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Aggregate Supply / Aggregate Demand Model

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  • Mere aggregation of the microeconomic model. Useful for evaluating factors and conditions which affect the level of Real Gross Domestic Product (GDP adjusted for inflation) and the level of inflation.

  • AD curve has traditional negative slope.AD is the total demand (total spending) for a countrys goods and services at a given price level in a given time period.

    AD = C + I + G + ( X M)

  • The AD curve shows the relationship between the average price level and real output. Price level0pyReal GDP/National Income/National output/Real outputAD

  • Consumption (C) :Total spending by consumers on domestic goods and services.

    For example durable goods such as cars, mobile phones,(long period) and non durable goods such as rice, newspaper, toilet paper. (short period)

  • What causes changes in consumption:

    Changes in income

    Changes in interest rates

    Changes in wealth

    Changes in expectations and consumer confidence

  • Investment (I):

    Represents addition of capital stock (factories, machines, computers) to the economy.

    Represents investments carried out by firms, for example: replacement investment and induced investment

  • What causes changes in investment?

    Interest ratesChanges in the level of national incomeTechnological changesExpectations and business confidence

    For example, the diagram for investment shows:

  • Government spending:

    Government spending represents the variety of goods and services spent on health, education, transport, law and order, social security, housing and defence.

  • What causes changes to government spending?

    Commitment to financial support to industrySpending to correct market failureNew education or health policy new schools or hospitals

  • Net Export: (X-M)X = export:Export are domestic goods and services bought by foreigners.M = import:Imports are goods and services bought from foreign producers. Imports is also an outflow of import expenditure.When export revenue exceeds import expenditure, this is positive. Increase AD.When import expenditure exceeds export revenue, this is negative. Reduce AD.

  • When price in the economy falls from p to p1, C+I+G+(X-M) increases from Y to Y1.

    AD = C+I+G+(X-M)P0PP1 Y Y1 Real output

  • Changes in AD:

    Changes in price causes a movement along the AD curve, from one level of real output to another

    Changes in the components of AD will cause a shift in the demand curve.

  • A change in AD is caused by a change in an influence on AD other than a change in price level;

    An increase in AD is a rise in planned spending and is represented by a shift to the right of the AD curve;

    A decrease in AD is shown by a shift to the left of the AD curve

  • An increase in government spending, which may occur in a deliberate attempt to increase AD;

    An increase in consumption arising from an increase in wealth, an increase in the money supply, a cut in taxation, a rise in population, increased optimism (feel-good factor) etc.

  • An increase in investment due to change in technology, a rise in expectation, a fall in the rate of interest;

    An increase in export because of a rise in quality, a fall in the countrys exchange rate, a rise in income abroad.

  • I7%4%0 I1 I2 InvestmentInterest rateThe relationship between investment and interest rate shows when interest rate Decreases, there is no incentive to save, and lead to increase in borrowing, which increases investment from I1 to I2. Increase in interest rate will have the oppositeEffect.

  • What causes changes in net export?

    Export:If foreign income rises, this leads to more imported goods and services being consumed.

    Import:When national income grows, this leads to an increase in consumption. As more goods and services are being consumed, some of these will be imported goods.

  • Government policies affecting AD:

    Fiscal policy taxesExpansionary fiscal policyMonetary policy interest rates

  • Aggregate supply is the total quantity of goods and services firms are willing and able to sell at a given price level in a given period of time.The Short Run Aggregate Supply (SRAS) Curve

  • The Short Run Aggregate Supply (SRAS) curve is drawn on the assumption that the prices of all factors of production are fixed;

    The curve slopes up from left to right, this is because higher output is likely to raise the cost per unit produced and therefore to supply more, firms have to charge a higher price;

  • A rise in the price level is likely to encourage firms to raise output in the short run;

    Influences other than a change in the price level cause firms to change how much they wish to supply the different values of the price level and shift the SRAS.

  • A change in weather conditionA change in raw material costsA change in wage ratesA change in corporation tax

  • The Long Run Aggregate Supply (LRAS) CurveIn the long run, wage rates and the prices of other inputs can change.There are two main views on the shape of LRAS Curve.

  • The idea of the long run AS curve is that in the long run, the real productive capacity of an economy does not vary (i.e., is perfectly inelastic) with respect to changes of the price level, a nominal quantity, but it may vary with changes of real phenomena, i.e., real matters such as resource availability, productivity, and technological changes. The long run changes of these real phenomena may be depicted in the short-run analysis as shifts or drifts of LRAS to the right with on-going growth, or as leftward shifts consequent upon supply-shocks that may have lasting adverse effects on the economy's output capacity.

