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- The aggregate demand-supply model is the basic macroeconomic model for studying output And price level determination. In short run, the interaction between aggregate demand and aggregate supply determines the level of the output, employment, and capacity utilization as well as the price level (the source of inflation). In the long run, a decade or more say, aggregate supply is considered as the major factor behind economic development and well-being of a nation.
- The aggregate demand schedule (or curve) shows the combinations of the price level and the level of output at which the goods and money markets are simultaneously in equilibrium. The aggregate demand schedule (or curve) slopes downward owing to inverse relationship between price level and the level of output demanded. In addition to price level, there are other factors such as income levels, rate of interest, government policy, exchange rate, expected rate of inflation and business expectations influence the aggregate demand in an economy. When these factors or variables change, the aggregate demand curve will shift.
- In short run, the aggregate supply curve slopes upward from left to right for part of its range because at any point in time there is a limit on the output of goods and services. This limit increases as with increased production, the availability of idle resources decreases and 'limit' is reached when the production reaches full employment level of output. When the resources available are fully employed the short run aggregate supply curve becomes vertical. At this point, further increases in price level will have no effect on output. In short, the aggregate supply curve, in short run, slopes upward from left to right for a part of Its range and straightens at the end.
- In the short run, the discrepancy between actual and expected price level causes in output and employment. But in the long run, if all other things remain constant; the higher price level will come to be accurately expected by firms, narrowing down the difference between expected and actual price levels. This is important because in the long run, the incurred by business firms rise as economic agents reach to higher prices.
- The higher level of output in the short run was possible only because the unanticipated rise in the price level led to higher profits to business firms. As soon as the costs increase in line with final prices, the incentive to produce higher levels of output disappears and the production reverts to its original level. In this situation, the level of output will be at itsnatural rate and deviations from this state are possible only when actual price level differs from the expected price level in the short run. Thus, in the long run, the natural rate of output is the equilibrium rate of output for the economy.
- In the long run, the natural rate of output is the level of output to which the economy will tend to adjust in the long run. This indicates that in the long run the average price level has no effect on the level of output (Y). Any unanticipated price rise in the short run will be offset in the long run by an increase in costs as contracts with the suppliers of inputs are renegotiated. Therefore, in the long run the output of an economy does not depend on the price level, but on factors such as, labor import costs, capital stock, technological progress, etc. These factors are not influenced by changes in the average price level and so is the case with aggregate supply in the long run. Therefore, in the long run, the aggregate supply of an economy is vertical at the natural rate of output.
- Most of the factors that affect the position of the 'aggregate supply curve in short run also affect the position of the aggregate supply curve in the long run, with few exceptions. Some of the important factors affect aggregate supply curve are change in costs of production, supply shocks, investment spending and technological changes, availability of raw materials, supply of labor, human capital and incentives.