 Why do you understand by Aggregate demand and supply?

Explain in
details?
Answer:
What Is Aggregate Demand?
Aggregate demand is an economic measurement of total amount of demand for all finished
goods and services produced in an economy. Aggregate demand is expressed as total amount of
money exchanged for those goods and services at a specific price level and point in time.
Understanding Aggregate Demand
Aggregate demand represents the total demand for goods and services at any given price level in
a given period. Aggregate demand over the long-term equals gross domestic product
(GDP) because the two metrics are calculated in same way. GDP represents the total amount of
goods and services produced in an economy while aggregate demand is desire for those goods.
As result of same calculation methods, aggregate demand and GDP increase or decrease
together.
Technically speaking, aggregate demand only equals GDP in long run after adjusting for price
level. This is because short-run aggregate demand measures total output for a single nominal
price level whereby nominal is not adjusted for inflation. Other variations in calculations can
occur depending on methodologies used and various components.
Aggregate demand consists of all consumer goods, capital goods (factories and equipment),
exports, imports, and government spending programs. Variables are all considered equal as long
as they trade at same market value.
Calculating Aggregate Demand
The equation for aggregate demand adds the amount of consumer spending, private investment,
government spending, and net of exports and imports. The formula is shown as follows:
Aggregate Demand= C+I+G+Nx
Where:
C=Consumer spending on goods and services
I=Private investment and corporate spending on non-
final capital goods (factories, equipment, etc.)
G=Government spending on public goods and socialservices (infrastructure, Medicare, etc.)
Nx=Net exports (exports minus imports)
Aggregate demand formula above is also used by Bureau of Economic Analysis to measure GDP
in U.S.
Factors That Can Affect Aggregate Demand
Following are some of key economic factors that can affect the aggregate demand in an
economy.
I. Changes in Interest Rates
Whether interest rates are rising or falling will affect decisions made by consumers and
businesses. Lower interest rates will lower the borrowing costs for big-ticket items such as
appliances, vehicles and homes. Also, companies will be able to borrow at lower rates, which
tends to lead to capital spending increases.
Conversely, higher interest rates increase cost of borrowing for consumers and companies.
Result, spending tends to decline or grow at slower pace, depending on the extent of increase in
rates.
II. Income and Wealth
As household wealth increases, aggregate demand usually increases as well. Conversely, a
decline in wealth usually leads to lower aggregate demand. Increases in personal savings will
also lead to less demand for goods, which tends to occur during recessions. When consumers are
feeling good about the economy, they tend to spend more leading to a decline in savings.
III. Changes in Inflation Expectations
Consumers who feel that inflation will increase or prices will rise, tend to make purchases now,
which leads to rising aggregate demand. But if consumers believe prices will fall in the future,
aggregate demand tends to fall as well.
IV. Currency Exchange Rate Changes
If the value of the U.S. dollar falls (or rises), foreign goods will become more (or less
expensive). Meanwhile, goods manufactured in the U.S. will become cheaper (or more
expensive) for foreign markets. Aggregate demand will, therefore, increase (or decrease). 
Limitations of Aggregate Demand
Aggregate demand is helpful in determining the overall strength of consumers and businesses in
an economy. Since aggregate demand is measured by market values, it only represents total
output at a given price level and does not necessarily represent quality or standard of living.
Also, aggregate demand measures many different economic transactions between millions of
individuals and for different purposes. As a result, it can become challenging when trying to
determine the causality of demand and run a regression analysis, which is used to determine how
many variables or factors influence demand and to what extent.
Aggregate Demand Curve
If you were to represent aggregate demand graphically, aggregate amount of goods and services
demanded is represented on the horizontal X-axis, and the overall price level of the entire basket
of goods and services is represented on the vertical Y-axis.
The aggregate demand curve, like most typical demand curves, slopes downward from left to
right. Demand increases or decreases along curve as prices for goods and services either increase
or decrease. Curve can shift due to changes in money supply, or increases and decreases in tax
rates.
Example:
An example of an aggregate demand curve is given in Figure.

The vertical axis represents the price level of all final goods and services. The aggregate price
level is measured by either the GDP deflator or the CPI. The horizontal axis represents the real
quantity of all goods and services purchased as measured by the level of real GDP. Notice that
the aggregate demand curve, AD, like the demand curves for individual goods, is downward
sloping, implying that there is an inverse relationship between the price level and the quantity
demanded of real GDP

What Is Aggregate Supply?

Aggregate supply, also known as total output, is total supply of goods and services produced
within an economy at a given overall price in given period. It is represented by aggregate supply
curve, which describes the relationship between price levels and quantity of output that firms are
willing to provide. Typically, there is a positive relationship between aggregate supply and price
level.
Aggregate supply is usually calculated over a year because changes in supply tend to lag changes
in demand.
Changes in Aggregate Supply
A shift in aggregate supply can be attributed to many variables, including changes in size and
quality of labor, technological innovations, an increase in wages, an increase in production costs,
changes in producer taxes, and subsidies and changes in inflation. Some of these factors lead to
positive changes in aggregate supply while others cause aggregate supply to decline. For
example, increased labor efficiency, perhaps through outsourcing or automation, raises supply
output by decreasing the labor cost per unit of supply. By contrast, wage increases place down-
ward pressure on aggregate supply by increasing production costs.
Aggregate Supply Explained
Rising prices are typically an indicator that businesses should expand production to meet a
higher level of aggregate demand. When demand increases amid constant supply, consumers
compete for goods available and, therefore, pay higher prices. Dynamic induces firms to increase
output to sell more goods. Resulting supply increase causes prices to normalize and output to
remain elevated.
Aggregate Supply Curve
The upward-sloping curve is the aggregate supply schedule, or AS curve. This curve represents
the quantity of goods and services that businesses are willing to produce and sell at each price
level (with other determinants of aggregate supply held constant).
According to the curve, businesses will want to sell $3000 billion at a price level of 150; they
will want to sell a higher quantity, $3300 billion, if prices rise to 200. As the level of total output
demanded rises, businesses will want to sell more goods and services at a higher price level.
 Fig:- Aggregate Supply Curve
Example of Aggregate Supply
XYZ Corporation produces 100,000 widgets per quarter at a total expense of $1 million, but cost
of a critical component that accounts for 10% of that expense doubles in price because of a
shortage of materials or other external factors. In that event, XYZ Corporation could produce
only 90,909 widgets if it is still spending $1 million on production. This reduction would
represent a decrease in aggregate supply. In this example, lower aggregate supply could lead to
demand exceeding output. That, coupled with increase in production costs, is likely to lead to
rise in price.
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