ASAD - Aggregate Supply and Aggregate Demand Overview

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Aggregate Supply and Aggregate Demand

Introduction

This section introduces the aggregate supply and aggregate demand model to explain the determination of equilibrium national output and the general price level, as well as to analyze and evaluate the effects of public policy. It is important to discuss the aggregate demand and aggregate supply concepts individually to provide students a firm understanding of the mechanics of the aggregate demand and aggregate supply model.

Module Lessons Preview

In this module, we will study the following topics:

Aggregate Demand: In macroeconomics, aggregate demand (AD) or domestic final demand (DFD) is the total demand for final goods and services in an economy at a given time. It specifies the amounts of goods and services that will be purchased at all possible price levels. This is the demand for the gross domestic product of a country.

Spending Multipliers: The multiplier effect refers to the idea that an initial spending rise can lead to even greater increase in national income. In other words, an initial change in aggregate demand can cause a further change in aggregate output for the economy.

Aggregate Supply: In economics, aggregate supply (AS) or domestic final supply (DFS) is the total supply of goods and services that firms in a national economy plan on selling during a specific time period. It is the total amount of goods and services that firms are willing and able to sell at a given price level in an economy.

Short-Run Equilibrium & Changes in AS/AD: In the short run, the equilibrium price level and the equilibrium level of total output are determined by the intersection of the aggregate demand and the short-run aggregate supply curves. In the short run, output can be either below or above potential output.

Aggregate Supply in the Long Run: The Long-Run Aggregate Supply (LAS) represents the relationship between the price level and output in the long-run. It differs from the Short-Run Aggregate Supply (SAS) in that no input prices are assumed to be constant. Thus, LAS is a representation of potential output.

LRAS and the PPC: Economic growth is the process through which an economy’s production possibilities curve shifts outward. We measure it as the rate at which the economy’s potential level of output increases.

 

Key Terms

Aggregate - total

Aggregate Demand (AD) - Curve that shows the amount of real output (Real GDP) that buyers collectively desire to purchase at each possible price level - Demand for all goods combined (aggregate)

Aggregate Supply (AS) - Level of real domestic output producers will produce at a given price level

Short Run (SRAS) VS Long Run Aggregate Supply (LRAS) - SRAS is when input prices (usually nominal wage) do not match price level changes. LRAS is when input prices (usually nominal wages) do match price level changes

Recessionary Gap - When SRAS and AD are not in equilibrium. SRAS/ AD equilibrium is the left of LRAS. Economy is operating below full capacity and unemployment is above NRU.

Inflationary Gap - When SRAS and AD are not in equilibrium. SRAS/ AD equilibrium is the right of LRAS. Economy is operating above full capacity and unemployment is less than NRU.

Average Propensity to Consume (APC) - (consumption)/ (income). The percentage of total income consumed

Average Propensity to Save (APS) - (saving)/ (income). The percentage of total income saved. APC + APS = 1

Marginal Propensity to Consume (MPC) - Tells us how much more you will consume if you earn an additional dollar. (Change in consumption) / (change in income). Falls as an individual becomes more wealthy.

Marginal Propensity to Save (MPS) - Tells us how much you will save if you earn an additional dollar. (change in saving) / (change in income). Rises as an individual becomes more wealthy.

Spending Multiplier - Consumption increases as income increases. In other words, one person’s consumption becomes another’s income (there is a multiplier effect). Tells us how any change spending (government, investment, exports, consumption) can ultimately change AD and GDP. 1/ (1 – MPC)

Taxing Multiplier - -MPC/ (1-MPC)

Sticky Wages and Prices - When workers’ earnings don’t adjust quickly to changes in labor market conditions. Can slow the economy’s recovery from a recession. When demand for a good drops, its price typically falls too.

Stagflation - when you experience high inflation and high unemployment at the same time.

Productivity - the rate of output per unit of input.

Potential GDP - the level of output that an economy can produce at a constant inflation rate. Although an economy can temporarily produce more than its potential level of output, that comes at the cost of rising inflation.

Supply Shock - an event that directly alters the firms’ costs, and as a result, the prices they charge. Shifts the economy’s aggregate supply curve and as a result, the Phillips curve.

Phillips Curve - illustrates the short-run relationship between inflation and unemployment.

Short Run VS Long Run Phillips Curve - inflation and unemployment are unrelated in the long-run. As a result, the long-run Phillips curve is vertical at the natural rate of unemployment.

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