MACROECONOMICS

ASSIGNMENT

TOPIC:
BASICS OF SUPPLY & DEMAND

NAME - MAYANK BHARTI

ROLL NO.-210003046
BRANCH-MECHANICAL ENG.
 AGGREGATE OF SUPPLY AND DEMAND

INTRODUCTION:
Aggregate supply and demand reflects to the concept of supply and demand but at
a macroeconomic scale. Aggregate Supply and Demand provide a macroeconomic
view of the country’s total demand and supply curves. Aggregate supply and
aggregate demand are both plotted against the aggregate price level in a nation and
the aggregate quantity of goods and services are exchanged at a specified price.
Aggregate supply and demand each describe a relation between the overall price
level (think consumer price index or GDP deflator) and output (GDP). Taken
together aggregate supply and demand can help us solve for the equilibrium levels
of price and output in the economy. And when a change shifts either aggregate
supply or demand, we can determine how price and output shift.
The aggregate supply (AS) curve describes, for each given price level, the quantity
of output firms are willing to supply. The aggregate demand (AD) curve shows the
combinations of the price level and level of output at which the goods and money
markets are simultaneously in equilibrium.
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The AS curve is upward-sloping because firms are willing to supply more output at
higher prices. The AD curve is downward-sloping because higher prices reduce the
value of the money supply, which reduces the demand for output. The intersection
of the AD and AS schedules at E determines the equilibrium level of output, Y0 ,
and the equilibrium price level, P0.

THE AGGREGATE SUPPLY CURVE:

Firms decides about what quantity to supply based on the profits they expect to
earn. Profits are also determined by the price of the outputs the firm sells and by
the price of the inputs—like labor or raw materials—the firm needs to buy.
Aggregate supply (AS), refers to the total quantity of output—in other words, real
GDP—that firms will produce and sell. The aggregate supply curve shows total
quantity of output—real GDP—that firms will produce and sell at each price level.
In the short run the AS curve is horizontal (the Keynesian aggregate supply curve)
whereas, in the long run the AS curve is vertical (the classical aggregate supply
curve).
In short run, a firm’s supply is constrained by the changes made to production
factors such as the amount of labor deployed, raw material inputs, or overtime
hours. However, in long run, firms are able to open new plants, expand plants or
adopt new technologies, indicating that maximum supply is less constrained.

Factors that Affect Aggregate Supply:

1. Supply Shocks:
Adverse supply shocks shift AS to the left, i.e., a decrease in the AS curve.
Usually, a huge rise in oil prices can cause a supply shock. Natural catastrophes or
hikes in taxes can also shift AS to the left. It is either a leftward shift in the short
run AS curve (the one on the left) or by the leftward shift in the vertical long-run
AS curve. However, the long run AS curve is best suited for natural disasters or
setbacks in the economy, such as corrupt governments.
 AGGREGATE OF SUPPLY AND DEMAND

2. Resource Price Changes:

Changes in the short run resource prices can alter the Short Run Aggregate Supply
curve. Unless the price changes reflect differences in long-term supply, the Long
Run Aggregate Supply is not affected.
3. Changes in Expectations for Inflation:
If suppliers expect goods to sell at much higher prices in the future, they will be
less willing to sell in the current period. As a result, the Short Run Aggregate
Supply will shift to the left.
4. Capacity Increase:
A rightward or an increase in AS implies an increase in the productive capacity of
the economy. You can think of this as an outward shift in the production possibility
curve. An increase in the quality and quantity of the factors of production or
technological advancements or any increase in productivity can cause an outward
shift.
Governments can influence AS through Supply Side policies and improvements in
health and education services. This result can be better imagined by an increase in
the Long Run AS. An increase in natural resources can also shift the AS curve to
the right.
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THE CLASSICAL SUPPLY CURVE

The classical aggregate supply curve is vertical, indicating that the same
amount of goods will be supplied whatever is the price level. The classical
supply curve is based on the assumption that the labor market is in equilibrium
state with full employment of the labor force. In a single market, manufacturers
facing with high demand can raise the price for their products and go out to buy
more materials, more labor, and so forth. This has the side effect of shifting
production away from lower demand sectors into this particular market. But if high
demand is economywide and all the factors of production are already at work,
there isn’t any way to increase overall production, and all that happens is that all
prices increase (wages too).

