Economists look at supply and demand when studying the buying decisions of individuals and specific firms. When this information is combined for an entire economy, economists look at aggregate supply and demand. Aggregate supply is further broken down into two types: long-run and short-run. Combined, these three indicators give an overall view of the economy and its potential for meeting needs in a world of scarce resources.
Aggregate demand is the total goods and services demanded in an economy, represented by the gross domestic product, or GDP, of an economy. It is formed by four factors: consumer spending, investment, government spending and net exports, which is exports minus imports. Aggregate demand has an inverse relationship with the price level; as goods become relatively more expensive, fewer goods are demanded, due to the increased price. Due to this inverse relationship, aggregate demand is represented graphically by a downward sloping line. Unlike aggregate supply, aggregate demand is the same in the short and long runs.
Long-Run Aggregate Supply
In the long run, aggregate supply is a fixed amount; it is the total potential output of an economy -- the production capacity of a nation with full employment and full utilization of resources. Graphically, it is represented by a vertical line, because the supply is fixed and does not change relative to the price level.
Short-Run Aggregate Supply
Though long-run aggregate supply is a fixed amount, short-run aggregate supply slopes upward. Short-run aggregate supply has a direct relationship with the price level. As the price level rises, more suppliers will want to produce at that price. In the short term, it is possible to produce either under or over the capacity of the long-run supply curve. When producing beyond the long-run aggregate supply in the short term, the economy experiences inflation. When producing under the long-run aggregate supply, the economy experiences unemployment.
Shifts in Supply and Demand
Aggregate supply and demand can be affected by changes in the price level and by other unique factors. GDP shifts with changes in the exchange rate, the distribution of income across consumers, the economic expectations of consumers and government and expansionary or contractionary monetary and fiscal policies. Aggregate supply increases as available resources increase, as more capital becomes available, as technological developments make production more efficient and as entrepreneurs expand the potential of the economy. Aggregate supply rarely decreases.