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Aggregate Demand and Aggregate Supply

What Is Aggregate Supply?

❶Learning Outcomes By the end of this lesson you should be able to: Wednesday, March 24, Published at

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This is depicted in the AD framework as a downward sloping AD curve. Why does it make sense for the AD curve to slope downward and to the right? We will suggest three different rationales for the downward sloped curve: We make the assumption that at any given point in time, there is a fixed amount of money in circulation.

At higher price levels, the money in circulation can purchase fewer items. A total of items could be purchased under these conditions. At higher prices, the money in circulation will spread over fewer goods. When prices fall, the purchasing power of the money in circulation goes up, and people can buy more goods and services. This relationship between prices and the amount of goods and services that can be purchased with a given money supply is called the real balances effect.

It justifies our depiction of the AD curve as a downward sloping curve. The interest rate effect explains impact that the price level has on interest rates, and thus on certain components of AD. When the price level goes up, people need more money to transact their daily purchases. Therefore, higher prices lead to an increase in the demand for money.

With a fixed amount of money in circulation, increasing the demand for money will cause the interest rate to go up. Think of how you would behave if you were running a bank and the demand for money increased. You would try to encourage additional people to deposit money into the bank, and at the same time discourage people from coming into the bank to demand money. The way to do both simultaneously would be to increase the interest rate.

As interest rates go up, investment demand and certain interest-rate sensitive consumption purchases will fall. Thus, increases in the price lead to increases the interest rate, which reduces the demand for both Consumption and Investment, and thus real output. The interest rate effect is therefore an additional justification for the downward sloping AD curve. Domestic prices also have an impact on Net Exports NX through what is called the foreign purchases effect. Since NX are part of AD, this contributes to an inverse relationship between the price level and the demand for our real domestic output.

The opposite is also true. The foreign purchases effect contributes to our argument for why the AD is downward sloping. Anything that changes the price level triggers these three effects and is represented by movement along a given AD curve. There are other factors that influence aggregate demand besides the price level, and these factors are referred to as determinants of AD.

When these other factors change, they cause a shift in the entire AD curve and are sometimes called aggregate demand shifters. The graph below illustrates what a change in a determinant of aggregate demand will do to the position of the aggregate demand curve. As we consider each of the determinants remember that those factors that cause an increase in AD will shift the curve outward and to the right and those factors that cause a decrease in AD will shift the curve inward and to the left.

There are several factors that could increase or decrease consumption that are unrelated to changes in the price level. For instance, increases in consumer wealth would increase consumption at each price level and would be illustrated by a rightward shift in AD.

Decreases in consumer wealth would have the opposite effect. Increases in consumer indebtedness would decrease consumption and shift the aggregate demand curve to the left, while decreases in indebtedness would have the opposite effect. Increases in taxes will decrease consumption and shift the AD curve to the left while decreases in taxes will increase consumption and shift the AD curve to the right. Consumer expectations about the future of the economy can have a strong impact on consumptions.

Optimism about the economy will increase consumption and shift the AD curve to the right, while widespread pessimism dampens consumer spending and shifts the AD curve to the left. You can probably think of other factors that will shift the AD curve because they impact consumption independent of the price level.

There are several factors unrelated to changes in the price level that could increase or decrease Investment and thereby shift the AD curve. For instance, any change in the interest rate not brought about by a change in the price level would change the level of investment in the economy, and shift the AD curve.

Increases in the interest rate will reduce investment demand; decreases in the interest rate will increase investment demand. Business taxes can be structured to either encourage investment shifting the AD to the right or discourage investment shifting AD to the left. Technological improvements in an industry might make old equipment obsolete and stimulate investment, shifting AD to the right. Finally, like the impact of expectations on consumers, optimism or pessimism on the part of business owners can lead to increases or decreases in investment activity and shift the AD curve to the right or left.

The political process will sometimes lead to increases or decreases in the level of government spending. Increases in government spending will shift the AD curve to the right; decreases in government spending will shift the AD curve to the left. There are two important factors unrelated to the price level that could increase or decrease the level of Net Exports and thereby shift the AD Curve.

