Transcript agg demand pp

Aggregate Demand and
Supply
Aggregate Demand and Supply
Aggregate Demand (AD)
Aggregate Demand

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The sum of all expenditure in the economy over a
period of time
Macro concept – WHOLE economy
Formula:
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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)
Aggregate Demand Curve
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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
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:
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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
Aggregate Demand Curve
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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)
Aggregate Demand Curve
At a lower
higher rate
of of
The
level
This level of output will
inflation
(3.0%)
risingof
National
Income
Atassociated
an inflation
level
be
with
a
interest
rates
mean
that
requires
fewer
units
2%, the AD
curve
particular
level
of gives
C,
I andof
(X-M)
of
labour
– allofhave
a level
output
Y1we
unemployment
which
negative effects on rises
AD –
unemployment
will call U = 5%
NY7%
fallsshown
to Y2 by U =
to
7%
Inflation
3.0%
2.0%
AD
Y2
U = 7%
Y1
U = 5%
Real National Income
Shifts in the Aggregate Demand
This
would
Shifts in
AD willcause
be
Any
exogenous
Curve
Inflation
a
rise in national
caused
factor
causing
by
changes
in factors C,
income
(economic
affecting
I,rise,
G and
I or G C,
toand
or a
growth)
lead
(X-M)
to
a fall
in
trade
surplus
(exogenous factors)
unemployment (U
e.g.
increasing
income
causes
a shift
totax
=
2%)
(and
vice
rates affect consumption
the
right in AD
versa)
2.0%
AD2
AD
Y1
U = 5%
Y2
U = 2%
Real National Income
Consumption Expenditure
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Exogenous factors affecting consumption:
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Tax rates
Incomes – short term and expected income over lifetime
Wage increases
Credit
Interest rates
Wealth
 Property
 Shares
 Savings
 Bonds
Investment Expenditure

Spending on:
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Machinery
Equipment
Buildings
Infrastructure
Influenced by:
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Expected rates of return
Interest rates
Expectations of future sales
Expectations of future inflation rates
Government Spending
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Defence
Health
Social Welfare
Education
Foreign Aid
Regions
Industry
Law and Order
Import Spending (negative)
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Goods and services bought from abroad – represents an
outflow of funds from the UK (reduces AD)
Export Earnings (Positive)

Goods and services sold abroad – represents a flow of
funds into the UK (raises AD)
Key variables
Macroeconomic policy
Fiscal Policy
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Government Income (taxes and borrowing)
Government Spending
Monetary Policy
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Interest Rates (Bank of England)
Aggregate Supply (AS)
Capacity of the Economy
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Costs of Production
Technology
Education and Training
Incentives
Tax regime
Capital stock
Productivity
Labour Market
Aggregate Supply
Inflation
AS
Economy starts to overheat
Y1
Yf
Between
and
Yf
An
represents
output Y1
level
‘Full
of Yf,
Y1
increases
in
capacity
The
ofOutput
the
Employment
would
suggest
theAS –
Thisshape
shape
are
possible
but
the
is important
in
atcurve
economy
this
point
is
working
the
reflects
a
nearer
the
economy
determining
the and
economy
below
fulliscapacity
working
to
gets
to
Yf,
the
more
Keynesian
view
outcome
full
there
capacity
wouldare
be
and
problems
in
ofthe
theeconomy
AS curve.
cannot
widespread
produce
any
experienced
with
more
unemployment
acquiring resources to
boost production
(production
bottlenecks) especially
labour skills shortages.
Real National Income
Aggregate Supply
Inflation
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
Aggregate Supply
Inflation
SRAS 1
SRAS
SRAS assumes
Short run
aggregate
costs
such
as
supply (SRAS)
overall
wage
assumes
firms only
rate remain
able
to increase
fixed,
changes
output
at higher
in
such
costs
costs (e.g.
overtime
cause
a shift
in
payments)
the
SRASthereby
curve
pushing
up price
(exogenous
level
shocks – input
costs)
SRAS 2
Real National Income
Aggregate Supply
Inflation
LRAS
Yf
This is because they
Classical
economists
believe that
in the
long
run,the
there
assume
longwill
runbe
no unemployment of
aggregate
supply
resources because
curve
(LRAS)
is
markets
will clear,
thus whatever
the
vertical
(perfectly
rate
of inflation, firms
inelastic).
will supply the
maximum capacity of
the economy.
Real National Income
Aggregate Supply
Inflation
AS
For our analysis,
we will assume
the AS curve
looks like this!
Real National Income
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
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
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