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Aggregate Demand and Supply. 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

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Aggregate demand
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
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 curve1
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 curve2
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 curve3
Aggregate Demand Curve

Inflation

This level of output will be associated with a particular level of unemployment which we will call 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

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

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

3.0%

2.0%

AD

Y2

Y1

Real National Income

U = 5%

U = 7%


Shifts in the aggregate demand curve
Shifts in the Aggregate Demand Curve

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

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

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

Inflation

2.0%

AD2

AD

Y1

Y2

Real National Income

U = 5%

U = 2%


Consumption expenditure
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
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
Government Spending

  • Defence

  • Health

  • Social Welfare

  • Education

  • Foreign Aid

  • Regions

  • Industry

  • Law and Order


Import spending negative
Import Spending (negative)

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


Export earnings positive
Export Earnings (Positive)

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




Fiscal policy
Fiscal Policy

  • Government Income (taxes and borrowing)

  • Government Spending


Monetary policy
Monetary Policy

  • Interest Rates (Bank of England)



Capacity of the economy
Capacity of the Economy

  • Costs of Production

  • Technology

  • Education and Training

  • Incentives

  • Tax regime

  • Capital stock

  • Productivity

  • Labour Market


Aggregate supply
Aggregate Supply

Inflation

AS

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.

The shape of the AS

curve 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

Yf

Y1

Real National Income


Aggregate supply1
Aggregate Supply

Inflation

AS2

AS1

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

Real National Income

Yf1

Yf2


Aggregate supply2
Aggregate Supply

Inflation

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)

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

SRAS 2

Real National Income


Aggregate supply3
Aggregate Supply

Inflation

LRAS

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.

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

Yf

Real National Income


Aggregate supply4
Aggregate Supply

AS

Inflation

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

Real National Income


Putting ad and as together
Putting AD and AS together

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)

AS

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

Inflation

2.5%

2.0%

AD 1

AD

Y1

Y2

Yf

Real National Income


Putting AD and AS together

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

AS

Inflation

3.5%

AD2

2.5%

2.0%

AD1

AD

Yf

Y1

Y2

Real National Income

Y3


Sustained growth
Sustained Growth

Inflation

AS

AS1

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

2.0%

AD2

AD

Y1

Y2

Real National Income


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