Macroeconomics - AD and AS

Aggregate Demand

Total demand for a country’s goods and services at a given price level in a given time period. Measure of total expenditure.

Why is AD downward sloping?

• Wealth Effect: As average price falls, consumers “feel richer”, and their ability to purchase goods and services increases.

• Trade Effect: As the average price falls, exported goods become more attractive to foreigners, while imported goods become less attractive to locals, as their own goods are cheaper.

• Interest Rate Effect: When prices are lower, people need less money for transactions. Demand for money falls, people hold on to less cash, and deposit more in the banks. Since banks now have money sitting around, they lower interest rates, and consumption increases.

Marginal propensity to consume

Willingness of a household to spend any extra income.

Determinants of consumption (LICAH)

• Level of real disposable income

• Interest Rate

• Consumer confidence (about unemployment)

• Asset prices

• Household indebtedness

Determinants of saving

• Tax incentives

• Age structure

Determinants of Investment

• Interest Rates

• Business confidence (expected profit and expected demand)

• Corporation Tax

• Spare capacity

• Level of competition

• Price of capital

Hurdle

Minimum return needed to justify the cost of funding a project. If funding a project is cheaper (because of low interest), then:

• You don’t need to earn as much to cover costs

• Hurdle rate drops

• Easier to justify the costs of funding a project.

Government spending

• Current spending

• Capital spending

• Welfare spending

• Debt Interest payments

Budget deficit

Government Spending > Tax Revenue, in a fiscal year

Budget surplus

Government Spending < Tax Revenue

National Debt

Accumulation of budget deficits.

Determinants of Government Spending

• Political priorities

• Economic priorities

Determinants of Net Exports

• Real disposable income earned abroad

• Real disposable income earned at home

• Strong or weak exchange rates

• Protectionism at home ad abroad

• Relative inflation levels at home

Aggregate Supply

The total quantity of goods and services that a country is able and willing to produce. Can be in the short term (SRAS) and long term (LRAS)

Productive efficiency

You can’t make more of one good without making more of the other.

SRAS Shifts

Change in the costs of production

• Wages

• Raw material/commodity prices

• Oil price

• Business taxes

• Import price (of raw materials, components, etc.)

LRAS Shift

Quantity and quality of FoP:

• Labor productivity

• Investment

• Infrastructure

• Quantity of labor

• Competition

• New resource discoveries

Negative Output Gap (deflationary gap)

Where actual output is less than potential output.

Positive Output Gap (inflationary gap)

Where actual output is greater than potential output.