Aggregate demand and aggregate supply are two mainly important components to any economy.
Aggregate demand refers to the total amount of goods and services that will be purchased by all the sectors, consumers, firms, and the government, at all possible price levels. Since this is the total amount spent on the national output it can be considered as the national expenditure. The components of national expenditure can be shown in the form of an equation. (E= C + I +G + (X-M). What is spent by all the quarters of the economy is the income earned by contributing to the national output and hence the aggregate demand becomes equal to the national income because the process is a circular flow.
Aggregate demand is determined by several factors as mentioned below.
- General Price level.
Aggregate demand or the amount spent on national output changes with the chance of the price level. Purchasing power or the real value of the income varies with the fluctuation of the prices of goods and services. If the price level in the economy is high, the real value of money deteriorates and fewer number goods and services are demanded. A fall in the price level increases the aggregate demand. As a result, the aggregate demand curve slopes downward from left to right.
- Wealth effect
When the price level changes the value of the assets in the form of money or any other assets changes. An increase in price level reduces the purchasing power of the assets and the fall in the price level increases the same. As a result, the aggregate demand fluctuates accordingly.
- The foreign policy
An increase in price level reduces the demand for goods exported because the goods will be expensive to the foreign buyers and it will affect the aggregate demand. The inflationary situation encourages imports from countries where there is no inflation.
- Availability and the cost of credit.
Most of the consumer durables are purchased on a credit basis. If the credit facilities available and the cost or the rate of interest is less, more money is available for consumption and investment. It will increase the aggregate demand. The higher rate of interest and unavailability of credit facilities curtails the aggregate demand.
- Other factors
Changes in population and age structure, changes in government tax policy, range of goods and services available in the market, etc. will influence the aggregate demand of a country.
The aggregate demand curve slopes downwards from left to right showing an inverse relationship between the General Price level and the income as below.
The increase in price level prom ´to “P1” has reduced the aggregate demand from “Q” to “Q1” and when the price falls from “P’ to “P2”, the aggregate demand has gone up from “Q” to “Q2”. The downward demand curve explains this negative relationship between the price level and the aggregate demand or the national expenditure.
Aggregate supply can be defined as the total amount of goods and services that the firms are willing to sell at a given price in an economy over a given period of time. This refers to the national output produced by all the firms over a given period of time.
Economists observe differences in the behavior of aggregate supply in the short run and the long run. Short-Run is the period of time that is not sufficient to change the fixed factors. Therefore, in the short run, it is assumed that the prices of all the factors of production are fixed. Changing the variable factors, there is a possibility of increasing the output up to a certain limit. Increasing output involves a higher unit cost, the firms increase supply by a higher percentage than the increase in the price level. Hence, the aggregate supply curve is price elastic and slopes upwards from left to right.
As per the view of the classical or the supply-side economists, in the long run, all the factors of production are in full employment. Hence, the aggregate supply curve is vertical and the supply is completely inelastic. Short-Run Aggregate Supply is a dependent variable influenced by the following factors.
- General Price level of the economy – this is the most important factor that influences the aggregate supply.
- Changes in the wage rates
- Changes in the cost on other factors
- Changes in corporate taxes
- Unfavorable weather conditions
- Natural disasters
- Decrease in productivity
Changes in the price level do not shift the AS curve and the relevant point moves along the supply curve accordingly. But the changes in any other factors other than the price level make the AS curve shift either to right or left accordingly.
In the short run the economy reaches the equilibrium output when the aggregate demand becomes equal aggregate supply at a particular price level’ it is considered as the equilibrium price and the quantity is the equilibrium output. The economic equilibrium changes due to the changes in any of the factors influencing either aggregate demand, aggregate supply, or both by shifting aggregate demand or aggregate supply curves.
As per the above diagram, aggregate demand becomes equal at the price level “P”.