Aggregate demand _ aggregate supply and their interaction by fanzhongqing

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									2010
Eastbourne College

JJRH




        AGGREGATE DEMAND &
         AGGREGATE SUPPLY
                AND
         THEIR INTERACTION
            [CHAPTER 4]




OCR AS Economics Heinemann Chapter 4 Pages 82 - 102
                                  General Introduction
The economist’s ‘tool kit’ (what you must be able to do!):

       Interpret economic information and use it to enhance your understanding of
        economics
       Write in a clear and effective way, in particular to develop the writing skills that will
        enable you to demonstrate that you really understand what you have been studying.
       Pick out the main features in a data set
       Have a knowledge of trends and how to understand what is meant by the rate of
        change in a data set
       Have a basic understanding of index numbers and how these are used
       What is meant by an average value in a data set
       How to interpret data that is present in a variety of visual forms



There are four main guidelines you need to bear in mind when communicating your
knowledge of economics in an exam:

   1.   Present clear, accurate and relevant information
   2.   Put down your ideas in an organised and coherent way
   3.   Use the vocabulary of economics
   4.   Make sure that what you write is legible and that your spelling, punctuation and
        grammar are correct!

OCR examiners will be impressed when your answers match these criteria and will be more
likely to give you the benefit of the doubt.




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Macroeconomics: the study of economic variables that affect economies as a whole

Introduction
Macroeconomics considers the economy as a whole and relationships between one country
and others for example we focus on changes in economic growth; inflation; unemployment
and our trade performance with other countries (i.e. the balance of payments). The scope
of macroeconomics also includes looking at the relative success or failure of government
policies.



What is happening in the economy can have a significant impact on us all. The quality of our
lives is influenced by, among other factors, how easy it is to find a job (unemployment) and
the prices we pay for the products we are able to buy (inflation). These factors are, in turn,
influences by the aggregate (total) level of demand and the aggregate level of supply in the
countries in which we live.




NB     Remember aggregate means      total, it does not mean average!




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                 Aggregate Demand (AD)

      The total demand for goods and services produced in an economy at a given price
       level and in a given time period
           o Price level: the average of each of the prices of all the products produced in
               the economy
      This planned expenditure comes from
           o Households consumer expenditure (C)
           o Firms             investment (I)
           o Government government spending (G)
           o Foreigners        net exports (X-M) – exports(X) minus imports(M)
      So


                          AD = C + I + G + (X-M)

Definitions:

           o Price level: the average of each of the prices of all the products produced in
             the economy

           o Consumer expenditure (C): spending by households on consumer products

           o Investment (I): spending on capital goods

           o Government spending (G): spending by the central and local government on
             goods and services

           o Exports (X): products sold abroad

           o Imports (M): products brought from abroad

           o Net exports (X-M): the value of exports minus the value of imports




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The components of AD
    consumer expenditure (C) is also known as ______________________
        o For most countries it is the LARGEST component of AD
        o Accounts for spending by households on clothing, food, insurance,
          transport.....etc......
        o Accounts for about...........% of economic activity in the US!



    Investment (I) is spending on capital goods by firms
        o Capital goods such as buildings, ________________and__________________
        o the most volatile component of AD



    Government spending (G) by central and local government on
        o Education, _______________________ and________________________
        o Does not include transfer payments such as:
              housing benefits
              job seeker’s allowance
              state pensions
        o Transfer payments would be reflected in higher consumer expenditure



    Net exports (X-M)
        o Add foreigners’ spending on the country’s goods and services and deduct
            spending by the country’s population on imports
        o If X > M (trade surplus) then net exports will be ________________
        o If X < M (trade deficit) then net exports will be ________________




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Calculations of Percentage Contributions


If aggregate demand for 2000 was £500bn:


                  Consumption £200 bn
                      (C)
                    Investment             £100 bn
                        (I)
                  Government £150 bn
                  Spending (G)
                   Exports (X)             £100 bn
                   Imports (M)              £50 bn

