Demand and supply have been generalized to explain macroeconomic variables in a market economy. The Aggregate Demand-Aggregate Supply model is the most direct application of supply and demand to macroeconomics. Compared to microeconomic uses of demand and supply, different theoretical considerations apply to such macroeconomic counterparts as aggregate demand and aggregate supply. The AD-AS or Aggregate Demand-Aggregate Supply model is a macroeconomic model that explains price level and output through the relationship of aggregate demand and aggregate supply.
It is based on the theory of John Maynard Keynes presented in his work “The General Theory of Employment, Interest, and Money”. It is one of the primary simplified representations in the modern field of macroeconomics and is used by a broad array of economists, from libertarian, monetarist supporters of laissez-faire, such as Milton Friedman to Post-Keynesian supporters of economic interventionism, such as Joan Robinson.
Brief history of demand curve and supply curve According to Hamid S. Hosseini, the power of supply and demand was understood to some extent by several early Muslim economists, such as Ibn Taymiyyah who illustrates- “If desire for goods increases while its availability decreases, its price rises. On the other hand, if availability of the good increases and the desire for it decreases, the price comes down”. In 1691, John Locke worked on some considerations of the consequences of the lowering of interest and the raising of the value of money. It includes an early and clear description of supply and demand and their relationship.
In this description demand is rent: “The price of any commodity rises or falls by the proportion of the number of buyer and sellers” and “that which regulates the price of goods is nothing else but their quantity in proportion to their rent. ” The phrase “supply and demand” was first used by James Denham-Steuart in his Inquiry into the “Principles of Political Oeconomy” which was published in 1767. Adam Smith used the phrase in his book “The Wealth of Nations” (1776) and David Ricardo titled one chapter of his work “Principles of Political Economy and Taxation” (1817) On the Influence of Demand and Supply on Price.
In The Wealth of Nations, Smith generally assumed that the supply price was fixed but that its value would decrease as its “scarcity” increased, in effect what was later called the law of demand also. Ricardo, in Principles of Political Economy and Taxation, more rigorously laid down the idea of the assumptions that were used to build his ideas of supply and demand. Antoine Augustin Cournot first developed a mathematical model of supply and demand in his 1838 Researches into the Mathematical Principles of Wealth including diagrams.
In1870, Fleeming Jenkin in the course of “Introducing the diagrammatic method into the English economic literature” published the first drawing of supply and demand curves including comparative statics from a shift of supply or demand and application to the labor market. The model was further developed and popularized by Alfred Marshall in the textbook “Principles of Economics” (1890). The Standard demand curve and the aggregate demand curve The standard demand curve represents the quantity of a good that a consumer will buy at a given price, holding all else constant.
For example, consumer A might buy zero oranges at $1 each, one orange at 75 cents each, and two at 50 cents each, while consumer B might buy one at $1, two at 75 cents, and three at 50 cents. When charted on a grid with price on the vertical axis and quantity purchased on the horizontal axis, these points form the individual demand curves for consumers A and B. The aggregate demand curve represents the total quantity of all goods (and services) demanded by the economy at different price levels. An example of an aggregate demand curve is given in Figure 1. The vertical axis represents the price level of all final goods and services.
The aggregate price level is measured by either the GDP deflator or the CPI. The horizontal axis represents the real quantity of all goods and services purchased as measured by the level of real GDP. Notice that the aggregate demand curve, AD, like the demand curves for individual goods, is downward sloping, implying that there is an inverse relationship between the price level and the quantity demanded of real GDP. The standard supply curve and the aggregate supply curve The standard supply curve is a graph showing the relationships between the price of a good and the quantity supplied.
The supply curve slopes upward because other things equal, a higher price means a greater quantity supplied. The aggregate supply curve shows the relationship between the price level and the quantity of goods and services supplied in an economy. The equation for the upward sloping aggregate supply curve, in the short run, is Y = Ynatural + a (P – Pexpected). In this equation, Y is output, Ynatural is the natural rate of output that exists when all productive factors are used at their normal rates, “a” is a constant greater than zero, P is the price level, and Pexpected is the expected price level.
This equation holds only in the short run because in the long run the aggregate supply curve is a vertical line, as output is dictated by the factors of production alone. An aggregate supply curve is shown in Figure 2. The aggregate supply curve equation means that output deviates from the natural rate of output when the price level deviates from the expected price level. The constant, a, shows how much output changes due to unexpected deviation in the price level. The slope of the aggregate supply curve is (1/a) which depicts the short-run aggregate supply curve and the long- run aggregate supply curve.
The vertical axis is the price level. The horizontal axis is output or income. The short-run aggregate supply curve is downward sloping with slope equal to (1/a) while the long-run aggregate supply curve is vertical with no slope. The reason that the short-term aggregate supply curve is upward sloping is a bit more complex. Factors that determine the slope of AD-AS curve model The slope of AD curve reflects the extent to which the real balances change the equilibrium level of spending, taking both assets and goods markets into consideration.