  • The long run AS curve

    ASReal outputPriceADSRASe

  • When nominal wages are flexible, as usually assumed in the long run, the AS curve is perfectly vertical. Another reason is that the total amount of goods that the economy produces when all factors are efficiently used at their normal rate of utilization does not vary with the price level. In the long run, price does not affect the AS, rather AS depends in the availability of the factors of production.

  • The New Classical view is that the LRAS curve is vertical.Reason: The classical view believes that if there is unemployment, wages will fall to restore full employment, therefore in the long run the economy will operate at full employment hence the vertical supply curve.

  • The Keynesian view is that the shape of the long run aggregate supply (LRAS) curve can be perfectly elastic at low levels of economic activity, less elastic at higher levels and perfectly inelastic when full employment is reached.

  • Reasons: Keynesians believe that at low output, and hence low levels of employment, the LRAS curve will be horizontal due to considerable spare capacity in the economy and output can be increased without raising cost per unit produced;

  • Keynesians also believe that as pressure begins to be placed on capacity and shortages in skilled labour occur, unit costs begin to rise and the LRAS curve slopes upwards;

    Once the full employment level is reached, it is not possible to raise output and the LRAS curve becomes vertical.

  • Note: The New Classical economists and the Keynesian economists both agree that, if full employment is reached, the LRAS curve will be vertical.

    A change in LRAS is a change in the production potential of the economy;

    An increase in the LRAS is shown by a shift to the right of the LRAS and a decrease by a shift to the left;

  • The quantity of factors of production increases due to an increase in investment, discovery of new materials, an increase in the size of the labour force;The quality of factors of production increases due to:1 improvement in education and training, 2. technological progress, this will raise productivity (output per worker hour).

  • Macroeconomic equilibrium occurs where Aggregate Demand meets Aggregate Supply.Only at the combination of GDP and price level given by the intersection the AD and AS curves are spending behavior (demand) and production (supply) activity consistent. A shift in either the AD or the AS curve leads to changes in the equilibrium values of the price level and real GDP.

  • ADASY0P0Real outputPricee

  • If the price level deviates from this equilibrium (P0), pressures on business and consumers will move the economy back toward point e. Two conditions should be satisfied to attain macroeconomic equilibrium: (1) at the prevailing price level, desired expenditure must be equal to national output. The idea is agents are willing to buy all that is produced. The AD curve is constructed in such a way that this condition holds everywhere on it. (2) at the prevailing price level, firms must wish to produce the prevailing level of national output, no more and no less. This is introduced by the consideration of AS.

  • Although the economy is self-correcting in the long-run, this process can take up to a decade or more.Particularly, if output is below potential output, the economy can suffer an extended period of depressed aggregate output an high unemployment during this period of self-correction.John Maynard Keynes: In the long run we are all dead. He recommended that governments not wait for the economy to correct itself, but use fiscal policy to get the economy back to potential output more quickly.

  • This is the rationale for active stabilization policy, which is the use of government policy to reduce the severity of recessions and control excessively strong expansions.However, the ability to improve the economys performance is not always guaranteed; it depends on the kinds of shocks the economy faces.

  • This is the rationale for active stabilization policy, which is the use of government policy to reduce the severity of recessions and control excessively strong expansions.However, the ability to improve the economys performance is not always guaranteed; it depends on the kinds of shocks the economy faces.

  • If policy makers react quickly to a negative demand shock, they can use monetary or fiscal policy to shift the aggregate demand curve back to the right. If it was possible to anticipate shifts of the AD curve and counteract them, it could short-circuit the whole process of going through a period of low aggregate output and falling prices.This is desirable because:The temporary fall in aggregate output is associated with high unemployment.Price stability is regarded as a desirable goal (avoiding deflation-a fall in the aggregate price level.

  • However, some policy measures to increase aggregate demand may have long-term costs in terms of lower long-run growth.It also could be that the policy-makers are not perfectly informed, and the effects of their policies are not perfectly predictable. This could cause the attempts to create more stability to end up creating more instability.Despite this, many economists believe in the use of macroeconomic policy to offset major negative shocks to the AD curve.

  • The effect of a negative supply shock is to lower aggregate output but increase to a higher aggregate price level. Two bad things happen simultaneously: a fall in aggregate output leads to a rise in unemployment, and a rise in the aggregate price level decreases the purchasing power of incomes.In contrast to the case of a demand shock, there are no easy remedies for a supply shock. This means that there are no government policies that can easily counteract the changes in production costs that shift the SRAS curve.

  • Using monetary or fiscal policy to shift the AD curve would do one of two things: A policy to increase AD to limit the rise in unemployment would reduce the decline in output but cause even more inflation.A policy to decrease AD, it curbs inflation but causes a further rise in unemployment.This is then a trade-off with no right answer; it requires facing harder choices than usual.In the end, economic policy eventually chooses to stabilize prices at the cost of higher unemployment.