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Building a Model of Aggregate Demand and Aggregate Supply

Mathematics and Statistics

To build a useful macroeconomic model, we need a model that shows what determines total supply or total demand for the economy, and how total demand and total supply interact at the macroeconomic level. This model is called the aggregate demand/aggregate supply model. This module will explain aggregate supply, aggregate demand, and the equilibrium between them. The following modules will discuss the causes of shifts in aggregate supply and aggregate demand.

The Aggregate Supply Curve and Potential GDP

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 (AS) is the relationship between real GDP and the price level for output, holding the price of inputs fixed. The aggregate supply (AS) curve shows the total quantity of output that firms choose to produce and sell (i.e., real GDP) at each different price level.

[link] shows an aggregate supply curve. In the following paragraphs, we will walk 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 Aggregate Supply Curve
Aggregate supply (AS) slopes up, because as the price level for outputs rises, with the price of inputs remaining fixed, firms have an incentive to produce more and to earn higher profits. The potential GDP line shows the maximum that the economy can produce with full employment of workers and physical capital.

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. Remember that the price level is different from the inflation rate. Visualize the price level as an index number, like the GDP deflator, while the inflation rate is the percentage change between price levels over time.

As the price level (the average price of all goods and services produced in the economy) rises, the aggregate quantity of goods and services supplied rises as well. Why? The price level shown on the vertical axis represents prices for final goods or outputs bought in the economy—like the GDP deflator—not the price level for intermediate goods and services that are inputs to production. Thus, the AS curve describes how suppliers will react to a higher price level for final outputs of goods and services, while holding the prices of inputs like labor and energy constant. If firms across the economy face a situation where the price level of what they produce and sell is rising, but their costs of production are not rising, then the lure of higher profits will induce them to expand production.

The slope of an 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, which is defined as 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—while making the assumption of no rise in input prices—can encourage a considerable surge in the quantity of aggregate supply 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: perhaps nearly all of the expert workers in a certain industry will have jobs or factories in certain geographic areas or industries will 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. (Read the following Clear It Up feature to learn why the AS curve crosses potential GDP.)

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 this example, 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 Demand Curve

Aggregate demand (AD) is the relationship between the total spending in an economy on domestic goods and services and the price level for output. (Strictly speaking, AD is what economists call total planned expenditure. This distinction will be further explained in the appendix The Expenditure-Output Model . For now, just think of aggregate demand as total spending.) It includes all four components of demand: consumption, investment, government spending, and net exports (exports minus imports). This demand is determined by a number of factors, but one of them is the price level—recall though, that the price level is an index number such as the GDP deflator that measures the average price of the things we buy. The aggregate demand (AD) curve shows the total spending on domestic goods and services at each price level.

[link] presents an aggregate demand (AD) curve. Just like the aggregate supply curve, the horizontal axis shows real GDP and the vertical axis shows the price level. The AD curve slopes down, which means that increases in the price level of outputs lead to a lower quantity of total spending. The reasons behind this shape are related to how changes in the price level affect the different components of aggregate demand. The following components make up aggregate demand: consumption spending (C), investment spending (I), government spending (G), and spending on exports (X) minus imports (M): C + I + G + X – M.

The Aggregate Demand Curve
Aggregate demand (AD) slopes down, showing that, as the price level rises, the amount of total spending on domestic goods and services declines.

The wealth effect holds that as the price level increases, the buying power of savings that people have stored up in bank accounts and other assets will diminish, eaten away to some extent by inflation. Because a rise in the price level reduces people’s wealth, consumption spending will fall as the price level rises.

The interest rate effect is that as prices for outputs rise, the same purchases will take more money or credit to accomplish. This additional demand for money and credit will push interest rates higher. In turn, higher interest rates will reduce borrowing by businesses for investment purposes and reduce borrowing by households for homes and cars—thus reducing consumption and investment spending.

The foreign price effect points out that if prices rise in the United States while remaining fixed in other countries, then goods in the United States will be relatively more expensive compared to goods in the rest of the world. U.S. exports will be relatively more expensive, and the quantity of exports sold will fall. U.S. imports from abroad will be relatively cheaper, so the quantity of imports will rise. Thus, a higher domestic price level, relative to price levels in other countries, will reduce net export expenditures.

Truth be told, among economists all three of these effects are controversial, in part because they do not seem to be very large. For this reason, the aggregate demand curve in [link] slopes downward fairly steeply; the steep slope indicates that a higher price level for final outputs reduces aggregate demand for all three of these reasons, but that the change in the quantity of aggregate demand as a result of changes in price level is not very large.

Read the following Work It Out feature to learn how to interpret the AD/AS model. In this example, aggregate supply, aggregate demand, and the price level are given for the imaginary country of Xurbia.

Equilibrium in the Aggregate Demand/Aggregate Supply Model

The intersection of the aggregate supply and aggregate demand curves shows the equilibrium level of real GDP and the equilibrium price level in the economy. At a relatively low price level for output, firms have little incentive to produce, although consumers would be willing to purchase a high quantity. As the price level for outputs rises, aggregate supply rises and aggregate demand falls until the equilibrium point is reached.

