Aggregate Demand
Classical Model
Classical economics advocated the laissez faire or free market
system. They believe that government interference in competition or
the functioning of the market markets it worse. Government should
not intervene in the economy to correct any problems. The
government should simply ensure that the free market economy works
by eliminating any imperfections in the market and maintaining a
balance fiscal budget. The economy will automatically return to
equilibrium where full employment is reached.Says a classical
economist posits thats that supply creates its own demand.
Assumptions
1. And wages are flexible, therefore the market clears itself
very rapidly (prices and wages will always work back to
equilibrium).
2. Expectations are rational but are based on imperfect
information. (They are not based on facts).3. Labour is homogenous
and all factor inputs except capital are in abundant supply and
fully employed
Classical UnemploymentUnemployment refers to people between the
ages of 15-65 who are willing and able to work but cannot find paid
jobs.
Classical assume that the economy reaches full employment
without government intervention as a result of the labour market
being allowed to clear itself instantaneously. Unemployment implies
surplus labour in the market and all employers have to do is to
reduce wages and employ more people until the surplus is
eliminated. The classicals focus on the economy being in
equilibrium at all times. They believe that disequilibrium
unemployment is caused by the government and the trade union. The
government and/or the trade union bids up the wage rate causing
surplus labour (unemployment), firms must then reduce the wage rate
which increases demand for labour until the economy is back in
equilibrium. The unemployment that remains is called voluntary
unemployment (people who have chosen not to work for lower wages in
the long run) Graph
Labour market equilibrium and classical unemployment
Potential and actual labour marketPotential supply of labour all
workers who are able to supply their labour services to the market
(this lessens as the voluntarily unemployed withdraw themselves
from the market.
Actual labour supply workers who are willing to work at the
existing wage rate after the voluntarily unemployed have left the
labor market.
Classicals believe the disequilibrium unemployment exists
because of structural and frictional unemployment as well as
government intervention (real wage unemployment).
Graph
Savings and Investment
The demand for loanable funds is determined by the demand for
investment. However, the supply of loanable funds is derived from
savings. The price/cost of investment is the interest rate. If
savings differs from investment then the interest rate will adjust
until they are equal.Graph
If savings werent sufficient to match investment then interest
rate increases, savings increases (as people divert investment to
savings since interest rate is high)
Graph
If the initial rate of interest is IR2 planned investment will
be greater than planned savings resulting in a shortage of loanable
funds. Interest rate will increase to IR1 (equilibrium) resulting
in an increase in savings and a decrease in investment. However, if
IR were to go above equilibrium financial institutions would have
surplus funds which they would get rid of by lowering the
IR.Aggregate Demand
AD = C+I+G+X-M
This shows how equilibrium output for the economy is determined
with the general price levels. The AD curve represents all planned
expenditures in the economy or the total amount of goods and
services in the whole economy that are demanded at any given price
level.Price level
The average price for all goods and services in the economy
Graph
As price levels fall from P1 to P2 AD increases from Y1 to Y2
causing a movement down the AD curve and vice versa.
Factors that cause the AD curve to shift1. Consumer spending2.
investment spending
3. Government spending
4. Net export spending
Consumer spending
If consumers expect the income in the economy to increase then
at any price level they will demand more goods and services.
However, if incomes were to decrease and the economy is thrown into
a recession then AD will fall causing the demand curve to shift to
the left.
Investment Spending
If investors believe that the economy is going to grow in the
future then they will be motivated to invest today. Investors will
also watch the interest rates to see how it is changing. If they
expect the interest rate to fall then they will be motivated to
invest thus increasing AD.
Government Spending
To increase AD government generally undertake expansionary
fiscal policies. When they spend more in the economy and collect
less tax. This results in, a rightward shift in the AD curve
(expansionary fiscal policy involves spending on factors such as
job creation hence consumers will have more money to spend which
causes increases in AD.Net export spending
The increase in importation by foreign economies will lead to a
rise in exports from the domestic economy leading an increase in
production, increase in employment, increase in income and
ultimately lead to an increase in AD and vice versa. If the price
of foreign goods were to increase then the domestic economy will
import less which will cause AD to fall and vice versa.
Aggregate Supply
This is the real value of output produced by an economy. It
shows the relationship between average price levels and final
output within the economy.
