The aggregate supply and demand model is used to show the determination of the
equilibrium levels of both output and prices.
The aggregate supply schedule, AS , shows at each level of prices the quantity of real
output firms are willing to supply.
The Keynesian supply schedule is horizontal, implying that firms supply as many
goods as are demanded at the existing price level. The classical supply schedule is
vertical. It would apply in an economy that has full price and wage flexibility.
In such a frictionless economy, employment and output are always at the fullemployment
level.
The aggregate supply curve describes the dynamic price adjustment mechanism of
the economy.
The aggregate demand schedule, AD , shows at each price level the level of output at
which the goods and assets markets are in equilibrium. This is the quantity of output
demanded at each price level. Along the AD schedule fiscal policy is given, as is the
nominal quantity of money.
A fiscal expansion shifts the AD schedule outward and to the right. An increase in
the nominal money stock shifts the AD curve up by the same proportion as the
money stock increases.
Supply-side economics makes the claim that reducing tax rates generates very large
increases in aggregate supply. In truth, tax cuts produce very small increases in
aggregate supply and relatively large increases in aggregate demand.
Over long periods, output is essentially determined by aggregate supply and prices
are determined by the movement of aggregate demand relative to the movement of
aggregate supply.
