Aggregate Demand and Supply Notes

Aggregate Demand

Aggregate Demand

• Aggregate Demand (AD) is the total spending on goods and services in an economy over a period of time.

• It is downward sloping, similar to a demand curve in microeconomics.

• In macroeconomics:- Price is replaced with the "average price level" of all goods and services.

  • Quantity is replaced with the total quantity of all goods and services, also known as national output or "real output."

• National output = national income = national expenditure

• The x-axis is often labeled "real output" (adjusted for inflation) or "national income (Y)."

• AD illustrates an inverse relationship between the average price level and total real output demanded.

• Lower average price level leads to a higher quantity of goods and services demanded, which reflects the law of demand at an aggregate level.

Components of Aggregate Demand

1. Consumption (C): Total spending by consumers on domestic goods and services.- Includes durable and non-durable goods.

   • Durable goods: Used by consumers over a longer period (more than a year), e.g., cars, computers, cell phones.

   • Non-durable goods: Used up immediately or relatively quickly, e.g., rice, toilet paper, newspapers.

2. Investment (I): Addition of capital stock to the economy, carried out by firms.- Replacement investment: Spending on capital to maintain productivity of existing capital.

   • Induced investment: Spending on capital to increase output in response to higher demand.

3. Government Spending (G): Government spending at any level (federal, state/provincial, municipal/city) on various goods and services.- Examples: Healthcare, education, law and order, transportation, housing, defense.

   • Does not include transfer payments.

4. Net Exports (X-M): Exports (X) are domestic goods and services bought by foreigners, while imports (M) are goods and services bought from foreign producers.- Net exports = total export revenue minus total import expenditure.

Shape of the Aggregate Demand Curve

• $AD = C + I + G + (X - M)$

• When the average price level falls from $PL<em>1$ to $PL</em>2$, the level of output demanded increases from $Y<em>1$ to $Y</em>2$.

• Y represents national income, which is equal to national output.

Changes in Aggregate Demand

• A change in the average price level (PL) leads to a movement along the AD curve, resulting in a change in the level of real output.

• A shift of the AD curve is caused by a change in one of its components: C, I, G, or (X-M).

Causes of Changes in Consumption (C)

1. Changes in income taxes:- Higher taxes reduce disposable income, decreasing consumption.

   • Lower taxes increase disposable income, increasing consumption.

2. Changes in interest rates:- Lower interest rates reduce the cost of borrowing, encouraging loans and spending.

   • Lower interest rates reduce the incentive to save, encouraging spending.

3. Changes in wealth:- Wealth is the value of assets people own, while income is money earned.

   • More wealth can lead to more spending.

   • Examples:- Changes in housing prices.

     • Changes in the value of shares of stock.

4. Changes in consumer confidence/expectations:- Optimism about the future leads to increased spending.

   • Pessimism leads to decreased spending.

5. Levels of household indebtedness:- High levels of debt require more money to be spent on repaying loans, reducing spending on new goods and services.

Causes of Changes in Investment (I)

1. Changes in interest rates:- Lower interest rates encourage firms to invest more, either using retained profits or borrowing money.

2. Changes in business taxes:- Corporate taxes (taxes on firms' profits) affect how much profit firms have left to reinvest.

3. Technological change:- Firms must invest in new technologies to remain competitive.

4. Changes in business confidence/expectations:- Expectations about the economic climate and future earnings affect investment decisions.

5. Levels of corporate indebtedness:- High levels of debt require more money to be used to repay loans rather than invest.

Causes of Changes in Government Spending (G)

1. Political and economic priorities:- Government spending is directly affected by its priorities.

   • Supporting a particular industry increases government spending.

   • Correcting a market failure may increase government spending.

   • Increased spending on education or healthcare will cause government spending to rise.

Causes of Changes in Net Exports (X-M)

1. Changes in exports (X):- Changes in income of foreigners.

   • Changes in exchange rates affect the relative prices of goods and services.

   • Trade policies.

   • Relative inflation rates among trading partners.

2. Changes in imports (M):- Changes in national income affect spending on imported goods and services.

   • Changes in exchange rates.

   • Trade policies.

   • Relative inflation rates.

Aggregate Supply

• Aggregate Supply is the total quantity of goods and services produced in an economy over a particular period at different price levels.

• Short-Run Aggregate Supply (SRAS) shows the relationship between the price level and the quantity of real output produced by firms when costs of factors of production (especially wages) do not change.

• SRAS is the sum of the supply curves of all industries in an economy.

• In macroeconomics, "price" is replaced with the "average price level" and "quantity" with "real output."

Short Run vs. Long Run in Macroeconomics

• Short run: Costs of resources are roughly constant or inflexible despite changes in the price level.

• Long run: Costs of all resources, including labor, are flexible and change with the price level.

• Wages are significant because they are a large part of firms’ costs of production.

• Wages are often rigid because:- Labor contracts fix wages for a period of time.

  • Minimum wage legislation fixes the lowest legal wage.

  • Workers and labor unions resist wage cuts.

