Aggregate Supply and Demand Curves

We can deepen our understanding of macroeconomic equilibrium with the help of a familiar set of tools: supply and demand curves. Recall that in Chapter 4 we introduced the notion of market supply and demand curves and used that apparatus to analyze the prices and quantities of individual products. We applied this tool to the wheat market, the oil market, and the real estate market.

This graphical apparatus can also help us understand major macroeconomic issues of output determination, inflation, and stagflation. Using aggregate supply and demand, we can see how monetary expansion leads to rising prices and higher output. We can also see why increases in efficiency may lead to higher output and to a lower overall price level. Moreover, this analysis will show why a tax cut might lead to an expansion of output and employment in the short run, while higher spending may end up only raising prices and leaving output unaffected in the long run.

Figure 5-7 shows the aggregate supply and demand schedules for the output of an entire economy. On the horizontal, or quantity, axis is the total output (real GNP) of the economy. On the vertical axis is the Overall price level (say, as measured by the CPI).

The downward-sloping black curve is the aggregate demand schedule, or AD curve. It represents what all the entities in the economy-consumers, businesses, foreigners, and governments-would buy at different aggregate price levels.

The upward-sloping red curve in Figure 5-7 is the aggregate supply schedule, or AS curve. This curve represents the relationship between the prices businesses will charge and the volume of output they produce and sell. Thus as the level of total output demanded rises, businesses as a whole will charge higher prices: along the AS curve, overall P rises as real output Q rises.

Combining AS and AD, we can also find the equilibrium values of price and quantity; that is, we find the real GNP and the associated price level that would satisfy both buyers and sellers. Given the forces determining AS and AD in Figure 5-7, the overall economy is in equilibrium at point E . Only at that point, where the level of output is Q = 3000 and P = 150, are spenders and sellers content. Only at point E is the overall price level such that buyers are willing to buy exactly what sellers are willing to produce and sell.

Slopes of AS and AD Curves Why do the curves have the pictured slopes in Figure 5-7? Start with the AD curve. It slopes downward, indicating that the volume of spending increases as the overall price level falls. The reason for this lies in the consumption spending of households. As the dollar price of things I buy falls, my dollar income enables me to buy more units of food, clothing, or books. For example, if the CPI falls 5 percent, my income and wealth are unlikely to fall 5 percent as well: my wage may be set for l to 3 years, and the dollar value of my money holdings won’t fall at all. Since my real purchasing power increases, my real consumption spending is likely to rise. Even after the lower price level begins to undermine my income (through lower wages),l find the value of my dollar wealth (cash, bonds, bank accounts) does not shrink as much as the price level does. Thus a lower overall price level leads to higher real consumption and higher total demand-i.e., the AD curve slopes down.

Must the AS curve slope upward? Actually, as we will see in the coming chapters, the exact shape of the aggregate supply schedule is intensely debated among macroeconomists today. Most economists agree that in the very long run the AS curve is vertical But in the short and medium runs, the AS curve slopes upward from southwest to northeast. Let’s analyze more carefully,then,the way aggregate supply relates t prices.