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Aggregate Supply and Aggregate Demand

Aggregate Supply and Aggregate Demand

Author: Kate Eskra

This lesson covers aggregate supply and aggregate demand.

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Source: Image of Aggregate Supply and Aggregate Demand Graph created by Kate Eskra, Image of Aggregate Demand created by Kate Eskra, Image of SRAS created by Kate Eskra, Image of LRAS created by Kate Eskra

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Hi, welcome to macroeconomics. This is Kate. This tutorial is on aggregate supply and aggregate demand. As always, my key terms are in red, and my examples are in green.

In this tutorial, we'll be talking about what aggregate supply and aggregate demand look like and what they are. I'll give you three reasons why aggregate demand slopes downward. And they are the wealth effect, interest rate effect, and exchange rate effect.

We'll talk about the difference between the short run aggregate supply and long run aggregate supply. And we'll finally look at the intersection of SRAS and AD. And you'll see that that represents our economy's equilibrium price level and level of real GDP, or output.

Here is what the graph looks like. Notice that in microeconomics on the x-axis we generally have quantity. Here we do have quantity again, but instead of the quantity of only one specific item, we're looking at the quantity of everything, or all output in our economy, which is GDP.

On the y-axis it also is price. But again, it's not the price of just something specific. It's the overall price level.

So this is the most common graph that we're going to be using in macroeconomics to show overall or macroeconomic activity. Let's start with aggregate demand, abbreviated AD. It's the total amount of goods and services demanded in the economy at a specific point in time and at a prevailing price level.

Here's what an aggregate demand curve looks like. If you notice here, I put that AD equals C plus I plus G plus X minus M. So this is if you watch the tutorial on GDP, GDP equals consumer purchases, investment outlays by businesses usually, government spending, and net exports. That's what is comprised of aggregate demand.

So would aggregate demand be really like the sum of all demand curves for everything in the economy? Kind of, but let's think about it this way. In microeconomics, why do demand curve slopes downward? They slope downward because as the price of something specifically falls, people buy more of it. We can't exactly use that same analysis when looking at aggregate demand.

But there are three reasons why aggregate demand slopes downwards, so let's go through them. The first one is the wealth effect. Notice here, as the price levels fall-- so as prices in our economy go down-- wouldn't you feel like you had more money?

You really wouldn't necessarily be wealthier, but people feel like they're wealthier as prices tend to fall. And because your money can go further, people will tend to buy more. So the part of aggregate demand that's increasing here is the C-component. So the consumer purchases will increase due to this wealth effect as prices fall. The wealth effect is defined as the perception that wealth is increased, resulting in an increase in consumption, or that C-component of aggregate demand.

The second reason why aggregate demand curves slope downard is because of the interest rate effect. As prices go down, again along this y-axis, this is going to increase the amount of money circulating in an economy. And that will tend to drive down interest rates.

Remember, interest rates are what we pay whenever we borrow money. So this probably isn't going to impact your purchasing of groceries or your purchasing of clothing. But people will start to buy more things as interest rates fall that require loans, like cars, houses, appliances, furniture, really what we consider durable goods. So again, this is impacting that C-component of aggregate demand, but just a different type of consumer purchases, these requiring loans.

Also, it's really going to impact business investment. They'll take advantage of lower rates and invest more in their companies. So here, due to the interest rate effect as the price level falls, we see the C and the I being impacted on anything that's interest sensitive. So the interest rate effect is defined as, as interest rates fall, consumption increases due to the decrease in the cost of borrowing. As a result, purchases and business investment-- so again C and I would both increase.

Finally, aggregate demand curves slope downward because of the exchange rate effect. So again, as price levels fall-- as prices come down-- our goods are going to become relatively cheaper to foreigners, because our exchange rate starts to fall. When that happens, foreigners will try to take advantage of it by buying more from us. So our exports are going to increase.

