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2.2 AGGREGATE DEMAND AND AGGREGATE SUPPLY 1. Distinguish between the microeconomic concept of demand for a product and the macroeconomic concept of aggregate demand The microeconomic demand curve has the “price” of the one good on the y-axis, the macroeconomic aggregate demand curve has a measure of the average price level of all goods and services. Where the microeconomic demand curve has the “quantity” of the one good on the x-axis, the macroeconomic aggregate demand curve has The total quantity of all goods and services, which is national output. (Real GDP) . Define aggregate demand AGGREGATE DEMAND: The total (or aggregate) real expenditures on final goods and services produced in the domestic economy that buyers would willing and able to make at different price levels, during a given time period (usually a year). Aggregate demand (AD) relates the economy's price level, measured by the GDP price deflator, and aggregate expenditures on domestic production, measured by real gross domestic product. The aggregate expenditures are consumption, investment, government purchases, and net exports made by the four macroeconomic sectors (household, business, government, and foreign). 2. Construct an aggregate demand curve. The aggregate demand curve The AD curve shows the relationship between AD and the price level. It is assumed that the AD curve will slope down from left to right. This is because all the components of AD, except imports, are inversely related to the price level. 3. Explain why the AD curve has a negative slope. Trade, liquidity and wealth effects The AD curve slopes down because the components of AD are inversely related to the price level. There are three main effects to consider: 1. The price level and international trade – the ‘trade’ effect A rise in domestic prices makes exports less competitive and imports more competitive; hence exports (X) are likely to fall and imports (M) are likely to rise. Both of these reactions combine to create a trade effect, with lower aggregate demand at the higher price level. 3. Explain why the AD curve has a negative slope. 2. The price level and liquidity – the ‘liquidity/interest rate’ effect When the price level increases, households and firms need to spend more money to continue to consume the scarce resources they need. This makes them relatively ‘short of cash’ than they were at the lower price level. The liquidity of an asset refers to how easily it is converted to cash, with cash itself being ‘perfectly liquid’. The loss of liquidity associated with a rise in the price level forces some households and firms to borrow from banks, which reduces the liquidity of banks. In response, banks are likely to raise interest rates as compensation for this lost liquidity. The banks need to keep a certain amount of their reserves in a highly liquid form to meet any unexpected increase in demand for cash. As a result of the lost liquidity, interest rates are forced to rise, and both household and corporate spending may fall. Hence, aggregate demand is lower at the higher price level. 3. Explain why the AD curve has a negative slope. 3. The price level and the value of wealth – the ‘wealth’ effect Given that interest rates will rise as financial markets readjust to the higher price level, there are likely to be further ‘knock on’ effects on household (and corporate) wealth. Higher rates may lead to a fall in house prices, or at least slowdown house price inflation, and create a negative wealth effect. Rising interest rates tend to reduce corporate profits and reduce share values - again creating a negative wealth effect. A lower price level will, of course, have the reverse effect, that is to create a positive wealth effect on AD. The combined effect of these wealth effects is to alter consumer and corporate spending, and hence alter the level of AD. 4. Describe consumption, investment, government spending and net exports as the components of aggregate demand. Aggregate demand consists of the amount households plan to spend on goods (C), plus planned spending on capital investment, (I) + government spending, (G) + exports (X) minus imports (M) from abroad. The standard equation is: AD = C + I + G + (X – M) Aggregate demand can be illustrated by reference to the circular flow of income: 5. Explain how the AD curve can be shifted by changes in consumption due to factors including changes in consumer confidence, interest rates, wealth, personal income taxes (and hence disposable income) and level of household indebtedness. Determinates of Household spending (Consumption) consumer confidence interest rates Wealth personal income taxes (and hence disposable income) level of household indebtedness. 