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1 Introductory concepts 2  Market mechanism  3 Elasticities  4 Market structures 5  Market failures  6  Macro economic activity/eco growth  7 Inflation 8  Employment & unemployment  9  External Stability  10  Income distribution 11.Factors affecting economy  12  Fiscal/Budgetary policy  13  Monetary Policy   14 Aggregate Supply Policies  15 The Policy Mix

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Aggregate demand and supply diagrams

The relationship between AD, AS and the general level of prices can be represented graphically. The relationship between AD and the general level of prices in the economy is similar to the relationship between demand for an individual good or service and the price; an inverse relationship. The AD is therefore downward sloping but for different reasons:

Factors that affect AD are those that will affect any of the components of AD (C, I, G, X or M) and will result in the AD curve shifting. Each AD curve is drawn assuming that these factors remain constant (ceteris paribus). For example if there was a decrease in income tax rates, this would increase the disposable income of households. Higher disposable income may encourage households to increase their consumption at each price level which is represented by a shift of the demand curve to the right (as depicted in the first diagram below).

The AS curve represents the total real value of production that producers are willing and able to supply at various general price levels. The relationship between the general price level and AS is positive (similar to the microeconomic supply curve) and it also becomes steeper with increasing levels of output. As output increases and the economy approaches productive capacity it becomes increasingly difficult to expand production.  If the economy reaches productive capacity the AS curve would be vertical because any increase in AD could not be met and the resulting shortages in multiple markets would cause prices to rise across the economy.

When the AS curve is drawn it is also assumed that all of the factors that affect AS are held constant. For example, if there is an increase in labour productivity, then this effectively means that more output is being produced for each hour worked. This means that at each price level firms are able to supply the market with more output, resulting in a shift of the aggregate supply curve to the right. Higher productivity also reduces the cost per unit which may mean that firms are willing and able to supply goods and services to the market at a lower price (also represented by a shift of the AS curve to the right as depicted in the second diagram below).

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