Aggregate Demand :
In macroeconomics, aggregate demand (AD) or domestic final demand (DFD) is the total demand for final goods and services in an economy at a given time. It specifies the amounts of goods and services that will be purchased at all possible price levels. This is the demand for the gross domestic product of a country. It is often called effective demand, though at other times this term is distinguished.
The aggregate demand curve is plotted with real output on the horizontal axis and the price level on the vertical axis.
The aggregate demand curve illustrates the relationship between two factors - the quantity of output that is demanded and the aggregate price level. Aggregate demand is expressed contingent upon a fixed level of the nominal money supply. There are many factors that can shift the AD curve. Rightward shifts result from increases in the money supply, in government expenditure, or in autonomous components of investment or consumption spending, or from decreases in taxes.
According to the aggregate demand-aggregate supply model, when aggregate demand increases, there is movement up along the aggregate supply curve, giving a higher level of prices.
An aggregate demand curve is the sum of individual demand curves for different sectors of the economy. The aggregate demand is usually described as a linear sum of four separable demand sources:]
• is consumption (may also be known as consumer spending
• is government spending,
• is net export, where
• is total exports, and
• total imports
Aggregate Supply :
DEFINITION of 'Aggregate Supply'
The total supply of goods and services produced within an economy at a given overall price level in a given time period. It is represented by the aggregate-supply curve, which describes the relationship between price levels and the quantity of output that firms are willing to provide. Normally, there is a positive relationship between aggregate supply and the price level. Rising prices are usually signals for businesses to expand production to meet a higher level of aggregate demand.
Also known as "total output".
There are two main reasons why the amount of aggregate output supplied might rise as Prises, i.e., why the AS curve is upward sloping:
• The short run AS curve is drawn given some nominal variables such as the nominal wage rate, which is assumed fixed in the short run. Thus, a higher price level P implies a lower real wage rate and thus an incentive to produce more output. In the neoclassical long run, on the other hand, the nominal wage rate varies with economic conditions. (High unemployment leads to falling nominal wages which restore full employment.) Hence in the long run the aggregate supply curve is vertical.
• An alternative model starts with the notion that any economy involves a large number of heterogeneous types of inputs, including both fixed capital equipment and labor. Both main types of inputs can be unemployed. The upward-sloping AS curve arises because (1) some nominal input prices are fixed in the short run and (2) as output rises, more and more production processes encounter bottlenecks. At low levels of demand, there are large numbers of production processes that do not use their fixed capital equipment fully. Thus, production can be increased without much in the way of diminishing returns and the average price level need not rise much (if at all) to justify increased production. The AS curve is flat. On the other hand, when demand is high, few production processes have unemployed fixed inputs. Thus, bottlenecks are general. Any increase in demand and production induces increases in prices. Thus, the AS curve is steep or vertical.
Aggregate supply is targeted by government "supply side policies" which are meant to increase productive efficiency and hence national output. Some examples of supply side policies include: education and training, research and development, supporting small/medium entrepreneurs, decreasing business taxes, making labor market reforms to diminish frictions that may hold down output, and investing in infrastructure.
Why AS is vertical ?
As a model, Long Run Aggregate Supply is made up of consumer goods, capital goods and public goods. Essentially it represents the real GDP of a country. Intuitively, a country's GDP level is too large to be significantly affected by price changes.
As a result the LRAS is vertical (inelastic) as the country will continue to produce regardless of prices. Perhaps for the sake of other more important factors such as employment and overall health of its economy.
Factors that will shift the inelastic long run aggregate supply should also have largescale effects inorder to affect the overall GDP of a country. For example an increase in population will mean more workforce in the economy, technological advancement will mean the country can produce more faster and efficiently and a war could destroy some capital assets.
What Is Full Employment GDP?
Full employment GDP is a term used to describe an economy that is operating at an ideal level of employment, where economic output is at its highest potential. It is a state of balance in which savings is equal to investment and the economy is neither expanding too rapidly nor falling into a recession. This level of economic output, as measured by real GDP, is neither too high to cause rising inflation nor too low to bring about falling prices.
In economics, equilibrium is that perfect state of balance, like two friends on a teeter-totter that weigh exactly the same. Absent any external force or change in weight, two friends that weigh the same will sit on a teeter-totter and it will rest completely horizontal. But, as soon as the weight of one side changes, the other side reacts. The two economic forces that must be in equilibrium to achieve full employment GDP are unemployment and inflation.
When unemployment goes down, inflation tends to go up, and when unemployment goes up, inflation tends to fall. All economies have a state of balance like this that we call the full employment level of gross domestic product, or full employment GDP for short.
Illustrating Full Employment GDP
Here is how economists illustrate full employment GDP. The red upward-sloping curve is called the short-run aggregate supply curve, or SRAS for short. This curve represents the economy's total supply of goods and services. The blue downward-sloping curve is the aggregate demand curve, or AD for short. This curve represents the economy's total demand for goods and services. Finally, the black vertical line is called the long-run aggregate supply curve, or LRAS for short. It represents the economy's long-run potential output of goods and services.
When all three of these lines intersect, there is both a short-term and a long-term equilibrium. In other words, the teeter-totter is horizontal - everything is in perfect balance and everyone lives happily ever after.
Full Employment GDP and Economic Growth
However, life is not always like that. The ups and downs of the economy - the expansions and contractions - in real GDP that we continue to experience over time will bring it above or below full employment.
For example, during a recession, additional unemployment is generated, which we call cyclical unemployment, or unemployment that is directly caused by an economic slowdown. As firms and employees adjust their expectations to the ups and the downs, cyclical unemployment dissipates and the economy generally moves back towards its potential output, or full employment.
