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Aggregate Demand and Supply - ___Aggregate Demand and Supply___

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					Aggregate Demand and
       Supply
Aggregate Demand and Supply
Aggregate Demand (AD)
            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)
       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
      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
      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)
            Aggregate Demand Curve
Inflation                       At a higher level
                               The lower rate of of
                                This level of output will
                               National Income of
                                 At an inflation rising
                                inflation (3.0%)level
                                be associated with a
                               requires fewer units
                                 2%, the AD mean that
                                interest rates curve gives
                                particular level of
                                C, labour – all have
                               of level of output of Y1
                                 a I and (X-M)
                                unemployment which we
  3.0%                         unemployment rises
                                negative effects on AD –
                                will call U = 5%
                               to 7% shown by U =
                                NY falls to Y2
                               7%

  2.0%


                                                  AD

               Y2      Y1
                      U = 5%
                                     Real National Income
             U = 7%
         Shifts in the Aggregate Demand
Inflation              Curve      This in AD will be
                                  Shifts would cause
                                  Any exogenous
                                  a rise in national
                                  caused
                                         factor causing C,
                                         by changes(economic
                                         income in factors
                                         growth) I,rise,
                                         affecting C, andand or a
                                         I or G to G lead
                                         (X-M)fall in
                                         to a surplus
                                         trade factors)
                                         (exogenous
                                         unemployment (U
                                                     a shift to
                                         causes (and vice
                                         e.g. increasing income tax
                                         = 2%) consumption
                                         rates affect
                                         the right in AD
                                         versa)

 2.0%

                                                          AD2
                                            AD

                   Y1           Y2
                  U = 5%      U = 2%
                                       Real National Income
    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
           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
          Government Spending

   Defence
   Health
   Social Welfare
   Education
   Foreign Aid
   Regions
   Industry
   Law and Order
     Import Spending (negative)

   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

   Government Income (taxes and borrowing)
   Government Spending
                Monetary Policy

   Interest Rates (Bank of England)
Aggregate Supply (AS)
     Capacity of the Economy

   Costs of Production
   Technology
   Education and Training
   Incentives
   Tax regime
   Capital stock
   Productivity
   Labour Market
              Aggregate Supply
Inflation                                AS    An output Y1 ‘FullY1
                                               Yf represents and Yf,
                                               Between level of
                                               increases in Output –
                                               Employment capacity
                                                The shape of the
                                               would suggestthe AS
                                                This shape
                                               are possible but the
                                                curve point working
                                               at this is important in
                                               economy is the
                                                reflects a
                                               nearer the economy
                                                determining the
                                               below full capacity and
                                               economy is working to
                                               gets to Yf, the more
                                                Keynesian
                                               full capacity beview
                                                outcome
                                               there would and
                                               problems are
                                                of the AS
                                               widespread curve.
                                                in the produce
                                               cannot economyany
                                               experienced with
                                               acquiring resources to
                                               unemployment
                                               more
            Economy starts to overheat
                                               boost production
                                               (production
                                               bottlenecks) especially
                                               labour skills shortages.




                          Y1             Yf
                                              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
                                 SRAS assumes
Inflation                        costs such as
                                 Short run aggregate
                                 overall wage
                                 supply (SRAS)
                                 rate remain
                                 assumes firms only
                                 fixed, changes
                                 able to increase
                       SRAS 1    in such costs
                                 output at higher
                                 costs (e.g. shift in
                                 cause a overtime
                                 the SRAS curve
                                 payments) thereby
                        SRAS     (exogenous
                                 pushing up price
                                 shocks – input
                                 level
                                 costs)
                        SRAS 2




                           Real National Income
            Aggregate Supply
Inflation                 This is because they
                 LRAS     believe that in the
                          Classical economists
                          long run, there will be
                          assume the long run
                          no unemployment of
                                      supply
                          aggregate because
                          resources
                          curve (LRAS) is
                          markets will clear,
                          thus whatever the
                          vertical (perfectly
                          rate of inflation, firms
                          inelastic).
                          will supply the
                          maximum capacity of
                          the economy.




                  Yf      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
                                     A shift in the AD
                          AS         curve situation, the
                                     In thisto AD1 as a
Inflation                            economya change in
                                     result of would be
                                     operating of the
                                     any or all at less
                                     than capacity, there
                                     factors affecting AD
                                     would be
                                     would increase
                                     unemployment and
                                     growth, reduce
                                     the economy might at
                                     unemployment but
                                     be growing only
                                     a cost of higher
                                     slowly. (a trade-off)
                                     inflation
2.5%

2.0%
                                        AD 1


                                      AD

               Y1   Y2   Yf    Real National Income
            Putting AD and AS together
                                             Further increases in
                                  AS
Inflation                                    AD would lead to
                                             successively
                                             smaller increases in
                                             growth and
                                             employment at the
3.5%                                         cost of ever higher
                                             inflation.
                                              AD2
2.5%

2.0%
                                               AD1


                                             AD
                              Yf
                   Y1   Y2   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

				
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