# 24.5: The Aggregate Demand-Supply Model

## Macroeconomic Equilibrium

In economics, the macroeconomic equilibrium is a state where aggregate supply equals aggregate demand.

learning objectives

• Analyze aggregate demand and supply in the long run

### Economic Equilibrium

In economics, equilibrium is a state where economic forces (supply and demand) are balanced. Without any external influences, price and quantity will remain at the equilibrium value.

Equilibrium: Similar to microeconomic equilibrium, the macroeconomic equilibrium is the point at which the aggregate supply intersects the aggregate demand.

### Supply and Demand

Determining the supply and demand for a good or services provides a model of price determination in a market. In a competitive market, the unit price for a good will vary until it settles at a point where the quantity demanded equals the quantity supplied. The result is the economic equilibrium for that good or service.

There are four basic laws of supply and demand. The laws impact both supply and demand in the long-run.

1. If quantity demand increases and supply remains unchanged, a shortage occurs, leading to a higher price until the quantity demanded is pushed back to equilibrium.
2. If quantity demand decreases and supply remains unchanged, a surplus occurs, leading to a lower price until the quantity demanded is pushed back to equilibrium.
3. If quantity demand remains unchanged and supply increases, a surplus occurs, leading to a lower price until the quantity supplied is pushed back to equilibrium.
4. If quantity demand remains unchanged and supply decreases, a shortage occurs, leading to a higher price until the quantity supplied is pushed back to equilibrium.

### Aggregate Supply and Aggregate Demand

Aggregate supply is the total supply of goods and services that firms in a national economy plan on selling during a specific time period. It is the total amount of goods and services that firms are willing to sell at a specific price level in an economy.

Aggregate supply: This graph shows the three stages of aggregate supply. It is the total supply of goods and services that firms in a national economy plan to sell during a specific time period. Changes in aggregate supply cause shifts along the supply curve.

Aggregate demand is the total demand for final goods and services in an economy at a given time and price level. It is the demand for the gross domestic product (GDP) of a country.

### Aggregate Supply-Aggregate Demand Model

Equilibrium is the price-quantity pair where the quantity demanded is equal to the quantity supplied. It is represented on the AS-AD model where the demand and supply curves intersect. In the long-run, increases in aggregate demand cause the price of a good or service to increase. When the demand increases the aggregate demand curve shifts to the right. In the long-run, the aggregate supply is affected only by capital, labor, and technology. Examples of events that would increase aggregate supply include an increase in population, increased physical capital stock, and technological progress. The aggregate supply determines the extent to which the aggregate demand increases the output and prices of a good or service.

When the aggregate supply and aggregate demand shift, so does the point of equilibrium. The aggregate demand curve shifts and the equilibrium point moves horizontally along the aggregate supply curve until it reaches the new aggregate demand point.

## Reasons for and Consequences of Shift in Aggregate Demand

A short-run shift in aggregate demand can change the equilibrium price and output level.

learning objectives

• Explain the causes of economic fluctuations using aggregate demand curves

### Aggregate Demand

In economics, aggregate demand is the total demand for final goods and services at a given time and price level. It gives the amounts of goods and services that will be demanded at all possible price levels, which, unless there are shortages, is equivalent to GDP. Aggregate demand equals the sum of consumption (C), investment (I), government spending (G), and net export (X -M). This is often written as an equation, which is given by:

$\mathrm{AD = C + I + G + (X – M)}$

### Shifts in the Aggregate Supply-Aggregate Demand Model

The aggregate supply-aggregate demand model uses the theory of supply and demand in order to find a macroeconomic equilibrium. The shape of the aggregate supply curve helps to determine the extent to which increases in aggregate demand lead to increases in real output or increases in prices. An increase in any of the components of aggregate demand shifts the AD curve to the right. When the AD curve shifts to the right it increases the level of production and the average price level. When an economy gets close to potential output, the price will increase more than the output as the AD rises.

AS-AD Model: The Aggregate Supply-Aggregate Demand Model shows how equilibrium is determined by supply and demand. It shows how increases and decreases in output and prices impact the economy in the short-run and long-run. The model is also used to show real and potential output.

When price increase dominates an economy, this means that the economy is near its potential output.