In the long run, economic output, as measured by GDP, returns to the full employment level, which classical economists refer to as potential output. Potential output is the highest level of real GDP that an economy can sustain over time.
DEFINITION of 'Below Full Employment Equilibrium'
A macroeconomic term used to describe a situation where an economy's short-run real gross domestic product (GDP) is currently lower than that same economy's long-run potential real GDP. Under this scenario, there is a recessionary gap between the two levels of GDP (measured by the difference between potential GDP and current GDP) that would have been produced had the economy been in long-run equilibrium.
The interaction of aggregate demand and aggregate supply determines macroeconomic equilibrium, and understanding macroeconomic equilibrium provides insight into changes in real GDP and the price level. In considering determination of real GDP and the price level, however, we must distinguish between the short run and the long run.
Short-run macroeconomic equilibrium occurs (geometrically) at the intersection of the short-run aggregate supply curve (SAS) and the aggregate demand curve (AD). This intersection indicates the price level at which the aggregate quantity of final goods and services supplied in the economy is equal to the aggregate quantity demanded, and indicates as well the coresponding level of real GDP.
To see that this point of intersection is an equilibrium point, consider first a situation where the price level is below that corresponding to the short-run equilibrium. At this price level, the quantity of real GDP that will be supplied by firms will be less than the quantity of real GDP that will be demanded by households, business firms, government, and net foreign demand. With firms unable to meet demand, inventories decline and back orders become the rule. In order to meet the strong demand, firms will begin to increase production; and in so doing will incur additional resource costs that will result in price increases (i.e., there will be a movement up along the SAS curve). As prices increase, this will lead to a moderating of demand (movement up along the AD curve). These movements will continue until quantity supplied equals quantity demanded -- at the point of intersection of the SAS and AD curves.
Similarly, if the price level is greater than the equilibrium level, the quantity of real GDP supplied will exceed the quantity demanded. In this case, inventories will accumulate, goods and services will go unsold, and eventually firms will lay off workers, cut production, and reduce prices in order to sell theor output. This translates into a movement down along the SAS curve, and as prices fall there will be a corresponding movement down along the AD curve. These movements will continue until equilibrium is reached.
Long-run macroeconomic equilibrium requires that real GDP be equal to potential GDP, and corresponds to a situation of full employment. That is, long-run macroeconomic equilibrium entails the economy being on its vertical long-run supply curve. This contrasts with the short-run equilibrium situation, in which real GDP may be less than or greater than (or equal to) potential GDP. Let's take a look at the different possible short-run situations vis-à-vis long-run equilibrium.
Consider first the case where there is a short-run equlibrium at a real GDP below the level of potential GDP. This is called a below full-employment equilibrium, and the difference between potential GDP and real GDP is called a recessionary gap. Note that this situation may correspond to a recession, but this will not necessarily be the case: if potential GDP has grown faster than real GDP recently, a recessionary gap may exist even with continued (slow) real GDP growth. In any case, the most obvious manifestation of a recessionary gap is the presence of high unemployment.
Short-run equilibrium at a real GDP in excess of potential GDP is called an above full-employment equilibrium. The excess of real GDP over potential GDP is called an inflationary gap. That is, this gap creates inflationary pressure. Unemployment in this situation would be below the full-employment level of unemployment.
The third possibility is with a short-run equilibrium at a real GDP just equal to potential GDP. This is a full-employment equilibrium, and is the only case where we have long-run equilibrium as well as short-run equilibrium.
Which of these three possibilities corresponds to the situation in which the U.S. economy presently may be found? Parkin notes that we experienced an inflationary gap in 1988-90, recessionary gaps in the early 80s and again in the early 90s, and he suggests that the economy was at full employment in mid-1994. What about now?
Fluctuations in real GDP around its long-term upward trend (reflecting increases in potential GDP) may stem from either fluctuations in aggregate demand or in aggregate supply. First consider the consequences of an increase in aggregate demand, as might occur in response to increases in expected future incomes, profits, or inflation; in response to a lower exchange rate or higher foreign incomes; in response to fiscal policy increasing government spending or transfer payments, or decreasing taxes; or in response to expansionary monetary policy (increasing the money supply) or lowering of interest rates.
Increased aggregate demand will result in a new short-run macroeconomic equilibrium, with a higher price level and a higher level of real GDP.
However, workers will now be receiving a lower real wage (since, by assumption, movements up along the SAS curve entail increases in output prices while wages and other factor prices remain constant), and profits of firms will have increased. In these circumstances, workers will seek wage increases and firms, eager to maintain employment and output levels, will grant such increases (without wage increases, firms risk losing workers).
But increased wages will shift the short-run aggregate supply curve to the left. This shift will cause a movement up along the aggregate demand curve, raising the price level and reducing the level of real GDP.
Note that we're looking at secondary effects of the increase in AD, and it will take time for the secondary effects to develop.
Similarly, changes in SAS can result in fluctuations in real GDP around potential GDP. For example, as we've just seen, a leftward shift of the SAS curve (as would occur with an increase in factor prices) will bring about a new short-run macroeconomic equlibrium, with higher prices and lower real GDP than prior to the shift. As Parkin notes, this combination of higher prices and reduced output -- stagflation -- was encountered following the increases in oil prices in the 1970s.
Note that in the real world, there are continual changes in various factors that influence either aggregate supply or aggregate demand. Hence, there are corresponding fluctuations in macroeconomic equilibrium -- the equilibrium price level and level of real GDP.