Movement along the AS curve
Graph
The short run AS curve
1. All factors of production are fixed; the firm will therefore
suffer from diminishing returns causing the cost of production to
rise. They will pass on the increase in price to the consumer.
2. The curve is upward sloping because an increase in output is
accompanied by an increase in price. Price is the only factor that
causes a movement along the curve. All other factors cause the
curve to shift.
Shifts in the Short run supply AS curveGraphFactors that cause
the AS curve to shift
1. Cost of production Increase in output leads to an increase in
AS thus causing the curve to shift outwards. However, if C.O.P
increases then output decreases AS decreases causing the curve to
shift inwards.
2. Improvement in technology Output increases then AS increases.
If there is no improvement in technology output would decrease
causing AS to fall.
3. Expectations bright future for say JA then employment will
increase, output would rise leading to an increase in AS.
4. Welfare Benefits If welfare is reduced then the unemployed
will want to work for lower wages thus reducing the cost of
production, thereby increasing output and AS.
5. Quality of the labour force If productivity per worker
increases so too will output and AS.
6. Wages As wages and salaries fall AD fall triggering a fall in
AS and vice versa.
Supply-side Economic Policies
1. The aim of these policies is to improve efficiency.2. It is
argued that government policy should target the level of total or
AS of goods and services rather than trying to directly manipulate
the level of AD for goods and services. As AS creates its own
demand therefore, it is non-inflationary. Therefore govt. should
say reduce tax to increase production which creates employment.3.
The main role of govt. is to create an environment which fosters
free enterprise and competition where market forces will allocate
resources most efficiently.4. Supply side policies shift the AS
curve to the right. NB These policies are seen as the only
non-inflationary means of achieving growth in output in the long
run.
Supply side policies in the Long Run
GraphThe shift of the LRAS to the right results in a new
equilibrium at a higher level of income (YF2) whilst the price
level remains the same.
Supply side policies focus on increasing AS by using
microeconomic policies to improve the performance of markets,
workers and firms. These include:
1. Reducing govt. spending, hence reducing the crowding out of
private investment.
2. Reducing taxation for firms3. Reduce trade union power to
increase the flexibility in the labour market.
4. Encouraging entrepreneurial culture.
5. Making it easier for firms to set up and provide advice
6. Deregulating and privatizing to increase competition
Long run AS curve
1. Classical believe that all markets will be equilibrium in the
long run
2. All markets will function efficiently if the govt. does not
interfere enabling resources to be fully utilized. Therefore the
economy will always be on the PPF producing at its full potential,
for full employment output level with its given resources.3. The
LRAS is a vertical line where there is full employment of output at
Yf. There is absolutely no spare capacity in the economy.
Therefore, AD was to increase price would increase output would
remain the same.
4. Classical believe that if govt. intervenes AD will increase
resulting in inflation as in point 3 above.
Graph
Price Level Determination
The classicalists base their analysis of inflation on the
quantity theory of money. It states that the general price level
(P) in the economy depends on the supply of money (M2), therefore P
= f (M) (price as a function of money). The greater the quantity of
money, the higher the level of prices. Inflation is caused by an
increase in the money supply. The classicalist come up with the
equation of exchange ie MV=PY where MV is the total level of
spending.M Supply of money
V- Velocity of circulation (how often money change hands)
PY is the total value of goods and services produced that makes
up the GDP. P is the general price level andY is the real value of
National Income. V and Y they claimed were determined independently
on the money supply. V was determined by how frequently people were
paid for instance weekly or monthly, the banking system and other
institutional arrangements for holding money. Says Law would ensure
that the real value of output Y was maintained at the full
employment level.Interaction between AD and ASAn increase in AD
graph
NB: Classical aim for full employment which is the reason
1. If the govt. expands the economy then AD will increase at
full employment causing price to increase and real output to
increase.
2. General price levels are increasing (P1 P2), economic
activity is increasing (YF1 to YF2) resulting in cost of production
increasing and people demanding higher wages to offset increased
prices.3. Firms will supply less causing output to fall to full
employment at a higher price.
