Aggregate Demand and Supply

1. Aggregate Demand and Supply

2. Aggregate Demand and Supply

3. Aggregate Demand (AD)

4. 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)

5. Aggregate Demand Curve • Shows the overall level of spending at different price levels • Note – Inflation is sometimes 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. But I prefer you to use price level. And recently governments have been targeting the money supply as well as interest rates.

6. Aggregate Demand Curve • Why does it slope down from left to right? • Assume Central Bank 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

7. Aggregate Demand Curve • The AD diagram: • Real GDP or Real National Income or Real Output on the vertical axis (shown by the initial Y) • Price level on the vertical axis

8. Aggregate Demand Curve P Level This level of output will be associated with a particular level of unemployment which we will call U = 5% At a higher rate of inflation (3.0%) rising interest rates mean that C, I and (X-M) all have negative effects on AD – NY falls to Y2 The lower level of National Income requires fewer units of labour – unemployment rises to 7% shown by U = 7% At an inflation level of 2%, the AD curve gives a level of output of Y1 PL2 PL1 AD Y2 Y1 Real National Income (GDP) U = 5% U = 7%

9. Shifts in the Aggregate Demand Curve This would cause a rise in national income (economic growth) and lead to a fall in unemployment (U = 2%) (and vice versa) Shifts in AD will be caused by changes in factors affecting C, I, G and (X-M) (exogenous factors) e.g. increasing income tax rates affect consumption Price Level Any exogenous factor causing C, I or G to rise, or a trade surplus causes a shift to the right in AD AD2 AD Y1 Y2 Real National Income U = 5% U = 2%

10. 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

11. 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

12. Government Spending • Defence • Health • Social Welfare • Education • Foreign Aid • Regions • Industry • Law and Order

13. Import Spending (negative) • Goods and services bought from abroad – represents an outflow of funds (leakage) from Japan (reduces AD)

14. Export Earnings (Positive) • Goods and services sold abroad – represents a flow of funds (injection) into Japan (raises AD)

15. Key Variables

16. Macroeconomic Policy

17. Fiscal Policy • Government Income (taxes and borrowing) • Government Spending

18. Monetary Policy • Interest Rates (Central Bank) • Money Supply (through Quantitative Easing)

19. Aggregate Supply (AS)

20. Capacity of the Economy • Costs of Production • Technology • Education and Training • Incentives • Tax regime • Capital stock • Productivity • Labour Market

21. NOTE: Keynesian AS curve • In the following the “Keynesian AS” curve is used. • However you will find it easier (in the short run and the long run!) to use the model we have been using in class with a SRAS sloping up and a vertical LRAS

22. Aggregate Supply Price level AS Between Y1 and Yf, increases in capacity are possible but the nearer the economy gets to Yf, the more problems are experienced with acquiring resources to boost production (production bottlenecks) especially labour skills shortages. The shape of the AS curve is important in determining the outcome in the economy This shape reflects a Keynesian view of the AS curve. Yf represents ‘Full Employment Output’ – at this point the economy is working to full capacity and cannot produce any more. An output level of Y1 would suggest the economy is working below full capacity and there would be widespread unemployment. Economy starts to overheat Yf Y1 Real National Income

23. Aggregate Supply Price Level AS2 AS1 Increases in capacity can occur as a result of a shift in AS (akin to a shift outwards of the Production Possibility Frontier) (PPF) Real National Income Yf1 Yf2

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

25. Aggregate Supply Price Level LRAS This is because they believe that in the long run, there will be no extra unemployment of resources (there will be some unemp, approx equal to job vacancies) because markets will clear, thus whatever the rate of inflation, firms will supply the maximum capacity of the economy. Classical economists assume the long run aggregate supply curve (LRAS) is vertical (perfectly inelastic). Yf Real National Income

26. Aggregate Supply AS Price Level For our analysis, we will assume the AS curve looks like this! Real National Income

27. Putting AD and AS together A shift in the AD curve to AD1 as a result of a change in any or all of the factors affecting AD would increase growth, reduce unemployment but at a cost of higher inflation (a trade-off) AS In this situation, the economy would be operating at less than capacity, there would be unemployment and the economy might be growing only slowly. Price Level 2.5% 2.0% AD 1 AD Y1 Y2 Yf Real National Income

28. Putting AD and AS together Further increases in AD would lead to successively smaller increases in growth and employment at the cost of ever higher inflation. AS Price Level 3.5% AD2 2.5% 2.0% AD1 AD Yf Y1 Y2 Real National Income Y3

29. Sustained Growth Price Level 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. LRAS will also be gradually be shifting right. 2.0% AD2 AD Y1 Y2 Real National Income