41 Aggregate Supply and Demand
Building the Model: Aggregate Supply
The aggregate supply is the relationship between the quantity of real GDP supplied and the price level when all other influences on production plans (the money wage rate, the prices of other resources, and potential GDP) remain constant. The AS curve, as shown in Figure 6.1, is upward-sloping. This slope reflects that a higher price level, combined with a fixed money wage rate, lowers the real wage rate, thereby increasing the quantity of labor employed and, hence, increasing real GDP. The potential GDP line is vertical because it is moving along at both the price level rate and money wage rate, and money prices of other resources change by the same percentage. (20)
Why does the AS Curve Slope Upward?
When the price level rises and the money wage rate is constant, the real wage rate falls and employment increases. The quantity of real GDP supplied increases. When the price level falls and the money wage rate is constant, the real wage rate rises and employment decreases. The quantity of real GDP supplied decreases. When the price level changes and the money wage rate and other resource prices remain constant, real GDP departs from potential GDP and there is a movement along the AS curve. (20)
What Shifts the Aggregate Supply?
Aggregate supply changes when any influence on production plans, other than the price level, changes. In particular, aggregate supply changes when:
- Potential GDP changes
- The money wage rate changes
- The money prices of other resources change
When potential GDP increases, aggregate supply increases and the AS curve shifts rightward. The potential GDP line also shifts rightward. Short-run aggregate supply changes and the AS curve shifts when there is a change in the money wage rate or other resource prices. A rise in the money wage rate or other resource prices decreases short-run aggregate supply and shifts the AS curve leftward. In this case, the potential GDP line does not shift. (20)
Building the Model: Aggregate Demand
The quantity of real GDP demanded is the sum of consumption expenditure ( C ), investment ( I ), government expenditures ( G ), and net exports ( X âˆ’ M ), or:
Y = C + I + G + (X — M)
X = Exports and M = Imports
The relationship between the quantity of real GDP demanded and the price level is called aggregate demand . Other things remaining the same, the higher the price level, the smaller is the quantity of real GDP demanded. In Figure 6.2, the AD curve is downward sloping. Moving along the aggregate demand curve, the only thing that changes is the price level. (20)
Why does the AD Curve Slope Downward?
There are three reasons for the negative relationship between the price level and the quantity of real GDP demanded:
- The buying power of money : When the price level rises, the buying of money decreases and so people decrease consumption expenditure.
- The real interest rate : When the price level rises, the demand for money increases, which raises the nominal interest rate. Because the inflation rate does not immediately change, the real interest rate also rises so that people decrease their consumption expenditure and firms decrease their investment.
- The real price of exports and imports : When the price level rises, domestic goods become more expensive relative to foreign goods, so people decrease the quantity of domestic goods demanded. (20)
What Shifts the Aggregate Demand?
Any factor that influences expenditure plans, other than the price level, changes aggregate demand and shifts the aggregate demand curve. Factors that change aggregate demand are:
- Expectations : Expectations of higher future income, expectations of higher future inflation, and expectations of higher future profits increase aggregate demand and shift the AD curve rightward.
- Fiscal policy and monetary policy : The government influences the economy by setting and changing taxes, making transfer payments, and purchasing goods and services, which is called fiscal policy. Tax cuts, increased transfer payments, or increased government purchases increase aggregate demand. Monetary policy consists of changes in interest rates and in the quantity of money in the economy. An increase in the quantity of money and lower interest rates increase aggregate demand.
- The world economy : Exchange rates and foreign income affect net exports ( X âˆ’ M ) and, therefore, aggregate demand. A decrease in the exchange rate or an increase in foreign income increases aggregate demand. (20)