Interpreting the aggregate demand/aggregate supply model |...

Interpreting the aggregate demand/aggregate supply model

Posted 2023-03-28 19:51:46

Key points

The aggregate demand/aggregate supply model is a model that shows what determines total supply or total demand for the economy and how total demand and total supply interact at the macroeconomic level.
Aggregate supply is the total quantity of output firms will produce and sell—in other words, the real GDP.
Aggregate demand is the amount of total spending on domestic goods and services in an economy.

Introduction

In order for a macroeconomic model to be useful, it needs to show what determines total supply or total demand for the economy and how total demand and total supply interact at the macroeconomic level.

We have a model like this! It's called the aggregate demand/aggregate supply model.

Equilibrium in the aggregate demand/aggregate supply model

Let's begin by looking at the point where aggregate supply equals aggregate demand—the equilibrium. We can find this point on the diagram below; it's where the aggregate supply, AS, and aggregate demand, AD, curves intersect, showing the equilibrium level of real GDP and the equilibrium price level in the economy.

At a relatively low price level for output, firms have little incentive to produce, although consumers would be willing to purchase a high quantity. As the price level for outputs rises, aggregate supply rises and aggregate demand falls until the equilibrium point is reached.

In this example, the equilibrium point occurs at point start text, E, end text, at a price level of 90 and an output level of 8,800.

Confusion sometimes arises between the macroeconomic aggregate supply and aggregate demand model and the microeconomic analysis of demand and supply in particular markets for goods, services, labor, and capital.

While they may have superficial resemblance, their underlying differences are much greater.

For example, the vertical and horizontal axes have distinctly different meanings in macroeconomic and microeconomic diagrams. The vertical axis of a microeconomic demand and supply diagram expresses a price—or wage or rate of return—for an individual good or service. This price is implicitly relative; it is intended to be compared with the prices of other products—for example, the price of pizza relative to the price of fried chicken.

In contrast, the vertical axis of an aggregate supply and aggregate demand diagram expresses the level of a price index like the Consumer Price Index or the GDP deflator—combining a wide array of prices from across the economy. The price level is absolute: it is not intended to be compared to any other prices since it is essentially the average price of all products in an economy.

The horizontal axis of a microeconomic supply and demand curve measures the quantity of a particular good or service. In contrast, the horizontal axis of the aggregate demand and aggregate supply diagram measures GDP, which is the sum of all the final goods and services produced in the economy, not the quantity in a specific market.

In addition, the economic reasons for the shapes of the curves in the macroeconomic model are different from the reasons for the shapes of the curves in microeconomic models.

Demand curves for individual goods or services slope down primarily because of the existence of substitute goods, not the wealth effects, interest rate, and foreign price effects associated with aggregate demand curves.

Individual supply and demand curves can have a variety of different slopes, depending on the extent to which quantity demanded and quantity supplied react to price in that specific market, but the slopes of AS and AD curves are much the same in every diagram—short-run and long-run perspectives emphasize different parts of the AS curve.

In short, just because an AD/AS diagram has two lines that cross, do not assume that it is the same as every other diagram where two lines cross. The intuitions and meanings of macro and micro diagrams are only distant cousins in the economics family tree.

Interpreting the AD/AS model

It's time to see what all this means on a practical level! The table below gives information on aggregate supply, aggregate demand, and the price level for the imaginary country of Xurbia.

What does this information tell you about the state of the Xurbia’s economy? Where is the equilibrium price level and output level—the short-run macroequilibrium? Is Xurbia risking inflationary pressures or facing high unemployment? How can you tell?

Price level: aggregate demand/aggregate supply
Price level	Aggregate demand	Aggregate supply
110	$700	$600
120	$690	$640
130	$680	$680
140	$670	$720
150	$660	$740
160	$650	$760
170	$640	$770

We need to build an AD/AS diagram to better understand this data! We'll start by plotting the AS and AD curves from the data provided.

Step 1. Draw your x axis and y axis. Label the x axis "Real GDP" and the y axis "Price level".

Step 2. Plot AD on your graph using the values for price level and aggregate demand on the chart.

Step 3. Plot AS on your graph using the values for price level and aggregate supply on the chart.

You should now have a diagram that looks like the one below!

Step 4. Find the equilibrium by determining where AD and AS intersect—in this case, our equilibrium is at a price level of 130 and real GDP of $680.

Step 5. Draw conclusions from the given information.

If equilibrium occurs in the flat range of AS, then economy is not close to potential GDP and will be experiencing unemployment but stable price level. If equilibrium occurs in the steep range of AS, then the economy is close to or at potential GDP and will be experiencing rising price levels or inflationary pressures, but will have a low unemployment rate.

In our example, we can see that the equilibrium is fairly far from where the AS curve becomes steep. This implies that the economy is not close to potential GDP. Thus, unemployment will be high, and changes in the price level are likely to be small.

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