The first has to do with changes in national income abroad. As income abroad grows relative to income in the United States, foreigners are able to buy US products more easily and Americans can afford fewer foreign goods.

Net exports will go up, shifting the AD curve to the right. If incomes abroad fall relative to income in the US, the AD curve will shift left due to a decrease in net exports. The second factor has to do with exchange rates, or the relative value of our currency to the currency of a trading partner.

If the value of the yen relative to the dollar changes so that it takes Yen to buy one US dollar, this will decrease the amount that Japanese citizens will buy in the US, and increase the amount that US citizens can buy in Japan. This change in the exchange rate will cause net exports to fall and the AD curve to shift to the left. If the Japanese Yen were to appreciate relative to the dollar, net exports would rise and the AD curve would shift to the right.

Return to the course in I-Learn and complete the activity that corresponds with this material. Although this might not be entirely true, the point they are often trying to make is that supply and demand play an integral role in many business decisions and experiences you have.

Understanding supply and demand in economics is important for building your knowledge in more advanced economic and business concepts. To make sure you build a good base of knowledge, we must first learn about aggregate supply and the fundamental building blocks that it is composed of.

Aggregate supply AS is defined as the total amount of goods and services produced and supplied by an economy's firms over a specific time period at given price levels. It is usually represented by a supply curve, which describes the relationship between price levels and the quantity of output that firms are willing to provide. It includes the supply of the following types of goods:. Although price can certainly have an effect on supply, there are other things that can also cause changes in the overall aggregate supply of goods and services.

Let's explore those now. Changes in labor force: Anything that causes the amount of workers to increase in an economy will cause aggregate supply to increase or shift to the right. If the labor force decreases, the overall supply of goods and services will decrease also. More workers, all else constant, equals more goods and services supplied. Changes in input prices: If the cost of energy, wages, raw materials or other key input prices to manufacture and produce goods and services increases, aggregate supply will decrease, all else constant.

If these prices fall, aggregate supply will increase. For example, if the cost of specific raw materials, such as steel or petroleum, decreases because of more competition and companies offering the key resource, aggregate supply will increase. The companies will be able to make more of the product because of lower costs. Likewise, if the wages a company has to pay workers increases due to labor union negotiations or state minimum wage mandates, aggregate supply will decrease.

Companies simply won't be able to work their employees as much due to higher costs. This determinant is worth mentioning by itself because of the magnitude and impact it can have on production improvements, innovations, and efficiency in the workplace.

Improvements in technology cause aggregate supply to increase. For example, if a manufacturing site is able to automate many processes with robots, computers, or machines and can now produce a product 24 hours a day at lower prices, aggregate supply will increase.

Get FREE access for 5 days, just create an account. Capital stock, in the simplest terms, is the money available in an economy for businesses to invest and purchase necessary items to produce goods or resell later at a profit. As capital increases in an economy, aggregate supply can increase. For example, with more capital, businesses can buy machines, hire more people, and make enhancements to their businesses to increase production.

A decrease in capital will result in a decrease in aggregate supply. Anything that makes resources or firms more productive will increase aggregate supply. If the work force in an economy has access to better training and education, they will have more productive workers and aggregate supply will increase.

If firms try to reduce costs and use old equipment or don't spend money to properly train their workers, aggregate supply will decrease because of lower productivity. Increases in government regulations usually makes it more expensive to produce goods and services, which decreases aggregate supply.

For example, if manufacturing companies have longer approval processes to open a plant or increased environmental paperwork that causes them to spend additional time and money on legal and compliance work, they will produce fewer goods and services. If government regulations are decreased, this will cause an increase in aggregate supply. Business taxes and subsidies: Any sort of additional tax that a business has to pay will increase the overall cost of production and decrease aggregate supply.

On the other hand, if the government offers subsidies to manufacturers or farmers to produce or grow certain products, this will lower the overall cost of producing a good and increase aggregate supply. In summary, aggregate supply AS is defined as the total amount of goods and services produced and supplied by an economy's firms over a specific time period at given price levels.

Aggregate supply includes consumer, capital, public, and traded goods and is usually represented in economics by a supply curve on a graph. Many things can change the amount of goods and service supplied in an economy. A few of the determinants are size of the labor force, input prices, technology, productivity, government regulations, business taxes and subsidies, and capital.

