6.1: Short-run aggregate demand and output

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Consider first just the private market sector. Assume there are households and businesses in this simple economy, but no government and no financial markets. The households and businesses buy domestically produced and imported goods and services. Businesses also sell some output in export markets to residents of other countries. This basic model offers a simple but useful example of how the actual economy works.

This initial short-run model is based on the following assumptions:

All prices and wages are fixed at a given level.
At these prices and wages, businesses produce the output that is demanded and labour accepts opportunities to work.
Money supply, interest rates and foreign exchange rates are fixed because at this stage we ignore the financial sector.

With constant prices aggregate demand determines total output, real GDP. Figure 6.1 uses an AD/AS diagram like those developed in Chapter 5 to illustrate these conditions and develop an aggregate expenditure function.

Figure 6.1 Aggregate demand, aggregate expenditure and output when the price level is constant

Aggregate demand determines total output, real GDP.

The horizontal AS curve in the upper part of Figure 6.1 shows that the price level is fixed at P₀. As a result, the equilibrium real GDP in this example is determined by the position of the AD curve. Changes in the position of the AD curve would cause changes in real output and real income, and corresponding changes in employment.

The position of the AD curve in the diagram is determined by things, other than price, that affect expenditure decisions. Understanding these expenditure decisions and their effects are the focus of this and the next several chapters.

The lower part of Figure 6.1 shows the relationship between planned aggregate expenditure (AE) and income as measured by real GDP(Y) when the price level is fixed. It also shows that, if the aggregate expenditure function (AE) has the right position and slope, there is a level of output at which planned expenditure and output are equal (). Then revenue the business sector receives from sales of current output just covers the costs of production including expected profit. Planned expenditure and planned output are in equilibrium.

Aggregate demand is determined by equality between aggregate expenditure (AE) and real GDP.

This equality between planned expenditure and output determines the position of the AD curve, as shown in the upper part of the diagram.

The interactions of expenditure, output, and income shown in the lower part of Figure 6.1 define a basic macroeconomic model.