Aggregate Demand Curve and Aggregate Supply Curve - Term Paper Example

 Inflation, recession, unemployment and economic growth have always been matters of concern for economists as well as for economies. The aggregate demand and aggregate supply models enable us to analyze changes in real GDP and price levels. While aggregate demand curve shows the relationship between price level and real GDP, the aggregate supply curve helps us understand the relationship between real domestic output and price level. The relation between price level and real GDP and price level and real output can be influenced by a number of determinants like exchange rate and taxes etc. Introduction Macroeconomics is related with the performance, structure and behavior of the economy as a whole and it is concerned with analyzing the underlying factors of the main aggregate trends in the economy with respect to the total output of goods and services, inflation, unemployment and international transactions (Snowdon and Vane, p. 1). Macroeconomics not only concern what determines production, consumption, unemployment and income, but also concerned with understanding why and how these variables change over time. The performance of the overall economy is a significant concern for everyone in the economy because it influences the income, prices and job prospects as well as more substantial concern for the government and policy makers to understand how the macro-economy works. Inflation, unemployment and economic growth are the very basic indicators of macroeconomics that in turn influence the political and social systems in a country because these indicators are widely considered in political events and election campaigns. As an economy performs well, the macroeconomic management can be said to be successful as it will experience low unemployment and inflation. When macro-economy performs poorly in a country, the country experiences more unemployment and as a result poor standard of living as well. In order to understand how different variables affect the economy as a whole, aggregate demand and aggregate supply model are used. In microeconomics, demand and supply are well understood and widely accepted frameworks to look at particular industries, but the aggregate demand and aggregate supply models are not as perfect as in microeconomics (Guell, p. 107). This piece of research work presents detailed analysis of aggregate demand curve and aggregate supply curve and examines significant factors that influence both the aggregate demand and aggregate supply. Aggregate Demand Curve Aggregate demand or aggregate demand curve shows the amounts of real output that consumers collectively desire to buy at each possible price levels. There would be negative or inverse relationship between the price level and the amount of real GDP demanded. When price level increases, the quantity of real GDP demanded will decrease (McConnell and Brue, p. 193). Aggregate demand curve is a downward sloping curve showing the relationship between price level and the quantity of domestically produced goods and services that all customers, including households, firms, governments and foreigners are willing to buy (Gwartney, Stroup, Sobel, p. 193). When the price of an individual commodity decreases, the consumer wants to buy more and as it then is relatively less expensive for him. This is the reasons why demand curve for a single commodity is downward sloping or reason for its inverse effect. But, this is not the reason for the downward sloping of the ‘aggregate demand curve’. The downward slope of the aggregate demand curve is normally explained based on three factors that are real-balance effect, interest rate effect and foreign purchase effect. A change in the price level can produce real-balance effect. When prices increase, the real value of purchasing power of the public’s total or accumulated saving and balance will reduce. When price level decreases, the quantity of goods and service demanded will increase. The interest rate effect states that a lower price level will reduce the demand for money and decrease the real interest rate that in turn stimulates additional purchasing power. It is because, when the average price of goods and services become lower, consumers and businesses will need less money to meet their day to day requirements. The foreign purchase effect states that a lower price level make domestically produced goods less expensive relative to foreign goods provided that other things remain the same (McConnel and Brue, 194- 195). A change in the price level can make changes in the amount of aggregate spending and therefore a change in the amount of real GDP. The aggregate demand curve will shift when other determinants change. Other things include changes in consumer spending, consumer wealth and expectation, changes in investment spending, changes in the government spending and changes in the net export spending etc. Aggregate Supply Curve Aggregate supply curve shows the level of real domestic output that firms produce at each price level. The aggregate supply curve shows the relationship between the price level in a country and quantity of goods supplied by its producers. Aggregate supply curve is upward sloping in the short run but downward sloping in the long run (Gwartney, Stroup, Sobel, p. 195). McConnel and Brue emphasized that the production responses of producers to the changes in the price level differ in the long run, in which nominal wages match with the changes in the price level. (p. 197). The short run is a time in which some prices, especially in labor market are set by contracts and agreements. Households and businesses are unable to adjust these prices when there unexpected changes occur. But in the long run, people are able to modify their attitude and behavior in response to changes in the price levels. It is thus highly important to differentiate both short and long run aggregate supply curves. The short run aggregate supply curve represent various quantities of goods and services that domestic firms supply in response to changing demand condition that make changes in the price level as well (Gwartney, Stroup, Sobel, p. 195). The upward-sloping aggregate supply curve for short run indicates relationship between price level and total amounts of goods and services the firm offer for sale. McConnel and Brue emphasized that the aggregate supply curve is relatively flat below the full employment because unemployed and unused resources allow producers to respond to price level increases in real output (p. 199). The Long run aggregate supply curve is a vertical curve at the full employment output of the economy. It is because in the long run wages and other input prices increase and decrease to match changes in the price level. The price level change is assumed that it will not affect firm’s profits. The aggregate supply curve depends on price level, the level of technology in an economy, the size of the labor force and skills, the amount and state of capital equipment, degree of entrepreneurship and managerial skills to combine resources (Gillespie, p. 300). An increase in price level leads to a movement along the aggregate supply curve and similarly a change in other factors, as mentioned above, will shift the aggregate supply curve. Conclusion This piece of research paper has outlined the relevance of macroeconomics as it is of prime concern for people as well as for government because the performance of the economy influences price, income and job prospects. This paper has analyzed aggregate demand curve and aggregate supply curve and considered both price and other factors that influence the movement or shift along the curve. In my opinion, the major determinants of aggregate demand curve are, as mentioned above, changes in consumer spending, investment spending, government spending, and exchange rates. This also includes household indebtedness, taxes, interest rates and technology etc. similarly, domestic resource prices, prices of imported resources, change in productivity and government regulations are the major determinants of aggregate supply curve. This research work suggests that further studies must be conducted in order to analyze and explore the underlying marketing and economic principles regarding how exchange rates can influence both aggregate demand and supply curve. This work also suggests that further studies to be conducted to analyze when and how the economy is operating below its full employment and how its unused machinery and equipment may influence the long run aggregate supply curve. References Gillespie A, Foundations of Economics, Illustrated edition, Oxford University Press, 2007, p. 300- 301 Guell R.C, Issues in Economics Today, Fourth Edition, The McGraw Hill Companies, 2008, p. 107- 110 Gwartney, Stroup, Sobel, Macroeconomics: Public and Private Choice, Twelfth illustrated edition, Cengage Learning, 2008, p. 193- 194 McConnell and Brue, Economics, Sixteenth Edition, The McGraw Hill Companies, 2004, p. 193 – 200 Snowdon B and Vane H.R, Modern macroeconomics: its origins, development and current state, Illustrated edition, Edward Elgar Publishing, 25, p. 1- 5 Read More