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What Is the Relationship Between Aggregate Supply and Aggregate Demand?

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  • Written By: Osmand Vitez
  • Edited By: Kristen Osborne
  • Last Modified Date: 07 October 2014
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Aggregate supply and aggregate demand is the total supply and total demand of all goods and services in an economy. Most nations have economies made up of individual industries and sectors, with each one adding to the overall economy. Consumer demand for goods and services affect how companies will meet that demand with products. This creates a symbiotic relationship that allows companies to determine which product will be most profitable to produce. The study of supply and demand is known as macroeconomics.

Macroeconomics is a top-down look at an economy. Rather than focusing on economic transactions at the individual level, it attempts to discover the shifts or changes in an economy through government policies and natural market forces. Aggregate supply and demand play an important role in the macroeconomic study. Changes in unemployment, national income levels, growth rates, inflation, price levels, and gross domestic product all affect both sides of this economic equation.

These two factors are typically represented by curves on a graphical chart. The supply curve starts at the bottom left and slopes upward toward the top right of the graph. While not a simple sum of all individual supply curves in economics, low levels of supply will represent a flat supply curve. As more companies increase produce products, the supply curve becomes more vertical as it slopes up the chart.

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The aggregate demand curve starts at the top left of the chart and slopes downward toward the bottom right of the graph. This curve slope down because of consumption and the real wealth effect. An increase in interest rates by the central bank will result in lower demand as purchasing power decreases. The real wealth effect forces demand down as the price for goods and services increase, creating lower demand.

Aggregate supply and aggregate demand affect the price of products. Each curve intersects at some point on the graph; this represents the equilibrium point for goods and services. At this price point, consumers will typically purchase the most products. Shifts occur when monetary policy increases or decreases the money supply. A loose money policy tends to increase supply and demand as more money exists for business investment and consumption, while a tight money supply has the opposite effect. Additionally, more government regulations or taxes will tend to retard the economy as these factors increase the barriers to entry or penalize individuals and firms for economic activity.

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Izzy78
Post 8

We were discussing aggregate demand and aggregate supply in my economics class recently, and another part of macroeconomics that the article doesn't mention is something like public goods that have a much different supply and demand curve. A good example might be a national park.

Every worker in the United States pays taxes, and certain percentage goes toward national parks and forests. There is likely a huge dead weight loss with these goods. Some people have never visited a national park in their life, and some people visit parks dozens of times a year, yet they all pay a certain amount for that service dependent upon their income. If you were to plot out the supply and demand curves, the actual point of consumption would be nowhere near the point where the lines cross.

The only real way to fix this would be to privatize the national parks and forests, but then you run into a whole slew of other issues concerning the rights of the government that are far beyond this article.

titans62
Post 7

@jmc88 - In situations like that, not only do the products related to that good with higher demand go up, you also have related goods whose price is affected. Thinking about corn, a higher demand in corn means farmers are going to stop planting soybeans and wheat on some parts of their land so that they can grow more corn. They then will cause soy and wheat products to increase in price, too.

Like someone else mentioned, the determinants of aggregate supply and demand are extremely complicated, and I think it makes it very exciting to study those relationships.

jmc88
Post 6

@Emilski - You can take that example even one step further into looking at aggregate demand and supply. I think a good example that is kind of related and is happening right now is corn production.

For many years, farmers in the US produced far more corn than could ever be sold, and the government subsidized what wasn't sold. I grew up in Illinois, and there were several years I remember when it was cheaper for the farmers to let corn sit and rot in a field and collect government money than to harvest it and get market value. When everyone got excited about ethanol, that all changed.

The price of corn shut up drastically in the course of a few years, because ethanol was replacing gasoline, which is very expensive relative to the other uses of corn. Just because people started using more ethanol, food products with corn syrup and everything else started to increase.

Emilski
Post 5

I always thought that macroeconomics was the much more interesting part of the system. Microeconomics are clearly important to understanding macroeconomics, but they can only be used for so much. Everything that happens to a certain business is caused by several influences from the larger economy.

The other thing I always hated and still do hate is the graphical representation of supply and demand curves. They're often drawn as the sloping lines described in the article, and that is fine for a general depictions, but there is such much more that goes into determining what the real supply and demand curves of a company look like.

I think that is where macroeconomics becomes more important. If a company makes a product that relies on having a petroleum product, but the price of petroleum suddenly increases, their supply and demand curve is going to change radically.

hamje32
Post 4

@NathanG - Increasing the money supply does help certain institutions – the banks. The problem is that they are not always lending, and that’s why you don’t see the trickle down effect on consumer demand.

If they don’t lend, you can’t blame Keynes. You have to find out why the banks are sitting on their stash of cash. I still haven’t figured that one out.

NathanG
Post 3

@nony - I agree. That’s why I think the Keynesians are wrong in their approach to the money supply aggregate demand connection. The belief is that if you flood the markets with money then people will spend. That has not happened.

All it does is lay the groundwork for inflation or deflation, take your pick. In my opinion, the real incentives for consumer demand are increased wealth through reduced taxation.

That was what Reagan did – and it worked – and I personally believe that it’s the only thing that will ever work. Couple that with low interest rates, and you have an even greater incentive for consumers to spend.

nony
Post 2

@Mammmood - The aggregate demand and aggregate supply model looks at a number of factors. Interest rates alone don’t tell the whole story. If people think the economy is still in the dumps, they won’t spend, regardless of what incentives you offer.

I can at least speak for myself. I need to make sure that I have enough money in the bank to weather a layoff, should it happen. Just because you knock interest rates down to near zero doesn’t mean that I am going to go off and buy a flat panel TV. Any extra money I have goes into savings, until the economy is on the mend.

Mammmood
Post 1

The article mentions interest rates as one of the key components in the aggregate demand aggregate supply model. Higher interest rates lower demand. If this is indeed so, does it follow that lower interest rates increase demand?

This seems to be the obvious inference, and it has been the basis of monetary policy for quite some time. However, in my opinion, it has not been borne out in fact.

We have had recessions where interest rates were at historic levels but people were still not spending, or demanding, goods and services. How do you explain that?

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