Understanding Economic Policymaking: GDP, Business Cycle & Aggregate Supply - Demand I (Part 4)

What Drives The Business Cycle - Aggregate Supply and Aggregate Demand

Understanding the Drivers of Economic Activity

So far, we've examined the current state of economies, the ideal state they aim to achieve, and the gap between these two conditions. However, we’ve yet to address a fundamental question: 

• What actually drives an economy?
• What determines a country’s level of GDP?
• What causes output gaps—whether positive or negative?

As mentioned at the beginning of this post, most modern economies—particularly those in which we live—are largely driven by the private sector. Economic activity results from countless individual decisions made by businesses, consumers, and investors—not centrally planned by governments. While it may sometimes seem that the government plays a dominant role, the truth is that the majority of economic decisions are made independently and in a decentralized manner, based on goals such as profit, utility, or cost efficiency.

Before we move on to economic policy, it's essential to understand these underlying drivers of economic activity. By identifying what motivates the economy, we can better determine how to influence it and guide it toward the ideal conditions we've discussed.

To explore this, we’ll use a simple yet powerful diagram—one that will be familiar if you’ve studied economics before: the supply and demand model. Traditionally, this model is used in microeconomics, where:

• The vertical axis represents price

• The horizontal axis represents quantity

• The demand curve slopes downward (higher prices lead to lower demand)

• The supply curve slopes upward (higher prices encourage greater production)

We will now adapt this model to the macroeconomic level. Instead of showing the market for a single good, our version will represent the entire economy—including all goods, services, consumers, and producers.

In this context:

• The vertical axis will represent the overall price level—a measure of how prices are rising or falling across the entire economy, not just for a single product.
• The horizontal axis will represent GDP—the total quantity of goods and services produced in the economy.

This adapted diagram will help us visualize the forces that shape economic output and price levels, laying the groundwork for deeper insights into economic policy.

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Introducing Aggregate Demand and Aggregate Supply

To analyze the overall economy, we will use a diagram similar to the one used in microeconomics—based on supply and demand curves. However, instead of focusing on individual markets, we will apply this model to the entire economy.

• The downward-sloping curve from left to right will now represent Aggregate Demand (AD).
  This curve reflects the total demand for all goods and services in the economy. It includes spending by consumers, businesses (investment), the government, and foreign buyers (net exports). Like in microeconomics, the curve slopes downward because, as the overall price level falls, the total quantity of goods and services demanded tends to increase.

• The upward-sloping curve represents Aggregate Supply (AS)—the total output produced by all firms in the economy. Similar to individual producers in microeconomic models, firms are willing to produce more when prices are high (due to higher profit margins), and less when prices are low.

Together, the Aggregate Demand and Aggregate Supply model provides a simple yet powerful framework for understanding how price levels and economic output (GDP) are determined. This macroeconomic version of the supply and demand model is a foundational tool in economics, helping us examine how economies respond to various factors, including policy changes, shocks, and long-term trends.

Understanding Equilibrium in the Aggregate Demand and Supply Model

Using the Aggregate Demand (AD) and Aggregate Supply (AS) diagram, we can identify the point of equilibrium—the level of GDP where the economy stabilizes.

• Along the horizontal axis, we see the full range of potential GDP levels the economy could produce.

• The actual level of GDP—called the equilibrium GDP—is determined at the point where the AD and AS curves intersect.

This intersection reflects the total spending (demand) and total production (supply) in the economy at a specific time. It is conceptually similar to the circular flow model: total spending generates income, and production adjusts until both are balanced.

At the equilibrium point:

• The horizontal coordinate indicates the GDP (total output) for that period.

• The vertical coordinate shows the price level (average prices across the economy).

This point provides a snapshot of the economy at a specific moment—showing both the output and the general price level.

Comparing this with the business cycle, we see that actual GDP can fluctuate over time—sometimes above, sometimes below equilibrium—resulting in inflationary or recessionary gaps.

These fluctuations occur due to shifts in either aggregate demand or aggregate supply. The current diagram illustrates a static equilibrium—a specific moment in time. To understand real-world changes, we must explore what causes these curves to shift, helping us develop a dynamic view of the economy.

Source: coursera

Nurture Your Season. Align Your Cycle.

Let this gentle image remind you: 

Growth doesn’t have to be rushed.

Explore visuals that spark self-awareness 

and balance in your personal and professional life.

🌾 Reflection Section: What Drives Our Personal Cycles?

Is my current “output” aligned with my inner values and spiritual purpose?

This image of eggs resting in soft grass invites us to pause and reflect.

In economics, the business cycle is driven by aggregate supply (what is produced) and demand (what is desired). Similarly, our lives follow a rhythm—a personal cycle influenced by what we’re capable of offering and what our soul is yearning for.

• 🥚 Personal Aggregate Demand: What are you seeking more of in this season — purpose, peace, productivity?

• 🌿 Personal Aggregate Supply: What are you capable of producing with your current energy, resources, and intentions?

Like eggs, our potentials are not always visible from the outside—they must be nurtured in the right conditions. The grass around them represents the supportive or chaotic environments we live in. We often push for productivity without pausing to reflect:

Is my current “output” aligned with my inner values and spiritual purpose?

📖 Qur’anic Insight:

(Quran Surah 13 Ar-Ra’d (The Thunder) Ayat 11)

“Indeed, Allah will not change the condition of a people until they change what is in themselves.”

💬 This verse reminds us: sustainable change begins from within. Like economic policies, personal transformation must be strategic, intentional, and rooted in reflection.