Economists use a variety of models to explain how national income is determined, including the aggregate demand - aggregate supply (AD - AS) model. This model is derived from the basic circular flow concept, which is used to explain how income flows between households and firms.
Aggregate demand (AD) is the total demand by domestic and foreign households and firms for an economy's scarce resources, less the demand by domestic households and firms for resources from abroad.
Aggregate demand consists of the amount households plan to spend on goods (C), plus planned spending on capital investment, (I) + government spending, (G) + exports (X) minus imports (M) from abroad. The standard equation is:
Aggregate demand can be illustrated by reference to the circular flow of income.
Aggregate demand is generated as income is transferred to spending as a result of the circular flow of income. Income is spent on consumer goods and services (C) plus spending on capital goods by firms (I). Spending is also generated by government when it allocates resources to public goods, merit goods and income transfers, such as pension benefits. Finally, there is 'net overseas spending', which is overseas spending on an economy's exports of goods and services, less what the economy spends on importing goods and services.
The AD - AS model shows how changes in the level of AD and AS affect an economy’s national output (income) and its price level.
AD can be found by adding-up the value of all the individual components at various average price levels.
Apart from imports, the components of AD are inversely related to prices. Each component responds differently to changes in prices, in other words they have different elasticities with respect to the price level.
For example, we can assume that overseas demand is elastic with respect to price, because overseas consumers can choose from many global suppliers. This makes them highly sensitive to changes in the prices of imported products.
The AD curve shows the relationship between AD and the price level. It is assumed that the AD curve will slope down from left to right. This is because all the components of AD, except imports, are inversely related to the price level.
For convenience, the AD curve is normally drawn as a straight line, though it can be argued that it is more likely to be non-linear, many suggesting it has a rectangular hyperbola shape.
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