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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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