Aggregate Supply (AS)
Understanding the concept of aggregate supply (AS) is like getting a bird's eye view of a country's total production capacity. Imagine the country as a single factory, and the AS curve represents the maximum number of goods and services it can produce over a given period.
AS is plotted as an upward-sloping curve on a graph, where the y-axis shows the overall price level of goods and services, while the x-axis represents the real output or Real GDP. This upward slope indicates that as the price level increases, production becomes more profitable, prompting producers to manufacture more.
Aggregate Demand (AD)
Aggregate demand (AD), on the other hand, is the total demand for all goods and services in an economy. It's demonstrated on the same graph as the AS curve, but slopes downwards. This is because as prices rise, the purchasing power of money decreases, leading consumers to buy less. There are four components to AD—consumption, investment, government spending, and net exports.
When the AD curve shifts to the right, as in the Wall Street Journal's euro zone example, it signals an increase in total demand. This shift can be fueled by various factors, such as a boost in consumer confidence or a government spending spree.
Unemployment
Unemployment represents the portion of the workforce that is ready and able to work but cannot find employment. When AD increases, firms ramp up production to meet this demand and typically need to hire more workers, which in turn reduces the unemployment rate.
A crucial point to understand is that unemployment is inversely related to AD. The AD increases lead to a higher demand for labor, which decreases unemployment. Low unemployment is one sign of a healthy economy, as more people working means more income and, subsequently, more spending fueling the economy further.
Inflation
Inflation is when the average price level of goods and services increases over time, reducing the purchasing power of money. In the euro zone economy scenario, inflation rises due to an increased AD. Firms respond to higher demand by hiking prices, which translates into inflation.
Here's a simple way to picture it: As more people bid on the same number of goods, sellers raise the price, resulting in inflation. It's like being at an auction where more bidders drive the price of the auctioned item higher.
Euro Zone Economy
The euro zone economy is a unique case study, considering it encompasses 19 European countries sharing a single currency—the euro. The dynamics of this economy are complex because monetary policy decisions taken by the European Central Bank (ECB) affect all member countries. An increase in AD across the euro zone can indicate a collective economic improvement, potentially driven by increased exports, investment, or consumer spending.
The euro zone economy experiencing simultaneous drops in unemployment and rises in inflation is a sign of possible economic expansion and heating, often referred to as 'reflation'.
Price Level
The price level is a measure of the average of all prices within an economy, providing a snapshot of the economy's overall costliness. It's what is represented on the y-axis of the AS and AD graph. When discussing inflation, it's essentially the price level that we are referring to. If the price level increases, it means inflation is on the rise, and vice-versa.
An elevated price level reduces the real value of money—how much you can actually buy with it—which is why rising price levels are often met with concern by consumers and policymakers alike.
Real GDP
Economic Thermometer
Real Gross Domestic Product (Real GDP) is the inflation-adjusted measure that reflects the value of all goods and services produced by an economy in a given year. It's like the economy’s thermometer, gauging the economy's size and health. On our AS-AD graph, Real GDP lies along the x-axis, serving as an indicator of economic output without the distraction of price level changes.
Growth Indicator
Higher Real GDP signifies more economic activity and often coincides with better employment conditions—a phenomenon clearly visible in the improved euro zone economy.
