Question

Explain why most macroeconomists believe that the primary determinant of GDP is aggregate demand in the short-run but aggregate supply in the long-run.

Answer 1

Ans) In short run, many costs, like for eg- wages (due to contract), are sticky. So, short run aggregate supply curve is upward sloping because when price level of output increases due to increased aggregate demand while input costs remain fixed, the opportunity cost of additional profits motivates the sellers to produce more output. And hence in short run, GDP is determined by aggregate demand. Increase in AD will increase price level and thereby increases GDP while a decrease in aggregate demand decreases price level and thereby decreasing output. That is, in short run, aggregate supply responds to aggregate demand.

In long run, aggregate supply is independent of price level because, now, costs become flexible due to expiration of contracts etc. So, in long run, output depends upon the factors of production and technology. And hence the output is determined by the available resources and technology. Since aggregate supply is affected by factors of production and technology, in long run, aggregate supply determines level of output (GDP).