Aggregate Demand and Supply (AD & AS)

Variations in Economic Activity (AD & AS)

Aggregate Demand (AD)

• Aggregate demand (AD) represents the total demand for all goods and services in an economy at a specific average price level.
• AD is calculated using the expenditure approach: AD = C + I + G + (X-M).
  • C = Consumption (total spending on goods/services by consumers)
  • I = Investment (total spending on capital goods by firms)
  • G = Government spending (total spending by the government)
  • (X-M) = Net exports (difference between revenue from selling goods/services abroad and expenditure on goods/services from abroad)
• An increase in AD signifies economic growth, while a decrease indicates the opposite.
• Government spending in Sweden accounts for 53% of AD, while in the UK, it constitutes 25%.
• Approximate contributions to AD in the UK:
  • Consumption: 60%
  • Investment: 14%
  • Government spending: 25%
  • Net Exports: 1%
• A 1% increase in consumption or government spending will have a greater impact on economic growth than a 1% increase in net exports.

The Aggregate Demand (AD) Curve

• The AD curve illustrates the relationship between the average price level and the total output in an economy.
• The AD curve slopes downwards.
• Lower average price levels correspond to greater aggregate demand.
• Higher average price levels correspond to less aggregate demand
• A change in the average price level (AP) in the economy causes movement along the AD curve, leading to either a contraction or expansion of AD.

Diagram Analysis

• An increase in the AP results in a movement along the AD, resulting in a contraction of real GDP.
• "Y" denotes national income or real GDP.
• A decrease in the AP result in a movement along the AD, resulting in an expansion of real GDP.
• A shift in the entire AD occurs when there is a change in any of the non-price determinants of AD in an economy

Diagram Analysis

• An increase in any of the determinants of AD shifts the AD curve to the right.
• Real GDP increases at every price level.
• A decrease in any of the determinants of AD shifts the AD curve to the left.
• Real GDP decreases at every price level.
• Each component of AD is influenced by several factors, and changes in any of these factors can potentially alter AD.
• Consumption is affected by changes to consumer confidence, interest rates, wealth, income taxes, level of household indebtedness, and expectations of future price level.
• Investment is affected by changes to interest rates, business confidence, technology, level of corporate indebtedness, and business taxes.
• Government spending is affected by changes to political and economic priorities.
• Net exports are influenced by changes to the income of trading partners, trade policies, and exchange rates.

Factors that Influence Consumption

• Consumer confidence:
• Stronger economy leads to higher consumer confidence.
• Secure jobs and regular salary payments increase consumer confidence, leading increased consumption and decreased saving.
• Weakening or recessionary economy reduces consumer confidence.
• Job insecurity decreases consumption and increases savings.
• Interest rates:
• Changes in base interest rates will change consumer spending and savings.
• Higher interest rates incentivize saving, resulting in less consumption.
• Increased monthly repayments on loans or mortgages reduces consumption.
• Wealth
  • Increased consumer wealth typically increases consumption.
  • Rising property or share prices increase consumer confidence to borrow. This leads to increased consumption.

Factors that Influence Investment

• Interest rate:
• Decreasing interest rates encourage investment.
• There is an inverse relationship between investment and interest rates.
• Business confidence:
• Firms invest when there is confidence in a good return on their investment
• Investment decisions are linked to profit maximization.
• Longer periods of economic growth increase business confidence.
• Slowing growth decreases future expectations of profits which makes investment decisions harder.
• Technology:
• Firms are incentivized to invest when new technology reduces costs and raises output.
• Business taxes
  • Increased business taxes reduces profits, and thus results in less money for investment.
• Level of corporate indebtness -Higher levels of debt result in higher monthly repayments, thus less money available for new inestment.

Factors that Influence Government Spending

• Political Priorites
• Influenced by the political priorites of governing parties.
• Some parties believe the state should provide more goods/services and spending increases.
• Economic Priorities
• Fiscal Policy is set annually and announced during the Government's Budget presentation.
• Expenditure is directly related to the Government's objectives and policy aims.

Factors that Influence Net Exports

• Income of trading partners

• Increased household income of trading partners results in more product purchases and increased exports.

• Decreased household income of trading partners results in less product purchases and decreased exports.

• Exchange rate

  • When the domestic currency appreciates, consumers' money goes further abroad, and so imports increase, while exports decrease because they are more expensive for foreigners.
  • When the domestic currency depreciates, consumers' money goes less far abroad, imports decrease, while exports increase because they are less expensive for foreigners.

• Trade policies

  • Protectionism increases results in decreased demand for imports because they are more expensive.
  • Decreased protectionism results in increased demand for imports that are less expensive; and exports usually increase due to free trade.

