What relationship does the aggregate demand curve show? What relationship does the aggregate supply curve show?

The aggregate demand (AD) curve represents the total quantity of goods and services demanded across all levels of an economy at various price levels. It is depicted as a downward-sloping curve on a graph where the y-axis represents the price level and the x-axis signifies the level of output or real GDP.

To understand why the AD curve slopes downward, picture a scenario where prices fall. When the general price level decreases, consumers' purchasing power increases, leading them to buy more goods and services. Businesses respond by demanding more raw materials and labor to meet this increased consumer demand, which translates to higher investment spending. Moreover, a lower price level makes a nation's goods more competitive internationally, leading to an increase in exports minus imports, known as net exports. These factors collectively explain why there's an inverse relationship between the price level and the quantity of output demanded.

The relationship between the price level and output, or real GDP, is a crucial concept in macroeconomics. It explains how changes in the price level affect the production and consumption of goods and services. A higher price level typically reduces consumer buying power, leading to less consumer spending, and discourages investment by making capital more expensive. On the flip side, a lower price level can stimulate economic activity by making consumption and investment more affordable.

It's essential to note that in the short run, changes in price levels can lead to significant swings in output as firms adjust their production to meet the demand. However, in the long run, output is determined by factors such as technology, resources, and capital, making the long-run aggregate supply curve vertical, a concept covered in more detail in the next sections.

The aggregate supply (AS) curve shows the total quantity of goods and services that producers in an economy are willing and able to sell at different price levels. Unlike the AD curve, the AS curve's shape can vary between the short term and the long term.

In the short term, the AS curve tends to be upward-sloping. As prices rise, profitability increases, encouraging firms to expand production, leading to a greater output. However, the AS curve is not uniformly steep across all price levels. Near full employment, resource constraints can cause the AS curve to become steep, as producing additional output becomes increasingly difficult.

In the long term, the AS curve is typically considered vertical. At this point, output is driven by factors such as technology, labor, capital, and natural resources, rather than the price level. This long-run curve represents the maximum sustainable output of the economy and is unaffected by price changes.

There are two prevailing schools of thought in macroeconomics regarding the shape of the aggregate supply curve: Keynesian and Classical.

Keynesian Aggregate Supply Curve

The Keynesian AS curve is characterized by three distinct segments: horizontal, upward-sloping, and vertical. In the horizontal range, the economy has plenty of idle resources, and output can increase without increasing the price level. In the upward-sloping range, resources are becoming scarcer, so increasing output leads to higher prices. Finally, in the vertical range, the economy is at full capacity, and output cannot increase regardless of price changes.

Classical Aggregate Supply Curve

The Classical perspective argues that the long-run AS curve is vertical, reflecting the idea that economic output is determined by the supply of factors of production and is independent of the price level. According to this theory, the economy naturally moves toward full employment and potential output over time, assuming flexibility in wages and prices.

Economic equilibrium occurs at the intersection of the aggregate demand and aggregate supply curves. This point reflects the equilibrium price level and the corresponding level of output or real GDP. At equilibrium, the quantity of goods and services demanded equals the quantity produced, balancing the economy without excess supply or demand.

An understanding of economic equilibrium helps policymakers and economists predict how changes in external factors, such as fiscal policy or global economic conditions, might shift the AD or AS curves and influence the overall economy. When either curve shifts, it leads to a new equilibrium, resulting in changes to both the price level and output, which in turn impacts inflation, employment, and growth rates.