Aggregate demand and supply are two fundamental concepts in macroeconomics that help us understand how the economy works. The concepts of supply and demand can be applied to the economy as a whole.
Aggregate supply is the total quantity of output firms will produce and sell, in other words, the real GDP. The upward-sloping aggregate supply curve, also known as the short run aggregate supply curve, shows the positive relationship between price level and real GDP in the short run. The aggregate supply curve slopes up because when the price level for outputs increases while the price level of inputs remains fixed, the opportunity for additional profits encourages more production. Potential GDP, or full-employment GDP, is the maximum quantity that an economy can produce given full employment of its existing levels of labor, physical capital, technology, and institutions .
Aggregate demand is the amount of total spending on domestic goods and services in an economy. The downward-sloping aggregate demand curve shows the relationship between the price level for outputs and the quantity of total spending in the economy. The aggregate demand curve slopes down because of the wealth effect, the interest rate effect, and the exchange rate effect. The wealth effect states that when the price level falls, the real value of household wealth rises, which increases consumer spending. The interest rate effect states that when the price level falls, interest rates fall, which increases investment spending. The exchange rate effect states that when the price level falls, the real exchange rate falls, which increases net exports .
The intersection of the aggregate demand and aggregate supply curves determines the equilibrium price level and the equilibrium level of real GDP. The equilibrium price level is the price level at which the quantity of aggregate demand equals the quantity of aggregate supply. The equilibrium level of real GDP is the level of real GDP at which the quantity of aggregate demand equals the quantity of aggregate supply. If the price level is above the equilibrium price level, there is a surplus of goods and services, which leads to a decrease in the price level. If the price level is below the equilibrium price level, there is a shortage of goods and services, which leads to an increase in the price level .
In the long run, the aggregate supply curve is vertical at the potential GDP level. In the long run, changes in the price level do not affect the quantity of aggregate supply, only the price level. In the long run, the economy will always return to the potential GDP level, regardless of the price level. In the short run, the aggregate supply curve is upward sloping, which means that changes in the price level affect the quantity of aggregate supply. In the short run, the economy may not be at the potential GDP level, and changes in the price level can affect the level of real GDP .
In summary, aggregate demand and supply are two fundamental concepts in macroeconomics that help us understand how the economy works. The aggregate supply curve shows the positive relationship between price level and real GDP in the short run, while the aggregate demand curve shows the negative relationship between the price level for outputs and the quantity of total spending in the economy. The intersection of the aggregate demand and aggregate supply curves determines the equilibrium price level and the equilibrium level of real GDP. In the long run, the aggregate supply curve is vertical at the potential GDP level, while in the short run, the aggregate supply curve is upward sloping, which means that changes in the price level affect the quantity of aggregate supply .