Calculate the percentage contribution for each component. Please
show your working for future reference and revision
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Factors affecting the components of AD
There are a range of influences on each component of AD:

CONSUMER EXPENDITURE (C) - usually accounts for 40-60% of GDP



      Real disposable income
          o The main influence on (C)
          o Richer households/economies spend more than poorer ones
          o Average propensity to consume (APC): the proportion of disposable income
              spent. It is consumer expenditure divided by disposable ..................................
          o Who would have the greater APC, a banker or a teacher?_________________
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      Wealth_______________________________________________________________
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   Consumer confidence and expectations____________________________________
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   The rate of interest
       o Changes to interest rates (IR’s) can have a significant influence on (C)
       o An ↓ in IR’s will stimulate a rise in C for three main reasons:
               1. Makes it cheaper to borrow → ↑ spending on expensive items
               2. Reduces the incentive to save
               3. Cheaper to repay existing loans/mortgages → ↑disposable income
       o Net savers (people who save more than they borrow) will lose out if IR’s fall
           as their ability to spend will fall
       o Their are however three main reasons why (C) will not ↑ with a ↓IR’s
               1. The perception that the ↓IR is only temporary
                   _________________________________________________________
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              2. The IR will fall further still
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              3. Fearful of the future
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   Age structure of the population
       o Generally thought that the young and the elderly have a high APC but this is
           not always the case




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         Distribution of income
              o As previously discussed, the poor have a higher APC than the rich do
              o Govn’t measures to redistribute income from the rich to the poor are likely to
                 ↑ (C)

         Inflation______________________________________________________________
          _____________________________________________________________________
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                                                        ARTICLE
Robust consumption demand results into fast recovery – Indiatimes.com 3 May ‘10
Robust consumption demand in the initial months of the economic recovery has resulted into faster than expected recovery
in India. If such demand
                                          sustains in the future, the economy will very soon attain a 9% plus growth in the
                                          coming years, as it will induce more projects for capacity expansion and hence,
                                          the demand for investment. Healthy auto sales numbers, above 30% growth in
                                          production of consumer durables for the three consecutive months portray a rosy
                                          picture for consumption demand. But will it continue to remain strong in the
                                          near future?

                                             The Reserve Bank of India has pointed out this concern in its latest report on
                                             Macroeconomic and Monetary Developments in 2009-10. “Notwithstanding the
                                             overwhelming positive sentiments about stronger growth in the near term,
                                             certain downside risks remain. One amongst them is the private consumption
                                             demand, which accounts for about 60% of aggregate demand, needs to gain
                                             significant momentum,” says RBI in its latest Macroeconomic Outlook for
2010-11. So, here we attempt to assess the future trend of consumption demand and possible risks pertaining to it.

The consumer confidence indices could be one such barometer to judge the general consumer pulse. There are a few such
surveys conducted but all are hinting range bound movement in consumer sentiments. In addition, the current optimism
levels observed were way below the levels observed during the pre-crisis period. Let us take an example of MasterCard
Consumer Confidence Index for the first half of the calendar year 2010.

In the latest survey, the index was at 68.2 points showing only a small variation compared to the scores of 68.0 and 68.8,
respectively in the first half of 2009 and second half of 2009. It shows consumer’s confidence in the country has not
increased substantially over the period, but has remained in a stable optimistic range between 64 and 70 points since H2
2008. It is far below than the optimism level observed during the pre-crisis period. (see chart)

Growth in personal loans, another indicator for the private demand, confirms the trend. In the pre-crisis era, Indian
consumers were observed to resort on bank credit to finance their spending. Auto loans, loans to purchase consumer durables
and credit card outstanding have shown an annual growth of 6.1% and 36%, respectively during FY08. During the financial
crisis, these loans recorded a sharp decline, as there was poor consumption expenditure. But the latest figures pertaining to
first three quarters of FY10 were also not encouraging.

