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Aggregate Demand and
Supply
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http://www.bized.ac.uk
Aggregate Demand and Supply
Copyright 2005 – Biz/ed
http://www.bized.ac.uk
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)
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Aggregate Demand Curve
•Shows the overall level of
spending at different
price levels
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Aggregate Demand Curve
• Why does it slope down from left to right?
– Assume RBNZ 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 (C) will fall
• Investment (I) will fall
• International competitiveness will decrease
because $NZ will appreciate– exports fall, imports
rise
• Therefore – a rise in the price level leads to
lower levels of aggregate demand
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Aggregate Demand Curve
• The AD diagram:
• Price Level on the vertical axis –
assume an initial ‘target rate’ of P1
(as measured by the CPI)
• Real GDP or Real National Income
or Real Output on the vertical axis
(shown by the initial Y)
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Aggregate Demand Curve
Price
Level
Thethe
This
At
lower
level
higher
of
level
output
Price
of
At the
price
level
will
Level
National
beofassociated
P2,
Income
rising
P1, the
AD
curve
with
interest
requires
a particular
rates
fewer
mean
units
gives
a Ilevel
level
that
of
labour
C,
of
and
– of
(X-M)
output
Y1 rises
all
unemployment
haveof
negative
which
effects
to
7% we
shown
on will
AD by
call
– NY
UU=
= 5%
falls
7%
to Y2
P2
P1
AD
Y2
U = 7%
Y1
U = 5%
Real National Income
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Price
Level
Shifts in the Aggregate Demand
Curve This would cause a
Any
exogenous
Shifts
in national
AD
will be
rise in
factor
causinginC,
caused
by changes
income (economic
factors
C, I,
I oraffecting
G to rise,
orG and
growth)
and
lead
to a
(X-M)
factors)
a (exogenous
trade surplus
fallincreasing
in unemployment
e.g.
income
causes a shift
to tax
(U =affect
2%)consumption
(and vice
rates
the right
in AD
versa)
P1
AD2
AD
Y1
U = 5%
Y2
U = 2%
Real National Income
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Consumption Expenditure
• Exogenous factors affecting consumption:
– Tax rates
– Incomes – short term and expected income over
lifetime
– Wage increases
– Availability of credit
– Interest rates
– Wealth
• Property
• Shares
• Savings
• Bonds
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Investment Expenditure
• Spending on:
–
–
–
–
Machinery
Equipment
Buildings
Infrastructure
• Influenced by:
–
–
–
–
Expected return on investment
Interest rates
Business confidence (expected future revenues)
Expected inflation rates (inflationary expectations)
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Government Spending
•
•
•
•
•
•
Defence (Army, Navy, etc)
Health
Education
Law and Order
Regions
Industry
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Import Spending (negative)
• Goods and services bought from abroad –
represents an outflow of funds from NZ
(reduces AD)
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Export Earnings (Positive)
• Goods and services sold abroad – represents a
flow of funds into NZ (raises AD)
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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
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Price
Level
Aggregate Supply
AS
Economy starts to overheat
Y1
Yf
Between
Y1 and‘Full
Yf,
Yf represents
The
An
output
shape
of theofAS
Y1
This
shape
increases
in level
capacity
are
Employment
Output’
–
curve
would
is
suggest
important
the
in
possible
but
the
nearer
reflects
a the
at
this
point
the
economy
to Yf,
determining
economy
is gets
working
the
Keynesian
view
economy
is working
the
more
problems
areto
outcome
below
full
in
capacity
the
ofcapacity
the ASwith
curve.
full
and
experienced
economy
and
there would be
cannot
any
acquiringproduce
resources
to
widespread
boost production
more.
unemployment.
(production bottlenecks)
especially labour skills
shortages.
Real National Income
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Price
Level
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
Real National Income
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Putting AD and AS together
in this
the situation,
AD curve to
theAD1
AS A shiftIn
Price
Level
as a result
economy
of a change
would be
in any
or all of
operating
the factors
at less
affecting
than
AD would
capacity,
increase
there
growth,
would
reducebe
unemployment
unemployment
but
and
at
a cost the
of higher
economy
inflation
might(abe
trade-off)
growing only slowly.
P2
P1
AD 1
AD
Y1
Y2
Yf
Real National Income
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Putting AD and AS together
AS Further increases in AD would
Price
Level
lead to successively smaller
increases in growth and
employment at the cost of
ever higher inflation.
P3
AD2
P2
P1
AD1
AD
Y1
Y2
Yf
Y3
Real National Income
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Sustained Growth
Price
Level
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
P1
AD2
AD
Y1
Y2
Real National Income
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