The Aggregate Supply/Aggregate Demand Model
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Table of Contents
This section covers the following topics:
- Classical and Keynesian economics
- Aggregate demand
- Short and long-run aggregate supply
- Macroeconomic equilibrium
Section Summary
In terms of macroeconomic policy during a recession or depression, classical economists suggested letting the free market operate and removing any restrictions (such as regulation or labor unions) that prevented this from happening. Classical thinkers believed in Say’s Law, or that supply creates its own demand, and that the economy would always move back toward potential output.
Keynesian economists pointed out that sometimes the economy gets caught in a downward spiral. Production falls, workers lose their jobs and spend less, causing production to fall again, and so on. In short, the level of income that the economy was moving towards (equilibrium income) wasn’t always potential income. In these situations, the government was to increase spending, prop up demand and help the economy recover.
One way of understanding the macro economy is through the lens of the aggregate supply / aggregate demand model. This model has three different curves, the first of which is aggregate demand.
The aggregate demand curve shows the total market demand for final goods and services. It also relates real output (which is the same as real GDP) with the price level (an estimate for the value of a dollar: inflation is a rise in the price level). The aggregate demand curve is downward sloping because of the real wealth, interest rate and international trade effects, which increase real output when the price level falls. Each of these effects is amplified by the multiplier effect. The aggregate demand curve can shift due to any event that changes one of the components of GDP: consumption, investment, government spending and net exports.
The short-run aggregate supply curve shows the total amount of goods and services that firms are willing to sell, and also relates real output to the price level. The curve is upward sloping because... Sign up to continue reading The Aggregate Supply/Aggregate Demand Model >