Decrease in AD graph
Government contracts the economy by increased taxation and
decreased govt. spending causing AD, price and wages to fall. Cost
of production decreases, firms purchasing power increases resulting
in AS increasing and price falling at equilibrium full employment
(Yf)
Increase in cost graphCost of production increases AS falls Real
output falls but price increases govt. reflates the economy by
increasing govt. spending and reducing tax AD increases, price
increases at full employment.Keynesian ModelThis model was created
by Maynard Keynes who argued for govt. to intervene in the economy
to reflate it when it was growing too slowly through fiscal
policies and deflate it when it was growing too quickly.
They argue that markets would not achieve a state of equilibrium
at the full employment level of income.
Inflation is often caused by cost push factors such as the high
cost of production.
Fiscal policy is more effective than monetary policy
Keynes use 4 things to justify his arguments:
1. Labour market
2. Market for loanable funds
3. The multiplier
4. The inflationary and deflationary gap
Keynesian Labour Market
Keynes believes that markets do not clear instantaneously and
are slow to adjust, for instance the labour market. The economy can
be at equilibrium below the full employment level, therefore
cyclical or involuntary unemployment does exist.People are not
willing to work for lower wages because it erodes their purchasing
power and ultimately the SOL. Therefore, if there is surplus
labour, wages would not decline but remain rigid causing
unemployment to persist.Graph
At W 1 the level of unemployment is between Q1 and Q2 ie S >
D.During a recession if wages were to fall. It would worsen the
recession and disequilibrium would be made worse.
The Market for Loanable Funds
Savings and InvestmentsSavings = Investment at various levels of
employment. An increase in savings reduces investment because this
would mean a reduction in consumption and ultimately a fall in
aggregate expenditure. Unsold stock would increase, production
decreases as well as investment. Keynes rejected the classicals
belief that by increasing savings investment will increase. He
believed that an increase in savings decreases investment and
suggested that for investment to occur it really depends on
business confidence about the future. Interest rate would have to
be very low to encourage investment.
GraphNote
1. The order for investment to increase, interest rate must
decrease.2. Keynes rejected the quantity theory of money because he
believed that an increase in the money supply may not necessarily
cause prices to increase and inflation to occur. An increase in the
money supply may mean that an economy faced with high unemployment,
idle machines and idle resources now has the opportunity to use
these resources to increase real income without necessarily
increasing price. A decrease in the money supply to reduce price
may instead cause employment to fall, output to fall and prices to
increase.3. Keynes rejected says law and instead noted that demand
creates its own supply. If AD increases then AS will increase as
well as employment and vice versa.4. Keynes believe that an
unregulated market would stimulate demand. The govt. should
intervene to control AD. The cure for unemployment is to increase
govt. spending thus increasing AD and economic activity.
The Consumption FunctionThe Keynesian Consumption Function shows
the relationship between the level of consumption and the level of
income.
The curve is upward sloping because consumption increases with
income.
The point where the consumption function cuts the vertical (1)
axis is where income is zero (0) (autonomous consumption).
Consumers consume when income is zero because they can borrow, beg
or use their savings. There is however, consumption which is based
on income and therefore varies with the level of income. This
consumption is known as induced consumption.
Keynes highlighted two assumptions regarding the behaviour at
consumption spending. These are:1. Peoples consumption decisions
are based on their current income.
2. Increments of income are partially spent and partially
saved.
Consumer is spending $20, 000.00 when income is zero (0).
Therefore the $20,000.00 is autonomous consumption.Consumption
Function Graph
NB Consumption can never start at zero because consumers are
always consuming.
The Consumption Function Formula is C = a+by
C consumption, a autonomous, b MPC (marginal propensity to
consume),
y National income
There are 2 concepts associated with the consumption function,
namely:
1. MPC marginal propensity to consume2. APC average propensity
to consume
APC that proportion of income devoted to consumption
APC = C/Y
MPC the proportion of the change in disposable income devoted to
consumption
MPC = C/Y
APS Average Propensity to Save the proportion of income devoted
to savings S/Y.
MPS The proportion of the change in disposable income devoted to
savings
MPS = S/Y
Y = C+S
C= Y-S
S= Y-C
APS + APC = 1
MPS + MPC = 1
Table
YCAPCMPC
020
2535
5050
7565
10080
The APC decreases while the MPC remains constant as income
increases.
NB. As income increases people tend to save more, hence the APC
is always falling.
The MPC is constant because the Consumption Function is linear
and therefore has a constant gradient.
Graph
The change in the MPC causes the consumption function to pivot
which changes the gradient of the consumption function.
Graph
Savings
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