As wages, energy, and raw material prices increase, aggregate supply decreases, all else constant. Enhancements in technology, increases in government subsidies, and better productivity through training or education can cause increases in aggregate supply, all else constant. To unlock this lesson you must be a Study. Did you know… We have over college courses that prepare you to earn credit by exam that is accepted by over 1, colleges and universities.

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By creating an account, you agree to Study. Explore over 4, video courses. Find a degree that fits your goals. Aggregate Supply in the Economy: Definition and Determinants Learn about one of the fundamental components of economics.

Find out what aggregate supply is and seven of the most common areas that influence it in today's economy. Start Your Free Trial Today. An error occurred trying to load this video. Try refreshing the page, or contact customer support. You must create an account to continue watching. Register for a free trial Are you a student or a teacher? I am a student I am a teacher. Intramarket Sector Spreads Calls and Puts American Options and Moneyness Long and Short Call and Put Positions Covered Calls and Protective Puts.

The Aggregate Supply Curve The aggregate supply curve shows the relationship between a nation's overall price level, and the quantity of goods and services produces by that nation's suppliers. The curve is upward sloping in the short run and vertical, or close to vertical, in the long run. Net investment, technology changes that yield productivity improvements, and positive institutional changes can increase both short-run and long-run aggregate supply.

Institutional changes, such as the provision of public goods at low cost, increase economic efficiency and cause aggregate supply curves to shift to the right. Supply Shocks - Supply shocks are sudden surprise events that increase or decrease output on a temporary basis. Examples include unusually bad or good weather or the impact from surprise military actions.

Unless the price changes reflect differences in long-term supply, the LAS is not affected. Changes in Expectations for Inflation - If suppliers expect goods to sell at much higher prices in the future, their willingness to sell in the current time period will be reduced and the SAS will shift to the left. The Aggregate Demand Curve The aggregate demand curve shows, at various price levels, the quantity of goods and services produced domestically that consumers, businesses, governments and foreigners net exports are willing to purchase during the period of concern.

The curve slopes downward to the right, indicating that as price levels decrease increase , more less goods and services are demanded. Factors that can shift an aggregate demand curve include: Real Interest Rate Changes - Such changes will impact capital goods decisions made by individual consumers and by businesses.

Lower real interest rates will lower the costs of major products such as cars, large appliances and houses; they will increase business capital project spending because long-term costs of investment projects are reduced. The aggregate demand curve will shift down and to the right. Higher real interest rates will make capital goods relatively more expensive and cause the aggregate demand curve to shift up and to the left. Changes in Expectations - If businesses and households are more optimistic about the future of the economy, they are more likely to buy large items and make new investments; this will increase aggregate demand.

The Wealth Effect - If real household wealth increases decreases , then aggregate demand will increase decrease Changes in Income of Foreigners - If the income of foreigners increases decreases , then aggregate demand for domestically-produced goods and services should increase decrease.

The net result will be an increase decrease in aggregate demand. Inflation Expectation Changes - If consumers expect inflation to go up in the future, they will tend to buy now causing aggregate demand to increase.


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The demand curve only shows the relationship between the price and quantity. If one of the other determinants changes, the entire demand curve shifts.

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Determinants of Aggregate Supply Changes in labor force: Anything that causes the amount of workers to increase in an economy will cause aggregate supply to increase or shift to the right. If the labor force decreases, the overall supply of goods and services will decrease also. Section Determinants of Aggregate Supply The graph below illustrates what a change in a determinant of aggregate supply will do to the position of the aggregate supply curve. As we consider each of the determinants remember that those factors that cause an increase in AS will shift the curve outward and to the right and those factors that cause a decrease in AS will shift the curve upward and .

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Learn aggregate supply determinants with free interactive flashcards. Choose from different sets of aggregate supply determinants flashcards on Quizlet. Aggregate Demand is an economic measurement of the total demand for final goods and services in an economy at a specific time period. It is congruent with the laws defining the Gross Domestic Product (GDP) of a country in the long run after price.