There was a decline of 28.3% and 1.3%, respectively, in credit card outstanding and loans given to purchase consumer
durables. If lower interest rates offered on these loans could not boost the consumption demand, it needs to be watched
closely whether the demand continues when interest rates will move northward in the coming months.
Increase in salaries and bonuses this year, relaxation in income tax slabs may increase disposable income in hands of
consumers boosting spending. But, high inflation may spoil the party. It is largely because the average salary hike is
expected to be in the range of 10-15 % this year.




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INVESTMENT (I)

Firms invest when they anticipate that such spending will be profitable! Influences on this
include:

      Changes in real disposable income
          o ↑in real disposable income → ↑in (C) thereby encouraging firms to
             expand their capacity in order to cater for the extra demand

      Expectations
          o Firms are more likely to increase (I) if they feel optimistic about future
              economic prospects
          o It is the speed of the change in expectations that creates the volatility of (I)

      Capacity utilisation (the extent to which firms are using their capital goods)
          o Firms are more likely to invest if they are reaching______________________
          o Why might a firm choose not to invest if there is still spare capacity?_______
              _______________________________________________________________
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      Current profit levels – high profit levels can encourage (I) in two ways
                  1. __________________________________________________to invest
                  2. ↑ optimism about the future



      Corporation tax (tax on a firms profits)
           o A cut in corporation tax____________________________________________
               _______________________________________________________________
               _______________________________________________________________
               _______________________________________________________________
           o Gov’t can stimulate a firms (I) by ____________________________________
               _______________________________________________________________
               _______________________________________________________________
      IR’s – an ↑ in IR’s could ↓ (I) in four main ways:
                  1. ↑ the opportunity cost______________________________________
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                  2. ↑ cost of borrowing thereby discouraging (I) projects

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                  3. Affect the expected return on the investment____________________
                     _________________________________________________________
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                  4. ↓ demand for the firms shares________________________________
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      Advances in technology – a firm will buy new capital equipment for two main
       reasons:
                 1. ↑ the quality of its product → ↑ in demand
                 2. ↓ the unit cost (average cost per unit of output) of production →
                     ↑ profit or ↑ in competitiveness

      Price of capital equipment (K) – a ↓ in the price of K may make it viable for more
       firms to invest or expand capacity


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GOVERNMENT SPENDING (G)



      Perceived level of market failure
          o Economies with a high level of state intervention usually have a greater
              proportion of (G) in its AD than ‘free market’ economies

      The level of economic activity in the economy
          o High levels of unemployment → ↑ in (G) in order to stimulate AD so as to
              increase national output
          o High levels of inflation → ↓ in (G) in order to deflate (slow) the economy

      Political motivation
           o Electoral promises to improve education, health care, transport
               infrastructure.......etc........
           o ↑ spending before an election to ↑ votes

      National security
          o Tackling crime
          o ‘War on terror’



NET EXPORTS (X-M)

      Real disposable incomes abroad
          o ↑ in incomes abroad → ↑ in X → ↑ in (X-M)
          o Why will an ↑ in incomes abroad → ↑ in X?________________________
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          o ↓ in incomes abroad → ↓ in X → ↓ in (X-M)

      Real disposable incomes domestically
          o ↑ in incomes at home might → ↓ in X and ↑ in M → ↓ in (X-M)
          o Why?__________________________________________________________
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   Domestic price level
      o An ↑ in domestic price levels (inflation) could → ↓ in X and an ↑in M
      o Why?__________________________________________________________
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   The exchange rate
       o A depreciation (fall) of £ in relation to other currencies could lead to an ↑ in
           UK X and a ↓ in M. Why?_________________________________
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       o An appreciation (rise) of a £ in relation to other currencies could lead to a
           ....... in UK X and an ........ in M

   Trade barriers
       o Free trade can ↑ net exports (X-M)
       o Why?__________________________________________________________
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       o Why could it equally ↓ net exports?_________________________________
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                     The Aggregate Demand Curve
       Shows the relationship between the level of aggregate demand and the overall price
        level; this curve shows the total amount of goods and services demanded in an
        economy at any given overall level of prices
       The AD is made up of all the components discussed in previous lessons
       The price is an average of all prices of goods and services in the economy



Price level                  AD is inversely related to the price level

                                      An ↑ in the price level (inflation) causes a fall, or
                                      contraction, in real output

        P2



        P1



                                                               AD



                                 Y1            Y2                     Real Output or Real GDP



       Why is the AD curve downward sloping?

