Aggregate Demand and Aggregate Supply - Research Paper Example

Aggregate Demand and Aggregate Supply Abstract Demand and supply are two major concepts of economics. Every economy is developed and functions based on these concepts. Demand works on a basic law of ‘the quantity of a good demanded per period of time will fall as the price rises and rise as the price falls, other things being equal (ceteris paribus)’ (Sloman and Sutcliffe). It is also essential to note the various factors that determine demand. These include, a) tastes, b) number and price of the substitute goods, c) number and prices of the complementary goods, d) distribution of income e) income, and f) expected changes in the prices (Sloman and Sutcliffe). This paper has moved on to discuss the details of aggregate demand and aggregate supply and how it works. The main focus has been to explain the essential elements like the demand and supply curve, the factors that affect the demand and supply and a through explanation of the model of aggregate demand and aggregate supply. The paper also provides an explanation for the working of this model with the help of a graph to identify how the variables affect the aggregate demand and aggregate supply. Introduction: The aggregate demand – aggregate supply model is a macroeconomic model and is used to evaluate the factors which have an impact on the Real Gross Domestic Product (GDP) and the inflation levels of an economy. This model is a comparative statistics model and the insights can be obtained by identifying the equilibrium and then by making changes by changing one parameter at a time and using the results to evaluate the new equilibrium. It is known that the economy deals with two main elements, i.e. consumption and production. This can also be expressed and understood with the demand and supply. Demand is an unlimited element (Sloman and Sutcliffe, p. 234). This is based completely on the wants and needs of people (Sloman and Sutcliffe, p. 232). It has been noted that if there was no price to be paid for the goods and services the needs of people would be never ending and people would demand for anything and everything they want (Sloman and Sutcliffe, p. 234). Supply on the other hand is relatively very limited and is based completely on the availability of resources and the technology (Sloman and Sutcliffe, p. 234). This paper aims at dealing with the model of aggregate demand and aggregate supply. An attempt has been made to discuss the model and to analyze both the aggregate demand curve and the aggregate supply curve (Sloman and Sutcliffe, p. 232). Aggregate Demand – Aggregate Supply Model: The aggregate demand and aggregate supply model is an aggregation of the microeconomic model. This model represents the quantity of the output for the entire economy rather than focusing only on a single industry (Sloman and Sutcliffe, p. 223). The focus is on the national production rather than on any singly industry. The figure below provides a clear example of the Aggregate demand and aggregate supply model. Figure: Aggregate Supply / Aggregate Demand Model (Evans) In the above figure, it can clearly be noted that there are two variables which have been represented by the model. The horizontal axis represents the real gross domestic product, and is represented by ‘Y’. This provides an insight to the true value of the annual national production and this is adjusted based on the inflation (Evans, p. 12). The vertical axis represents the level of inflation of the price. The Implicit Price Deflator is used to calculate the value of the real GNP from the nominal and the inflated GNP (Evans, p 13). The interaction of the Aggregate Supply, and the aggregate demand curves are used to determine the equilibrium levels of the real national output or the real Gross domestic Product (Evans, p12). The equilibrium is also a helps in evaluating the national inflation rate. There is a tradition al negative slope for the aggregate demand curve and this highlights that at any national income the levels of purchases possible is much higher at lower prices than that at higher prices. A total of all the spending levels in the national income accounts, along with the spending in the net exports, consumption, government purchases and the investments together form the Aggregate Demand (Sloman and Sutcliffe, p 223). The Aggregate demand curve highlights ‘the overall level of spending at different price levels’ (Bized). This is a macro concept and refers to the whole economy. The formula for Aggregate demand is: ‘AD = C+I+G+(X-M) Where, C= Consumption Spending I = Investment Spending G = Government Spending (X-M) = difference between spending on imports and receipts from exports (Balance of Payments)’ (Bized) The key variables that affect the aggregate demand are as follows: i) Inflation ii) Unemployment iii) Growth iv) Balance of Payments The Aggregate supply curve on the other hand is relatively flat for a major part of the length and it has a sudden upward curve which at a point even turns vertical. The aggregate supply curve’s flat portion represents the non inflationary region, while the steep vertical portion represents the inflationary period. This sharp curve can be understood as the economic statistic which is generally referred to as the Capacity Utilization Rate (Sloman and Sutcliffe, p 223). This is a measure of the percent of the capacity that is used by the manufacturers across the nation. In literature, an industry is said to be using all of its productive assets if it is running at a 100 percent capacity (Evans). In real terms there are a few industries that do run at 100 percent however the national average in most cases is quite rarely above 90% (Evans, p 2). Also in time of recession like the current period, the average goes down to almost 80 – 85% (Evans p 2). In some cases however with the level of recession the figures have even dropped down to 70% (Evans p 2). Some of the industries are most affected and face issues like low levels of human resources and hug bottle necks (Evans p 2). This may be due to the high levels of expenses in terms of overtimes to workers, higher costs for raw materials and also the production inefficiencies as well (Evans p 