And at the same time as our exchange rate falls, our dollars won't go as far purchasing things from other countries. So we buy less from other countries and import less. If you think about it, if X is increasing and M is decreasing, our net exports are increasing. And that's the portion of aggregate demand here, the component that would be increasing as exchange rates fall, when the price levels come down.

The exchange rate effect here, just your definition. Exchange rate movements impact demand. Domestic currency depreciation-- that means as our price level comes down, our exchange change rate comes down-- increases the cost of imports. So that results in a potential decrease in imports, which is that M. The lower domestic exchange rate also increases foreign demand for our goods, increasing our exports.

So that's aggregate demand. Now let's look at aggregate supply. There's two aggregate supply curves. The one on the graph that I showed you is the SRAS, or short run aggregate supply curve. So let's start here.

This is the total amount of goods and services supplied in an economy in the short run. In the short run, our aggregate supply curve does slope upward. Again, aggregate supply is the total amount produced at various price levels. And it slopes upward in the short run, because businesses can actually produce more as the price levels rise. They won't necessarily have to pay their workers more immediately.

As prices go up, eventually workers are going to argue for higher wages. Because as prices go up, things got more expensive, and they'll want more money. But that doesn't happen immediately. That adjustment takes some time. So they can produce more because they won't have to pay their workers immediately more money.

They can also start drawing down their inventories. They can use up stuff that they have already on hand. And so in the short run, aggregate supply can slope upwards. As prices go up, they can choose to produce a little bit more for these reasons here. As price levels fall, they could produce a little bit less.

But the long run aggregate supply curve, abbreviated LRAS, is the total amount of goods and services supplied in an economy in the long run. And this is also known as the Solow growth curve. This is a vertical or straight up and down line.

The idea here is, sure, we can ramp up our production in the short run. But that can really only get us so far. In the long run, we really do have a limited amount of resources. We have a limited amount of materials and workers. So that straight up and down line represents our potential, currently, for how much we can produce.

For that potential or production capacity to change, something else would need to change. We would need to discover more stuff, or invent new kinds of technology. Something would have to change in order to shift that curve over and to the right, to change or production capabilities.

So if we combine the two curves here, what we do is we use the short run aggregate supply curve and the intersection of the aggregate demand curve, and that will give us equilibrium. Our Y star-- I know it's confusing because it's on the x-axis-- but Y star is what's used to talk about our equilibrium level of production, or real GDP. Another word sometimes used is output.

And P star is easy. It represents our current price level. What we'll be doing with this graph in the future is showing when anything changes-- like aggregate demand or aggregate supply-- what will then happen to our new equilibrium price level and real GDP.

So in this tutorial, we looked at aggregate supply and aggregate demand, graphed them. You saw what they look like, why they are shaped the way that they do. The three reasons aggregate demand slopes downward is because of the wealth, interest rate, and exchange rate effects.

We talked about the difference between short run and long run aggregate supply curves. And then finally, I showed you that the intersection of the SRAS and AD gives us our equilibrium price level and our equilibrium level of output, or real GDP.

Thanks so much for listening, have a great day.

Terms to Know
Aggregate Demand (AD)

Total amount of goods and services demanded in an economy at a specific point in time and at a prevailing price level.

Exchange Rate Effect

Exchange rate movements impact demand; domestic currency depreciation increases the cost of imports, resulting in a potential decrease in imports, M; the lower domestic exchange rate increases foreign demand for domestic goods, increasing exports, X.

Interest Rate Effect

As interest rates fall, consumption increases due to the decrease in the cost of borrowing; as a result, purchases and business investment (consumption, C, and investment, I, respectively) both increase.

Long Run Aggregate Supply (LRAS)

Total amount of goods and services supplied in an economy in the long run.

Short Run Aggregate Supply (SRAS)

Total amount of goods and services supplied in an economy in the short run.

Wealth Effect

Perception that wealth has increased, resulting in an increase in consumption, C.