in the context of its existing market and legal institutions.
At these relatively low levels of output, levels of unemployment are high, and many factories are running only part-time or have closed their doors. In this situation, a relatively small increase in the prices of the outputs that businesses sell—with no rise in input prices—can encourage a considerable surge in the quantity of aggregate supply—real GDP—because so many workers and factories are ready to swing into production.
As the quantity produced increases, however, certain firms and industries will start running into limits—for example, nearly all of the expert workers in a certain industry could have jobs or factories in certain geographic areas or industries might be running at full speed.
In the intermediate area of the AS curve, a higher price level for outputs continues to encourage a greater quantity of output, but as the increasingly steep upward slope of the aggregate supply curve shows, the increase in quantity in response to a given rise in the price level will not be quite as large.
At the far right, the aggregate supply curve becomes nearly vertical. At this quantity, higher prices for outputs cannot encourage additional output because even if firms want to expand output, the inputs of labor and machinery in the economy are fully employed.
In our example AS curve, the vertical line in the exhibit shows that potential GDP occurs at a total output of 9,500. When an economy is operating at its potential GDP, machines and factories are running at capacity, and the unemployment rate is relatively low at the natural rate of unemployment. For this reason, potential GDP is sometimes also called full-employment GDP.
The aggregate supply curve is typically drawn to cross the potential GDP line. This shape may seem puzzling—How can an economy produce at an output level which is higher than its potential or full-employment GDP?
The economic intuition here is that if prices for outputs were high enough, producers would make fanatical efforts to produce: all workers would be on double-overtime, all machines would run 24 hours a day, seven days a week. Such hyper-intense production would go beyond using potential labor and physical capital resources fully to using them in a way that is not sustainable in the long term. Thus, it is indeed possible for production to sprint above potential GDP, but only in the short run.
So, in the short run, it is possible for producers to supply less or more GDP than potential if demand is too low or too high. In the long run, however, producers are limited to producing at potential GDP.
For this reason, economists also refer to the AS curve as the short run aggregate supply curve, or SRAS curve. The vertical line at potential GDP may also be referred to as the long run aggregate supply curve, or LRAS curve.
Aggregate demand, or AD, refers to the amount of total spending on domestic goods and services in an economy. Strictly speaking, AD is what economists call total planned expenditure. We'll talk about that more in other articles, but for now, just think of aggregate demand as total spending.
Aggregate demand includes all four components of demand:
•Consumption
•Investment
•Government spending
•Net exports—exports minus imports
•Aggregate supply is the total quantity of output firms will produce and sell—in other words, the real GDP.
•The upward-sloping aggregate supply curve—also known as the short run aggregate supply curve—shows the positive relationship between price level and real GDP in the short run.
•Aggregate supply curves slope up because when the price level for outputs increases while the price level of inputs remains fixed, the opportunity for additional profits encourages more production.
•Potential GDP, or full-employment GDP, is the maximum quantity that an economy can produce given full employment of its existing levels of labor, physical capital, technology, and institutions.
•Aggregate demand is the amount of total spending on domestic goods and services in an economy.
•The downward-sloping aggregate demand curve shows the relationship between the price level for outputs and the quantity of total spending in the economy.
The short run aggregate supply curve, or aggregate supply curve, was constructed assuming that as the price of outputs increases, the price of inputs stays the same. How would an increase in the prices of important inputs, like energy, affect aggregate supply?
[Show solution.]
•What is the economic reason that the aggregate supply curve, or short run aggregate supply curve, slopes up?
•What are the components of the aggregate demand curve?
•What are the economic reasons that the aggregate demand curve slopes down?
•Briefly explain the reason for the near-horizontal shape of the aggregate supply curve, or short run aggregate supply curve, on its far left.
•Briefly explain the reason for the near-vertical shape of the aggregate supply curve, or short run aggregate supply curve, on its far right.
•What is potential GDP?
Oct 4, 2023 · Aggregate demand is a measurement of the total demand for all of the finished goods and services in an economy. An increase in aggregate demand generally corresponds with...
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The aggregate demand curve shows the inverse relationship between the price level spending on real GDP. Figure 1 shows an economy that responds to a decrease in the price level by increasing the amount of aggregate demand.
The aggregate demand curve represents the total quantity of all goods (and services) demanded by the economy at different price levels. An example of an aggregate demand curve is given in Figure . The vertical axis represents the price level of all final goods and services.
AD = C + I + G + X − M. C M. M C I G. 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.
Oct 27, 2020 · The aggregate demand curve shows a relationship between aggregate demand and the general price level. A fall in the general price level causes an expansion of AD. A rise in the general price level causes a contraction of AD. Why does the aggregate demand curve slope downwards from left to right?
