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Aggregate Demand and
Supply
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Aggregate Demand and Supply
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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
• Note – Inflation used for the vertical
axis – follows from new thinking on the
derivation of AD curves from the likes of
David Romer @ University of California
– Assumes Central Banks do not target
the money supply but short term
interest rates
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Aggregate Demand Curve
• Why does it slope down from left to right?
– Assume Bank of England 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 will fall
• Investment will fall
• International competitiveness will decrease –
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:
• Inflation on the vertical axis –
assume an initial ‘target rate’ of
2.0% (as measured by the HICP or
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
Inflation
Thea lower
This
At
higher
level of
level
rate
output
of
of
At an
level
will
inflation
National
be inflation
associated
(3.0%)
Income
of 2%,
the
ADrates
with
rising
requires
a interest
particular
fewer
units
curve
gives
level
mean
of
labour
ofthat
– C,aIlevel
and
of output
of Y1 rises
(X-M)
unemployment
all have
which
negative
to
7% we
shown
effects
will by
callon
UU=
= 5%
AD
7%
– NY falls to Y2
3.0%
2.0%
AD
Y2
U = 7%
Y1
U = 5%
Real National Income
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Shifts in the Aggregate Demand
This
cause
Shiftswould
in AD will
be
Curve
Any exogenous
Inflation
caused
bynational
changes in
a rise in
factor
causing
factors
C,C,
I,
incomeaffecting
(economic
andG(X-M)
IG
or
toand
rise,
or
growth)
lead
(exogenous
factors)
a
surplus
to trade
a fall in
e.g. increasing
unemployment
causes
a shift (U
to
income tax rates
=
2%)
(and
the
right
in vice
AD
affect
consumption
versa)
2.0%
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
– Credit
– Interest rates
– Wealth
• Property
• Shares
• Savings
• Bonds
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Investment Expenditure
• Spending on:
–
–
–
–
Machinery
Equipment
Buildings
Infrastructure
• Influenced by:
–
–
–
–
Expected rates of return
Interest rates
Expectations of future sales
Expectations of future inflation rates
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Government Spending
•
•
•
•
•
•
•
•
Defence
Health
Social Welfare
Education
Foreign Aid
Regions
Industry
Law and Order
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Import Spending (negative)
• Goods and services bought from abroad –
represents an outflow of funds from the UK
(reduces AD)
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Export Earnings (Positive)
• Goods and services sold abroad – represents a
flow of funds into the UK (raises AD)
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Key Variables
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Macroeconomic Policy
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Fiscal Policy
• Government Income (taxes and borrowing)
• Government Spending
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Monetary Policy
• Interest Rates (Bank of England)
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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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Aggregate Supply
Inflation
AS
Economy starts to overheat
Between Y1 and Yf,
The
shape
the
AS
Yf
Anrepresents
output
level
‘Full
of
Y1
increases
in of
capacity
are
This
shape
curve
important
Employment
wouldissuggest
thein –
possible
but
theOutput’
nearer
reflects
agets
the
economy
to Yf,
determining
the
at
economy
this
point
is
working
the
morefull
problems
are to
outcome
in
the
economy
below
iscapacity
working
Keynesian
view
experienced
with
economy
full
andcapacity
there would
andacquiring
be
of
the
AS
curve.
resources
to boost
cannot
widespread
produce any
production (production
more.
unemployment.
bottlenecks)
especially
labour skills shortages.
Y1
Yf
Real National Income
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Inflation
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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Aggregate Supply
Inflation
SRAS 1
SRAS
SRAS 2
SRAS
assumes
Short run
costs
suchsupply
as
aggregate
(SRAS)
overall assumes
wage
firms
only able to
rate remain
increase
output at
fixed, changes
higher costs (e.g.
in such costs
overtime
cause
a shift in
payments)
the
SRAS
curve
thereby
pushing
(exogenous
up price level
shocks – input
costs)
Real National Income
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Aggregate Supply
Inflation
LRAS
Yf
This is because they
Classical
believe that in the
economists
long run, there will be
no
unemployment
of
assume
the long
resources because
run aggregate
markets will clear,
supply
curve
thus whatever
the
rate of inflation,
firms
(LRAS)
is vertical
will
supply the
(perfectly
maximum capacity of
inelastic).
the economy.
Real National Income
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Aggregate Supply
Inflation
AS
For our analysis,
we will assume
the AS curve
looks like this!
Real National Income
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Putting AD and AS together
AS
Inflation
2.5%
2.0%
A shift in the AD
In
thisto
situation,
curve
AD1 as athe
economy
bein
result of awould
change
operating
at the
less
any or all of
than
capacity,
there
factors
affecting
AD
would
be
would increase
unemployment
growth, reduce and
the
economy might
unemployment
but at
be
growing
only
a cost of higher
slowly.
inflation (a trade-off)
AD 1
AD
Y1
Y2
Yf
Real National Income
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Putting AD and AS together
AS
Inflation
3.5%
Further increases in
AD would lead to
successively
smaller increases in
growth and
employment at the
cost of ever higher
inflation.
AD2
2.5%
2.0%
AD1
AD
Y1
Y2
Yf
Y3
Real National Income
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Sustained Growth
Inflation
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
2.0%
AD2
AD
Y1
Y2
Real National Income
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