What is Aggregate Demand and Supply?

Aggregate Demand and Supply

The concept of aggregate demand and supply is important in macroeconomics.

Total production in the economy can be expressed as aggregate supply and total expenditure can be expressed as aggregate demand.

Macroeconomics looks at the economy as a whole. Microeconomics looks at individuals, businesses and sectors of the economy.

The Circular Flow of Income Model, (the relationship between production, income and expenditure) helps to understand the big picture.

So on a demand and supply diagram, the forces interact to create an equilibrium position.

aggregate demand and supply

The Macroeconomy in Equilibrium

Laissez-faire economics would say that the economy should be left alone to fix its problems.

This is the market economy in action.

From earlier studies, you can understand that supply and demand adjust to ensure that the economy will always move towards equilibrium levels.

At the Macroeconomic level, we are dealing with Aggregate Demand and Supply. 

When the economy is in disequilibrium (where supply is greater than demand) the theory would say that the general price level will fall to stimulate demand.

This effect will stimulate demand and once again the economy will aim to the equilibrium position.

Now looking at the five sector circular flow model,

The economy is in equilibrium when

Aggregate demand = Aggregate supply

In this model the following must also be true for equilibrium

        Total injections = Total leakages

or

I+G+X = S+T+M

                                    and

Aggregate Supply = Aggregate Demand

or

Total Production (GDP) = C+I+G+X-M

If the economy is in disequilibrium

say, Injections > Leakages

we will have I+G+X > S+T+M

Because of this, the components of aggregate demand will be higher than aggregate supply.

The excess demand will cause an increase in aggregate supply (production) until once again

aggregate demand = aggregate supply

Now to learn more about this, take this Introductory Macroeconomics Tutorial Course Introductory Macroeconomics Tutorial Course

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