6. Explain how the AD curve can be shifted by changes in investment due to factors including interest rates, business confidence, technology, business taxes and the level of corporate indebtedness. Determinates of Investment Spending interest rates business confidence Technology business taxes the level of corporate indebtedness 7. Explain how the AD curve can be shifted by changes in government spending due to factors including political and economic priorities. Determinates of Government Spending Political priorities economic priorities 8. Explain how the AD curve can be shifted by changes in net exports due to factors including the income of trading partners, exchange rates and changes in the level of protectionism. Determinates of Net Exports Spending income of trading partners exchange rates changes in the level of protectionism 9. Define the term aggregate supply. Aggregate supply (AS) is defined as the total amount of goods and services (real output) produced and supplied by an economy’s firms over a period of time. It includes the supply of a number of types of goods and services including private consumer goods, capital goods, public and merit goods and goods for overseas markets. At higher price levels across the economy firms expect that they can sell their final products at higher prices, and there will be a positive relationship between the price level and aggregate supply. 10. Explain, using a diagram, why the short-run aggregate supply curves (SRAS Curve) is upward sloping Short run aggregate supply (SRAS) shows total planned output when prices in the economy can change but the prices and productivity of all factor inputs e.g. wage rates and the state of technology are held constant. In the short run, the SRAS curve is assumed to be upward sloping (i.e. it is responsive to a change in aggregate demand reflected in a change in the general price level) The up sloping SRAS curve indicates a direct relationship between the price level and the amount of real output that firms will offer for sale. 10.Explain, using a diagram, why the short-run aggregate supply curves (SRAS Curve) is upward sloping 11. Explain, using a diagram, how the AS curve in the short run (SRAS) can shift due to factors including changes in resource prices, changes in business taxes and subsidies and supply shocks. Changes in Input Prices Domestic Resource Availability (Land, Labor, Capital & Entrepreneurial ability) Prices of Imported Resources Market Power 11. Explain, using a diagram, how the AS curve in the short run (SRAS) can shift due to factors including changes in resource prices, changes in business taxes and subsidies and supply shocks. Changes in Productivity technology Changes in Legal-institutional Environment (LIE) Business Taxes and Subsidies to Businesses Government Regulations 11. Explain, using a diagram, how the AS curve in the short run (SRAS) can shift due to factors including changes in resource prices, changes in business taxes and subsidies and supply shocks. A change in aggregate supply is caused by any factor affecting supply EXCEPT the price level. Illustrate aggregate demand and shifts in aggregate demand Shifts in AD A change in any of the components of aggregate demand will cause a shift in the aggregate demand curve. An increase in AD, such as that caused by an increase in household spending, is shown by a rightward shift in the whole AD curve. The shift in demand will have an effect on the price level and national output, but the effects may not be uniform because aggregate supply (AS) may not be linear. 12. Explain, using a diagram, that the monetarist/new classical model of the long-run aggregate supply curve (LRAS) is vertical at the level of potential output (full employment output) because aggregate supply in the long run is independent of the price level. Aggregate supply There is some dispute between Keynesians and Monetarists about what determines the level of aggregate supply. Keynesians argued that supply was determined by the level of aggregate demand, while classical (economists followed Say's Law which argued that aggregate supply was determined by supply-side factors. 12. Explain, using a diagram, that the monetarist/new classical model of the long-run aggregate supply curve (LRAS) is vertical at the level of potential output (full employment output) because aggregate supply in the long run is independent of the price level. The gradient of the AS curve Different theories of the shape of the AS curve arise from different explanations about how real output responds to changes in aggregate demand. The Classical view: The Classical view of real output was that it was fixed at a particular level. At this level, all the factors of production in the economy would be fully employed. Changes in AD will only bring about changes in the price level, not the level of real output. 12. Explain, using a diagram, that the monetarist/new classical model of the long-run aggregate supply curve (LRAS) is vertical at the level of potential output (full employment output) because aggregate supply in the long run is independent of the price level. A neo-classical long run aggregate supply (LRAS) is perfectly inelastic at the level of potential output (full employment level of output). They believe that the potential output of the economy is dependent on the quantity and quality (productivity) of the factors of production, not on the price level. Thus the LRAS curve is independent of the price level. neo-classical Classical theories revolved mainly around the role of markets in the economy. If markets worked freely and nothing prevented their rapid clearing then the economy would prosper. Any imperfections in the market that prevented this process should be dealt with by government. The main roles of government are therefore to ensure the free workings of markets using 'supply-side policies' and to ensure a balanced budget. 