Question

Why Aggregate supply is important in the National Income calculations? Your answer should tell the impact of Aggregate supply on Output and Employment.

Answer 1

Aggregate supply is important because in long run the market adjusts itself to reach the full employment level if output when an economy has experienced a positive or negative demand shock.

Positive demand shock, it increases output beyond the level of full employment, unemployment to fall below the natural rate and also, increases the price level. In long run workers realise that their real wages have decreased due to increased price level, so, they start demanding higher wages which increases the cost of production and leads to decrease in aggregate supply at each price level bringing the economy back to full employment level and unemployment rate increases to natural level.

Negative demand shock, it decreases the aggregate demand in the economy leading to a fall in output below the full employment level, unemployment level above the natural rate and decreases the price level too. In long run, firms have to revise their inflation expectations because they are able to get inputs at cheaper price leading to increase in aggregate supply at each price level. This increases the output level to full employment output level and decreases unemployment rate to natural level.

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