Aggregate Demand and Aggregate Supply (UXL) Microeconomics, the study of the economic decisions of individuals and companies, is based on the laws of supply and demand. Supply refers to the amount of a particular product that producers are willing and able to sell at a given price. Demand refers to the amount of a particular product that consumers are willing to buy at a given price. The law of demand states that when prices for a product rise, people's demand for the product will fall. These effects are often represented on a graph. For demand, the price level is shown on the vertical axis, and the amount demanded is shown on the horizontal axis. A line between a point on the vertical axis and a point on the horizontal axis, known as the graph's curve, slopes downward, showing that the demand for a product is lower when the price is higher, and higher when the price is lower. Oranges damaged by unexpected freezing temperatures hang from a tree in a grove in California. Crops of all types can be damaged by bad weather, limiting the supply and driving up prices for consumers. JUSTIN SULLIVAN/GETTY IMAGES Macroeconomics is the study of the economic decisions and actions of the economy as a whole. Supply and demand in macroeconomics mean different things than they do in microeconomics. In macroeconomics, supply refers to the total quantity of goods and services that producers throughout the entire economy are willing to supply at a certain price level. Demand refers to the total quantity of goods and services that all consumers in the economy are willing to buy at a given time. The aggregate demand curve shows that as the overall price level in an economy increases, aggregate demand for goods and services decreases. With this curve, the vertical axis represents the total price level of the economy. The horizontal axis represents the quantity of goods and services that all sectors of the economy households, firms, and the government are willing and able to provide at each price level. When overall prices in the economy are higher, demand for goods and services is lower, so the curve slopes downward. The horizontal
axis is sometimes labeled output, the amount of goods and services produced by a business or country. In this case, output refers to an entire country's output. Sometimes the horizontal axis is labeled income, because a country's total income, that earned by everyone in the country, equals its total output. When prices in the economy change, it is represented as movement up and down the demand curve. For consumers, when prices go up, people's purchasing power (the financial ability to buy goods and services) decreases. In other words, their money buys less. As for businesses, when prices rise, the interest rate usually rises too. The interest rate is the amount lenders charge borrowers, expressed as a percentage of the amount borrowed, for the privilege of borrowing money. This rise in the interest rate means that businesses have to pay more interest on money they borrow to invest. So they will invest less. Government spending does not change by price level. Rising prices may also affect net exports, or the total value of U.S. exports of goods and services made in the U.S. minus the total value of U.S. imports of goods. If prices of U.S.-made goods and services rise, U.S. consumers, both in the U.S. and abroad, may begin to buy similar imported goods instead. Therefore, net exports will decrease. Shifts in the demand curve Sometimes, aggregate demand can change in response to factors other than price levels. These changes shift the entire aggregate demand curve along the graph. A decrease in aggregate demand is represented as a move of the entire demand curve to the left on the Aggregate Demand Curve CENGAGE LEARNING graph. This shift leftward means that consumer demand is lower at every price level. A shift rightward, in contrast, means that consumer demand is higher at every price level. A sudden event that increases or decreases demand temporarily is called a demand shock. An event that increases demand is a positive demand shock, and one that decreases demand is a negative demand shock. For instance, in 2008, housing prices across the United States began falling quickly. This sudden price drop was a demand shock that started an economic downturn. Natural disasters can also cause negative
demand shocks. Shocks happen with regard to individual products and services too. For example, a media report that a particular food is very healthful will be a positive demand shock with regard to that food, whereas a report that the food is very unhealthful could be a negative demand shock. Confidence in the economy (or a lack of it) has significant effects on aggregate demand. When consumers feel confident that their jobs are secure, that the value of their homes is increasing, or that their stocks will perform well, they will demand more at every price level. This becomes a self-reinforcing effect: Consumer demand and spending stimulates the economy, employment is high and jobs are stable, and so demand and spending increase. Businesses, too, feel confident that their businesses will do well, so they hire more workers and invest in new equipment. On the other hand, if consumers worry about keeping their jobs, the value of their homes declining, paying off their loans, or paying higher prices in the future, they will cut back on their spending. Businesses, too, will cut spending. The decreased spending becomes self-reinforcing, too; consumer demand drops, businesses lay off workers, and the downward spiral continues. Government policies can affect demand, and this is a