Aggregate Supply And Demand

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Economists have developed aggregate supply and demand analysis to help explain the major trends in output and prices.

We begin by explaining this important tool of macroeconomics and then use it to understand some important historical events.

Definitions of Aggregate Supply and Demand Different forces interact to determine overall economic activity. These variables fall into two categories: those affecting aggregate supply and those affecting aggregate demand. Dividing variables into these two categories helps us understand what determines the levels of output, prices, and unemployment.

Aggregate supply refers to the total quantity of goods and services that the nation's businesses are willing to produce and sell in a given period. Aggregate supply (often written AS) depends upon the price level, the productive capacity of the economy, and the level of costs.

In general, businesses would like to sell everything they can produce at high prices. Under some circumstances, prices and spending levels may be depressed, so businesses might find they have excess capacity. Under ...
... other conditions, such as during a wartime boom, factories may be operating at capacity as businesses scramble to produce enough to meet all their orders.

We see, then, that aggregate supply depends on the price level that businesses can charge as well as on the economy's capacity or potential output. Potential output in turn is determined by the availability of productive inputs (labor and capital being the most important) and the managerial and technical efficiency with which those inputs are combined.

National output and the overall price level are determined by the twin blades of the scissors of aggregate supply and demand. The second blade is aggregate demand, which refers to the total amount that different sectors in the economy willingly spend in a given period.

Aggregate demand (often written AD) is the sum of spending by consumers, businesses, and governments, and it depends on the level of prices, as well as on monetary policy, fiscal policy, and other factors.

The components of aggregate demand include the cars, food, and other consumption goods bought by consumers; the factories and equipment bought by businesses; the missiles and computers bought by government; and net exports.

The total purchases are affected by the prices at which the goods are offered, by exogenous forces like wars and weather, and by government policies.Using both blades of the scissors of aggregate supply and demand, we achieve the resulting equilibrium, as is shown in the right-hand circle of Figure 1.

National output and the price level settle at that level where demanders willingly buy what businesses willingly sell. The resulting output and price level determine employment, unemployment, and foreign trade.

Aggregate Supply and Demand Curves Aggregate supply and demand curves are often used to help analyze macroeconomic conditions. Supply and demand curves have been used to analyze the prices and quantities of individual products.

An analogous graphical apparatus can also help us understand how monetary policy or technological change acts through aggregate supply and demand to determine national output and the price level.

With the AS-AD apparatus, we can see how a monetary expansion leads to rising prices and higher output. We can also see why increases in efficiency may lead to higher output and to a lower overall price level.

The downward-sloping curve is the aggregate demand schedule, or AD curve. It represents what everyone in the economy — consumers, businesses, foreigners, and governments — would buy at different aggregate price levels (with other factors affecting aggregate demand held constant).

From the curve, we see that at an overall price level of 150, total spending would be $3, 000 billion (per year). If the price level rises to 200, total spending would fall to $2, 300 billion.

The upward-sloping curve is the aggregate supply schedule, or AS curve. This curve represents the quantity of goods and services that businesses are willing to produce and sell at each price level (with other determinants of aggregate supply held constant).

According to the curve, businesses will want to sell $3, 000 billion at a price level of 150; they will want to sell a higher quantity, $3, 300 billion, if prices rise to 200. As the level of total output demanded rises, businesses will want to sell more goods and services at a higher price level.

Macroeconomic Equilibrium. Let's put the AS and AD concepts to work to see how equilibrium values of price and quantity are determined. What this means in plain English is that we want to find the real GDP and the aggregate price level that would satisfy both buyers and sellers.

For the AS and AD curves shown in Figure 2, the overall economy is in equilibrium at point E. Only at that point, where the level of output is Q = 3, 000 and P = 150, are spenders and sellers satisfied. Only at point E are demanders willing to buy exactly the amount that businesses are willing to produce and sell.

How does the economy reach its equilibrium? Indeed, what do we mean by equilibrium? A macroeconomic equilibrium is not a combination of overall price and quantity at which buyers nor do sellers wish to change their purchases, sales, or prices. Figure 2 illustrates the concept.

If the price level were higher than equilibrium, say, at P = 200, businesses would want to sell more than purchasers would want to buy; businesses would desire to sell quantity C, while buyers would want to purchase only amount B.

Goods would pile up on the shelves as firms produced more than consumers bought. Eventually, firms would cut production and begin to shave their prices.

As the price level declined from its original too high level of 200, the gap between desired spending and desired sales would narrow until the equilibrium at P = 150 and Q = 3, 000 was reached. Once the equilibrium is reached, neither buyers nor sellers wish to change their quantities demanded or supplied, nor there no pressure on the price level to change.

The Growth Century. The final act in our macroeconomic drama concerns the growth of output and prices over the entire period since 1900. Output has grown by a factor of more than 16 since the turn of the century. How can we explain this long-term pattern?