[link] combines the AS curve from [link] and the AD curve from [link] and places them both on a single diagram. In this example, the equilibrium point occurs at point E, at a price level of 90 and an output level of 8,800.

Aggregate Supply and Aggregate Demand
The equilibrium, where aggregate supply (AS) equals aggregate demand (AD), occurs at a price level of 90 and an output level of 8,800.

Confusion sometimes arises between the aggregate supply and aggregate demand model and the microeconomic analysis of demand and supply in particular markets for goods, services, labor, and capital. Read the following Clear It Up feature to gain an understanding of whether AS and AD are macro or micro.

Defining SRAS and LRAS

In the Clear It Up feature titled “Why does AS cross potential GDP?” we differentiated between short run changes in aggregate supply which are shown by the AS curve and long run changes in aggregate supply which are defined by the vertical line at potential GDP. In the short run, if demand is too low (or too high), it is possible for producers to supply less GDP (or more GDP) than potential. In the long run, however, producers are limited to producing at potential GDP. For this reason, what we have been calling the AS curve, will from this point on may also be referred to as the short run aggregate supply (SRAS) curve. The vertical line at potential GDP may also be referred to as the long run aggregate supply (LRAS) curve.

Key Concepts and Summary

The upward-sloping short run aggregate supply (SRAS) curve shows the positive relationship between the price level and the level of real GDP in the short run. Aggregate supply 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. The aggregate supply curve is near-horizontal on the left and near-vertical on the right. In the long run, aggregate supply is shown by a vertical line at the level of potential output, which is the maximum level of output the economy can produce with its existing levels of workers, physical capital, technology, and economic institutions.

The downward-sloping aggregate demand (AD) curve shows the relationship between the price level for outputs and the quantity of total spending in the economy. It slopes down because of: (a) the wealth effect, which means that a higher price level leads to lower real wealth, which reduces the level of consumption; (b) the interest rate effect, which holds that a higher price level will mean a greater demand for money, which will tend to drive up interest rates and reduce investment spending; and (c) the foreign price effect, which holds that a rise in the price level will make domestic goods relatively more expensive, discouraging exports and encouraging imports.

Self-Check Questions

The short run 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?

Higher input prices make output less profitable, decreasing the desired supply. This is shown graphically as a leftward shift in the AS curve.

In the AD/AS model, what prevents the economy from achieving equilibrium at potential output?

Equilibrium occurs at the level of GDP where AD = AS. Insufficient aggregate demand could explain why the equilibrium occurs at a level of GDP less than potential. A decrease (or leftward shift) in aggregate supply could be another reason.

Review Questions

What is on the horizontal axis of the AD/AS diagram? What is on the vertical axis?

What is the economic reason why the SRAS curve slopes up?

What are the components of the aggregate demand (AD) curve?

What are the economic reasons why the AD curve slopes down?

Briefly explain the reason for the near-horizontal shape of the SRAS curve on its far left.

Briefly explain the reason for the near-vertical shape of the SRAS curve on its far right.

What is potential GDP?

Critical Thinking Questions

On a microeconomic demand curve, a decrease in price causes an increase in quantity demanded because the product in question is now relatively less expensive than substitute products. Explain why aggregate demand does not increase for the same reason in response to a decrease in the aggregate price level. In other words, what causes total spending to increase if it is not because goods are now cheaper?

Problems

Review the problem shown in the Work It Out titled "Interpreting the AD/AS Model." Like the information provided in that feature, [link] shows information on aggregate supply, aggregate demand, and the price level for the imaginary country of Xurbia.

Price Level: AD/AS
Price Level AD AS
110 700 600
120 690 640
130 680 680
140 670 720
150 660 740
160 650 760
170 640 770
  1. Plot the AD/AS diagram from the data shown. Identify the equilibrium.
  2. Imagine that, as a result of a government tax cut, aggregate demand becomes higher by 50 at every price level. Identify the new equilibrium.
  3. How will the new equilibrium alter output? How will it alter the price level? What do you think will happen to employment?

The imaginary country of Harris Island has the aggregate supply and aggregate demand curves as shown in [link].

Price Level: AD/AS
Price Level AD AS
100 700 200
120 600 325
140 500 500
160 400 570
180 300 620
  1. Plot the AD/AS diagram. Identify the equilibrium.
  2. Would you expect unemployment in this economy to be relatively high or low?
  3. Would you expect concern about inflation in this economy to be relatively high or low?
  4. Imagine that consumers begin to lose confidence about the state of the economy, and so AD becomes lower by 275 at every price level. Identify the new aggregate equilibrium.
  5. How will the shift in AD affect the original output, price level, and employment?

Santher is an economy described by [link].

Price Level: AD/AS
Price Level AD AS
50 1,000 250
60 950 580
70 900 750
80 850 850
90 800 900
  1. Plot the AD/AS curves and identify the equilibrium.
  2. Would you expect unemployment in this economy to be relatively high or low?
  3. Would you expect prices to be a relatively large or small concern for this economy?
  4. Imagine that input prices fall and so AS shifts to the right by 150 units. Identify the new equilibrium.
  5. How will the shift in AS affect the original output, price level, and employment?
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