The Aggregate Demand and Supply model provides a framework for our study of the operation of the economy.
Aggregate Demand is the negative relationship between planned aggregate expenditure on final goods and services and the price level, assuming all other conditions in the economy are constant.
Aggregate Supply is the positive relationship between outputs of goods and services and the price level, assuming factor prices, capital stock, and technology are constant.
Short-Run Equilibrium Real GDP and Price are determined by short-run Aggregate Demand and Aggregate Supply, illustrated by the intersection of the AD and AS curves.
Potential Output is the output the economy can produce on an ongoing basis with given labour, capital, and technology without putting persistent upward pressure on prices or inflation rates.
The Natural Unemployment Rate is the ‘full employment’ unemployment rate observed when the economy is in equilibrium at potential output.
Growth in potential output comes from growth in the labour force and growth in labour productivity coming from improvements in technology as a result of investment in fixed and human capital.
Business Cycles are the short-run fluctuations in real GDP and employment relative to Potential Output (GDP) and full employment caused by short-run changes in Aggregate Demand and Supply.
Output Gaps are the differences between actual real GDP and potential GDP that occur during business cycles.
Unemployment rates fluctuate with output gaps.
Inflationary Gaps and Recessionary Gaps are the terms used to describe positive and negative output gaps based on the effects the gaps have on factor prices.
Actual output adjusts to Potential Output over time if factor input and final output prices are flexible and changes in prices shift the Aggregate Supply curve to equilibrium with Aggregate Demand at YP.
Fiscal and monetary policy are tools governments and monetary authorities can use to stabilize real output and employment or speed up the economy’s adjustment to output gaps.