The Interaction of Aggregate Demand and Supply

Aggregate Supply and Aggregate Demand Interaction

What are Aggregate Demand and Supply?

Aggregate Demand (AD) is the total spending on goods and services in a period of time at different price levels. A multitude of factors can influence it, including income, wealth, expectations about future income, interest rates, and fiscal and monetary policy.
Aggregate Supply (AS) shows the total output of an economy at different price levels over a period of time. AS is influenced by matters such as productivity, taxation, costs of production, technological advancement, and capacity of the industry.

Equilibrium in AD-AS model

A market is at equilibrium when AD equals AS. This intersection point determines both the level of real output (real GDP) and the general price level in an economy.
Changes in AD or AS can shift the equilibrium point. If there’s an increase in AD (AD curve shifts to the right) but AS remains the same, then price levels will rise (inflation), and real output will increase.
Conversely, if AS increases (AS curve shifts to the right), and AD remains same, then price levels will decrease (deflation), and real output will increase.

Short Run and Long Run AS

Short run aggregate supply (SRAS) takes into account nominal wages, the costs of raw materials, and other short-term factors. In the short run, an increase in AD will lead to an increase in both price level and output.
Long run aggregate supply (LRAS) reflects expected price level. It’s built on assumption that in the long run, an economy’s output is not influenced by price level. If prices rise but AD remains constant, the economy will return to its existing LRAS.
If the economy is producing at its LRAS, then it is said to be producing at its potential output. Short-term fluctuations in AD can’t push the economy past this point.

Factors that Shift the AD and AS Curves

Any change in the components of AD (consumption, investment, government spending, exports and imports) will shift the AD curve.
Changes in productivity, costs of production, technological advancement may shift the AS curve.

The Importance of Expectations

Expectations about future inflation, government policy, and global events can shift both the AD and AS curves.
If people expect prices to rise in the future, they may consume more now, increasing AD. Similarly, if firms expect higher costs in the future, they may cut production, reducing AS.

Knowing the ins and outs of the AD-AS model is a crucial part for understanding macroeconomic theory and policy. Understanding this interaction helps in crafting and predicting the responses to different economic policies and external shocks.