In economics, aggregate demand is the total demand for final goods and services in the economy while aggregate supply is the total supply.
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
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:
- The Wealth Effect:Consumers are wealthier, which stimulates the demand for consumption goods
- The Interest Rate Effect: Interest rates fall, which stimulates the demand for investment goods
- The Real Exchange Rate Effect: The exchange rate depreciates which stimulates the demand for net exports
Why does the aggregate supply curve slope upwards?
There are three reasons
- 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.
- 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.
- The Misperception Theory
Four Steps for Analyzing Macroeconomic Fluctuations
- Decide whether the event shifts the aggregate demand curve or the aggregate supply curve (or perhaps both)
- Decide in which direction the curve shifts
- Use the diagram of aggregate demand and aggregate supply to see how the shift changes output and the price level in the short run
- 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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