13. Explain, using a diagram, that the Keynesian model of the aggregate supply curve has three sections because of “wage/price” downward inflexibility and different levels of spare capacity in the economy. Keynesian LRAS: shows three possible phases: In the horizontal range there is low levels of economic activity. There is excess capacity so very little price pressure and high unemployment. In the upper sloping range, the economy is approaching full employment so there is price pressure and increase in output so lower unemployment. In the vertical range, the economy is at full employment and it’s impossible to increase output. All price pressure. Keynesian 13. Explain, using a diagram, that the Keynesian model of the aggregate supply curve has three sections because of “wage/price” downward inflexibility and different levels of spare capacity in the economy. 1. 2. 3. The Sticky-Wage Theory: An unexpectedly low price level raises the real wage, which causes firms to hire fewer workers and producer a smaller quantity of goods and services. The Sticky-Price Theory: An unexpectedly low price level leaves some firms with higher-than-desired prices, which depresses their sales and leads them to cut back production. The Misperceptions Theory: An unexpectedly low price level leads some suppliers to think their relative prices have fallen, which induces a fall in production. 13. Explain, using a diagram, that the Keynesian model of the aggregate supply curve has three sections because of “wage/price” downward inflexibility and different levels of spare capacity in the economy. When the demand for labor falls (maybe due to the onset of a recession), the wage rate should fall, so that the market clears. However, Keynes argued that because wages were sticky downwards, this would not happen and unemployment would persist. This unemployment he termed demand deficient unemployment 13. Explain, using a diagram, that the Keynesian model of the aggregate supply curve has three sections because of “wage/price” downward inflexibility and different levels of spare capacity in the economy. Keynes argued that relying on markets to get to full employment was not a good idea. He believed that the economy could settle at any equilibrium and that there would not be automatic changes in markets to correct this situation. 13. Explain, using a diagram, that the Keynesian model of the aggregate supply curve has three sections because of “wage/price” downward inflexibility and different levels of spare capacity in the economy. A “Keynesian” long run aggregate supply 14. Compare and contrast, using the two models above, the way that factors leading to changes in the quantity and/or quality of factors of production (including improvements in efficiency, new technology, reductions in unemployment, and institutional changes) can shift the aggregate supply curve over the long term. Shifts in long-run aggregate supply curve are usually gradual and anticipated, unlike shifts in the SRAS which can be dramatic and unanticipated. LRAS can shift for many reasons, including: 1. The level of spending on new, technology which enables an economy to produce in greater volume or improved quality - even using the same quantity of scarce resources. 2. Long term inward investment from abroad, which enables increased production. Inward investment, like domestic investment, increases an economy’s productive capacity. 3. Migration and population growth, which increases the quantity of human capital. 4. Education and training, which increases the quality of human capital. 5. Competition in product and labor markets, which improves efficiency and productivity. 6. Effective supply-side policy, which creates the right environment for households to supply factors of production and for firms to produce output. 14. Compare and contrast, using the two models above, the way that factors leading to changes in the quantity and/or quality of factors of production (including improvements in efficiency, new technology, reductions in unemployment, and institutional changes) can shift the aggregate supply curve over the long term. long-run aggregate supply curve 15. Explain, using a diagram, the determination of short-run equilibrium, using the SRAS curve. Shifts of the short-run aggregate supply curve can be brought about by such things as technology, changes in wages and other resource prices, or changes in resource quantities. While changes in aggregate supply determinants and resulting shifts of the short-run aggregate supply curve are less dramatic than changes affecting aggregate demand, they DO change. In most cases the changes are slow and steady. 