                  1. The wealth effect - an ↑in the price level (inflation) leads to the ‘real’
                     value of a consumer’s wealth to ↓. This means their purchasing
                     power ↓ and therefore their consumption ↓’s

                  2. The interest rate effect - When prices are relatively high interest rates
                     tend to be relatively high. This is because interest rates represent the
                     cost of borrowing. With a consumer’s purchasing power being
                     diminished due to the wealth effect, one way to maintain the same
                     level of consumption as before is to borrow more and so the demand
                     for loans ↑’s. Assuming that the supply of money is fixed this ↑ in
                     demand leads to an ↑in IR’s thereby discouraging investment and
                     consumption


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                  3. The international trade effect - _______________________________
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SHIFTS AND MOVEMENTS OF THE AD CURVE

   •   A change in price level will cause a movement along the AD curve.

   •   All other influences on the components of AD will cause a shift.

   •   Such influences have already been discussed such as changes in:

          o   Interest rates
          o   Government policy such as direct taxes
          o   Exchange rates
          o   Expectations
          o   Technological advancement


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                   Aggregate Supply (AS)
      AS is the total output of goods and services that producers in an economy are willing
       and able to produce at different _________________in a given__________________
      AS is the sum of all the industry supply curves
      It shows the relationship between the price level and real output/real GDP


Price level




              0                        Y            YFE             Real GDP

YFE – represents full employment in the economy



THE SHAPE OF THE Long-run AS CURVE (LRAS)

      The Shape of the AS curve is influenced by the level of capacity existing in the
       economy

      When output is low and unemployment high, as shown over the range 0 to Y in the
       above diagram, AS is perfectly elastic (more can be supplied without raising the price
       level)

      Any increase can be achieved by offering unemployed workers jobs at the going rate
       and paying the going price for raw materials and capital equipment




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      Between Y and YFE AS becomes increasingly inelastic. i.e. less responsive to changes
       in price level

      As resources become scarcer, producers have to employ less efficient workers and
       machinery

      This pushes up units costs of production and the price level

      At YFE all resources are employed (full employment or full capacity) and the AS
       becomes perfectly inelastic

      At full employment it is not possible to produce any more, extra demand will only
       lead to higher prices (pure inflation)



SHIFTS IN THE AS CURVE

The short run

      The short run means that firms can do little to increase their factors of production
           o For example, hire new staff, buy capital equipment (machinery), and expand
               to new premises. They are simply left with what they have.
      AT LEAST ONE FIXED FACTOR OF PRODUCTION
      The short run AS curve is upward sloping because if real output is to increase in the
       short run, firms have to get the current workforce to work harder (overtime
       incentives) as they cannot attract new labour by increasing the wage rate. This
       means increased costs to companies, which are then passed on to the consumer in
       the form of higher prices



Price level                               SRAS



                                                           Draw in a shift to the right of the
                                                           AS curve and label it AS1

                                                           Draw in a shift to the left and
                                                           label it AS2




                                                   Real GDP


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      The main causes of shifts in the short run AS curve are due to changes in the costs of
       production such as:
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      If the costs of production fall, firms will be willing to produce more and thus AS
       increases. (Shifts to AS1).
      A rise in the cost of production will cause a decrease in AS. (Shift to the left to AS2).


