2.2aggregate demand 2.3 aggregate supply

AD

the total planned expenditure on goods and services at a given price level

Components of AD

• consumption- 60%

• Investment- 17%

• Government Spending- 20.9%

• Net exports- -2.9%

Why is AD sloping downwards

1. The interest rate effect: At higher average price (AP) levels, there are likely to be higher interest rates. Higher interest rates reduce investment and are an incentive for households to save - and vice versa

2. The wealth effect: As AP increases, the purchasing power of households decreases and the AD falls - and vice versa

3. The exchange rate effect: As AP falls, interest rates are likely to fall too. Lower interest rates lower the exchange rate. With a lower exchange rate, the economy's goods/services are more attractive abroad and exports increase, thereby increasing real GDP

influences on consumption

• changes to interest rates

• Changes to consumer confidence

• Changes to wealth

Investment

the total spending on capital goods by firms

Influences on investment

• rate of economic growth

• Interest rates

• demand for exports

• influence of government and regulations

influences of government expediture

Government expenditure is influenced by the trade/business cycle and spending linked to achieving policy aims

• Social Protection (Welfare payments such as state pension, universal credit)

• Health care services

• Education

influence on net trade

Change in Condition	Effect on Exports	Effect on Imports	(X-M)
UK real income increases	Little effect	Consumers purchase more	Trade balance weakens
Real income increases abroad	Customers overseas purchase more UK products; exports increase	Little effect	Trade balance strengthens
UK £ appreciates	Exports more expensive for customers overseas; exports decrease	UK consumers' money goes further abroad; imports increase	Trade balance weakens
UK £ depreciates	Exports less expensive for customers overseas; exports increase	UK consumers' money is worth less abroad; imports decrease	Trade balance strengthens
World economy booms	Increased demand for UK exports	Little effect	Trade balance strengthens
World economy slows	Decreased demand for UK exports	Little effect	Trade balance weakens
Protectionism increases	Depends on retaliation measures from other countries	Decreased demand for imports as they are more expensive	Trade balance strengthens
Protectionism decreases	Likely to increase	Increased demand for imports as they are less expensive

Aggregate supply

the total supply of goods and services available to a particular market from producers.

why SRAS is upwards sloping

• The SRAS curve is upward sloping due to two reasons

  • The aggregate supply is the combined supply of all individual supply curves in an economy which are also upward sloping

  • As real output increases, firms have to spend more to increase production e.g. wage bills will increase

    • Increased costs result in higher average prices

SRAS

• Influenced by changes in the costs of production

• where at least one factor of production is fixed

LRAS

• Influenced by a change in the productive capacity of the economy

• changes in the quality and quantity of FoP

factors affecting SRAS

Change in Condition	Explanation	Impact on SRAS
Increase in costs of raw materials/energy	As the price of input costs rise, fewer goods/services can be produced with the same amount of money	SRAS decreases - shifts left
Decrease in costs of raw materials/energy	As the price of input costs decrease, more goods/services can be produced with the same amount of money	SRAS increases - shifts right
Appreciation of E/R	Producers often import raw materials Stronger currency = cheaper imports Cheaper imports = decrease in input costs Lower costs = more output	SRAS increases - shifts right
Depreciation of E/R	Producers often import raw materials Weaker currency = more expensive imports More expensive imports = increase in input costs Higher costs = less output	SRAS decreases - shifts left
Decrease in tax rates	Taxes represent an additional cost for firms Decreasing taxes =  decrease in costs Lower costs = more output	SRAS increases - shifts right
Increase in tax rates	Taxes represent an additional cost for firms Increasing taxes =  increase in costs Higher costs = less output	SRAS decreases - shifts left

The classical LRAS view

• LRAS is perfectly inelastic (vertical) at a point of full employment of all available resources

• in the long- run, an economy will always return to this full employment level of output

The Keynesian LRAS view

• Supply is elastic at lower levels of output as there is a lot of spare production capacity in the economy

• The Keynesian view believes that an economy will not always self-correct and return to the full employment level of output (Y_FE)

factors influencing LRAS

1. Technological advances: these often improve the quality of the factors of production e.g. development of metal alloys

2. Changes in relative productivity: process innovation often results in productivity improvement e.g. moving from labour intensive car production to automated car production

3. Changes in education and skills: over time this increases the quality of labour in an economy

4. Changes in government regulations: these can improve the quantity of the factors of production. e.g. deregulation of fracking (extracting oil from shale deposits) increased oil reserves

5. Demographic changes and migration: a positive net birth rate or positive net migration rate will increase the quantity of labour available

6. Competition policy: regulating industries so as to prevent monopoly power results in more firms supplying goods/services in an economy and this increases the potential output of an economy