In this unit, we explore the forces affecting growth, inflation, and unemployment at the aggregate level, such as output, income, or the components within GDP. Aggregate demand is the total amount of goods and services people want to purchase. It measures what people want to buy rather than what is produced. The aggregate demand is the sum of consumption, investment, government expenses, and net exports. Aggregate supply is an economy's total output at a given price level. We consider aggregate supply in the short run and the long run.
Completing this unit should take you approximately 3 hours.
Aggregate demand is the total demand for all finished goods and services produced domestically in an economy. If consumer consumption rises because many people are employed and spending more, aggregate demand for goods and services will increase. Additionally, if investment increases due to a decrease in interest rates, production and output will increase. Therefore, aggregate demand will rise.
Read this text, which compares Say's Law and Keynes' Law. Jean-Baptiste Say (1767–1832), the French economist, argued that supply creates its demand, but John Maynard Keynes (1883–1946), the English economist, countered that demand creates its supply. Today's economists believe neither side tells the whole story – demand and supply work together. They claim Say's Law works better in the long run, while Keynes' Law is more appropriate for the short run.
Aggregate supply (AS) is the total quantity of output firms produce and sell (in other words, real GDP). The aggregate supply (AS) curve shows the total quantity of output firms produce and sell at each price level. Aggregate demand (AD) is the total spending on domestic goods and services in an economy. The aggregate demand (AD) curve shows the total spending on domestic goods and services at each price level.
Read this text on how the aggregate supply curve relates to real and potential GDP and how price levels influence the aggregate demand curve. What is the point of equilibrium? Can you differentiate the short-run aggregate supply and the long-run aggregate supply?
This text discusses and graphically depicts how productivity growth and input prices change the aggregate supply curve. What is stagflation? What are examples of some other supply shocks?
Read this text on how imports, business and consumer confidence, and government policies can influence aggregate demand. Why do economists differ on the effect of tax cuts on the economy?
Watch these videos to understand the aggregate demand curve and the
factors that shift it. Later we will put aggregate demand and supply
together on the same graph to analyze the resulting equilibrium and its
implications on the economy's health.
Read this text, which uses the aggregate demand/aggregate supply models to show periods of economic growth and recession. How do unemployment and inflation impact these models?
Read this text illustrating the neoclassical, intermediate, and Keynesian zones in the aggregate demand/supply models. We will study these models in more detail in Unit 6.
Short-run aggregate supply is upward-sloping and represents the total production of goods and services available in an economy at different price levels while some resources are fixed. The long-run aggregate supply is an economy's production level when all available resources are used efficiently. It equals the highest level of production an economy can sustain. Changes in prices of factors of production shift the short-run aggregate supply curve. Changes in capital stock, the stock of natural resources, and technology levels can also cause the short-run aggregate supply curve to shift. The long-run aggregate supply curve is perfectly inelastic and vertical because firms can adapt to price-level changes better in the long run than in the short run.
Watch these videos for definitions of short- and long-run aggregate supply. Pay attention to what distinguishes the short run from the long run. What causes price and wage stickiness in the short run, and what are the implications for the shape of the supply curves?
For example, the short-run aggregate supply curve slopes upward due to the lag between product and resource prices, making it profitable for firms to increase output when the price level rises. The long-run aggregate supply curve is vertical when a country is at full employment. The long-run aggregate supply curve is vertical because, in the long run, resource prices adjust to changes at the price level, which leaves no incentive for firms to change their output. In the long run, prices and wages do not affect the aggregate supply curve.
In macroeconomics, the short run is the period when wages and some other prices are sticky. The long run is the period when full wage and price flexibility, and market adjustment, are achieved – when the economy is at the natural level of employment and potential output. In this section, we explore aggregate economic equilibrium in the short and long run. At a macro level, equilibrium is where aggregate supply equals aggregate demand. We examine shifts in aggregate supply and demand and the short-term and long-term effects on the economy.
Review this text, which graphically displays recessionary and
inflationary gaps and relates them to the labor market. The text also
discusses policy choices that address economic issues resulting from
these gaps.
This video explores the labor market effects and role in creating short-run recessionary or inflationary gaps and re-establishing the economy's long-term equilibrium. We can define cyclical unemployment as unemployment due to recessionary events in an economy. A general economic downturn means less spending, which means more layoffs and an increased group of cyclically unemployed people.
Cyclical unemployment is the only type of unemployment of the three we discussed in Unit 2 (frictional, structural, and cyclical) that is avoidable and can be minimized – it is completely due to recessionary gaps.
Watch these videos on how inflation occurs in the economy. They discuss the specific cases of cost-push inflation and demand-pull inflation. Note which of the two curves – aggregate demand or aggregate supply – causes the inflation problem in each case. The second video discusses a specific case from our history – the demand-pull inflation in the United States during the Lyndon Johnson administration (1963–1969).
Watch these videos, which examine different schools of economic thought about the shape of the aggregate supply curve. Is there a way to reconcile these beliefs with a unifying theory? John Meynard Keynes insisted on the need for government intervention when the economy was struggling from high unemployment during the Great Depression. The presentations offer perspectives on the challenges of explaining and addressing economic problems. We explore these theories in more detail in Unit 6.
Take this assessment to see how well you understood this unit.