The long run

      There are two main causes of a shift to the LRAS.
                   1. Quantity of resources
                   2. Quality of resources
      In the case of labour
           o The quantity of labour may increase as a result of:
                                  Net immigration of working age people
                                  Women entering the workforce
                                  A rise in retirement age
           o The quality of the labour force could be improved by:
                                  Education and training
      In the case of machinery
           o The quantity of machinery may increase as a result of:
                                  _____________________________________________
           o The quality could be improved by:
                                  _____________________________________________



Notes: Supply-side polices_____________________________________________________

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                  Macroeconomic Equilibrium
      Occurs when AD and AS are equal.

      At equilibrium there is no reason for the economy’s output and price level to change.

      Total domestic output and the price level will be stable.



Price level                                         LRAS

                                                              Draw in the equilibrium point

                                                              Label the price level P

                                                              Label the output level Y




                                                            AD

                                                                     Real GDP

WHAT IF:

      Demand is greater than supply

              o   This would create a shortage of goods and services in the economy.
              o   Firms stocks would be declining.
              o   Demand would encourage them to expand and increase output
              o   Surplus AD may also push up the price level depending on the level of spare
                  capacity

      Supply exceeded demand
          o Unsold goods and services would cause AS to contract
          o The price level may fall (again depending on the level of spare capacity)
          o A point of interest: why might prices be ‘sticky’ whilst going down?________
              _______________________________________________________________
              _______________________________________________________________

NB Anything that causes AD or AS to change (shift) will move the economy
to a new macroeconomic equilibrium position.
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          The circular flow of income
   A model that seeks to explain how the economy works and how changes in AD occur




                                   Households




    Factor incomes          Spending       Products           Factor services




                                       Firms




   In this simplistic model there are two sectors
                         1. Households
                         2. Firms
   Between these two sectors are the flows:
                 Income
                 Products
                 Factor services (the services provided by households in return for
                     income)
   Why is this not a realistic model?__________________________________________
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INJECTIONS AND LEAKAGES




INJECTIONS                                                          LEAKAGES




      INJECTIONS – shift AD to the right
              1. Investment
              2. Exports
              3. Government spending

      LEAKAGES – shift AD to the left
             1. Savings
             2. Imports
             3. Taxes

      Macroeconomic equilibrium occurs when:


                          Value of Injections = Value of leakages



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                     The multiplier effect
      The process by which any change in a component of AD results in a greater final
       change in Real GDP (real output)
      When injections exceed leakages AD will increase – this ↑AD will have a greater final
       effect on the economy
      How does it work?______________________________________________________
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Price level                                   AS



                                                   AD1 – the increase after the initial injection


                AD   AD1         AD2               AD2 – the final rise once leakages match initial injection




           P1
           P



                       20      25      35                     Real GDP

EXAMPLE:

      The government (G) injects £5bn into the economy by building new schools,
       represented by a shift in the AD curve from AD to AD 1
          o Contractors (builders, architects, surveyors etc) are employed to create the
              schools, as well as teachers and support staff to run them
                  The contractors and teachers now have income to spend on goods
                      and services
                           Firms selling those goods and services will receive more
                             income
                                  o Firms might choose to expand and hire more
                                      workers/capital.......etc........
      Spending will continue to rise until leakages match the initial injection

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                            Changes in AD

      There are three key influences on the effect of a change in AD on real GDP,
       unemployment and inflation
                         1. The size of the initial change
                         2. The size of the multiplier
                         3. The original level of economic activity

Label the below diagrams and analyse what is happening with respect to (w.r.t) AD, real
GDP, unemployment and inflation




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                             Changes in AS
Label these diagrams and analyse the effects of the shift in AS




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THE OUTPUT GAP

      The difference between an economy’s actual and potential real GDP
          o Negative output gap: actual output < potential output
          o Positive output gap: actual output > potential output

Price level                                AS



                                                     YFE




                                  AD

                         Y                YFE              Real GDP
                             -VE Output
                                Gap

                                gap

Price level                                AS

                                                     AS1         How is this possible?!



                                                     AD



                                                +VE Output gap




                                          YFE YFE*         Real GDP

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