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Aggregate Demand and


Supply

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Aggregate Demand and Supply

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Aggregate Demand (AD)

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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)

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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

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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

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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)

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Aggregate Demand Curve


Inflation Thea lower
This
At higher
level oflevel
rate
output
of
of
At an
will be inflation
inflation
National associated
(3.0%)
Income level
of 2%,
with
rising
requires the
ainterest ADrates
particular
fewer units
curve
level
mean
of labour gives
ofthat– C,aIlevel
and
3.0% of output
(X-M)
unemployment of Y1 rises
all have
which
negative
to 7% we shown
effects
will call
by on
UU=
= 5%
AD
7% – NY falls to Y2

2.0%

AD

Y2 Y1
U = 5%
Real National Income
U = 7%

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Shifts in the Aggregate Demand


Inflation
Curve This
Shiftswould
Any
cause
in AD will
exogenous
be a
rise in by
caused national
changes in
factor
factors causing
incomeaffecting
(economicC,C,
I,
IG or
andG(X-M)
growth) toandrise,
leador
(exogenous
a factors)
to trade surplus
a fall in
e.g. increasing
causes a rates
unemployment
income tax shift (U
to
=
the2%)
affect (and
right in vice
consumptionAD
versa)

2.0%

AD2
AD

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

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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

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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

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Government Spending

• Defence
• Health
• Social Welfare
• Education
• Foreign Aid
• Regions
• Industry
• Law and Order

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Import Spending (negative)

• Goods and services bought from abroad –


represents an outflow of funds from the UK
(reduces AD)

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Export Earnings (Positive)

• Goods and services sold abroad – represents a


flow of funds into the UK (raises AD)

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Key Variables

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Macroeconomic Policy

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Fiscal Policy

• Government Income (taxes and borrowing)


• Government Spending

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Monetary Policy

• Interest Rates (Bank of England)

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Aggregate Supply (AS)

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Capacity of the Economy


• Costs of Production
• Technology
• Education and Training
• Incentives
• Tax regime
• Capital stock
• Productivity
• Labour Market

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Aggregate Supply
Inflation AS Between Y1 and Yf,
The
This
Yf shape in of
shape
Anrepresents
output
increases the
level AS
‘Full
of
capacity Y1
are
curve
wouldissuggest
Employment
possible important
but thein –
theOutput’
nearer
reflects
determining
the
at economy
economy
this point agets
is the to Yf,
working
Keynesian
the morefull
outcome
economy
below problems
in the view
iscapacity
workingare to
experienced
economy
full
andcapacity with
there wouldand be
of the
acquiring
cannot
widespread
AS curve.
resources
produce
to
any
Economy starts to overheat boost production
more.
unemployment.
(production bottlenecks)
especially labour skills
shortages.

Y1 Yf
Real National Income

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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

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

Real National Income

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

Yf Real National Income

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Aggregate Supply
Inflation AS
For our analysis,
we will assume
the AS curve
looks like this!

Real National Income

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Putting AD and AS together


A shift in the AD
AS In thisto
situation,
AD1 as athe
Inflation curve
economy
result of awould
changebein
operating at the
any or all of less
than capacity,
factors there
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)
2.5%

2.0%
AD 1

AD

Y1 Y2 Yf Real National Income

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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

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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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