The Aggregate Supply - Aggregate Demand Model
A valuable complement to the Circular Flow Diagram and the National Income Identity is the Aggregate Supply - Aggregate Demand (AS-AD) graph. If you return to the Classification Scheme Table associated with the Circular Flow Diagram you see that in each market the list of variables contains a number of indicators of price and quantity. The theoretical / analytical framework for interpreting these data, for providing explanations of past movements and forecasts of future patterns, is the Supply - Demand (S-D) model which you should all be familiar with since it is the economists' favorite tool for explaining price movements.
At the heart of the supply-demand model of prices are the supply and demand curves which appears below. The demand curve is a visual representation of the behavior of buyers in a market while the supply curve is a visual representation of the behavior of sellers in a market. At only the equilibrium price will we have suppliers willing and able to bring to the market exactly what demanders want. More importantly, if the market is in disequilibrium (wrong price), then there will be automatic forces which will bring prices toward the equilibrium level. In this sense the equilibrium price can be viewed as the price the market will move toward automatically. Once the equilibrium price is established, there will be no pressure for price to change.
The good news is that it should be easy enough to move from your understanding of S-D curves to an understanding of the AS-AD curves. In fact it looks very much like the supply-demand model which you used to gain some insight into the determination of prices in individual markets. Your investment in understanding the supply - demand framework in microeconomics will pay further dividends here because it shares a number of properties with its macroeconomic counterpart, the Aggregate Supply - Aggregate Demand model. The Aggregate Supply - Aggregate Demand graph which appears below looks very similar to the one above, but there are a few very important distinctions. On the vertical axis we are again measuring price, but in this case it is the aggregate price level (CPI or GDP price deflator). On the horizontal axis we once again have quantity, but here it is total output in the economy (GDP).
AS -AD Model
To use the model it is necessary to understand what the curves represent and / or what factors affect the position and slope of the curves. As before, each of the curves is meant to summarize the behavior of a group of decision makers, although in this case the aggregate supply curve represents the behavior of suppliers and demanders in the aggregate output market. The aggregate supply curve represents the behavior of producers of the goods and services included in GDP - the manufacturing firms that produce your automobiles and the law firms that provide legal services. The aggregate demand curve, meanwhile, represents the behavior of the buyers of those goods and services - the households that buy groceries and the firms that buy computers and the government that buys military hardware and the Europeans who buy US produced machine tools.
While each of these decision makers is likely to behave in a "unique" way, there are some common denominators which allow us to move from the behavior of individuals to the aggregate curves. Rukstad provides a simple schematic which identifies the set of factors that are likely to affect the AS - AD model. For example, the AD curve is directly affected by the size of the population and the individual components of demand that affect the non financial markets as well as developments in the financial markets. For example, a decline in stock prices (financial markets) could result in a reduction in aggregate demand which would be shown as a left ward shift in the aggregate demand curve. Similarly, a decrease in interest rates comparable to what we saw in early 1998 may stimulate housing demand which we would see as a rightward shift in the aggregate demand curve. Aggregate supply, meanwhile, depends upon the price of the inputs and their productivity. If there was a substantial increase in productivity of labor, then the costs of production would fall which would be seen as an outward shift in the aggregate supply curve.
Determinants of Aggregate Supply and Aggregate Demand
While it would be a bit premature to work with the model which we will be developing during the course, we can see how it can be useful with the help of a simple example. Let's look at a situation similar to the dramatic oil price shocks in the 1970s. From the schematic above we know this is a supply-side effect and you should expect to see a decrease in the aggregate supply curve - an inward shift. In this situation the economy will move toward the new equilibrium and we should therefore expect to see stagflation - the simultaneous appearance of higher prices and lower output which will generate a higher unemployment rate.
Impact of Supply-side Price Shock
We will also talk about public policy. For example, what will happen if the central bank of the US, the FED, reduces the supply of money? We will see how we can translate this into the model to provide us with a prediction of the likely consequences of the FED policy. Before we look more deeply into the specifics of the model, however, we will need to look more closely at the macroeconomic variables that you are familiar with from your reading of newspapers and magazines and from television news stories.