AGGREGATE SUPPLY AND DEMAND

As defined in the previous section, we can express the overall demand in the economy known as Aggregate Demand by use of the following equation:

AD = C + I + G + (NX), where

AD = Aggregate Demand, C = Consumption, I = Investment, G = Government Spending, and NX = Net Exports.

However, overall demand in the economy can be expressed in one of two ways, each of which depends on whether one examines changes in demand as incomes change or as price changes. These give rise to the Keynesian Cross and the Marshallian Cross, which are detailed below.

Keynesian Cross

In the Keynesian Cross model shown in the diagram above, the Z Line represents the equal relationship between an increase in total output and income being matched by an equal increase in total spending. However, in reality, a certain increase in total output and income will lead to a less than equal rise in total rise in spending, due to some of this income being subject to taxation, and also since some of this spending may be transferred abroad through the purchase of foreign imports. This gives rise to the D Line, which represents the actual relationship between total income and spending in the economy. Therefore, equilibrium will be achieved at Point E, where aggregate demand represented by total spending is equal to aggregate supply represented by total output.

The stability of this equilibrium is ensured by changes in inventory levels. For example, if total spending exceeds total output, levels of unsold stock will fall, leading to higher prices for a smaller supply of goods and services. This will depress demand and spending, thus ensuring the reacquisition of Point E again. Conversely, if total spending is below total output, levels of unsold inventory will fall, leading to reduced production until the economy operates at Point E again.

Lastly, with Aggregate Demand being defined as the total sum of consumption, investment, government spending and net exports within the economy, we can use the Keynesian Cross model to show that increases in any one of these components will lead to the D Line shifting up, leading to increased spending and output. Conversely, any decreases in the components of Aggregate Demand will lead to the D Line shifting down, resulting in decreased spending and output.

Marshallian Cross

In contrast to the Keynesian Cross Model, the Marshallian Cross Model uses classic demand and supply theory to measure changes in output and prices but on a macroeconomic level.

As in the usual microeconomic context, aggregate demand (AD) is shown as downward sloping. However, on a macroeconomic basis, this is due to the fact if the nominal money supply (MS) is constant, a fall in price P will lead to a rise in the real money supply (MS/P), thus encouraging lower interest rates and higher spending. This is referred to as the Keynes Effect. Therefore an increase in aggregate demand will shift the AD curve to the right, resulting in a corresponding increase in output Y.

However, in the Marshallian Cross model, a long-run aggregate supply curves which is perfectly vertical. This is because with the economic resources within the economy being limited, the maximum potential output will be restricted to Y* – regardless of the general level of prices within the economy.

What this implies is that while increased aggregate demand will still result in increased production, the extent of this increase will be determined by whether the economy is operating above or below maximum capacity at Y*. If below, an increase in aggregate demand will lead to a greater increase in output with a lower increase in price levels.

However, if operating above maximum capacity, the same increase in aggregate demand will lead to a much lower increase in production and a much higher increase in prices. This gives rise to the upward sloping gradient of the aggregate supply curve represented by AS in diagram above.