AQA Chapter 13: AS & AS

Aggregate Demand

Understanding Aggregate Demand (AD)

• Aggregate Demand (AD) =

– Total level of planned real expenditure on UK produced goods and services

• The components of aggregate demand

• Household Spending (C)

• Gross Fixed Capital Spending (I)

• Value of Change in Stocks (inventories)

• Government Consumption (G)

• Exports of Goods and Services (X)

• (minus) Imports of Goods and Services (M)

• AD sums to GDP (expenditure based)

The Aggregate Demand Curve

Real National Output

Price Level

AD1

P1

Y1

P2

Y2

P3

Y3

An Outward Shift in Aggregate Demand

RNO

Price Level

AD1

P1

Y1 Y2

AD2

An Inward Shift in Aggregate Demand

Real National Output

Price Level

AD4

P1

Y4 Y3

AD3

Causes of Changes in Aggregate Demand

• Changes to Government Fiscal Policy

– An increase/decrease in level of taxation

– Changes in real government spending on health, education, transport

– An increase in the size of the budget deficit (where government spending > tax revenue)

• Changes to Monetary Policy

– Changes in official base interest rates by the Bank of England

– Fluctuations in the exchange rate for sterling (e.g. a fall in the value of sterling against the Euro or the US dollar)

• Changes in Business & Consumer Confidence

• Fluctuations in the growth of national income and expenditure in other countries (the global economic cycle)

– E.g. the effects of a recession in the United States

– A cyclical recovery within the Euro Zone

The UK and Global Economic Fluctuations

– Demand-side economic shocks

• Growth of income & demand in OECD economies

– E.g. an economic recession in the United States

– Asian economic downturn / financial turbulence

• Interest rates decisions in Europe and in the USA

• Performance of global stock markets - particularly in the USA

• Foreign Investment decisions of global multinationals

– Supply-side economic shocks

• Fluctuations in international commodity prices

Fiscal Policy and Aggregate Demand

• Aggregate Demand =

• Consumer spending +

• Investment spending +

• Government spending +

• Exports

• -

• Imports

• = Gross Domestic Product

• Fiscal Policy can affect AD through several channels

• Direct changes in government spending (current and capital)

• Changes in direct taxes

– Income tax / National Insurance

– Corporation tax

– Taxation of saving

• Tax incentives for R&D

• Changes in indirect tax

– Changes in excise duties

– Changes in VAT

• Changes in the budget deficit or surplus

Taxes and Aggregate Demand

Cut in personal income tax

Boost to disposable income

Adds to consumer demand

Cut in indirect taxes

Lower prices – higher real incomes

Adds to consumer demand

Adds to business capital spending

Cut in corporation tax

Higher “post tax” profits for businesses

Cut in tax on interest from saving

Boost to disposable income of people with net savings

Adds to consumer demand

Expansionary Fiscal Policy

Monetary Policy and Aggregate Demand

Expansionary Monetary Policy

Lower Nominal Interest Rates

Stimulates Capital Investment Spending

Increase in Economic Activity

Expansionary Monetary Policy

Increase in Bank Loans

Stimulates Household Spending

Increase in Economic Activity

Expansionary Monetary Policy

Exchange Rate Depreciation

Stimulates Net Exports

Increase in Economic Activity

Expansionary Monetary Policy

Rise in Equity Prices

Rise in House Prices

Rise in Value of Household Wealth

Increase in Economic Activity

Interest Rate Channel

Bank Lending Channel

Exchange Rate Channel

Wealth Effect Channel

AQA Chapter 13: AS & AS

SRAS / LRAS / AD

Short Run Aggregate Supply (SRAS)

• SRAS is the relationship between real GDP and the price level

– SRAS shows how much output the economy can generate in the short term at each price level

– A rise in the price level should stimulate an expansion of supply

• We hold the following constant:

– Wage rates for labour

– Other resource prices such as raw material prices and components

– Long run potential GDP (see LRAS)

• Changes in aggregate demand cause either a contraction or an expansion along the SRAS curve

Short Run Aggregate Supply Curve

Real National Output

Price Level SRAS1

P1

Y1

P2

Y2

A rise in the price level will cause an expansion of aggregate supply in the economy

Producers are responding to higher prices (driven up by increased demand)

Real national output will increase from Y1 to Y2

Shifts in short run aggregate supply

• Changes in unit labour costs (ULCs)– Unit labour costs are defined as wage costs adjusted for the

level of productivity

• Changes to raw material costs and other components – Fluctuations in the world price of oil, copper, aluminum and

other essential inputs in many production processes

– These costs might be affected by movements in the exchange rate which cause fluctuations in the prices of imports

• Changes to producer taxes and subsidies levied by the government as part of their fiscal policy– Changes in VAT on building materials or duty on fuels

Inward Shift in SRAS

Price LevelSRAS1

Y2

P2

Y1

SRAS2

RNO

Inward shift of SRAS

Less output can be supplied at each price

level

Long Run Aggregate Supply (LRAS)

• LRAS is located at potential GDP – it represents a level of real national output in the economy

• Potential GDP is assumed to be independent of the price level

– The price level is fixed

– Technology does not change

– All resources are fully employed

– The economy is on its production possibilities curve

Long Run Aggregate Supply (LRAS)

• Changes in potential GDP are brought about by:

– Changes in full-employment labour supply available for production (i.e. more people join the labour force)

– Changes in the stock of capital inputs – affected by the level of gross capital investment

– Changes in the productivity of factor inputs e.g. higher labour productivity or an increase in capital productivity

– Advances in the general state of technology

• An outward shift of LRAS signifies an increase in long-run potential “full-employment” output

Short Run (SRAS) and Long Run Aggregate Supply (LRAS)

Price Level

RNOYp

SRAS

LRAS

Potential GDP

Short run GDP exceeds potential

Short run GDP below potential

Positive output gap

Negative output gap

Inter-relationships between SRAS and LRAS

GeneralPrice Level

Real National OutputYp

SRAS

LRAS

AD

AD2

P1

Y2

Inter-relationships between SRAS and LRAS

GeneralPrice Level

Real National OutputYp

SRAS

LRAS

AD

AD2

P1

Y2

SRAS2

P2

AQA Chapter 13: AS & AS

Non-linear AS (Keynesian LRAS)

A different way of showing aggregate supply

The Non-Linear AS Curve

Price LevelLRAS

Yfc

Elastic supply

ADAD2

AD3

??????

An Increase in Long Run Aggregate Supply

Price Level

RNO

LAS1 LAS2 LAS3

Ad1 Ad2Ad3

Supply-Side Economic Policies

• Changes to the structure of taxation

• Measures to make markets more contestable / competitive

• Active labour market policies to increase the supply and efficiency of labour

• Policies to raise the stock of capital inputs

• Policies to increase spending on R&D

• Privatisation of state owned industries

• Opening up of capital markets to finance higher levels of investment