SHORT-RUN EQUILIBRIUM: The condition that exists for the aggregate market when the product and financial markets are in equilibrium, but the resource markets are not. This condition results in the short run because of worker misperceptions about real wages and/or rigid wages and prices. It is represented by the intersection of the AD (aggregate demand) curve and the SRAS (short-run aggregate supply) curve and can be greater than or less than full employment.
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The total real expenditures on final goods and services produced in the domestic economy that buyers are willing and able to undertake at different price levels, during a given time period (usually a year). Aggregate demand, usually abbreviated AD, is an inverse relation between price level and aggregate expenditures. This is one half of the AS-AD (aggregate market) analysis. The other half is aggregate supply. Aggregate demand consists of four aggregate expenditures--consumption expenditures, investment expenditures, government purchases, and net exports--made by the four macroeconomic sectors--household, business, government, and foreign. Aggregate demand is the total expenditures on gross domestic product. It relates the economy's price level, usually measured by the GDP price deflator, and aggregate expenditures on domestic production, usually measured by real gross domestic product. The aggregate demand relation between aggregate expenditures and price level is inverse--a higher price level is related to a decrease in aggregate expenditures and a lower price level is related to an increase in aggregate expenditures.
Aggregate demand plays a similar role in the aggregate market (AS-AD) analysis as that played by market demand in the standard market analysis. Both represent the "buying side" of the market with negatively-sloped curves. Both relate price and quantity. However, differences emerge because aggregate demand is for ALL production in the economy, while market demand is that for a single product. Moreover, the negative slope of the aggregate demand curve is attributable to the interest-rate effect, real-balance effect, and net-export effect, while the slope of the market demand curve is attributable to the income effect and substitution effect.
A closer inspection of aggregate demand can be had by examining four specific topics: (1) the role aggregate demand plays in the aggregate market, (2) the aggregate demand curve, (3) the four aggregate expenditures making up aggregate demand, and (4) the price level and the difference between aggregate demand and aggregate expenditures.
Aggregate MarketAggregate demand is an integral part of the AS-AD (aggregate market) analysis. The aggregate market is a handy model of the macroeconomy designed to analyze the relationship between total production (real gross domestic product) and the price level (the GDP price deflator). Without the aggregate demand side of the model, very little analyzing can be accomplished. In the same way that the standard market analysis is based on the interaction between market supply and market demand, the aggregate market analysis is based on the interaction between aggregate supply and aggregate demand. There is NO analysis without both.
The aggregate market analysis is used to understand assorted macroeconomic events, especially business cycles, inflation, and unemployment. It is also used to analyze the effects of assorted government policies designed to achieve the macroeconomic goals of full employment, stability, and economic growth. The aggregate market is currently THE standard model for macroeconomic analysis.
The Aggregate Demand Curve
A typical aggregate demand curve is presented in the exhibit to the right. Consider a few highlights of this curve.
|Aggregate Demand Curve
- First, note that the price level is measured on the vertical axis and real production (or more specifically aggregate expenditures on real production) is measured on the horizontal axis. The price level is measured by the GDP price deflator and real production is measured by real GDP.
- Second, note that this aggregate demand curve has a negative slope. The aggregate expenditures that the four sectors of the economy would like to make at higher price levels are relatively low. However, at lower price levels, aggregate expenditures are greater.
- Third, the price level and aggregate expenditures on real production are the only two variables allowed to change in the construction of this curve. Everything else that could affect aggregate demand is assumed to remain constant. Analogous to market demand, these other variables are ceteris paribus factors that fall under the heading of aggregate demand determinants.
- Fourth, this aggregate demand curve captures the relation between the price level and real production during a given time period, usually one year. However, depending on the particular aggregate market analysis, the time period could be shorter (one month or one quarter) or longer (several years).
Aggregate ExpendituresAggregate demand is the relation between aggregate expenditures made on real domestic production and the price level. Aggregate expenditures are the total expenditures on real gross domestic product undertaken in a given time period by the four sectors--household, business, government, and foreign. Expenditures made by each of these sectors are commonly termed consumption expenditures, investment expenditures, government purchases, and net exports.
Consumption Expenditures: Consumption expenditures are the expenditures by the household sector on final goods and services undertaken in a given time period. Consumption expenditures are a rather large part of aggregate expenditures, about two-thirds, that are used by households to purchase things like food, clothing, and kitchen appliances. It is often convenient to work with three specific categories of consumption expenditures--nondurable goods, durable goods, and services.
Each of these three categories of consumption expenditures plays a different role in the macroeconomy. For example, households tend to cut back expenditures for durable goods more than nondurable goods when the economy is heading into a business-cycle contraction. Additionally, expenditures on services tend to rise with the economy's long-run march toward prosperity.
- Nondurable goods include food, clothing, and facial tissue--and other things that seldom have a useful life of more than a year.
- Durable goods can be found among cars, furniture, and kitchen appliances. These are goods that should be around for more than a year.
