Section 15: Aggregate Demand and Supply

Aggregate Demand

We briefly introduced the topic of aggregate demand last section, but in this section we will spend more time examining the economy as a whole. We will first focus on the demand for all goods and services in the economy then the supply of all goods and services. Examining the economy as a whole will help us to better understand the impact of the business cycle, economic growth, and inflation. After we have a grasp on the economy, we will move our discussion to why a government may decide to intervene in the economy.

Aggregate Demand

Aggregate demand depicts the various quantities of a nation’s output that buyers want to purchase at each possible price level. Recall from last section that a nation’s output is its real GDP. Aggregate demand is a measure for the amount of goods and services produced by a nation that are demand by consumers. These consumers include households, businesses, and governments, both domestic and abroad that are willing and able to purchase the output. The price level is a measure of the prices of all goods and services in the economy. We will talk about its relationship to the inflation rate later in this section.

Relationship between price level and quantity demand Just as it is for the quantity demand and price of a single good or service, aggregate quantity demanded and price level are inversely related. When the price level falls the quantity of real GDP demanded will rise and when the price level rises the quantity of real GDP demanded will fall. We will see this both as a schedule (chart) and as a downward sloping curve on a graph.

Supplemental Resources:

Video Resource: https://youtu.be/oLhohwfwf_U

Check Your Understanding- Quiz:

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Changes in Aggregate Demand

When there is a change in the price level the quantity of goods and services in the economy will change, there will be movement from one point on an aggregate demand curve or schedule to another. However, similar to the determinants of demand for an individual good or service, aggregate demand also has determinants that cause the curve to reposition, or shift. These determinants will not cause movement from one point to another, but rather an entirely new demand schedule will be created based on whether there was an increase or a decrease in aggregate demand.

As mentioned in the last lecture aggregate demand is the real GDP of an economy. Real GDP is a measure of spending (we use the expenditure model to add all the goods and services consumed during the time period examined). We will use our equation for GDP to examine the determinants of demand.

GDP = C + I + G + Xn

Supplemental Resources:

Video Resource: https://youtu.be/scN-1B6plos

Check Your Understanding- Quiz:

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Aggregate Supply

Now that we have examined aggregate demand, we will move to the supply side. Again, we will be focusing on aggregate supply, the supply of all goods and services in the economy. Aggregate supply shows the relationship between production in the economy and its relation to the price level. Aggregate supply is slightly different than aggregate demand as the time horizon will influence the slope or quantity of output that is produced. Keep in mind that the time horizon is variable and different industries will have various levels of price stickiness that will influence the amount of time between each time horizon. We will examine aggregate supply over three different time horizons.

• The immediate short-run: input and output prices are fixed.
• The short-run: input prices are fixed, but output prices are flexible.
• The long-run: input and output prices are flexible.

We have already discussed the fact that prices are sticky. In the immediate short-run, think today…tomorrow… output prices are fixed. It takes time for businesses to adjust their prices. Grocery and retail stores must relabel prices on shelves, clothing items, etc. Restaurants will need to print new menus. All of this takes a bit of time to adjust. Resource prices are also fixed. Wages, raw materials, etc. all take time to negotiate. There are likely contracts that need to expire before they can be renegotiated.

As we move from the immediate short-run to the short-run the output prices become flexible. Businesses are able to adjust their prices more quickly by printing and retagging the goods and services they sell. However, resource prices remain fixed until we finally move to the long run.

The stickiness of prices influences the relationship between price level and aggregate supply. We will talk about all three curves and discuss which is most important in our economic analysis of the economy.

Supplemental Resources:

Video Resource: https://youtu.be/3nbalsyibKU

Video Resource: https://youtu.be/8W0iZk8Yxhs

Check Your Understanding - Quiz:

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Changes in Aggregate Supply

Now that we have examined the aggregate supply curve, lets discuss the determinants of aggregate supply. As with aggregate demand, there is a distinction between a change in the price level and a determinant of aggregate supply. When there is a change in the price level we will move from one point on an aggregate supply curve or schedule to another. A change in one of the determinants of aggregate supply will lead to an increase or decrease, either a shift to the left or right depending on the situation.

A final note before we begin our discussion, we will be examining the upward sloping, short-run aggregate supply curve. Recall that when referring to aggregate supply, we will be discussing short-run aggregate supply. Any other time horizon will be specified.

Supplemental Resources:

Video Resource: https://youtu.be/8oQxzHgceBA

Check Your Understanding - Quiz:

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Equilibrium

As with the demand and supply for an individual good or service, we can bring the aggregate demand and aggregate supply curves together to determine the equilibrium price level and level of real GDP. The equilibrium will occur at the point which the quantity demanded is equal to the quantity supplied, or the intersection of the aggregate demand and aggregate supply curves. The equilibrium level of output in the long-run occurs at the intersection of aggregate demand and short-run aggregate supply. At this level of output the economy is at the full employment level of output and the economy has the conditions for economic growth. In the short-run a recession may cause output to fall below the full employment level or a period of expansion may push the economy beyond the full employment level, but in the long run the economy will adjust and move back to the full employment level.

Changes in the Equilibrium

Increase in Aggregate Demand An increase in aggregate demand will shift in aggregate demand to the right. As a result, the price level will increase and output will expand. The economy will move to an increased level of output, but the price level will also increase. This situation is known as demand pull inflation. Recall that it is difficult expand output beyond the full employment rate of output, but in this situation the increasing price level causes firms profits to increase in the short-run. This will cause firms to expand production in any way possible to increase profits during this period.

Decrease in Aggregate Demand A decrease in aggregate demand will shift the aggregate demand curve to the left. This will cause a reduction in both the level of output and the price level. This situation is typically associated with a negative demand shock that pushes the economy into the recessionary phase of the business cycle.

Increase in Aggregate Supply The next scenario is an increase in aggregate supply, or a shift to the right in the supply curve. The increase in aggregate supply will result in a lower price level and increased level of output. If the increase in aggregate supply is the result of a temporary shock to the economy it is likely that the price level will not fully adjust due to sticky prices. The level of output will eventually return to the full employment level.

Decrease in Aggregate Supply A very worrisome situation for the economy is one where aggregate supply decreases. This situation is known as cost push inflation and was discussed in the previous section. When cost push inflation occurs the economy is not only experiencing inflation, but also high unemployment.

Supplemental Resources:

Video Resource: https://youtu.be/NgPqyM3I_8o

Check Your Understanding:

https://prezi.com/view/m6TtC6O3illQqY2PZdae/

Closed Captioning: https://web.microsoftstream.com/video/e8c7294d-becb-4dd8-af5d-76d676438b98

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