15. Explain, using a diagram, the determination of short-run equilibrium, using the SRAS curve. Illustrate short-run aggregate supply Short Run Aggregate Supply Curve – Classical In the short run an increase in aggregate demand may lead to an increase in output, but there will also be an increase in the price level. As firms realize that there has not been a real increase in demand, they will once again reduce output and the economy will tend back to the full employment level of output. Illustrate short-run aggregate supply Keynesian Aggregate Supply Keynes argued that in the long run, the economy can settle at an equilibrium below the full employment level of output. As a result, the AS curve looks like this. 16. Examine, using diagrams, the impacts of changes in short-run equilibrium. Short-run aggregate market equilibrium means the economy has no wide-spread shortages or surpluses in the product markets. However, this does not necessarily mean that ALL product markets are in equilibrium. A complex economy, like that in the United States, is bound to have shortages in some product markets and surpluses in others in short-run equilibrium. As such, prices in some markets rise, while those in other markets fall. These sorts of imbalances in specific markets reflect the ongoing reallocation of resources at the microeconomic level. What is required for aggregate market equilibrium at the macroeconomic level is that the microeconomic shortages and surpluses cancel out, that rising prices cancel falling prices, that the price level and real production do not change. 16. Examine, using diagrams, the impacts of changes in short-run equilibrium. Macro-equilibrium is when the quantity of real GDP demanded equals the quantity of real GDP supplied. Full employment Macroequilibrium is where SRAS intersects AD on the LRAS curve. 16. Examine, using diagrams, the impacts of changes in short-run equilibrium. Short-run equilibrium output Is when Aggregate Demand is equal to the short –run Aggregate Supply Long-run equilibrium output The Long-run equilibrium is where the aggregate demand is equal to long-run aggregate supply. 17. Explain, using a diagram, the determination of long-run equilibrium, indicating that long-run equilibrium occurs at the full employment level of output. Full employment level of national income: This is the level at Net National Income at which everyone who wants to work is able to. There is in other words sufficient demand to employ everyone. Classical economists argued that the economy would automatically tend to this equilibrium, whereas Keynesians said that it was the role of government, through their policy, to ensure we got there. 17. Explain, using a diagram, the determination of long-run equilibrium, indicating that long-run equilibrium occurs at the full employment level of output. 17. Explain, using a diagram, the determination of long-run equilibrium, indicating that long-run equilibrium occurs at the full employment level of output. The LRAS will shift if there are changes in the quantity and/or quality of factors of production (including improvements in efficiency, new technology, reductions in natural unemployment, and institutional changes) The LRAS curve is the same as the Production Possibilities Curve or Potential GDP Curve. 18. Examine why, in the monetarist/new classical approach, while there may be short-term fluctuations in output, the economy will always return to the full employment level of output in the long run. The Classical economists assumed that if the economy was left to itself, then it would tend to full employment equilibrium. This would happen if the labor market worked properly. If there was any unemployment, then the following would happen: Unemployment labor Fall in wages Increase demand for equilibrium restored at full employment Classical economists had complete faith in markets. They believed that the economy would always settle - automatically - at the full employment equilibrium in the long-run. Due to flexible prices and wages. However, they did acknowledge that there might be a slightly different reaction in the short run as the economy adjusted to its new long-run equilibrium. 18. Examine why, in the monetarist/new classical approach, while there may be short-term fluctuations in output, the economy will always return to the full employment level of output in the long run. 19. Examine, using diagrams, the impacts of changes in the long-run equilibrium. Classical economists believe that in the long run the economy will settle automatically at the full employment level of income. If something happens to increase the full employment potential of the economy, this will shift the LRAS curve to the right. Possible causes could be an increase in productivity, an improvement in skill levels or a change in the tax and benefits system. 20. Explain, using the Keynesian AD/AS diagram, that the economy may be in equilibrium at any level of real output where AD intersects AS. Keynes argued that relying on markets to get to full employment was not a good idea. He believed that the economy could settle at any equilibrium and that there would not be automatic changes in markets to correct this situation. He argued that wages would be 'sticky downwards'. In other words workers would not be happy about taking wage cuts and would resist this. This would mean that wages would not necessarily fall enough to clear the market and unemployment would linger. This unemployment he termed demand deficient unemployment. 