Aggregate Demand and Aggregate Demand and SupplySupply

Aggregate Demand and Aggregate Demand and SupplySupply

Aggregate Demand (AD)Aggregate Demand (AD)

Aggregate DemandAggregate Demand

The sum of all expenditure in the economy over The sum of all expenditure in the economy over a period of timea period of time

Macro concept – WHOLE economyMacro concept – WHOLE economy Formula:Formula:

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

imports and receipts from exports (Balance of imports and receipts from exports (Balance of Payments)Payments)

Aggregate Demand CurveAggregate Demand Curve

Shows the overall level of spending at Shows the overall level of spending at different price levelsdifferent price levels

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

Aggregate Demand CurveAggregate Demand Curve

Why does it slope down from left to right?Why does it slope down from left to right? Assume Bank of England sets short term interest ratesAssume Bank of England sets short term interest rates Assume a rise in the price level will be met by a rise in Assume a rise in the price level will be met by a rise in

interest ratesinterest rates Any increase in interest rates will raise the cost of Any increase in interest rates will raise the cost of

borrowing:borrowing: Consumption spending will fallConsumption spending will fall Investment will fallInvestment will fall International competitiveness will decrease – exports fall, International competitiveness will decrease – exports fall,

imports riseimports rise Therefore – a rise in the price level leads to lower levels Therefore – a rise in the price level leads to lower levels

of aggregate demandof aggregate demand

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

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

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

Aggregate Demand CurveAggregate Demand CurveInflation

Real National Income

AD

2.0%

Y1

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%

3.0%

Y2

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 Shifts in the Aggregate Demand CurveCurveInflation

Real National Income

AD

2.0%

Y1U = 5%

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

AD2

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 ExpenditureConsumption Expenditure

Exogenous factors affecting consumption:Exogenous factors affecting consumption: Tax ratesTax rates Incomes – short term and expected income over Incomes – short term and expected income over

lifetimelifetime Wage increasesWage increases CreditCredit Interest ratesInterest rates WealthWealth

PropertyProperty SharesShares SavingsSavings BondsBonds

Investment ExpenditureInvestment Expenditure Spending on:Spending on:

MachineryMachinery EquipmentEquipment BuildingsBuildings InfrastructureInfrastructure

Influenced by:Influenced by: Expected rates of returnExpected rates of return Interest ratesInterest rates Expectations of future salesExpectations of future sales Expectations of future inflation ratesExpectations of future inflation rates

Government SpendingGovernment Spending

DefenceDefence HealthHealth Social WelfareSocial Welfare EducationEducation Foreign AidForeign Aid RegionsRegions IndustryIndustry Law and OrderLaw and Order

Import Spending (negative)Import Spending (negative)

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

Export Earnings (Positive)Export Earnings (Positive)

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

Key variablesKey variables

Macroeconomic policyMacroeconomic policy

Fiscal PolicyFiscal Policy

Government Income (taxes and borrowing)Government Income (taxes and borrowing) Government SpendingGovernment Spending

Monetary PolicyMonetary Policy

Interest Rates (Bank of England)Interest Rates (Bank of England)

Aggregate Supply (AS)Aggregate Supply (AS)

Capacity of the EconomyCapacity of the Economy

Costs of ProductionCosts of Production TechnologyTechnology Education and TrainingEducation and Training IncentivesIncentives Tax regimeTax regime Capital stockCapital stock ProductivityProductivity Labour MarketLabour Market

Aggregate SupplyAggregate SupplyInflation

Real National Income

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

AS

Yf

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

Y1

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

Aggregate SupplyAggregate SupplyInflation

Real National Income

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)

Aggregate SupplyAggregate SupplyInflation

Real National Income

SRAS

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)

Aggregate SupplyAggregate SupplyInflation

Real National Income

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.

Yf

Aggregate SupplyAggregate Supply

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

Inflation

Real National Income

AS

Putting AD and AS togetherPutting AD and AS togetherInflation

Real National Income

AS

Yf

AD

2.0%

Y1

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

AD 1

Y2

2.5%

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 Putting AD and AS togethertogether

Inflation

Real National Income

AS

Yf

AD

2.0%

Y1

AD1

Y2

2.5%AD2

3.5%

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

Y3

Sustained GrowthSustained GrowthInflation

Real National Income

AD

AS

2.0%

Y1

AS1

Y2

AD2

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