And aggregate supply

In macroeconomics, the focus is on the demand and supply of all goods and services produced by an economy. Accordingly, the demand for all individual goods and services is also combined and referred to as aggregate demand. The supply of all individual goods and services is also combined and referred to as aggregate supply.

It is assumed that the government holds the supply of money constant. One can think of the supply of money as representing the economy's wealth at any moment in time. As the price level rises, the wealth of the economy, as measured by the supply of money, declines in value because the purchasing power of money falls. As buyers become poorer, they reduce their purchases of all goods and services. On the other hand, as the price level falls, the purchasing power of money rises. Buyers become wealthier and are able to purchase more goods and services than before. The wealth effect, therefore, provided one reason for the inverse relationship between the price level and real GDP. Real GDP is GDP evaluated at the market prices of some base year.

The second reason is the interest rate effect. As the price level rises, households and firms require more money to handle their transactions. However, the supply of money is fixed. The increased demand for a fixed supply of money causes the price of money, the interest rate, to rise. As the interest rate rises, spending that is sensitive to rate of interest will decline. Hence, the interest rate effect provides another reason for the inverse relationship between the price level and the demand for real GDP.

The third and final reason is the net exports effect. As the domestic price level rises, foreign-made goods become relatively cheaper so that the demand for imports increases. However, the rise in the domestic price level also means that domestic-made goods are relatively more expensive to foreign buyers so that the demand for exports decreases. When exports decrease and imports increase, net exports (exports — imports) decrease. Because net exports are a component of real GDP, the demand for real GDP declines as net exports decline.

Changes in aggregate demand are not caused by changes in price level. Instead, they are caused by changes in the demand for any of the components of real GDP, changes in the demand for consumption goods and services, changes in investment spending, changes in the government's demand for goods and services, or changes in the demand for net exports.

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The aggregate supply curve is defined in terms of the price level. Increases in the price level will increase the price that producers can get for their products and thus induce more output. But an increase in the price will also have a second effect; it will eventually lead to increases in input prices as well, which, ceteris paribus (Latin for " all else held constant"), will cause producers to cut back. So, there is some uncertainty as to whether the economy will supply more real GDP as the price level rises. In the short run, the input providers do not or cannot take account of the increase in the general price level right away so that it takes some time for input prices to fully reflect changes in the price level for final goods. For example, workers often negotiate multi-year contracts with their employers. These contracts usually include a certain allowance for an increase in the price level, called a cost of living adjustment (COLA). The COLA, however, is based on expectations of the future price level that may turn out to be wrong. Suppose, for example, that workers underestimate the increase in the price level that occurs during the multi-year contract. Depending on the terms of the contract, the workers may not have the opportunity to correct their mistaken estimates of inflation until the contract expires. In this case, their wage increases will lag behind the increases in the price level for some time. In the long-run, the increase in prices that sellers receive for their final goods is completely offset by the proportional increase in the prices that sellers pay for inputs. The result is that the quantity of real GDP supplied by all sellers in the economy is independent of changes in the price level.

Like changes in aggregate demand, changes in aggregate supply are not caused by changes in the price level. Instead, the are primarily caused by changes in two factors. The first of these is a change in input prices. For example, the price for oil, an input good, increased dramatically in the 1990s due to efforts by oil-exporting countries to restrict the quantity of oil sold. Many final goods and services use oil or oil products as inputs. Suppliers of these final goods and services faced rising costs and had to reduce their supply at all price levels.

A second factor that causes the aggregate supply curve to shift is economic growth. Positive economic growth results from an increase in productive resources, such as labor and capital. With more resources, it is possible to produce more final goods and services, and hence, the natural level of real GDP increases. Similarly, negatiye economic growth decreases the natural level of real GDP.

Combining the aggregate demand and aggregate supply curves it is possible to determine both the equilibrium price level, and the equilibrium level of real GDP.