20. Explain, using the Keynesian AD/AS diagram, that the economy may be in equilibrium at any level of real output where AD intersects AS. Keynes didn't distinguish between the short-run and the long-run as Classical economists tend to. He argued that the economy could settle at any equilibrium level of income at any time, and it was the government job to use appropriate policies to ensure that this equilibrium was a good one for the economy. 21. Explain, using a diagram, that if the economy is in equilibrium at a level of real output below the full employment level of output, then there is a deflationary (recessionary) gap. A deflationary gap exists when there is insufficient demand available in the economy to generate a fullemployment equilibrium. In other words there is not enough being bought to provide jobs for everyone who wants them. Deflationary or recessionary or under full employment gap, where planned expenditure is less than the full employment level of income. Occurs where AD intersects the SRAS curve at a level of real GDP that is below LRAS. 21. Explain, using a diagram, that if the economy is in equilibrium at a level of real output below the full employment level of output, then there is a deflationary (recessionary) gap. 22. Discuss why, in contrast to the monetarist/new classical model, the economy can remain stuck in a deflationary (recessionary) gap in the Keynesian model. Keynesian economists believe that free markets are volatile and not self correcting. Free market volatility: • The free-market system is naturally prone to periods of recession & depression • The volatility of aggregate demand (AD = C+I+G+X-M) can be explained by changes in consumer and business sentiment – also known as animal spirits. • In a world of stagnation or depression direct intervention in the economy may be essential Free markets are not always self-correcting: • When a recession or a depression occurs, the free market system is not necessarily self-correcting – indeed en-masse, individuals can become trapped in a deflationary depression which is in no one’s interest but which, left on our own, no one can counter-act. • Persistent deflation can be as costly as high inflation – it can be damaging especially in economies where there is a huge level of private & public sector debt • You cannot always rely on new inventions / innovations and other natural stabilizers to drag an economy out of a recession 23. Explain, using a diagram, that if AD increases in the vertical section of the AS curve, then there is an inflationary gap. Inflationary or over employment gap, where planned expenditure is greater than the full employment level of income. Occurs where AD intersects the SRAS at a level of real GDP that is above LRAS. Inflationary gap: This occurs when there is too much demand in the economy. This excess level of demand will tend to lead to demand-pull inflation. 23. Explain, using a diagram, that if AD increases in the vertical section of the AS curve, then there is an inflationary gap. 24. Discuss why, in contrast to the monetarist/new classical model, increases in aggregate demand in the Keynesian AD/AS model need not be inflationary, unless the economy is operating close to, or at, the level of full employment. The economy could settle below full employment. Clearly this is not a very desirable equilibrium as the level of output is very low and there would be high levels of unemployment. Thus any increase in AD would not bring about any price level pressure as long as there was excess capacity. Nevertheless this situation could, according to Keynes, persist in the long-term unless the government did something to stimulate the economy. This something would have to be some sort of reflationary policy , which boosted the level of aggregate demand. As aggregate demand grows so does the level of output, but as the economy nears full employment the dark specter of inflation emerges - in other words the price level starts to increase! This inflation is due to an excess level of demand and so is called demand-pull inflation . At the same time there will be increased pressure on the labor market as nearly everyone has a job, and so wages will begin to rise as firms have to offer more to get the people they want. This in turn will cause costs to increase, and result in cost-push inflation. 24. Discuss why, in contrast to the monetarist/new classical model, increases in aggregate demand in the Keynesian AD/AS model need not be inflationary, unless the economy is operating close to, or at, the level of full employment. 25. Explain, with reference to the concepts of leakages (withdrawals) and injections, the nature and importance of the Keynesian multiplier. Multiplier: The multiplier is concerned with how national income changes as a result of a change in an injection, for example investment. The multiplier was a concept developed by Keynes that said that any increase in injections into the economy (investment, government expenditure or exports) would lead to a proportionally bigger increase in National Income. This is because the extra spending would have knock-on effects creating in turn even greater spending. The size of the multiplier would depend on the level of leakages. 