Relationship of aggregate demand and supply

relationship of aggregate demand and supply

In the Keynesian framework, aggregate demand is the sum of consumption The aggregate supply curve shows the relationship between a nation overall price. The Aggregate Supply Curve The aggregate supply curve shows the relationship between a nation's overall price level, and the quantity of goods and services. Firms' demand for labor is negatively related to the wage rate. • Workers' The long-run aggregate supply curve (LAS) is the relationship between the quantity.

relationship of aggregate demand and supply

The aggregate supply curve 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 graph shows an upward sloping aggregate supply curve. The slope is gradual between 6, and 9, before become steeper, especially between 9, and 9, The aggregate supply curve. 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.

AD–AS model - Wikipedia

Wait, what's a GDP deflator again? The GDP deflator is a price index measuring the average prices of all goods and services included in the economy. Notice on the graph that as the price level rises, the aggregate supply—quantity of goods and services supplied—rises as well.

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Why do you think this is? The price level shown on the vertical axis represents prices for final goods or outputs bought in the economy, not the price level for intermediate goods and services that are inputs to production. The AS curve describes how suppliers will react to a higher price level for final outputs of goods and services while the prices of inputs like labor and energy remain 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.

Potential GDP 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.

relationship of aggregate demand and supply

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.

Aggregate demand and aggregate supply curves

In our example AS curve, the vertical line in the exhibit shows that potential GDP occurs at a total output of 9, An increase in real balances will lead to a larger increase in equilibrium income and spending, the smaller the interest responsiveness of money demand and the higher the interest responsiveness of investment demand.

An increase in real balances leads to a larger level of income and spending, the larger the value of multiplier and the smaller the income response of money demand.

The AD curve is flatter the smaller is the interest responsiveness of the demand for money and larger is the interest responsiveness of investment demand.

Also, the AD curve is flatter, the larger is the multiplier and the larger the income responsiveness of the demand for money. Effect of monetary expansion on the AD curve[ edit ] Aggregate demand curve shifts rightward in case of a monetary expansion An increase in the nominal money stock leads to a higher real money stock at each level of prices.

relationship of aggregate demand and supply

In the asset market, the decrease in interest rates induces the public to hold higher real balances. It stimulates the aggregate demand and thereby increases the equilibrium level of income and spending. Thus, as we can see from the diagram, the aggregate demand curve shifts rightward in case of a monetary expansion. Aggregate supply curve[ edit ] Main article: Aggregate supply The aggregate supply curve may reflect either labor market disequilibrium or labor market equilibrium.

relationship of aggregate demand and supply

In either case, it shows how much output is supplied by firms at various potential price levels. The aggregate supply curve AS curve describes for each given price level, the quantity of output the firms plan to supply. The Keynesian aggregate supply curve shows that the AS curve is significantly horizontal implying that the firm will supply whatever amount of goods is demanded at a particular price level during an economic depression.

The idea behind that is because there is unemployment, firms can readily obtain as much labour as they want at that current wage and production can increase without any additional costs e.

Firms' average costs of production therefore are assumed not to change as their output level changes. This provides a rationale for Keynesians' support for government intervention.

AD–AS model

The total output of an economy can decline without the price level declining; this fact, in conjunction with the Keynesian belief of wages being inflexible downwards, clarifies the need for government stimulus.

Since wages cannot readily adjust low enough for aggregate supply to shift outward and improve total output, the government must intervene to accomplish this result.

relationship of aggregate demand and supply

However, the Keynesian aggregate supply curve also contains a normally upward-sloping region where aggregate supply responds accordingly to changes in price level. The upward slope is due to the law of diminishing returns as firms increase output, which states that it will become marginally more expensive to accomplish the same level of improvement in productive capacity as firms grow.

It is also due to the scarcity of natural resources, the rarity of which causes increased production to also become more expensive. The vertical section of the Keynesian curve corresponds to the physical limit of the economy, where it is impossible to increase output.

The classical aggregate supply curve comprises a short-run aggregate supply curve and a vertical long-run aggregate supply curve. The short-run curve visualizes the total planned output of goods and services in the economy at a particular price level. The "short-run" is defined as the period during which only final good prices adjust and factor, or input, costs do not.

The "long-run" is the period after which factor prices are able to adjust accordingly. The short-run aggregate supply curve has an upward slope for the same reasons the Keynesian AS curve has one: The long-run aggregate supply curve is vertical because factor prices will have adjusted.