major goal of fiscal policy. Raising taxes can shift the demand curve to the left, decreasing demand, because consumers and businesses have less money to spend. To increase demand in times of recession, governments take two approaches. They cut taxes and offer credits and rebates during recessions. Consumers will have more money to spend so consumer demand will increase; tax incentives for businesses spur them to invest. Governments can also increase their own spending during recessions to keep people employed and provide some income and security for those who become unemployed or have low incomes. Trade policies, both those of the United States and those of other nations, can also affect aggregate demand. When other countries reduce their tariffs (taxes on imports or exports) on U.S. goods, as happens with free-trade agreements, U.S. goods are cheaper for people there to buy, and U.S. exports increase. When countries open to trade or develop their economies, economic demand increases, which means that they buy more U.S. products. On the other hand, if countries increase tariffs on U.S. goods, the goods become more expensive for consumers there, and U.S. exports decrease. Aggregate supply curves in the short and the long run In microeconomics, the law of supply states that producers supply more of a good or service when its price rises. The supply curve, like the demand curve, shows price on the vertical axis and amount supplied on the horizontal axis. For aggregate (total) supply, a macroeconomic factor, the vertical axis represents the price level in the economy as a whole. The horizontal curve represents total output in the economy. This level of production happens when firms combine the inputs of equipment and labor to produce output. Unlike the microeconomic supply curve, though, the aggregate supply curve is different in the short run and in the long run. At first, when price levels in the economy increase, firms produce more, so aggregate supply in the country increases. This increase occurs only in the short run, though, so on
a graph, this is represented by the short-run aggregate supply curve. This curve slopes up, just like a microeconomic supply curve. The supply increase does not go on forever. Output is dependent on input, or the land, equipment, and labor used to produce output. Eventually, since overall price levels in the economy are rising, the price of inputs will increase too. For instance, sooner or later, employees will ask for higher wages because their cost of living has increased. For businesses, higher input costs cancel out the effect of higher revenues. Profits return to where they were before the new price level, and businesses return to their original level of production. But these input costs usually increase more slowly than final prices. Economists say that input prices are sticky, meaning that they stick to their original level for a while before they change. For instance, unions negotiate contracts that determine wages only once every several years, and many nonunion jobs change wages just once a year. So employees do not see an increase in wages for a period of time after price levels in the economy have increased. For prices of other inputs, too, such as food, there may be a contract between suppliers and the price-setting firm that is in effect for a certain time. The long run, to economists, is the period of time it takes for those sticky input prices to adjust to the overall economy's price-level changes. Therefore, the curve on a graph that represents aggregate supply in the long run, called the long-run aggregate supply (LRAS) curve, is not influenced by overall prices in the economy. It is represented on the graph as a vertical line at a certain level of output. Why the aggregate supply curve shifts Like the aggregate demand curve, the aggregate supply curve also can shift. Changes to any of the inputs used in production will shift the amount of output that firms are willing and able to produce. Supply shocks are sudden events that increase or decrease overall production in the short run. For example, a plentiful harvest could increase the food supply in the short run, and a drought could decrease it. In 1974, crop failures around the world decreased the food supply. A sudden rise in oil prices, as occurred in 1973, could decrease the amount of output businesses can produce. When firms expect higher input prices in the future, they will produce less at every price level in anticipation of their costs rising; however, the LRAS would shift only if those expectations came true.
Short and Long Run Aggregate Supply Curves CENGAGE LEARNING Anything that affects inputs permanently can cause shifts in the LRAS. Inputs traditionally include land, capital, and labor, but many experts also include technology as an input. Discovery of new reserves of oil, a natural resource, can increase production at every price. But depleting oil reserves could decrease aggregate supply. New technologies to increase crop yield could increase aggregate supply, but climate change could reduce the amount of land available for farming, decreasing aggregate supply. The number of workers will decrease across the economy over the next twenty years as baby boomers (members of a large generation born between 1946 and 1964) retire, which will in turn decrease aggregate supply. But when immigrants enter the country and join the labor force, aggregate supply increases. Improvements in a country's education system, resulting in better-trained workers, can also increase aggregate supply. When the longrun supply curve shifts, the short-run supply curve also shifts.