25. Explain, with reference to the concepts of leakages (withdrawals) and injections, the nature and importance of the Keynesian multiplier. Any increase in aggregate demand in the economy would result, according to Keynes, in an even bigger increase in National Income. This process came about because any increase in demand would lead to more people being employed. If more people were employed, then they would spend the extra earnings. This in turn led to even more spending, which led to even more employment which led to even more income which then led to even more spending which then led to ................. The length of time this process went on for would depend on how much of the extra income was spent each time. If the initial recipients of the extra income saved it all, then the process would stop very quickly as no-one else would get their hands on the extra income. However, if they spent it all the knock-on effects of the extra spending would carry on for some time. Therefore the higher the level of leakages, the lower the Multiplier would be. 25. Explain, with reference to the concepts of leakages (withdrawals) and injections, . the nature and importance of the Keynesian multiplier 26. Calculate the multiplier using either of the following formulae. Simply multiplier = 1/ (1-MPC) =1/MPS Complex multiplier = 1/ (MPS + MPT + MPM) Marginal propensity to consume(MPC): The proportion of each extra dollar of disposable income spent by households. For example, if a person earns 1 more and consumes 60% of it, then the MPC is 0.6. Marginal propensity to Save (MPS): The proportion of each extra dollar of disposable income saved by households. 26. Calculate the multiplier using either of the following formulae. 1/(MPS + MPT + MPM) = Complex Multiplier MPS = Marginal propensity to Save MPT = Marginal propensity to Tax MPM = Marginal propensity to Import 27. Use the multiplier to calculate the effect on GDP of a change in an injection in investment, government spending or exports. Calculating the value of the multiplier The formal calculation for the value of the multiplier is Multiplier = 1 / (sum of the propensity to save + tax + import) Therefore if there is an initial injection of demand of say £400m and The marginal propensity to save = 0.2 The marginal rate of tax on income = 0.2 The marginal propensity to import goods and services is 0.3 Then the value of national income multiplier = (1/0.7) = 1.43 An initial change of demand of £400m might lead to a final rise in GDP of 1.43 x £400m = £572m If The marginal propensity to save = 0.1 The marginal rate of tax on income = 0.2 The marginal propensity to import goods and services is 0.2 The value of the multiplier = 1/0.5 = 2 – the same initial change in aggregate demand will lead to a bigger final change in the equilibrium level of national income. 2 x 400m = 800m 28. Draw a Keynesian AD/AS diagram to show the impact of the multiplier. Explain the Accelerator effect of investment on national income. Accelerator: The principle states that a given change in demand for consumer goods will cause a greater percentage change in demand for capital goods. The principle is used to help explain business cycles. The accelerator theory suggests that the level of net investment will be determined by the rate of change of national income. If national income is growing at an increasing rate then net investment will also grow, but when the rate of growth slows net investment will fall. There will then be an interaction between the multiplier and the accelerator that may cause larger fluctuations in the trade cycle. 2.2 Aggregate Demand and Aggregate Supply Short-run equilibrium output Is when Aggregate Demand is equal to the short – run Aggregate Supply Long-run equilibrium output The Long-run equilibrium is where the aggregate demand is equal to long-run aggregate supply. 2.2 Aggregate Demand and Aggregate Supply Discuss the difference between Keynesian (interventionist) and neo-classical (free market) economist in the view of macroeconomic equilibrium Keynesian view is that the equilibrium level may occur at different levels and can be below full employment levels. Their view is that the government must intervene to steer the economy toward full employment using demand-side policies. 2.2 Aggregate Demand and Aggregate Supply The neo-classical view is that the economy will always move toward its long-run equilibrium at full employment. Thus the long-run equilibrium is where the AD meets the vertical LRAS curve. Any changes to AD will only result in price level changes, thus government intervention is not needed. 2.2 Aggregate Demand and Aggregate Supply Explain and illustrate that the difference between the equilibrium level of national income and the full employment level of national income will result in an inflationary or deflationary gap. When the short-run equilibrium is beyond the full employment level you will have an inflationary gap. When the short-run equilibrium is below the full employment level you will have an deflationary gap.