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AGGREGATE DEMAND AND AGGREGATE SUPPLY
Aggregate Demand.
AD is the total quantity of all final goods and services demanded over a period of time
and consists of the sum of demands of consumers, firms, central and local governments
and foreigners. The AD curve shows the relationship between the price level and this
demand for a particular time period.
The AD curve slopes downwards as shown alongside.
Price
Level
P1
P2
Aggregate Demand
Y1
Y2
Real National Output
Why does the AD curve slope downwards? (remember this is not actually a
requirement of IB syllabus)
i) Competitiveness in International markets - as inflation in a country rises then
domestically produced goods become relatively more expensive compared to foreign
goods thus reducing demand for them as more foreign goods are imported.
ii) Wealth effects - as inflation rises this reduces the real wealth of people and firms who
then cut expenditures (eg their savings are worth less, so they spend less to make this
up).
Shifts in AD
The AD curve will shift if any of the expenditures which go to make up expenditure shift.
E.g. the AD curve would shift outwards, to the right, if Investment or government
spending were increased or if the level of consumer expenditure were to rise for any
reason
Key factors therefore that may lead to changes in AD are:
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Changes to Fiscal PolicyAn increase/decrease in level of taxation E.g. changes in
income tax, national insurance or VAT
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Changes in real government spending on health, education, transport ใAn
increase in the size of the budget deficit (where government spending > tax
revenue)
Changes to Monetary Policy
Changes in interest rates by the Central Bank of a country
Fluctuations in the exchange rate
Changes in Business & Consumer Confidence
Fluctuations in the growth of national income and expenditure in other countries
(the global economic cycle)E.g. the effects of a recession in the United States
The level of spare capacity in the economy affects investment
Price
Level
P1
AD2
AD1
Y1
Y2
Real National Output
Aggregate Supply
There is much more debate about the shape of the AS curve and this debate lies at the
heart of the differences between Keynesians and supply-siders.
The AS curve shows the relationship between output and the price level.
We need to distinguish between the Short Run AS curve (SRAS) and the Long Run AS
curve (LRAS).
The SRAS curve
The Short Run is defined as the period when money wage rate and prices of all
other factor inputs are fixed. It is essential that you remember this i.e. the SRAS
curve is drawn on the assumption that input costs like money wage rates remain
constant.
The shape of the SRAS curve:
As firms start to increase output they start to experience shortages of certain inputs particularly skilled labour. Even if the prices of inputs remain constant, it is likely that
firms will have to use less efficient machinery or labour or that the existing workers are
put on overtime. If they have to do this, then the average cost will rise and so prices will
rise to persuade firms to increase output. The AS curve is therefore upward sloping
over this range of output. (Remember this is not a requirement of IB syllabus)
It is this curve that is most often drawn for the SRAS curve as seen below:
The SRAS curve will shift upwards if:
- wage rates are increased (firms require a higher price to persuade them to produce a
certain level of output);
- raw material prices rise for similar reasons as above;
- productivity falls which means that unit labour costs rise (ULC = Average
earnings/productivity);
In the diagram above - the shift from AS1 to AS2 shows an increase in aggregate
supply at each price level might have been caused by improvements in technology and
productivity or the effects of an increase in the active labour force.
An inward shift in AS (from AS1 to AS3) causes a fall in supply at each price level. This
might have been caused by higher unit wage costs, a fall in capital investment spending
(capital scrapping) or a decline in the labour force.
The LRAS curve
The long run is defined as that period in which nominal wages, or prices of other inputs,
can change.
The shape of the LRAS depends on the assumption about how workers react to
unemployment.
Classical or supply side economists see the labour market as functioning perfectly. If
there is unemployment then real wages will fall until demand equals supply again in the
labour market and there is no unemployment.
Therefore in the LR firms will always employ all workers who wish to work at the
equilibrium wage. Hence firms will be supplying the maximum potential level in the
economy. Therefore the LRAS curve is vertical at the full employment level of Output.
Any unemployment that might exist at this level of unemployment is purely voluntary.
They choose to remain unemployed and as such it is known as voluntary
unemployment. The percentage of the workforce who are voluntarily unemployed is the
natural rate of unemployment.
Keynesians, on the other hand, argue that wages are STICKY in the labour market and
particularly downwards sticky and so the market may not clear even in the long run.
They see that the LRAS could take on the characteristics looked at previously under the
SRAS:
- if the economy is in a huge recession then any increase in output is likely without an
increase in input prices and hence final prices;
- if the economy is near full employment the workers will be in a position to bid up
wages in response to a rise in demand;
- if the economy is at full employment firms cannot take on extra workers and so any
increase in demand will merely raise prices.
The diagrams below show the two views on the LRAS curve:
The Keynesian LRAS
The Classical LRAS
LRAS
P
Y