Question

After reviewing the concepts of aggregate demand (AD) and aggregate supply (AS), tell how the COVID 19 pandemic has impacted both the AD and AS as well as the general equilibrium. Your answer should have at least three components: the effects on AD, the effects on AS, and the effects on the general equilibrium, determined by the intersection between AD and AS

Answer 1

The aggregate supply curve

Firms make decisions about what quantity to supply based on the profits they expect to earn. Profits, in turn, are also determined by the price of the outputs the firm sells and by the price of the inputs—like labor or raw materials—the firm needs to buy. Aggregate supply, or AS, refers to the total quantity of output—in other words, real GDP—firms will produce and sell. The aggregate supply curve shows the total quantity of output—real GDP—that firms will produce and sell at each price level.

The graph below shows an aggregate supply curve. Let's begin by walking through the elements of the diagram one at a time: the horizontal and vertical axes, the aggregate supply curve itself, and the meaning of the potential GDP vertical line.

The horizontal axis of the diagram shows real GDP—that is, the level of GDP adjusted for inflation. The vertical axis shows the price level. Price level is the average price of all goods and services produced in the economy. It's an index number, like the GDP deflator.

[Wait, what's a GDP deflator again?]

Notice on the graph that as the price level rises, the aggregate supply—quantity of goods and services supplied—rises as well. Why do you think this is?

The price level shown on the vertical axis represents prices for final goods or outputs bought in the economy, not the price level for intermediate goods and services that are inputs to production. The AS curve describes how suppliers will react to a higher price level for final outputs of goods and services while the prices of inputs like labor and energy remain constant.

If firms across the economy face a situation where the price level of what they produce and sell is rising but their costs of production are not rising, then the lure of higher profits will induce them to expand production.

Potential GDP

If you look at our example graph above, you'll see that the slope of the AS curve changes from nearly flat at its far left to nearly vertical at its far right. At the far left of the aggregate supply curve, the level of output in the economy is far below potential GDP—the quantity that an economy can produce by fully employing its existing levels of labor, physical capital, and technology, in the context of its existing market and legal institutions.

At these relatively low levels of output, levels of unemployment are high, and many factories are running only part-time or have closed their doors. In this situation, a relatively small increase in the prices of the outputs that businesses sell—with no rise in input prices—can encourage a considerable surge in the quantity of aggregate supply—real GDP—because so many workers and factories are ready to swing into production.

As the quantity produced increases, however, certain firms and industries will start running into limits—for example, nearly all of the expert workers in a certain industry could have jobs or factories in certain geographic areas or industries might be running at full speed.

In the intermediate area of the AS curve, a higher price level for outputs continues to encourage a greater quantity of output, but as the increasingly steep upward slope of the aggregate supply curve shows, the increase in quantity in response to a given rise in the price level will not be quite as large.

At the far right, the aggregate supply curve becomes nearly vertical. At this quantity, higher prices for outputs cannot encourage additional output because even if firms want to expand output, the inputs of labor and machinery in the economy are fully employed.

In our example AS curve, the vertical line in the exhibit shows that potential GDP occurs at a total output of 9,500. When an economy is operating at its potential GDP, machines and factories are running at capacity, and the unemployment rate is relatively low at the natural rate of unemployment. For this reason, potential GDP is sometimes also called full-employment GDP.

Why does AS cross potential GDP?

The aggregate supply curve is typically drawn to cross the potential GDP line. This shape may seem puzzling—How can an economy produce at an output level which is higher than its potential or full-employment GDP?

The economic intuition here is that if prices for outputs were high enough, producers would make fanatical efforts to produce: all workers would be on double-overtime, all machines would run 24 hours a day, seven days a week. Such hyper-intense production would go beyond using potential labor and physical capital resources fully to using them in a way that is not sustainable in the long term. Thus, it is indeed possible for production to sprint above potential GDP, but only in the short run.

So, in the short run, it is possible for producers to supply less or more GDP than potential if demand is too low or too high. In the long run, however, producers are limited to producing at potential GDP.

For this reason, economists also refer to the AS curve as the short run aggregate supply curve, or SRAS curve. The vertical line at potential GDP may also be referred to as the long run aggregate supply curve, or LRAS curve.

The Aggregate Demand Curve

Aggregate demand, or AD, refers to the amount of total spending on domestic goods and services in an economy. Strictly speaking, AD is what economists call total planned expenditure. We'll talk about that more in other articles, but for now, just think of aggregate demand as total spending.

Aggregate demand includes all four components of demand:

• Consumption
• Investment
• Government spending
• Net exports—exports minus imports

This demand is determined by a number of factors; one of them is the price level. An aggregate demand curve shows the total spending on domestic goods and services at each price level.

You can see an example aggregate demand curve below. Just like in an aggregate supply curve, the horizontal axis shows real GDP and the vertical axis shows price level. But there's a big difference in the shape of the AD curve—it slopes down. This downward slope indicates that increases in the price level of outputs lead to a lower quantity of total spending.