The total demand in the economy for goods and services is called the aggregate demand and it is made up of several components of the circular flow.
Aggregate demand (AD) consists of four components:
This is also known as consumer expenditure. It consists of spending by households on goods and services.
This is spending by private sector firms on capital goods.
Government spending (G):
This covers government spending on goods and services.
Net exports (X–M):
This is the difference between the value of exports of goods and services and the value of imports of goods and services.
AD = C + I + G + X − M
Why does aggregate demand fall when the price level rises and vice versa? There are three reasons:
The wealth effect:
A rise in the price level will reduce the amount of goods and services that people’s wealth can buy. The purchasing power of savings held in the form of bank accounts and other financial assets will fall.
The international effect:
A rise in the price level will reduce demand for net exports as exports will become less price competitive while imports will become more price competitive.
The interest rate effect:
A rise in the price level will increase demand for money to pay the higher prices. This, in turn, will increase the interest rate. A higher interest rate usually results in a reduction in consumption and investment.
The aggregate supply refers to the ability of the economy to produce goods and services.
Aggregate supply is positively related to the price level. This is because a price rise will make more profitable sales and encourage organisations to increase their output.
Economists sometimes distinguish between
short-run aggregate supply (SRAS) and
long-run aggregate supply (LRAS).
Short-run aggregate supply is the output that will be supplied in a period of time when the prices of factors of production (inputs, resources) have not had time to adjust to changes in aggregate demand and the price level.
The short-run aggregate supply curve slopes up from left to right. As the price level rises, producers are willing and able to supply more goods and services.
Possible reasons for this positive relationship:
The profit effect:
As the price level increases, the price of factors of production such as wages do not change. So the price level rises, the gap between output and input prices widens and the amount of profit increases.
The cost effect:
Although the wage rates and raw material costs remain unchanged in the short run, average costs may rise as output increases.
Long-run aggregate supply is the output that will be supplied in the time period when the prices of factors of production have fully adjusted to changes in aggregate demand and the price level.
The long-run aggregate supply curve shows the relationship between real GDP and changes in the price level when there has been time for input prices to adjust to changes in aggregate demand.
We distinguish between two types of long-run supply curves (LRAS)
The Keynesian LRAS curve
Keynesians LRAS curve are perfectly elastic at low rates of output, then upward sloping over a range of output and finally perfectly inelastic.
The classical LRAS curve
Many economists argue that the long-run aggregate supply curve is vertical.
Their model is based on the ‘classical’ assumptions that real wage rates are flexible in the long run and that people are fully aware of price and wage changes, and hence do not believe that a given percentage pay increase will make them better off when prices are rising by the same percentage (i.e. they do not suffer from money illusion).