Aggregate Demand and Supply - Full Version

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Aggregate Demand and Supply

Aggregate Demand (AD)

Aggregate Demand• The sum of all expenditure in the economy over

a period of time

• Macro concept – WHOLE economy• Formula:

AD = C+I+G+(X-M)– C= Consumption Spending– I = Investment Spending– G = Government Spending– (X-M) = difference between spending on

imports and receipts from exports (Balance of Payments)

Aggregate Demand Curve

• Shows the overall level of spending at different price levels

• Note – Inflation used for the vertical axis – follows from new thinking on the derivation of AD curves from the likes of David Romer @ University of California – Assumes Central Banks do not target the money supply but short term interest rates

Aggregate Demand Curve• Why does it slope down from left to right?

– Assume Bank of England sets short term interest rates

– Assume a rise in the price level will be met by a rise in interest rates

– Any increase in interest rates will raise the cost of borrowing:

• Consumption spending will fall• Investment will fall• International competitiveness will decrease – exports

fall, imports rise

• Therefore – a rise in the price level leads to lower levels of aggregate demand

Aggregate Demand Curve• The AD diagram:• Inflation on the vertical axis –

assume an initial ‘target rate’ of 2.0% (as measured by the HICP or CPI)

• Real GDP or Real National Income or Real Output on the vertical axis (shown by the initial Y)

Aggregate Demand CurveInflation

Real National Income

At an inflation level of 2%, the AD curve gives a level of output of Y1

This level of output will be associated with a particular level of unemployment which we will call U = 5%

U = 5%

At a higher rate of inflation (3.0%) rising interest rates mean that C, I and (X-M) all have negative effects on AD – NY falls to Y2

U = 7%

The lower level of National Income requires fewer units of labour – unemployment rises to 7% shown by U = 7%

Shifts in the Aggregate Demand CurveInflation

Y1U = 5%

Shifts in AD will be caused by changes in factors affecting C, I, G and (X-M) (exogenous factors) e.g. increasing income tax rates affect consumption

Y2U = 2%

Any exogenous factor causing C, I or G to rise, or a trade surplus causes a shift to the right in AD

This would cause a rise in national income (economic growth) and lead to a fall in unemployment (U = 2%) (and vice versa)

Consumption Expenditure• Exogenous factors affecting consumption:

– Tax rates– Incomes – short term and expected income over

lifetime– Wage increases– Credit– Interest rates– Wealth

• Property• Shares• Savings• Bonds

Investment Expenditure• Spending on:

– Machinery– Equipment– Buildings– Infrastructure

• Influenced by:– Expected rates of return– Interest rates– Expectations of future sales– Expectations of future inflation rates

Government Spending

• Defence• Health• Social Welfare• Education• Foreign Aid• Regions• Industry• Law and Order

Import Spending (negative)

• Goods and services bought from abroad – represents an outflow of funds from the UK (reduces AD)

Export Earnings (Positive)

• Goods and services sold abroad – represents a flow of funds into the UK (raises AD)

Key Variables

Macroeconomic Policy

Fiscal Policy

• Government Income (taxes and borrowing)• Government Spending

Monetary Policy

• Interest Rates (Bank of England)

Aggregate Supply (AS)

Capacity of the Economy• Costs of Production• Technology• Education and Training• Incentives• Tax regime• Capital stock• Productivity• Labour Market

Aggregate SupplyInflation

The shape of the AScurve is important in determining the outcome in the economy

This shape reflects a Keynesian view of the AS curve.

Yf represents ‘Full Employment Output’ – at this point the economy is working to full capacity and cannot produce any more.

An output level of Y1 would suggest the economy is working below full capacity and there would be widespread unemployment.

Economy starts to overheat

Between Y1 and Yf, increases in capacity are possible but the nearer the economy gets to Yf, the more problems are experienced with acquiring resources to boost production (production bottlenecks) especially labour skills shortages.

AS1 AS2

Yf1 Yf2

Increases in capacity can occur as a result of a shift in AS (akin to a shift outwards of the Production Possibility Frontier) (PPF)

Short run aggregate supply (SRAS) assumes firms only able to increase output at higher costs (e.g. overtime payments) thereby pushing up price level

SRAS 1

SRAS 2

SRAS assumes costs such as overall wage rate remain fixed, changes in such costs cause a shift in the SRAS curve (exogenous shocks – input costs)

LRAS Classical economists assume the long run aggregate supply curve (LRAS) is vertical (perfectly inelastic).

This is because they believe that in the long run, there will be no unemployment of resources because markets will clear, thus whatever the rate of inflation, firms will supply the maximum capacity of the economy.

Aggregate SupplyFor our analysis, we will assume the AS curve looks like this!

Inflation

Putting AD and AS togetherInflation

In this situation, the economy would be operating at less than capacity, there would be unemployment and the economy might be growing only slowly.

A shift in the AD curve to AD1 as a result of a change in any or all of the factors affecting AD would increase growth, reduce unemployment but at a cost of higher inflation (a trade-off)

Putting AD and AS togetherInflation

2.5%AD2

Further increases in AD would lead to successively smaller increases in growth and employment at the cost of ever higher inflation.

Sustained GrowthInflation

Sustained growth (not to be confused with sustainable economic growth) occurs when AS and AD rise at similar rates – national income can rise without effects on inflation

Aggregate Demand and Supply - Full Version

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