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Aggregate Demand and Supply. Aggregate Demand (AD)

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  • Aggregate Demand and Supply

  • Aggregate Demand and Supply

  • Aggregate Demand (AD)

  • Aggregate DemandThe sum of all expenditure in the economy over a period of timeMacro concept WHOLE economyFormula:AD = C+I+G+(X-M)C= Consumption SpendingI = Investment SpendingG = Government Spending(X-M) = difference between spending on imports and receipts from exports (Balance of Payments)

  • Aggregate Demand CurveShows the overall level of spending at different price levelsNote 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 CurveWhy does it slope down from left to right?Assume Bank of England sets short term interest ratesAssume a rise in the price level will be met by a rise in interest ratesAny increase in interest rates will raise the cost of borrowing:Consumption spending will fallInvestment will fallInternational competitiveness will decrease exports fall, imports riseTherefore a rise in the price level leads to lower levels of aggregate demand

  • Aggregate Demand CurveThe 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 CurveInflationReal National IncomeAD2.0%Y1At an inflation level of 2%, the AD curve gives a level of output of Y1This level of output will be associated with a particular level of unemployment which we will call U = 5%U = 5%3.0%Y2At 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 Y2U = 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 CurveInflationReal National IncomeAD2.0%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 consumptionAD2Y2U = 2%Any exogenous factor causing C, I or G to rise, or a trade surplus causes a shift to the right in ADThis would cause a rise in national income (economic growth) and lead to a fall in unemployment (U = 2%) (and vice versa)

  • Consumption ExpenditureExogenous factors affecting consumption:Tax ratesIncomes short term and expected income over lifetimeWage increasesCreditInterest ratesWealthPropertySharesSavingsBonds

  • Investment ExpenditureSpending on:MachineryEquipmentBuildingsInfrastructureInfluenced by:Expected rates of returnInterest ratesExpectations of future salesExpectations of future inflation rates

  • Government SpendingDefenceHealthSocial WelfareEducationForeign AidRegionsIndustryLaw 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 PolicyGovernment Income (taxes and borrowing)Government Spending

  • Monetary PolicyInterest Rates (Bank of England)

  • Aggregate Supply (AS)

  • Capacity of the EconomyCosts of ProductionTechnologyEducation and TrainingIncentivesTax regimeCapital stockProductivityLabour Market

  • Aggregate SupplyInflationReal National IncomeThe shape of the AScurve is important in determining the outcomein the economyASYfThis 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 moreY1An output level of Y1 would suggest the economy is working below full capacity and there would be widespread unemploymentEconomy starts to overheatBetween 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 SupplyInflationReal National IncomeAS1AS2Yf1Yf2Increases in capacity can occur as a result of a shift in AS (akin to a shift outwards of the Production Possibility Frontier) (PPF)

  • Aggregate SupplyInflationReal National IncomeSRASShort run aggregate supply (SRAS) assumes firms only able to increase output at higher costs (e.g. overtime payments) thereby pushing up price levelSRAS 1SRAS 2SRAS 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 SupplyInflationReal National IncomeLRASClassical 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 SupplyFor our analysis, we will assume the AS curve looks like this!InflationReal National IncomeAS

  • Putting AD and AS togetherInflationReal National IncomeASYfAD2.0%Y1In this situation, the economy would be operating at less than capacity, there would be unemployment and the economy might be growing only slowly.AD 1Y22.5%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 togetherInflationReal National IncomeASYfAD2.0%Y1AD1Y22.5%AD23.5%Further increases in AD would lead to successively smaller increases in growth and employment at the cost of ever higher inflation.Y3

  • Sustained GrowthInflationReal National IncomeADAS2.0%Y1AS1Y2AD2Sustained 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

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