What are aggregate supply and aggregate demand?

In previous entries in our section of Concepts of Economics we have studied what are supply and demand as well as what are its conditioning factors. This time we will explain aggregate supply and aggregate demand. To begin with, we will start from the basis that the internal forces of the market, that is, the behavior of the economic agents of a country, are reflected in the supply and demand curves of that economy.

We speak of aggregate supply and demand curves because in both indices the individual offers and demands of all economic agents operating in the country, both domestic and foreign, appear added or aggregated. These variables do not explain how an isolated market works, as individual supply and demand curves did, but how the economy works as a whole.

What is aggregate demand (AD)?

Given a price level, aggregate demand represents the total expenditure that economic agents are willing to make, whether nationals or foreigners, in the interior of the country. Therefore, it adds the following magnitudes: household consumption or private consumption (C), business investment (I), public spending (G) and the net balance of exports expressed as the difference between gross exports and imports. (XM).

DA = C + I + G + (X – M)

Aggregate demand is, therefore, the total expenditure for a specific price level in an economy by families, companies, the public sector and foreigners. On the other hand, the graphical representation of aggregate demand is known as aggregate demand curve and shows the different quantities of product that economic agents are willing to purchase at each price level.

As with individual demand, aggregate demand increases as prices fall, and vice versa. On the other hand, as the average price level increases, aggregate demand will decrease, since the quantity of goods and services that can be purchased with the same money is reduced.

As we can observe, prices are the main variable that determines what economic agents demand, although not the only one. Other conditioning factors are the amount of money that circulates through the economy, the taxes established by the public sector or the income level of economic agents.

What is aggregate supply (OA)?

The aggregate offer describes the production that the companies would be willing to sell given an average price level, certain production costs and business expectations. In general, companies will want to sell everything they produce at the highest possible prices. However, both production costs and business expectations play an important role.

On one occasion, when we described the individual offer, we explained these three conditioning factors. However, in this case we will review them in macroeconomic key:

  • The average price level. When prices rise, profits will tend to increase; while the opposite will happen when prices decrease. However, low prices could increase aggregate demand and, with it, corporate profits, so studying the right price becomes an essential task in companies. In this way, the price level is the variable that most affects the behavior of the aggregate supply.

  • Production costs. Production costs are the sum of the cost of the factors of production and the cost of the combination of these factors, that is, the cost of the technology used. As we know, business profit is calculated as the difference between income and expenses. Therefore, as the price of the resources used or of the technology increases, business profits tend to decrease and, therefore, the aggregate supply is reduced. Similarly, when these production costs decrease the effect is just the opposite.

  • Business expectations. Aggregate supply also depends on expectations about an economy, which in turn conditions business objectives. For example, when the economic situation is favorable in a country, companies increase their investment. Meanwhile, in the face of an economic crisis or political and social conflicts, the confidence of the companies is reduced and with it the aggregate supply decreases.

The curve that graphically represents the aggregate supply is called aggregate supply curve and shows the different amounts of production that economic agents are willing to purchase at each price level.

(Bibliography: Economics. Penalonga Sweers Angel. McGrawHill)

In The Salmon Blog | What is supply and demand?, What are the conditioning factors of supply and demand?

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