Aggregate demand is the economy-wide demand for goods and services by all economic agents and aggregate supply is the total goods and services produced. The macroeconomic model of aggregate demand and aggregate supply determines the relationship between aggregate price level and aggregate output in the short run as well as the long run through the interaction of all the markets (Mankiw, 2008).
The aggregate demand curve, that is the relationship between AD and aggregate price level, is drawn for a given supply of money. It slopes downward since higher the price level, lower is the real money balances, on account of the Quantity Theory of Money, and so lower is the demand for goods and services. The aggregate supply curve is the relationship between total goods and services produced in the economy and the price level. The long run AS supply curve is vertical while, in the Keynesian macroeconomic model, the short run AS curve is horizontal since prices are assumed to be sticky in the short run. In the long run, changes in aggregate demand affect prices but in the short run, changes in aggregate demand affects output only.
Keynes proposed that low aggregate demand is responsible for low income and high unemployment that characterize economic downturns. This is in contrast to the classical view that aggregate supply, depending on the supply of labor capital and technology, determines national income. To reconcile these two views, it is considered that in the long run, prices are flexible so that aggregate supply determines the national income while in the short run, prices are sticky so that aggregate demand determines national income (Mankiw, 2008).
The IS-LM model of aggregate demand represents the interaction of the goods and money markets. The IS curve is a downward sloping relationship between rate of interest and output that is derived from the equilibrium in the goods market. Here, planned expenditure, given by the total of consumption, investment and government expenditure in the closed economy and in addition, net exports in the open economy, is equal to the actual expenditure, given by the total output. Consumption depends on the disposable income after paying taxes, investment on interest rates, through the loanable funds market, and exogenously given government expenditure and net exports. In the money market, the LM curve denotes the relationship between rate of interest and output such that real money supply is equal to the real money demand. Even though money supply and prices are exogenous in the short run, real money demand depends positively on output (through the quantity theory of money) and rate of interest (through the theory of liquidity preference). The intersection of the IS and LM curve gives the equilibrium rate of interest and output. Thus, the interaction of the money market, the goods market and the loanable funds market determines equilibrium output and rate of interest. This may or may not be equal to the full employment output which is achieved in the long run when prices are flexible (Mankiw, 2008).
Role of Government Policies
If the economy is producing less than full employment output at equilibrium, the government can increase output by either fiscal policy or monetary policy. Fiscal policies to