AGGREGATE SUPPLY AND AGGREGATE DEMAND

Why do we have booms, depressions, in flations and unemployment? What determines how fast an economy grows? For over a century economists have examined these problems. To day, we have a reasonably good understanding, though enough unanswered questions remain that they get more attention in current economic re search than does any other area.

The next five chapters present the basic theory of income, employment, and prices—the general analytical model that has proved most useful in understanding what determines the over all level of income, employment, and prices in the American economy. No section of the website is more important for you to understand thoroughly. Chapters 10—14 then turn to the ques tion of stabilization policy—how to avoid unem ployment and inflation in our economy, using the basic analysis to evaluate alternative government stabilization policies. Last, Chapters 15—18 focus on long-run economic growth; what determines the rate at which different economies grow over the long run, both here and in the underdeveloped world—and what we can do to speed economic growth, on which a rising standard of living for the world’s billions ultimately depends.

A SIMPLE MODEL

To understand the complex real economic world, it is useful to begin with a very simple model. You will recall from Chapter 3 that the essence of a model is that it focuses on a few critical variables and the relationships among them, abstracting from many details in order to highlight these essentials.

We want to understand the determinants of real g.n.p., of aggregate employment, and of the price level. Let us begin by focusing on two major variables—aggregate demand and aggregate supply. Aggregate demand is simply the com- bined expenditures of consumers, businesses, and governments that make up g.n.p., though at first we shall simplify even further by leaving the government out of the picture. Thus, aggregate demand is simply the sum of consumption and investment expenditure on currently produced goods and services.

Aggregate supply is the total amount of goods and services that will be produced (sup- plied) in response to different levels of aggregate demand. In our private-enterprise economy (leav- ing government aside for the moment), goods and services are produced only when they can be sold at a profitable price. If there is no market demand, businesses will soon stop producing. Thus, we think of supply as a schedule of dif- ferent amounts that will be produced in response to different levels of aggregate demand.

Obviously, as we look back on any time period, aggregate demand and the amount pro- duced (supplied) will be the same. ‘What is produced (measured in dollars) is identical with what is spent on it. This is simply g.n.p. looked at from the production and expenditure sides. But whether the two sides are equal at a high or low level of g.n.p.—whether at full employment and prosperity or at unemployment and depression— will depend in this simple model entirely on the level of aggregate demand. The amount produced (aggregate supply) responds solely to aggregate demand.

Now let us spell out the model in a little more detail.

AGGREGATE SUPPLY

What determines the economy’s aggregate supply schedule? The “real” productive capacity of any economic system sets the upper limit to its real g.n.p. at any time. This productive capacity—the economy’s production possibilities curve for total output from Chapter 2—depends on its under- lying real productive resources, its technology, and its economic organization.’ But an economy need not achieve this full production potential. History shows that nations often fall short of obtaining the maximum production possible from their economies, for example in the Great Depression of the 1930’s. This failure reflects a shortage of aggregate demand. There is not enough total spending by consumers and businesses to buy all the goods that could be produced at full em- ployment.

Conversely, aggregate spending may exceed the productive capacity of the economy at existing prices. If that occurs, prices are bid up and there is inflation.