THE KEYNESIAN AGGREGATE SUPPLY CURVE

The Keynesian aggregate supply curve is horizontal, indicating that firms will
supply whatever amount of goods is demanded at the existing price level. The
idea behind the Keynesian aggregate supply curve is, that because there is an
unemployment, firms can obtain as much labor as they want at the current wage.
Their average costs of production are therefore assumed not to change as much as
their output levels changes. They are accordingly willing to supply as much as is
demanded at the existing price level. The intellectual genesis of the Keynesian
aggregate supply curve lay in the Great Depression, when it seemed that output
could expand endlessly without increasing prices by putting idle capital and labor
to work. Today, we’ve overlaid this notion with what we call “short-run price
stickiness.” In the short run, firms are reluctant to change prices (and wages) when
demand shifts, at least for a little while, they increase or decrease output. As a
result, the aggregate supply curve is quite flat in the short run.
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(a) The Classical Supply Curve (b) Keynesian Long-Run Average Supply

THE AGGREGATE DEMAND CURVE:

The aggregate demand curve shows the combinations of the price level and level of
output at which the goods and money markets are simultaneously in equilibrium.
Expansionary policies—such as increases in government spending, cuts in taxes,
and increases in the money supply—move the aggregate demand curve to the right.
 AGGREGATE OF SUPPLY AND DEMAND

Consumer and investor confidence also affects the aggregate demand curve. When
confidence increases, the AD curve moves to the right. When confidence drops, the
AD curve moves to the left.

Aggregate demand includes all four components of demand:

 Consumption
 Investment
 Government spending
 Net exports—exports minus imports

Thus, demand is determined by a number of factors; one of them is the price level.
An aggregate demand curve shows the total spending on domestic goods and
services at each price level.
Aggregate Demand = C + I + G + X – M

Where, C = consumption spending;

V = investment spending;
G = government spending;
X = spending on exports;
M = minus imports;

Factors that Affect Aggregate Demand:

1. Net Export Effect:
When domestic prices increase, then demand for imports increase (since domestic
goods become relatively expensive) and demand for export decreases.
2. Real Balances:
When inflation increases, real spending decreases as the value of money decreases.
This change in inflation shifts Aggregate Demand to the left/decreases.
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3. Interest Rate Effect:

Real Interest is the nominal interest rate adjusted to the inflation rate. When
inflation increases, nominal interest rates increase to maintain real interest rates.
Lower real interest rates will lower the costs of major products such as cars, large
appliances, and houses; they will increase business capital project spending
because long-term costs of investment projects are reduced.
4. Inflation Expectations:
If consumers expect inflation to go up in the future, they will tend to buy now
causing aggregate demand to increase or shift to the right.

The wealth effect holds that as the price level increases, the buying power of
savings that people have stored up in bank accounts and other assets will diminish,
eaten away to some extent by inflation. Because a rise in the price level reduces
people’s wealth, consumption spending will fall as the price level rises.

The interest rate effect explains that as outputs rise, the same purchases will take
more money or credit to accomplish. This additional demand for money and credit
will push interest rates higher. In turn, higher interest rates will reduce borrowing
by businesses for investment purposes and reduce borrowing by households for
homes and cars—thus reducing both consumption and investment spending.

The foreign price effect points out that if prices rise in the United States while
remaining fixed in other countries, then goods in the United States will be
relatively more expensive compared to goods in the rest of the world. US exports
will be relatively more expensive, and thus the quantity of exports sold will fall.
Imports from abroad will be relatively cheaper, so the quantity of imports will rise.
Thus, a higher domestic price level, relative to price levels in other countries, will
reduce net export expenditures.
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All three of these effects are controversial, in part because they do not seem to be
very large. For this reason, the aggregate demand curve in our example aggregate
demand curve above slopes downward fairly steeply. The steep slope indicates that
a higher price level for final outputs does reduce aggregate demand for all three of
these reasons, but the change in the quantity of aggregate demand as a result of
changes in price level is not very large.

AGGREGATE DEMAND POLICY:

The aggregate supply and demand curves together determine the equilibrium level
of income and prices in the economy. We use the aggregate demand and supply
model to study the effects of aggregate demand policy in the two extreme supply
cases—Keynesian and Classical.

