Aggregate Supply & Aggregate Demand

CFA Level 1 - Macroeconomics

The Aggregate Supply Curve

The aggregate supply curve shows the relationship between a nation's overall price level, and the quantity of goods and services produces by that nation's suppliers. The curve is upward sloping in the short run and vertical, or close to vertical, in the long run.

Net investment, technology changes that yield productivity improvements, and positive institutional changes can increase both short-run and long-run aggregate supply. Institutional changes, such as the provision of public goods at low cost, increase economic efficiency and cause aggregate supply curves to shift to the right.

Some changes can alter short-run aggregate supply (SAS), while long-run aggregate supply (LAS) remains the same. Examples include:

• Supply Shocks - Supply shocks are sudden surprise events that increase or decrease output on a temporary basis. Examples include unusually bad or good weather or the impact from surprise military actions.
• Resource Price Changes - These, too, can alter SAS. Unless the price changes reflect differences in long-term supply, the LAS is not affected.
• Changes in Expectations for Inflation - If suppliers expect goods to sell at much higher prices in the future, their willingness to sell in the current time period will be reduced and the SAS will shift to the left.

The Aggregate Demand Curve

The aggregate demand curve shows, at various price levels, the quantity of goods and services produced domestically that consumers, businesses, governments and foreigners (net exports) are willing to purchase during the period of concern. The curve slopes downward to the right, indicating that as price levels decrease (increase), more (less) goods and services are demanded.

Factors that can shift an aggregate demand curve include:

• Real Interest Rate Changes - Such changes will impact capital goods decisions made by individual consumers and by businesses. Lower real interest rates will lower the costs of major products such as cars, large appliances and houses; they will increase business capital project spending because long-term costs of investment projects are reduced. The aggregate demand curve will shift down and to the right. Higher real interest rates will make capital goods relatively more expensive and cause the aggregate demand curve to shift up and to the left.
• Changes in Expectations - If businesses and households are more optimistic about the future of the economy, they are more likely to buy large items and make new investments; this will increase aggregate demand.
• The Wealth Effect - If real household wealth increases (decreases), then aggregate demand will increase (decrease)
• Changes in Income of Foreigners - If the income of foreigners increases (decreases), then aggregate demand for domestically-produced goods and services should increase (decrease).
• Changes in Currency Exchange Rates - From the viewpoint of the U.S., if the value of the U.S. dollar falls (rises), foreign goods will become more (less) expensive, while goods produced in the U.S. will become cheaper (more expensive) to foreigners. The net result will be an increase (decrease) in aggregate demand.
• Inflation Expectation Changes - If consumers expect inflation to go up in the future, they will tend to buy now causing aggregate demand to increase. If consumers' expectations shift so that they expect prices to decline in the future, t aggregate demand will decline and the aggregate demand curve will shift up and to the left.

(See more) Short and Long-run Macroeconomic Equilibrium

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