2). These extra costs incurred by the company, leads to the costs of the finished goods to increase and be more widespread (Sloman and Sutcliffe p 223). It is also essential to note that the Capacity Utilization rate by no means is a perfect indicator of the economy’s movements and does not in any manner give accurate results of the non inflationary environment to the inflationary environment (Evans p 5). The main reason being, that the capacity utilization rate only includes the measure of the manufacturing capacity, and this in turn excludes the service sector, which is, an essential part as well (Sloman and Sutcliffe p 236). It is also essential to understand the factors that affect the aggregate supply and aggregate demand. The next section will detail this and provide a clear image of how each of these is affected (Evans p 6). Factors affecting the aggregate demand and aggregate supply: Before moving into the factors that affect aggregate demand and aggregate supply, it is important to note the factors that affect the demand and supply. It is also essential to note the various factors that determine demand. These include, a) tastes, b) number and price of the substitute goods, c) number and prices of the complementary goods, d) distribution of income e) income, and f) expected changes in the prices (Sloman and Sutcliffe p 263). Factors that determine supply include: a) ‘Cost of production i) Changes in the prices of the inputs ii) Changes in the technology used iii) Changes in the organization iv) The policies of the government (Sloman and Sutcliffe p 223) b) Profitability of the alternatives or the substitutes (Sloman and Sutcliffe p 223) c) The profits earned when goods are jointly supplied (Sloman and Sutcliffe p 223) d) Unpredictable events like nature, shocks and others. (Sloman and Sutcliffe p 223) e) The future price change expectations and (Sloman and Sutcliffe p 223) f) The aims of the producers’ (Sloman and Sutcliffe p 223). Now moving onto the factors that impact the aggregate demand and aggregate supply, which can cause a change in the figure above and can move the slopes in different directions are as listed below: (Please note: (+) reflects the factors that increase and cause the curve to shift right, and (-) reflects the factors that decrease and cause the curve to shift left. ‘Factors that Effect Aggregate Supply and Aggregate Demand Aggregate Demand Aggregate Supply 1. Income (+) 1. Costs (-) 2. Wealth (+) (a) Labor (wages)   3. Population (+) (b) Resource   4. Interest rates (–) 2. Investment (prior) (+) 5. Credit availability (+) 3. Productivity (+) 6. Government demand (+) 4. Interest rates (-) 7. Taxation (–) 5. Credit availability (+) 8. Foreign demand (+) 6. Foreign supply (-) 9. Investment (+) 7. Expectations   10. Expectations   (a) Profits (+) (a) Inflationary (+) (b) Inflationary (?) (b) Income (+) (c) Interest rate (?) (c) Wealth (+) 8. Taxation (-)’ (d) Interest rate (+)   Table: Factors that affect the aggregate supply and aggregate demand (Evans) Conclusions: The aggregate demand and aggregate supply are major elements of any economy and can have a major impact on the overall performance of the economy. There have been several studies that have been conducted to gain a better perspective of how the various factors affect the aggregate demand and aggregate supply. As seen there are several factors that are present that have a major impact on the demand and supply (Sloman and Sutcliffe p 223). The changes in the demand and supply of products not only have an effect on the company but on the economy as a whole. Hence this topic is of great importance and understanding and recognizing the factors that affect the aggregate demand and supply is equally important (Sloman and Sutcliffe p 223). Any study in economics is considered to be incomplete without the knowledge of demand and supply. I feel that it is essential to have a strong knowledge on the aggregate supply aggregate demand model as it forms the basis of all economic activities. This is hence an essential topic and worth researching into to a greater extent. Suggested Areas for Further Research A few references that will prove to be helpful for others trying to research this topic is as listed below. Each of these books deals with the concepts of macroeconomics and assists the readers understand the concepts and also application into the real world and the economies. The topics of demand and supply explained in each of these books is very clear and provides a clear and detailed understanding of the modes in which the aggregate demand and aggregate supply have an impact on the business and the economy as a whole. These deserve a more focused research as the topic is very intensive with a major growth possibility and the impact of this topic is very strong on the business and the overall success of the business as well. Davis, M. A. (2009). Macroeconomics for MBAs and Masters of Finance. Cambridge University Press. Sub topics: onetary policies, Firms and growth Mankiw, N. G. (2008). Principles of Macroeconomics, 5th Edition. South-Western College Pub.Sub Topics: Thinking like an Economist, Ten Principles of Economics Tucker, I. B. (2008). Macroeconomics for Today, 6th Edition. South-Western College Pub. Subtopics: Macroeconomics Fundamentals, Macroeconomics Theory and Policy McConnell, Campbell, Stanley Bruce and Sean Flynn. Macroeconomics - 18th Edition. McGraw-Hill/Irwin, 2008. Sub topics: Individual Markets Demand and Supply, Application and Extension of supply and demand Analysis Mankiw, N. Gregory. Macroeconomics. Worth Publishers, 2006. Sub Topics: Mundell-Fleming model, Aggregate Demand and Aggregate Supply Swanenberg, A. (2005). Macroeconomics Demystified, 1st edition. McGraw-Hill. Subtopics: Aggregate Demand and Aggregate Supply, Bathtub Theorm Tucker, I. B. (2008). Macroeconomics for Today, 6th Edition. South-Western College Pub. Sub Topics: Macroeconomics Fundamentals, Macroeconomics Theory and Policy Works Cited Evans, Gary R. "The Aggregate Supply - Aggregate Demand Model." Evans, Gary R. 1999. pp. 1 – 3, 5,8, 11, 12, 13.. Sloman, Jack and Mark Sutcliffe. Economics for Business, Third Edition. London: Pearson Education Limited, 2004. p. 223, 233, 234, 236 Read More