THE KEYNESIAN CASE:

We combine the aggregate demand schedule with the Keynesian aggregate supply
schedule. The initial equilibrium is at point E, where AS and AD intersect. At that
point the goods and assets markets are in equilibrium.
Consider an increase in aggregate demand—such as increased government
spending, a cut in taxes, or an increase in the money supply—which shifts the AD
schedule out and to the right, from AD to AD. The new equilibrium is at point E,
where output has increased. Because firms are willing to supply any amount of
output at the level of prices P0, there is no effect on prices.
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THE CLASSICAL CASE:

In the classical case, the aggregate supply schedule is vertical at the full-
employment level of output. Firms will supply the level of output Y * whatever the
price level. The price level is not given but, rather, depends on the interaction of
supply and demand.
The aggregate supply schedule is AS, with equilibrium initially at point E. So, at
point E there is full employment as, under the classical assumption, firms supply
the full-employment level of output at any level of prices.
The expansion shifts the aggregate demand schedule from AD to AD’. At the
initial level of prices, say P0, spending in the economy would rise to point E’. At
price level P0 the demand for goods has risen. But firms cannot obtain the labor to
produce more output, and output supply cannot respond to the increased demand.
As firms try to hire more workers, they bid up wages and their costs of production,
so for that they charge higher prices for their output. Thus increase in the demand
for goods therefore leads only to higher prices, and not to higher output.
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The increase in prices reduces the real money stock and which leads to a reduction
in spending. The economy moves up to AD’ schedule until prices have risen
enough, and the real money stock has fallen enough, to reduce spending to a level
up to consistent with full-employment output. This is the case at price level P. At
point E’, the aggregate demand at the higher level of government spending is once
again equal to aggregate supply.

SUPPLY-SIDE ECONOMICS:
Supply side economics is the type of economic theory espoused by Ronald Reagan
and most in the Republican party. Supply side theory is aimed at increasing the
supply of goods and services available to consumers. The idea behind this
economic theory is that if you keep corporate taxes down then businesses will have
more money to spend on research and development of new products and services.
The wider the variety of offered products and services the more apt consumers will
find something that they think they need or want. Apple's I-series products are
examples of creating new demand by producing an innovative supply of new
goods and services. The greatest danger of supply side economic theory is long-
term deficits which will weigh heavily on the future economy.
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DEMAND SIDE ECONOMICS:

The opposite of supply side economics is demand side economics. Demand side
economics is all about increasing demand in the consumer. This has been referred
to as Keynesian economics. The idea here is that the quickest way to spur demand
is to increase the relative wealth of the people who want to make purchases. This
theory is mostly espoused by liberal Democrats who want to redistribute wealth by
taking extra income taxes from corporations and the rich in order to redistribute it
to the middle class and poor. Two ways to increase demand are to create jobs and
raise minimum wages. Tax rebates and tax cuts are two other ways to increase
discretionary funds to drive consumer spending. One danger of too much consumer
demand is inflation.

Supply Side VS Demand Side Economics:

Supply-side is the opposite of Keynesian theory (According to the Keynesian
theory, putting more money into consumers' pockets directly drives the demand
that increases growth). It states that demand is the primary driving force of
economic growth. Supporters use fiscal policy to better the lives of consumers
regardless of whether they work or not.
For example, the Obama benefit extensions cost taxpayers, but generated economic
growth per month, too. Its tools are government spending on sectors like education
and health care, which creates jobs and puts people to work.

PUTTING AGGREGATE SUPPLY AND DEMAND

TOGETHER IN THE LONG RUN:
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The long-run aggregate supply curve marches to the right over time at a fairly
steady rate. Two percent annual growth is pretty low, and 4 percent is high. In
contrast, movements in aggregate demand over long periods can be either large or
small, depending mostly on movements in the money supply. Output rises as the
curves shift to the right. Over long periods, output is essentially determined by
aggregate supply and prices are determined by the movement of aggregate demand
relative to the movement of aggregate supply.
The intersection of the economy’s aggregate demand curve and the long-run
aggregate supply curve determines its equilibrium real GDP and price level in the
long run. Long-run equilibrium occurs at the intersection of the aggregate demand
curve and the long-run aggregate supply curve.