Aggregate Demand and Aggregate Supply

Abstract

This note extends the IS/LM model to incorporate changes in the aggregate price level and to permit output to be determined by aggregate supply and demand. The note introduces the concept of the full-employment level of output, provides microfoundations that underpin the aggregate supply curve, and discusses the effects of fiscal and monetary policy when the economy is below and above the full-employment level of output. The note concludes by reviewing the exogenous components of the IS/LM-AD/AS model. Excerpt UVA-GEM-0127 Rev. May 31, 2019 Aggregate Demand and Aggregate Supply In “A Brief Introduction to Macroeconomics” (UVA-GEM-0125), we considered two different ways to think about how aggregate output is determined. Under the first approach, depends completely on the factors of production (e.g., capital and labor), and the only way to increase is to increase these factors or the efficiency with which these factors are combined. Under the second (IS/LM) approach, is determined by demand factors such as desired consumption, government spending, expectations of future income, and financial conditions. In this technical note, we demonstrate that the link between these two approaches lies in the behavior of the aggregate price level . In our model extension that links these approaches, we include the aggregate price level in our set of endogenous variables. That is, rather than treating as fixed and predetermined (as we did when introducing the IS/LM model), it will now be jointly determined along with the interest rate and GDP. We first discuss how changes in affect aggregate demand (AD)—desired spending by firms and households. We then separately discuss how changes in relate to aggregate supply (AS)—what firms and workers are willing to produce. In a short-run equilibrium, the economy is characterized by the price level such that aggregate demand equals aggregate supply. Aggregate Demand . . .