  • Wage cuts have negative effects on worker morale.

Short-Run Aggregate Supply

• SRAS curves are usually curved and get steeper as price increases, but are often drawn as a straight line for simplicity.

• SRAS is the aggregate supply curve in the short run when costs of factors of production do not change with a change in PL, especially wages.

• If industries increase output, the price level will rise, because average costs will increase (e.g., paying workers overtime), and firms will pass costs to consumers.

Shifts of the SRAS Curve

• Changes in PL as output changes occur along a single SRAS curve assuming that costs of factors of production remain constant.

• A change in the PL will lead to a change in output

• Changes in other factors will cause a shift of the SRAS curve

• A rightward shift is an increase in SRAS, while a leftward shift is a decrease in SRAS.

Factors that Shift the SRAS Curve

• A change in wage rates: increased wage rates will lead to increased costs of production for firms and therefore a fall in SRAS

• A change in the costs of raw materials: assuming the change in the price is significant and for widely used raw materials, an increase in the price would lead to a decrease in SRAS (price of oil would be significant enough, rubber maybe not)

• A change in the price of imports: if the capital or raw materials used by a country’s industries are imported, then this will lead to a change in the costs of production

• A change in government indirect taxes or subsidies: an increase in indirect taxes effectively increases the costs of production to firms and causes a decrease in SRAS while increases in subsidies decrease costs of production and cause an increase in SRAS (but only in significant industries)

• Supply shocks: events that have a sudden and strong impact on SRAS, such as war destroying physical capital, unfavorable weather conditions may lower crop yields, etc.

Short-Run Equilibrium

• Short-run equilibrium is determined by the intersection of the AD and SRAS curves, determining the price level, the level of real GDP, and the level of employment.

• If the PL is lower than equilibrium, there will be excess real GDP, pushing up the PL.

Two Schools of Thought Regarding LRAS

• New Classical/Monetarist model is more commonly used

• Keynesian long-run aggregate supply challenges some of the assumptions of the model and was developed by John Maynard Keynes

• Differences in the perspectives have implications on beliefs about different government policies

New Classical Long-Run Aggregate Supply

• New classical economists (including monetarists, supply-side economists, and the Austrian school) believe in the efficiency of market forces and there should be minimal intervention by the government

• View the LRAS curve as perfectly inelastic at the “full employment level of output”

• Full employment level of output ($Y<em>f$ or $Y</em>p$) represents the potential output that could be produced if the economy were operating at full capacity

• Note that full employment does not mean zero unemployment

• In this perspective, market-forces will always bring the economy back to $Y_f$ with no intervention needed

Keynesian Aggregate Supply

• Keynes argued that the economy could get stuck in short-run equilibrium for long periods of time

• Phase 1 - AS curve is perfectly elastic at low levels of economic activity because of “spare capacity” - output can be increased with no effect on PL

• Phase 2 - Spare capacity is used up as factors of production are increasingly scarce

• Phase 3 - Economy is at full capacity, the full employment level of output, and AS is perfectly inelastic - output cannot be increased given the current quantity and quality of factors of production, only changes in PL

Shifts of the LRAS Curve

• An increase in the quantity or quality of factors of production will lead to a shift of the PPC as well as the LRAS

Factors of production Influencing LRAS

• Land (all natural resources)- Increase in quantity- Land reclamation
  - Increased access to supply of resources
  - Discovery of new resources

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  • Improvement in quality (increase in productivity)- Technological advancements that allow for increased access to resources or the discovery of new resources

    • Fertilizers

    • Irrigation

• Labour + entrepreneurship- Increase in birth rate

  • Immigration

  • Training

  • Decrease in the natural rate of unemployment.

  • Re-training- Education

• Capital- Investment

  • Apprenticeship programmes

  • Technological advancements that contribute to more efficient capital

  • Research and development

Key Vocab and Points for Tests

• Aggregate Demand (AD): Total spending on goods and services in an economy.

• Consumption (C): Spending by consumers.

• Investment (I): Addition of capital stock to the economy.

• Government Spending (G): Government spending on goods and services (excluding transfer payments).

• Net Exports (X-M): Exports minus Imports.

• Aggregate Supply: Total quantity of goods and services produced in an economy.

• Short-Run Aggregate Supply (SRAS): Aggregate supply when costs of factors of production do not change.

• Short run: Costs of resources are inflexible.

• Long run: Costs of all resources are flexible.

• Short-Run Equilibrium: Determined by the intersection of AD and SRAS.

• New Classical/Monetarist Model: Believes in efficient market forces with minimal intervention.

• Keynesian Aggregate Supply: Economy can get stuck in short-run equilibrium; includes three phases of capacity.

Key Points:

• Aggregate Demand Curve: Inverse relationship between price level and real output demanded.

• SRAS Shifts: Changes in wage rates, costs of raw materials, price of imports, indirect taxes, subsidies, and supply shocks.

• LRAS Shifts: Changes in quantity or quality of factors of production (land, labor, capital).