3.2 Aggregate Demand and Aggregate Supply

Aggregate demand

Aggregate demand: The willingness of all purchasers of goods (consumers, businesses, the government, and foreigners) to purchase aggregate output at different price levels

Aggregate output

Aggregate output: the sum of all the goods and services produced in an economy over a certain period of time

- The total aggregate demand in the economy is the expenditure method of calculating output (C+I+G+(X-M))

Downward sloping AD curve (effects)

as the average price levels of the goods rise, AD in the economy falls

1. The wealth effect

2. Interest rate effect

The wealth effect

For any given nominal value of income, a lower price level enables households, firms and the government to have greater purchasing power, which results in greater consumption, investments and government spending

Interest rate effect

A fall in the general price level causes interest to drop, thus boosting the demand for money, ceteris paribus (all else being equal).

This leads to greater consumption, investment expenditure and government spending, that is higher aggregate demand in the economy.

Ceteris paribus: this is true if all else is equal

4 components that affect AD

1. consumer expenditure

2. investment spending

3. government spending

4.net exports

Changes to consumer expenditure:

1. Consumer confidence

2.Interest rates

3. Income taxes

Consumer confidence:

If consumers feel confident = optimistic about the economy then AD shifts right and vice versa

Interest rates

Some consumer expenditure is financed by borrowing. Higher interest rates mean borrowing is more expensive and AD will shift left

- Links to monetary policies

Income taxes

Lower income taxes mean more disposable income for consumers and businesses. This leads to an increase in AD (and vice versa)

- Income tax is taxes placed on your income/fiscal policy

Changes to investment spending:

1. Business taxes

2. Business confidence

3. Interest rates

Business taxes

Changes in business taxes will mean changes in the disposable income of the business = shifts AD to left or right Tax placed on the business profits

Business confidence

If businesses are optimistic about the future of the economy = more likely to invest

Interest rates:

Investment spending is often funded by borrowing. As such changes in interest rates will shift AD due to changes in investment spending.

Changes to government spending:

Economic priorities:

- The government can choose to increase or decrease its own level of spending

Changes to Net export:

1. Relative income

2. Exchange rates

3. Trade protectionism

Relative income

If domestic income increases relative to foreign countries then domestic consumers will demand more imports. This means the value of net exports decreases and AD shifts left

Exchange rates

If the domestic currency appreciates (increases in value) then exports become more expensive (fewer are bought) and imports become cheaper (more are bought) so AD shifts left and vice versa

- Appreciation = foreign countries demand less and domestic buys more (vice versa)

- If exchange rates depreciate then the cost of imports increases and the cost of exports decreases so net exports will increase and AD shift right

Trade protectionism

If the domestic government imposes restrictions on imports this will decrease imports = shift AD to the right

- If the government puts a tariff or a quota on foreign goods = imports become more expensive and spending on imports decreases so net exports increase and AD shifts right

Classical model

Classical model: why the economy will always return to the full employment level of output

- A price increase happens due to inflation shifting AD1 to AD2

- People would want more money (eg. if prices of goods are increasing, workers want higher wages

Aggregate supply

Total quantity of goods and services producd in an economy (real GDP) over a particular time period at different price levels

Full level of employment output (graph and what it shows)

Natural rate of unemployment: Sum of structural, seasonal and frictional unemployment

- No cyclical unemployment

- Assumes natural rate

- A positive relationship between PL and RGDP based on firms' SRAS As long as SRAS is constant then the output level is constant

- Increase in PL = output prices increased But resources prices haven't changed (in the short run) = profit increase

- As production becomes more profitable, firms increase the quantity of output produced

Points on the full level of employment graph

YP = potential RGDP based on the full employment level of output at the natural rate of unemployment (LRAS curve)

Ye = the equilibrium level of real GDP (intersection of AD and SRAS)

Potential output → level of unemployment = natural rate

SRAS curve

Shifts with changes in resource prices/ cost of FOP

Shows the relationship between the price level and the quantity of RGDP produced by firms when resource prices (especially wages) do not change

-An increase in resource prices = shifts to the left (and vice versa)

- Changes in the cost of FOP = shifts

- Resources have not changed IN the short run at least one FOP is fixed (usually capital and land)

- SRAS = output at the moment but shows the price changes

eg. wages, indirect taxes, energy prices (oil industry)

- Constant only when resource prices are constant

- The equilibrium level of output (or real GDP) occurs when AD intersects SRAS

- This determines the price level, the level of RGDP and the level of unemployment

LRAS

shifts with changes in the quality or quantity of the FOP OR natural rate of unemployment (full employment level of output)

- Long-run = there is gain and we can do something to change the natural rate of unemployment

- Perfectly inelastic (vertical line) in the short run represents the full employment level of output (the potential output = natural rate of unemployment)

- If all the FOP are operating to their potential = at the LRAS curve

*different to PPC because PPC assumes that there is NO unemployment

Shifts of AS in the long-run

Shifts of aggregate supply in the long run

- Over time, the LRAS curve can shift left or right

- A shift to the right = increase in RGDP ⇒ long-term economic growth for the country

- A shift to the left represents a fall in potential real GDP

Shifts due to changes in quality and quantity in FOP

- Changes in the natural rate of unemployment

- Improvements in technology

- Increases in efficiency

Increase in LRAS (graph)

An increase in LRAS is illustrated by a shift to the right of the LRAS curve

This shows that potential output in the economy has increased.