Short-run Aggregate Supply (SRAS)

• Aggregate supply represents the total supply of goods/services produced in an economy at a specific price level at a given time.
• The short run is a period where wages and other factor prices are inflexible.
• The long run is a period where full wage and factor price flexibility exists.
• The AS curve slopes upwards due to:
• The combined supply of individual supply curves, which are also upward sloping
• Firms must spend more to increase production as real output increases
• Higher costs result in higher average prices.
• A change in average price level in an economy will cause a movement along the SRAS curve

Diagram Analysis

• An increase in the AP leads to a movement along the SRAS curve
• Real GDP expands
• "Y" is the symbol used in macroeconomics to denote national income or real GDP
• An decrease in the AP leads to a movement along the SRAS curve
• Real GDP contracts

Shifts of the Entire SRAS Curve

• A change in the non-price determinants of supply in an economy, such as production costs or productivity changes, shifts the entire SRAS curve.

Diagram Analysis

• A decrease in costs/ increase in productivity: SRAS shifts to the right - output and real GDP increases
• An increase in costs/ decrease in productivity: SRAS shifts to the left - output and real GDP decreases

The Non-Price Determinants of the SRAS Curve

• Two main factors influence the SRAS:
• Changes in raw material and energy costs.
• Changes in indirect taxes.

Changes to the costs of raw materials/energy:

• Rising input costs decrease goods produced with the same amount of money, decreasing SRAS (shifts left).
• Decreasing input costs increase goods produced with the same amount of money, increasing SRAS (shifts right). -Input costs are influenced by wages, interest rates, government regulation and exchange rates.

Changes in indirect taxes

• Indirect taxes are an additional cost for firms.
• Decreasing taxes decreases costs and increases output, increasing SRAS shifts (right).
• Increasing taxes increases costs and decreases output, decreasing SRAS (shifts left).

Alternative Views of Aggregate Supply (AS)

• Classical and Keynesian economists have differnt views of aggregate supply

Monetarist/New Classical View of the Long-run Aggregate Supply (LRAS) Curve

• Classical economists believe that full employment occurs and the LRAS is perfectly inelastic (vertical)

• This is the maximum point of output on the production possibilities curve (PPC).

• The economy will always return to the full employment level of output with changes in just the price level. -During periods of economic growth, the economy is at an inflationary gap. -Self corrects by returning to long-run with a higher average price level

• During slowdowns or recessions there can be a recessionary gap that develops. In the long-run this will self-correct and return to a lower average price level.

• The Classical Perspective illustrates a vertical aggregate supply curve at the level of output with the full employment illustrating output

Keynesian View of the AS Curve

• Keynes suggests that the long-run aggregate supply curve (LRAS) was L shaped, with 3 distinct sections:
• 1. An elastic section:
• Supply is elastic at lower levels of output due to spare production capacity, firms increase output without raising prices.
• 2. A relatively price elastic section:
• Starting to bid with each other for resources, price levels begin to rise
• 3. A perfectly inelastic (vertical) section
  • This represents the full employment (YFE) of all necessary means, the closer the economy gets to this, the more price flation will occur as firms compte for scarec resources.
• The vertical portion of the LRAS curve corresponds to the classical view of LRAS.

Inflationary & Deflationary Output Gaps

• An output gap is the difference between the actual level of output (real GDP) and the maximum potential level of output

Inflationary Output Gaps

• Occurs when the real GDP is greated than the potential real GDP

Deflationary Output gaps

• Occurs when the real GDP is less than the potential real GDP
• This is because it is hard to know exactly what the maximum productive potential of an economy is Rapidly rising prices can indicate a positive gap is developing
• Rising unemployment and slowdown in economic growth can indicate that a negative gap is increasing

Shifts of the Long-run Aggregate Supply (LRAS) Curve

• The shift on the Classical LRAS curve, or the Keynesian AS curve outwards, increases the potential output of the economy and corresponds to an outward or inward shift on the production possibilities curve( PPC).

Shifts of the Long-run Aggregate Supply (LRAS) Curve

The shift to the right represents an increase in the potential output of the economy/ Changes to SRAS do not change the potential output of the economy Some causes for shift of Long-run Aggregate Supply(LRAS) Curve include:

• Changes in institutions increasing financial institutions can result in more access to finance and help to increase the potential supply.
• Creating and implementing new legislation (laws) can make it easier for new firms to enter markets thus increasing supply implementation of competition policy.

The Keynesian Model.

• As with the classical model, changes to any of the determinants of AS will in turn change the long term productive potential of the economy

Macroeconomic Equilibrium

• Real national output equilibrium occurs whenaggregate demand (AD) intersects with short-run aggregate supply (SRAS)

Classical Theory

• According to Classical Theory, changes to components of AD will shift the AD curve/ Changes to the SRAS curve will shift the SRAS curve

Classical Model

-Classical believe the economy will always return to its full potential level of output and that the YFE would be equal to the natural rate of unemployment. -Classical economists believe that in the long run the economy will always return to its full potential level of output and all that will change is the average price level with aggregate demand (AD) shifting left. -The economy is again back at the full employment level of output, but now at a lower average price with aggregate demand (AD) shifting right.

Keynesian View of Aggregate Supply (AS)

 - The low output leads to high unemployment and low confidence in the economy
      - This stops further investment and further reduces consumption
 -The economy is initially in equilibrium at the intersection of AD₁ and AS when the average price level (AP) slows or fails.