key term - Aggregate demand greater than aggregate supply

Definition

When aggregate demand exceeds aggregate supply, it indicates that the total quantity of goods and services demanded in the economy surpasses what producers are able to supply at a given price level. This imbalance can lead to upward pressure on prices and may result in inflation, as consumers compete for the limited goods available. Understanding this relationship is crucial for analyzing economic fluctuations and the dynamics of the AD-AS model.

5 Must Know Facts For Your Next Test

1. When aggregate demand is greater than aggregate supply, it can lead to inflation as prices rise to balance demand with limited supply.
2. This situation often occurs in an expanding economy where consumer confidence is high, leading to increased spending.
3. If this imbalance persists, it can cause a positive output gap, indicating that the economy is producing above its potential output.
4. The government and central banks may respond to such situations by implementing monetary or fiscal policies to decrease demand or increase supply.
5. In the long run, if aggregate demand continues to exceed aggregate supply, it can lead to overheating in the economy, prompting corrective measures.

Review Questions

• What are the potential short-term effects on prices and production when aggregate demand exceeds aggregate supply?
  • When aggregate demand surpasses aggregate supply, it often leads to higher prices due to increased competition for available goods and services. Producers may respond to this increased demand by attempting to ramp up production; however, if they are unable to keep pace with demand, it can create shortages. This imbalance can result in inflationary pressures, as consumers are willing to pay more for limited products.
• Discuss how government policies might be used to address a situation where aggregate demand is persistently greater than aggregate supply.
  • To address a situation where aggregate demand consistently exceeds aggregate supply, governments may employ contractionary fiscal policy by reducing public spending or increasing taxes. This approach aims to decrease overall demand in the economy. Additionally, central banks could raise interest rates, making borrowing more expensive and encouraging saving over spending. These measures aim to restore balance between aggregate demand and supply and mitigate inflationary pressures.
• Evaluate the long-term implications of sustained aggregate demand exceeding aggregate supply on economic stability.
  • Sustained conditions where aggregate demand consistently exceeds aggregate supply can lead to significant economic instability. The resultant inflation may erode purchasing power and create uncertainty among consumers and investors. If an economy overheats, it can lead to asset bubbles that eventually burst, resulting in severe economic downturns. Long-term imbalances might also prompt corrective measures that can lead to recessionary periods as adjustments are made in response to prior excesses.

Related terms

Inflation:

A sustained increase in the general price level of goods and services in an economy over a period of time.

Short-run aggregate supply (SRAS): The short-run aggregate supply curve, which shows the relationship between the quantity of goods and services supplied and the price level when some production costs are fixed.

Business cycle:

The fluctuations in economic activity characterized by periods of economic expansion and contraction.