How does the relationship between aggregate supply and aggregate demand determine inflation?

Aggregate supply is the total of all goods and services produced by an economy over a given period. When people talk about supply in the U.S. economy, they are referring to aggregate supply.

Aggregate supply is measured by gross domestic product (GDP). The U.S. economy is one of the largest suppliers in the world.

Short-run and Long-run Supply

The typical time frame measured is a year. That time frame is important because supply changes more slowly than demand. For example, demand can rise quickly, but companies can't ramp up production as fast. They've got to hire new workers and build new plants and equipment. When demand drops, it can take companies months to reduce supply. They've got to close factories and lay off workers.

Note

There's a big difference between supply in the short-run versus the long-run. Short-run supply depends on price.

As demand rises, customers are willing to pay a higher price. Businesses will increase supply to gain profits from higher prices until they reach their current capacity.

In the long-run, if the price and demand remain high, companies can boost supply. They have the time to add the workers, machinery, and factories required.

The amount supplied is called the natural rate of output. Short-run economic fluctuations can occur without affecting the long-run output rate.

Four Factors of Aggregate Supply

The amount supplied is determined by the four factors of production. U.S. economic success is based on an abundance of these factors of production. The following four factors determine long-run supply. 

1. Labor. The people who work for a living. The value of labor depends on workers' education, skills, and motivation. The reward or income for labor is wages. The United States has a large, skilled, and mobile labor force that responds quickly to changing business needs. But it faces increasing competitive labor from other countries. They provide similarly-skilled workers at a lower price. It's one reason why American jobs are outsourced.
2. Capital Goods. Man-made objects, such as machinery and equipment, which are used in production. The income derived from capital goods is interest. Silicon Valley is home to 2,000 tech companies, the densest concentration in the world. This proximity to suppliers, customers, and cutting-edge research gives them a competitive advantage.
3. Natural Resources. The raw goods and materials used by labor to create supply. The United States has a unique combination of easily accessible land and water. It has a moderate climate, miles of coastline, and lots of oil. The income from this is rent.
4. Entrepreneurship. The drive of business owners to produce and innovate. The income from this is profits. America's reliance on capitalism and a market economy supports a high level of entrepreneurship.

Note

Financial capital, such as money and credit, is not a factor of production.

Financial capital is used to buy the factors of production. In other words, financial capital isn't itself a component of anything produced. The ease of obtaining financial capital, whether through stocks, bonds, or loans, plays a critical role in supply. One of the reasons the U.S. economy is so powerful is the ease of obtaining financial capital.

Aggregate Supply Curve

The supply curve charts out how much will be supplied based on the price. Here's how it works. If someone asks you, "How much will you supply?" you would first ask them, "How much will you pay me?" If that answer were satisfactory, you'd ask, "How long have I got?" In other words, your answer would vary depending on the price and the time frame.

That's what the supply curve describes. The higher the price and the longer the time frame, the more you would produce. A normal supply curve slopes up to the right. An aggregate supply curve simply adds up the supply curves for every producer in the country.

Aggregate Supply and Aggregate Demand

Of course, you and the person would have to agree on both the price and the deadline. In other words, that person's demand curve would have to intersect with your supply curve.

Aggregate demand is when all the demand for everything in the country is added together. Everything in an economy depends on how these curves intersect.

Law of Supply and Demand

The amount supplied is guided by the laws of supply and demand. The law of supply says that supply increases when the price increases. The law of demand says that demand decreases as the price increases. The right price is when the amount supplied equals the amount demanded.

In other words, an economy must follow these five rules:

1. Prices or production adjust until supply equals demand
2. Demand creates supply, but supply won't create demand
3. When prices decline, businesses either a) decrease supply, b) lower the operating costs to maintain profit margins, c) go out of business, thus reducing output
4. When prices rise, businesses supply more in the short-term until they reach current capacity. In the long-run, they increase the factors of production so they can supply more. They may also create similar or related products to meet the demand.
5. If supply is constrained, then prices will continue to rise, creating inflation

What the United States Supplies

There are four components of GDP. The first, and most critical, is personal consumption. It's almost 70% of the total supply. It includes goods, such as automobiles and appliances, and services, such as health care and banking.

Business investment is a second component. Most of it is comprised of machinery and equipment. It also includes commercial and residential construction.

The third component is government spending. Most of this goes toward Social Security, defense, and Medicare. As a component of GDP, government spending can boost the economy out of a recession. The theory of Keynesian economics describes how this works.

Net exports, the fourth component, is exports minus imports. Exports add to GDP, while imports subtract. Most of this is capital goods, such as machinery and equipment, and consumer goods, especially pharmaceuticals.

The Bottom Line

Aggregate supply is the goods and services produced by an economy. It's driven by the four factors of production: labor, capital goods, natural resources, and entrepreneurship. These factors are enhanced by the availability of financial capital.

The aggregate supply or GDP of the United States is one of the largest in the world. The nation’s output consists of consumer goods, business investments, government spending, and exports.

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