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In an economy, money flows between economic agents - households, firms and the government - through various markets - the market for goods and services, markets for factors of production and the financial markets. Households receive income and use it to pay taxes to the government, consume goods and services, and to save through the financial markets.
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. ...
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