### Reasons for Aggregate Demand Shift

The slope of the aggregate demand curve shows the extent to which the real balances change the equilibrium level of spending. The aggregate demand curve shifts to the right as a result of monetary expansion. In an economy, when the nominal money stock in increased, it leads to higher real money stock at each level of prices. The interest rates decrease which causes the public to hold higher real balances. This stimulates aggregate demand, which increases the equilibrium level of income and spending. Likewise, if the monetary supply decreases, the demand curve will shift to the left.

## Reasons for and Consequences of Shift in Aggregate Supply

In economics, the aggregate supply shifts and shows how much output is supplied by firms at different price levels.

learning objectives

• Explain shifts in aggregate supply and their impact on the economy

### Aggregate Supply

In economics, aggregate supply is defined as the total supply of goods and services that firms in a national economy produce during a specific period of time. It is the total amount of goods and services that firms are willing to sell at a specific price level in the economy.

### Shift in Aggregate Supply

The aggregate supply curve may shift labor market disequilibrium or labor market equilibrium. If labor or another input suddenly becomes cheaper, there would be a supply shock such that supply curve may shift outward, causing the equilibrium price in to drop and the equilibrium quantity to increase.

Supply Shift: A supply shock could be caused by changing regulations or a sudden change in the price of an input, among other reasons.

During the short-run, there is one fixed factor of production, usually capital. However, the fixed factor does not stop the curve’s ability to shift outward. When the curve shifts to the right, it causes an increase in the output and a decrease in the GDP at a given price. Examples of events that cause the curve to shift to the right in the short-run include a decrease in the wage rate, an increase in physical capital stock, and technological progress.

In the long-run only capital, labor, and technology affect the aggregate supply curve because at this point everything in the economy is assumed to be used optimally. The long run curve is often seen as static because it shift the slowest. The long-run aggregate supply curve is vertical which shows economist’s belief that changes in aggregate demand only have a temporary change on the economy’s total output. Examples of events that shift the long-run curve to the right include an increase in population, an increase in physical capital stock, and technological progress.

### Reasons for Shifts

The short-run aggregate supply curve is affected by production costs including taxes, subsidies, price of labor (wages), and the price of raw materials. All of these factors will cause the short-run curve to shift. When there are changes in the quality and quantity of labor and capital the changes affect both the short-run and long-run supply curves. The long-run aggregate supply curve is affected by events that change the potential output of the economy.

Changes in short-run aggregate supply cause the price level of the good or service to drop while the real GDP increases. In the long-run the prices stabilize and the price level of the good or service increase in response to the changes.

## Key Points

• Equilibrium is the price -quantity pair where the quantity demanded is equal to the quantity supplied.
• In the long-run, increases in aggregate demand cause the output and price of a good or service to increase.
• In the long-run, the aggregate supply is affected only by capital, labor, and technology.
• The aggregate supply determines the extent to which the aggregate demand increases the output and prices of a good or service.
• The aggregate supply curve determines the extent to which increases in aggregate demand lead to increases in real output or increases in prices.
• The equation used to calculate aggregate demand is: $$\mathrm{AD = C + I + G + (X – M)}$$.
• The aggregate demand curve shifts to the right as a result of monetary expansion.
• If the monetary supply decreases, the demand curve will shift to the left.
• The aggregate supply curve shows how much output is supplied by firms at different price levels.
• The short-run aggregate supply curve is affected by production costs including taxes, subsides, price of labor (wages), and the price of raw materials.
• The long-run aggregate supply curve is affected by events that change the potential output of the economy.

## Key Terms

• aggregate: A mass, assemblage, or sum of particulars; something consisting of elements but considered as a whole.
• supply: The amount of some product that producers are willing and able to sell at a given price, all other factors being held constant.
• demand: The desire to purchase goods and services.
• aggregate demand: The the total demand for final goods and services in the economy at a given time and price level.
• Supply curve: A graph that illustrates the relationship between the price of a good and the quantity supplied.
• output: Production; quantity produced, created, or completed.
• supply shock: An event that suddenly changes the price of a commodity or service. It may be caused by a sudden increase or decrease in the supply of a particular good.