Aggregate Demand and Aggregate Supply

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In economics, aggregate demand is the total demand for final goods and services in the economy while aggregate supply is the total supply.

Key Definitions

Aggregate demand curve

  • a curve that shows the quantity of goods and services that households, firms, and the government want to buy at each price level

Aggregate supply curve

  • A curve that shows the quantity of goods and services that firms choose to produce and sell at each price level

Graphing the Aggregate Demand and Supply

  • Looks the exact same as a normal supply and demand graph only it is the aggregate of all goods and services demand and produced at certain price levels
  • On the vertical axis is the overall level of prices
  • On the horizontal axis is the economy's total output of goods and services
  • Supply is upward sloping and demand is downward sloping
  • Equilibrium output and price is the point where the aggregate supply and aggregate demand curves intersect

Aggregate Demand

Why does the aggregate demand curve slopes downward? In other words, why does a fall in the price level increases the quantity of goods and services demanded?

There are three reasons:

  1. The Wealth Effect:Consumers are wealthier, which stimulates the demand for consumption goods
  2. The Interest Rate Effect: Interest rates fall, which stimulates the demand for investment goods
  3. The Real Exchange Rate Effect: The exchange rate depreciates which stimulates the demand for net exports

Aggregate Supply

Why does the aggregate supply curve slope upwards?

There are three reasons

  1. The Sticky Wage Theory--This theory is at the foundation of New Keynesian economics. The reason for sticky wage is that in labour market, nominal wage is entered into a contract of various lengths, thus firms cannot adjust nominal wages instantaneously.
  2. The Sticky Price Theory--This is a derivative from Sticky Wage Theory. As firms cannot adjust wages in the short run, their cost of production remains constant and thus price will remain constant in the short run.
  3. The Misperception Theory

Four Steps for Analyzing Macroeconomic Fluctuations

  1. Decide whether the event shifts the aggregate demand curve or the aggregate supply curve (or perhaps both)
  2. Decide in which direction the curve shifts
  3. Use the diagram of aggregate demand and aggregate supply to see how the shift changes output and the price level in the short run
  4. Use the diagram of aggregate demand and aggregate supply to analyze how the economy moves from its new short run equilibrium to its long run equilibrium.

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