Aggregate demand and supply

Aggregate supply is the quantity of output firms are willing to supply, for each given price level. Aggregate supply is the aggregate of all the supply in the economyIt shows the relationship between the price level and real output (or real national income). Aggregate demand is the combination of price level and output at which the goods and money market are both in equilibrium.

Classical Aggregate supply curve The classical supply curve is based on the assumption that the labour market is in equilibrium with full employment of the labour force. AS curve is vertical in the long run.

Keynesian Aggregate supply curve AS curve is horizontal- firms will supply whatever is demanded at the existing price level. Keynes assumed that there is unemployment and output can be increased by increasing labour. There is short-run price stickiness. As a result, the AS curve is quite flat in the short run.

Aggregate demand Aggregate demand is the combination of price level and output at which the goods and money market are both in equilibrium. Aggregate demand depends on output and price level by way of real money supply.

Why is the AD curve downward sloping? Interest rates: If the price level rises, the rate of interest rises in an effort to stop the price rise getting out of hand. So, in response to a rise in the price level, the final effect is a fall in planned consumption and investment, and so a reduction in AD Changes in real wealth: The foreign sector: For a given exchange rate, if the price level rises, then home produced goods will become relatively more expensive in other countries, and so the demand for exports will fall.

Shifts in the AD curve

C,I,G,NX Interest rates Unemployment: Taxation Government spending The stock market Business confidence The exchange rate

Aggregate demand under Keynesian case AS AD1 AD2 P

Aggregate demand under Classical case

Aggregate Supply The Short-run aggregate supply curve: · Slopes upwards because at higher prices, firms respond by producing a greater quantity of output · As price level falls, firms respond by cutting back on output The slope of the SRAS: the SRAS is relatively flat at low levels of Y and relatively steep at high levels of Y, BECAUSE: · At low levels of output (when UE is high), firms are able to attract new workers without driving up wages and other costs, thus prices rise gradually as firms increase output · At high levels of output, when resources in the economy are more fully employed, firms find it costly to increase output as they must pay higher wages and other costs. Increases in output are accompanied by greater and greater levels of inflation as an economy approaches and passes full employment

Equilibrium income