Aggregate Supply and Demand

This week, in Macroeconomics, we discussed Aggregate Supply and Demand(AS & AD). Like the regular demand curve, the aggregate demand curve is downward sloping because as P, the price level increases, Real Money Balances(Money Supply/Price Level), or purchasing power, decreases. The relationship between P(y-axis) and GDP(denoted by Y on the x-axis) is a nonlinear, indirect relationship, forming a downwardly sloping curve, rather than line.

Aggregate Demand(a little curved)

Shifts in aggregate demand result from fiscal policy and financial shocks. Fiscal Policy: If government spending increase and/or taxes decrease, the AD curve shifts outward(from AD1to AD2). Financial Shocks: Adverse financial shocks result in an inward shift of the AD curve(from AD2 to AD1).

Aggregate supply, on the other hand, is related to the production side of the economy. It is a function of labor, capital, and technology. AS can vary on a spectrum between two extremes, the first extreme being that of perfect or complete price and wage flexibility. In this scenario, more of a long run situation, the LRAS curve is a vertical line at the full employment level of GDP. The second extreme is the case of perfect price inflexibility, and the AS is represented on the graph by a horizontal line. In reality, however, the economy rests at some state in between the two extremes where some price flexibility(stocks, bonds, and various commodities for example) and some price stickiness exists.

Aggregate Supply Extreme case #1

Aggregate Supply Extreme case #2

In order to graph aggregate supply, we use the following equation: Y=Y(full employment level)+a(P-expected P). In the equation, a is simply a coefficient, an adjustment factor. The relationship in which we are interested is the one between Y and P, a direct and linear relationship according to the equation. However, the actual AS curve is just that-a curve. AS is not perfectly linear, but instead curves upward.

Shifts in aggregate supply are the result of either favorable supply side shocks or unfavorable supply side shocks. Favorable supply side shocks to aggregate supply, which result in an outward shift of the AS curve, include the following: 1) Good weather in agriculture producing areas, 2) New discoveries or supplies of basic commodities, 3) New technologies, and 4) Increases in labor productivity. On the other hand, unfavorable supply side shocks cause an inward shift of the aggregate supply curve and include the following: 1) Bad weather conditions in agriculture producing areas, 2) Energy shortages, and 3) Unexpected political events(such as war or drastic taxes).

Shifts in Aggregate Supply

 All together, the AS-AD model looks something like this: