Definitions of Aggregate Supply and Demand

With this overview of the forces operating on the macroeconomy, we can now sketch in a preliminary way how they operate. Figure 5-6 is the key diagram for understanding the interaction of these forces. It expands Figure 5-5 by showing the relationship among the different variables inside the macroeconomy.

The new diagram in Figure 5-6 organizes the policy and external variables into two categories: those affecting aggregate supply and those affecting aggregate demand. The division of variables into these two categories will be essential to understanding what determines the level of output, prices, and unemployment in both the long and the short run. In the balance of this chapter, we will define and analyze the twin concepts of aggregate supply and demand.

Aggregate Supply Begin by examining the lower part of Figure 5-6, which shows the forces affecting aggregate supply. Aggregate supply refers to the amount of total national output that businesses willingly produce and sell in a given period. Aggregate supply (often written AS) depends upon the price level, upon businesses’ productive capacity, and upon the level of costs.

In general, businesses would like to sell all they can produce at high prices. However, in certain circumstances, prices and spending levels may be depressed, so businesses might sell less than their capacity or potential output. In other circumstances, such as wartime booms, businesses might for a time produce above their sustainable potential output.

We see, then, that aggregate supply is closely linked to the nation’s capacity or potential output. But what determines potential output and aggregate supply? As shown in the bottom left of Figure 5-6, aggregate supply is determined by the amount of productive inputs (labor and capital being the most important) and the efficiency with which those inputs are combined (that is, the technology of the society). We will inquire further into the determinants of potential output and aggregate supply in Chapter 10.

Aggregate Demand The other half of the mechanism determining overall output, employment, and prices is the set of forces affecting aggregate demand. Aggregate demand refers to the total or aggregate quantity of output that consumers, businesses, foreigners, and governments willingly spend in a given period. Aggregate demand (often written AD) depends upon the level of prices and incomes, as well as upon policy variables such as monetary and fiscal policy.

In other words, aggregate demand measures total spending by all the different entities in the economy on cars, food, and other consumption goods bought by consumers; on plant and equipment bought by businesses; on tanks, weather forecasters, and computers bought by government; and on net exports bought by other countries. The total purchases are affected by the prices at which the goods are offered, by people’s incomes, by financial conditions and expectations about the future, and by foreign economic conditions, as well as by government policies in the monetary and fiscal arenas.

Macroeconomic Equilibrium The overall outcome or equilibrium for the macroeconomy is determined by the interaction of aggregate supply and demand. That is, national output, the price level, and total employment will settle at levels that reflect the quantities that businesses willingly sell to willing buyers. We must remember, however, that important background forces of labor supply, capital stock, technology, and monetary and fiscal policies lie behind aggregate supply or demand. The interaction of AS (chiefly driven by potential GNP) and AD (driven by Spending and its determinants) produces the outcomes we are analyzing: the level of actual GNP, the number of jobs and the unemployment rate, prices, and thus the rate of inflation.

Figure 5-6 may look complicated, but it has actually oversimplified reality somewhat. One of the outcomes on the right is the level of investment in plant and equipment (which is part of GNP). Investment adds to the capital stock. As the economy accumulates capital, workers have more and better tools to work with, and the level of potential output rises. Hence, we might draw a thin line from output (real GNP) back to capital.

Nor is this the only influence of output back to the forces affecting aggregate supply. Education, research and development, depletion of subsoil minerals and fuels-each of these leaves a smaller or larger stock of useful capital assets for the future. In such ways does the interaction of AS and AD feed back to influence the economy’s aggregate supply.