→ You can draw this without any other curve to illustrate long-term growth (if the question does not ask for the other curves).

Improvements: Incorporating SRAS and AD (graph)

Any factor that shifts LRAS = in the long term, shifts SRAS too

As growth is funded by investments, AD will also shift

Long-term growth can be achieved with stable prices as long as AS keeps up with AD

LRAS and SRAS keep up with AD (due to investments) = price level does not change If the growth in the economy is happening = investments would happen (AD increase) → quality of FOP

Any factor that shifts LRAS must, in the long term, shift SRAS too. As the growth funded by investment, AD will shift

Long term growth can be achieved with stable prices as long as aggregate supply keeps up with (or exceed) aggregate demand.

Determinants of SRAS

Changes in resource prices:

Government action:

Supply shocks

Changes in resource prices:

Wages: could occur due to changes in legislation or union agreements (an increase in minimum wage, SRAS shifts left)

- Changes in non-labour resource prices: these could be the cost of import inputs like oil or capital goods

Government action:

Indirect taxes: These are taxes paid to firms who then pay those taxes to the government. These are treated as a cost of production = impact supply (SRAS)

-A decrease in the level of VAT would see SRAS shift right

Supply shocks

major events which impact aggregate supply in a country such as a major weather event, a war (SRAS)

If the impact is big enough = could change the LRAS

Deflationary/recessionary gap (graph)

Deflation: price level decreases

- Equilibrium output is less than the potential

- Unemployment is greater than the natural rate of unemployment.

- There is cyclical unemployment

Explain deflationary gap graph

Aggregate demand shifts to the left

The price level will decrease from P1 to P2

New equilibrium (Ye)

Recessionary gap: focuses on price

→ deflationary gap: focuses on RGDP (the same thing)

Inflationary gap (graph + explanation)

An increase in AD = demand-pull inflation

Equilibrium output is greater than potential

Unemployment is less than the natural rate of unemployment.

Price level increases

Output is increasing causing the price level to increase

There is no cyclical unemployment

Price levels will rise = and people will produce above and beyond

Unemployment is BELOW the natural rate of unemployment

Increase in any C+I+G (X-M) will shift AD to the right

Changes in SRAS curve ( increase in cost of FOP, graph + def)

-Cost-push inflation is caused by an increase in the cost of FOP

- Equilibrium is less than potential GDP but the price level is higher

-Unemployment is greater than the natural rate of unemployment

SRAS shift to the left = less output

Price increase from PL2 - PL1

*worse than demand-pull because output decreases and unemployment increases

Inflationary gap (PL increase) and recessionary gap (RGDP falls)

← PL 1 and PL 2, not P2 and P1 because the price level

*vice versa for SRAS shift right

Inflationary gap fix (Graph)

Deflationary gap fix (Graph)

A decrease in AD from AD1 to AD2, caused by any of the determinants of AD (C+I+G+X+(X-M)) then RGDP would fall from Yp to Y2

PL would fall from PL1 to PL2 = deflationary gap Firms would renegotiate with workers to decrease wages

Decrease in the cost of FOP and shift of SRAS from SRAS1 to SRAS2 ⇒ There would be a return to Yp (full employment of output) at a new lower price level of PL3

Keynesian Aggregate supply curve

The increase in output is smaller than the increase in price level

Price level would not change as much as AD → eg. if AD decreases from AD1 to AD2, the price level would not change because people can't accept lower wages

Keynesian belief

If aggregate demand decreases then the cost of production would become cheaper (accept lower wages) → Classical view

- But Keynians says that people are stubborn and people would not accept lower wages (wages are sticky) = the price level does not decrease

- Prices are relatively inflexible = workers are protected by laws, contracts and trade unions = output can become stuck in the short-term and will not return to the full level of unemployment

-If wages do not go down = firms will void lowering their prices as well → They will instead cut costs = oligopolistic firms will fear a price war = and prices will not fall even in a recession

Recessionary gap graph (Keynesian)

RGDP is below the full employment level of output

Keynes believed that PL remains constant. PL will not fall during a recession because wages are sticky = spare capacity in the economy.

In the Keynesian model, the output can remain stuck at this level and won't self-correct (eg. great depression)

The economy can be stuck in a recessionary gap for long periods of time because of low AD. Consumers won't spend, businesses won't invest and a country can't rely on net exports

Keynesians advocate government intervention, and demand-side fiscal policy to increase AD = only component the government can influence Demand side problem = fall in aggregate demand (focuses on demand)

Full employment level of output (keynesians graph)

The full employment level of output, the natural rate of unemployment, the output is equal to the potential Equivalent to the LRAS curve in the classical model

Slow and steady inflation

Inflationary gap (keynsians graph)

output is beyond the full employment level of output, unemployment is less than the natural rate of unemployment, RGDP is greater than the potential

Output is close to or at its limit

The price level rises dramatically. Firms are only operating above Yp because they are increasing their prices

There is a point on the perfectly inelastic portion of the curve that output cannot increase, any increase in AD is only inflationary.

Long term growth increasing potential (graph(

Shifts in the long run: Over time the LRAS curve or the Keynesian curve can shift to the left or right

- A shift to the right represents an increase in potential RGDP, this is long-term economic growth for the country

Any factor that shifts LRAS must shift SRAS too

Due to growth in the economy and being funded by investment, AD will also shift