An increase in real balances will lead to a larger increase in equilibrium income and spending, the smaller the interest responsiveness of money demand and the higher the interest responsiveness of investment demand. An increase in real balances leads to a larger level of income and spending, the larger the value of multiplier and the smaller the income response of money demand. This implies that the AD curve is flatter, smaller is the interest responsiveness of the demand for money and larger is the interest responsiveness of investment demand.
Also, the AD curve is flatter; the larger is the multiplier and the smaller the income responsiveness of the demand for money. We know that aggregate demand is comprised of C(Y – T) + I(r) + G + NX(e) = Y. Thus, a decrease in any one of these terms will lead to a shift in the aggregate demand curve to the left. The first term that will lead to a shift in the aggregate demand curve is C(Y – T). This term states that consumption is a function of disposable income. If disposable income decreases, consumption will also decrease. There are many ways that consumption can decrease. An increase in taxes would have this effect.
Similarly, a decrease in income–holding taxes stable–would also have this effect. Finally, a decrease in the marginal propensity to consume or an increase in the savings rate would also decrease consumption. The second term that will lead to a shift in the aggregate demand curve is I(r). This term states that investment is a function of the interest rate. If the interest rate increases, investment falls as the cost of investment rises. There are a number of ways that investment can fall. If the interest rate rises, say due to contractionary monetary or fiscal policy, investment will fall.
Similarly, in the short run, expansionary fiscal policy will also cause investment to fall as crowding out occurs. Another interesting cause of a fall in investment is an exogenous decrease in investment spending. This occurs when firms simply decide to invest less without regard for the interest rate. The term variable that will lead to a shift in the aggregate demand curve is G. This term captures the whole of government spending. The only way that government spending is changed is through fiscal policy. Recall that the budgetary debate is an ongoing political battlefield.
Thus, government spending tends to change regularly. When government spending decreases, regardless of tax policy, aggregate demand decrease, thus shifting to the left. The fourth term that will lead to a shift in the aggregate demand curve is NX(e). This term means that net exports, defined as exports less imports, is a function of the real exchange rate. As the real exchange rate rises, the dollar becomes stronger, causing imports to rise and exports to fall. Thus, policies that raise the real exchange rate though the interest rate will cause net exports to fall and the aggregate demand curve to shift left.
Again, an exogenous decrease in the demand for exported goods or an exogenous increase in the demand for imported goods will also cause the aggregate demand curve to shift left as net exports fall. An example of this type of exogenous shift would be a change in tastes or preferences. The aggregate demand curve also can shift right as the economy expands. When the aggregate demand curve shifts right, the quantity of output demanded for a given price level rises. Therefore, a shift of the aggregate demand curve to the right represents an economic expansion.
A shift of the aggregate demand curve to the right is simply affected by the opposite conditions that cause it to shift to the left. A change in one or more of the following determinants of aggregate supply will shift the aggregate supply curve in the short run. – Change in the input prices (domestic or imported resources price), change in productivity, change in legal institutional environment (business taxes and government regulation). An increase in short-run aggregate supply will shift the curve rightward; a decrease will shift the curve leftward.
The long run aggregate supply curve is vertical. Similarities between the Ad-AS curve model and the standard demand-supply curve model The conventional “aggregate supply and demand” model is actually a Keynesian visualization that has come to be a widely accepted image of the theory. The Classical supply and demand model, which is largely based on Say’s Law, or that supply creates its own demand depicts the aggregate supply curve as being vertical at all times. The both demand curve and the aggregate demand curve is negatively sloped from left to right and both curves represent the law of demand.
The short-run aggregate supply curve or SRAS curve has similarities the standard supply curve. Both are positively sloped. Both curves relate price and quantity. Differences between the Ad-AS curve model and the standard demand-supply curve model In aggregate demand curve, there is no substitute effect because we cannot substitute all goods. But in standard demand curve it exists. The aggregate demand curve has no income effect because a lower price level actually means less nominal income for the resource suppliers’ e. g. lower wages, rents, interests, and profits.
But in standard demand curve it exists. The major differences between the standard supply curve and the aggregate supply curve are as follows- for the market supply curve, the vertical axis measures supply price and the horizontal axis measures quantity supplied. For the short-run aggregate supply curve, however, the vertical axis measures the price level (GDP price deflator) and the horizontal axis measures real production (real GDP). The positive slope of the market curve reflects the law of supply and is attributable to the law of diminishing marginal returns.
In contrast, the positive slope of the short-run aggregate supply curve is attributable to: (1) inflexible resource prices that often makes it easier to reduce aggregate real production and resource employment when the price level falls, (2) the pool of natural unemployment, consisting of frictional and structural unemployment, that can be used temporarily to increase aggregate real production when the price level rises and (3) imbalances in the purchasing power of resource prices that can temporarily entice resource owners to produce more or less aggregate real production than they would at full employment.
Conclusion Whereas the standard supply and demand curve model discusses on individuals, the aggregate supply and demand curve model works with the whole economy. This model is built on the assumption that prices are sticky in the short run and flexible in the long run. This model also highlights the role of monetary policy. This model shows how shocks to the economy cause output to deviate temporarily from the level implied by the standard model. By this model, we can observe the economy more efficiently than before.