Aggregate Demand And Supply - Full Version

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Aggregate Demand and Supply

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Aggregate Demand and Supply

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Aggregate Demand (AD)

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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) Copyright 2005 – Biz/ed

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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 Copyright 2005 – Biz/ed

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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 Copyright 2005 – Biz/ed

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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) Copyright 2005 – Biz/ed

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Aggregate Demand Curve Inflation

Thea lower This At higher level of level rate output of of At an level will inflation National be inflation associated (3.0%) Income of 2%, the ADrates with rising requires ainterest particular fewer units curve gives level mean of labour ofthat – C,aIlevel and of output of Y1 rises (X-M) unemployment all have which negative to 7% we shown effects will call by on UU= = 5% AD 7% – NY falls to Y2

3.0%

2.0% AD Y2 U = 7%

Y1 U = 5%

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Shifts in the Aggregate Demand This cause Shiftswould in AD will be a Curve Any exogenous Inflation

caused changes in rise in by national factor causing factors C,C, I, incomeaffecting (economic andG(X-M) IG or toand rise, or growth) lead (exogenous factors) a surplus to trade a fall in e.g. increasing unemployment causes a rates shift (U to income tax = 2%) (and the right in vice AD affect consumption versa)

2.0%

AD2 AD Y1 U = 5%

Y2

U = 2%

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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 Copyright 2005 – Biz/ed

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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

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Government Spending • • • • • • • •

Defence Health Social Welfare Education Foreign Aid Regions Industry Law and Order

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

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

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Key Variables

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Macroeconomic Policy

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Fiscal Policy • Government Income (taxes and borrowing) • Government Spending

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Monetary Policy • Interest Rates (Bank of England)

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Aggregate Supply (AS)

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Capacity of the Economy • • • • • • • •

Costs of Production Technology Education and Training Incentives Tax regime Capital stock Productivity Labour Market Copyright 2005 – Biz/ed

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Aggregate Supply Inflation

AS

Economy starts to overheat

Y1

Yf

Between Y1 and Yf, The shape the AS Yf Anrepresents output level ‘Full of Y1 increases in of capacity are This shape curve important Employment wouldissuggest thein – possible but theOutput’ nearer reflects agets the economy to Yf, determining the at economy this point is working the morefull problems are to outcome in the economy below iscapacity working Keynesian view experienced with economy full andcapacity there would and be of the AS curve. acquiring resources to cannot widespread produce any boost production more. unemployment. (production bottlenecks) especially labour skills shortages.

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Inflation

Aggregate Supply AS1

AS2 Increases in capacity can occur as a result of a shift in AS (akin to a shift outwards of the Production Possibility Frontier) (PPF)

Yf1

Yf2

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Aggregate Supply Inflation

SRAS 1 SRAS SRAS 2

SRAS assumes Short run costs suchsupply as aggregate (SRAS) overall assumes wage firms only able to rate remain increase output at fixed, changes higher costs (e.g. in such costs overtime cause a shift in payments) the SRAS curve thereby pushing (exogenous up price level shocks – input costs)

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Aggregate Supply Inflation

LRAS

Yf

This is because they Classical believe that in the economists long run, there will be no unemployment of assume the long resources because run aggregate markets will clear, supply curve thus whatever the rate of inflation, firms (LRAS) is vertical will supply the (perfectly maximum capacity of inelastic). the economy.

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Aggregate Supply Inflation

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

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Putting AD and AS together AS

Inflation

2.5% 2.0%

A shift in the AD In thisto situation, curve AD1 as athe economy bein result of awould change operating at the less any or all of than capacity, there factors affecting AD would be would increase unemployment growth, reduce and the economy might unemployment but at be growing only a cost of higher slowly. inflation (a trade-off)

AD 1 AD Y1

Y2

Yf

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Putting AD and AS together AS

Inflation

3.5%

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

AD2 2.5% 2.0%

AD1 AD Y1

Y2

Yf

Y3

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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

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