Aggd&S1
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Transcript of Aggd&S1
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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
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Aggregate Demand Curve• Why does it slope down from left to right?
– 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 CurveInflation
Real National Income
AD
2.0%
Y1
At an inflation level of 2%, the AD curve gives a level of output of Y1
This level of output will be associated with a particular level of unemployment which we will call U = 5%
U = 5%
3.0%
Y2
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
U = 7%
The lower level of National Income requires fewer units of labour – unemployment rises to 7% shown by U = 7%
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Shifts in the Aggregate Demand CurveInflation
Real National Income
AD
2.0%
Y1U = 5%
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
AD2
Y2U = 2%
Any exogenous factor causing C, I or G to rise, or a trade surplus causes a shift to the right in AD
This would cause a rise in national income (economic growth) and lead to a fall in unemployment (U = 2%) (and vice versa)
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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 (reduces AD).
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Export Earnings (Positive)
• Goods and services sold abroad – represents a flow of funds (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 (RBI)
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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 SupplyInflation
Real National Income
The shape of the AScurve is important in determining the outcome in the economy
AS
Yf
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.
Y1
An output level of Y1 would suggest the economy is working below full capacity and there would be widespread unemployment.
Economy starts to overheat
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.
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Aggregate SupplyInflation
Real National Income
AS1 AS2
Yf1 Yf2
Increases in capacity can occur as a result of a shift in AS (akin to a shift outwards of the Production Possibility Frontier) (PPF)
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Aggregate SupplyInflation
Real National Income
SRAS
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 2
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)
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Aggregate SupplyInflation
Real National Income
LRAS Classical economists assume the long run aggregate supply curve (LRAS) is vertical (perfectly inelastic).
This is because they believe that in the long run, there will be no unemployment of resources because markets will clear, thus whatever the rate of inflation, firms will supply the maximum capacity of the economy.
Yf
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Aggregate SupplyFor our analysis, we will assume the AS curve looks like this!
Inflation
Real National Income
AS
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Putting AD and AS togetherInflation
Real National Income
AS
Yf
AD
2.0%
Y1
In this situation, the economy would be operating at less than capacity, there would be unemployment and the economy might be growing only slowly.
AD 1
Y2
2.5%
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)
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Putting AD and AS togetherInflation
Real National Income
AS
Yf
AD
2.0%
Y1
AD1
Y2
2.5%AD2
3.5%
Further increases in AD would lead to successively smaller increases in growth and employment at the cost of ever higher inflation.
Y3
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Sustained GrowthInflation
Real National Income
AD
AS
2.0%
Y1
AS1
Y2
AD2
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