- Services include health care, entertainment, education, legal advice, and other intangible activities that do not involve a physical product but provide satisfaction directly.
Investment Expenditures: The business sector is responsible for investment expenditures. While investment expenditures are commonly considered expenditures by the business sector on final goods and services undertaken in a given time period, they are not just any business expenditure, but rather expenditures for the purchase of capital goods like factories and equipment.
Similar to consumption expenditures, investment expenditures are divided into a three useful categories--structures, equipment, and change in inventories.
Investment expenditures play a key role in the instability of the macroeconomy. The slightest change in the economy can trigger a big boost in investment or an equally large drop. This makes investment the most volatile of the four expenditures. It also makes investment a prime cause of business cycles.
- Structures are buildings, including factories, office buildings, shopping malls, apartment complexes, and even residential houses.
- Equipment is the vast array of machinery and tools used for production, including delivery vehicles, computers, air compressors, forklifts, electric drills, pencil sharpeners, and a whole bunch of other tools that enter into every facet of production by a myriad of different businesses.
- Changes in inventories include increases or decreases in raw materials, intermediate goods, semi-processed products, and finished, but unsold goods, all of which are designed to smooth the flow of inputs and outputs to match production with sales orders.
Government Purchases: The government sector, like the household and business sectors, buys a portion of the final goods and services produced by the economy. The government's purchase of this production, is conveniently termed government purchases.
Consider two points about government purchases.
- First, all three levels of government are important--federal, state, and local. While a lot of attention is understandably focused on the federal level in the study of macroeconomics, federal government purchases are only about one-third of the total.
- Second, government purchases do not include ALL government spending, only those expenditures used to purchase final goods and services, that is, gross domestic product. Government spending on transfer payments, like Social Security and welfare, are not included as government purchases.
Net Exports: The foreign sector, which includes everyone who is not a citizen of the domestic economy, also purchases part of domestic production. Net exports is considered the expenditures by the foreign sector on gross domestic product. They are comprised of two parts--exports and imports. Exports are the purchase of domestic production by the foreign sector. Imports are the purchase of foreign production by the three domestic sectors (household, business, and government). Net exports are then exports minus imports.
While it might seem as though exports are the correct measure to include as part of aggregate demand, net exports are used for the following reasons.
- Net exports provide an overall picture of how the domestic economy interacts with the foreign sector.
- More important, the three expenditures on aggregate demand--consumption expenditures, investment expenditures, and government purchases--include a significant amount of imported goods produced by foreign economies. By subtracting imports from exports, and calculating net exports, it is possible, in one fell swoop, to eliminate this foreign production from aggregate demand, and end up only with aggregate expenditures on domestic production.
Price LevelA deeper peek into aggregate demand requires a word or two about the price level. Recall that the basic explanation of aggregate demand includes the phrase, "at different price levels."
The price level is essentially the price of the final goods and services produced in the economy, that is, the price of real production. However, because the economy produces thousands of different goods and services, the price level is actually an average of thousands of different prices. The price level is commonly measured using one of two price indexes that average these thousands of prices.
The price level is also key to distinguishing between two similar concepts--aggregate demand and aggregate expenditures. While aggregate demand and aggregate expenditures might seem like the same concept, they are not. The difference between aggregate demand and aggregate expenditures is analogous to the difference between demand and quantity demanded.
- Consumer Price Index: The most widely recognized measure of the price level is the Consumer Price Index (CPI). The CPI is an average of the prices of the goods typically purchased by urban consumers. While it is a relatively good indicator of the price level, it does not include the prices of goods typically purchased only by rural consumers or the business, government, and foreign sectors, which constitute about 40 percent of gross domestic product.
- GDP Price Deflator: The price index generally prefer by economists is the GDP price deflator. The GDP price deflator is a bi-product from the calculation of real GDP, which makes it an average of the prices of ALL final goods and services produced in the economy, including those purchased by all households (urban and rural), as well as the business, government, and foreign sectors. It is the preferred index for measuring the price level used in the aggregate market analysis and aggregate demand because it provides a comprehensive coverage of production.
Aggregate expenditures are the expenditures (like the quantity demanded) made at a specific price level. Aggregate demand (like market demand) includes all price-quantity pairs, that is, all price level-aggregate expenditure pairs. Key to this difference is that a change in the price level causes a change in aggregate expenditures. A change in any factor other than the price level causes a change in aggregate demand.
- Aggregate Demand: This is the range of expenditures at different price levels. It includes an assortment of price level-aggregate expenditure combinations. This is comparable to demand.
- Aggregate Expenditures: These are the combined purchases that the four sectors make at a specific price level. This is comparable to quantity demanded.
Other DemandsAggregate demand is one of several types of "demand" in the study of economics. When economists speak of "demand" with no modifiers, they are usually referring to "market demand." In addition to market demand and aggregate demand, two other types of demand include factor demand, which is the demand for the services of factors of production, and money demand, which is the demand for money circulating around the economy.
AGGREGATE DEMAND, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2024. [Accessed: March 4, 2024].
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