Households are the primary demanders of goods and services in the economy. They are also the primary suppliers of labour and other economic resources.
^^Business firms are the primary suppliers of output and the primary demanders of labour and other economic resources.^^ The interactions between households and businesses take place in two types of markets: output markets and input markets.
The circular flow model shows the movement of income and spending between households and businesses in the economy. In output markets businesses trade goods and services for expenditures from households. In Input markets, households trade their land, labour and capital in exchange for income in the form of rent, wages, and interest.
Circular flow model with Government and foreign sector:
The expenditures approach is the most commonly used measure of GDP. Using the expenditures approach, GDP can be divided into four basic components: consumption expenditure (C), private investment (I), government expenditure and investment (G), and net exports (exports [X] minus imports [M]). The expenditures approach measures GDP as
^^GDP = C + I + G + (X - M)^^
1) Consumption (C):
2) Investment (I)
3)Government Expenditure and Investment (G) :
4)Net Exports (X - M)
Aggregate demand (AD) is the demand for all goods and services in an economy.
Aggregate supply (AS) is the supply of all goods and services in an economy.
Aggregate means to gather a set of items together to form a total or whole.
The price level is a measure of the average level of prices in an economy.
In the AD/AS model the horizontal axis represents total output per period (GDP) and the vertical axis represents the price level in the economy. The intersection of AD and AS tells the equilibrium level of GDP and the equilibrium price level in the economy.
As the price level rises, businesses have an incentive to increase their production of goods and services, which will move the economy upward along the AS curve.
As in the usual model, the AS curve is positively sloped, indicating that the quantity of goods and services produced tends to increase as the prices of goods and services increase.
Aggregate demand is composed of all of the consumption, investment, government spending, and net export expenditures that make up GDP. Changes in any of these components of AD will cause shifts in AD. Changes in government spending or in exports and imports can also shift AD.
Aggregate supply represents the production of all final goods and services in the economy. Important shifters of AS include the prices of inputs needed to produce goods and services, the productivity of inputs, changes in technology used in production, and the cost of financing business activities. If the overall prices of widely used inputs increase, AS will shift inward.
As in the demand and supply model, shifts in either the AD or AS curves can cause changes in the quantity of output and the price level in the economy.
The graph below illustrates the impacts of increases in AD and AS in the economy.
Panel A shows the impact of two different increases in AD.
The first increase is from AD1 to AD2, along the relatively flat portion of the AS curve.
The second increase is from AD3, to AD4, along the steeper portion of the AS curve.
As in the usual demand and supply model, an increase in AD from AD1 to AD2, or from AD3, to AD4, generates a temporary shortage of goods and services at me old price level.
This shortage puts upward pressure on prices and gives suppliers incentive to increase their production.
As a result, the economy moves along the AS curve to a higher price level and higher amount of GDP than before.
Panel B illustrates the impact of an in increase in AS on the economy.
A shift in AS from AS1, to AS2, causes a temporary surplus of goods and services at the old price level.
The surplus puts downward pressure on prices.
As prices fall, the economy moves downward along the AD curve to a new equilibrium.
An increase in AS causes an increase in economic output and a decrease in the price level.
Business Cycles are recurring expansions and contractions in the level of aggregate economic activity.
Business cycle expansions are periods of increasing economic activity, rising production, and increasing employment.
Business cycle contractions or recessions are periods of decreasing economic activity, falling production, and falling employment.
Business cycles are the recurring expansions and contractions in GDP over time.
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