Understanding Aggregate Demand

Aggregate Demand

• Defined as the total demand for goods and services in an economy
• Composed of consumption expenditure, government expenditure, investment spending, and net exports over a specific period
• Calculated using the formula: C+I+G+(X-M)

Aggregate Demand Curve

• Slopes downward

Reasons for the Negative Slope

• Wealth Effect: As the average price level decreases, the real wealth of people increases, enhancing their ability to purchase goods and services
• Assets like property and stock gain real value
• Interest Rate Effect: Lower price levels lead to lower interest rates, increasing disposable income for spending
• Incentive to save decreases
• Net Balance Effect: A lower price level makes goods/services cheaper for foreign buyers, increasing exports and decreasing imports
• Improves the net trade balance

Determinants of Aggregate Demand Components

• Consumption: Consumer spending amount is vital for the economy, making up a large portion of real GDP in market/mixed economies
• Confidence: Anxious consumers reduce spending, shifting the AD curve leftward and reducing national output
• Confident consumers increase spending, shifting the AD curve rightward
• Unemployment: Unemployment concerns impact people and annual real incomes, affecting the ability to consume
• closely monitored by governments, especially seasonally
• Real Interest Rates: Lower interest rates reduce borrowing costs, encouraging spending and discouraging saving, shifting the AD curve rightward
• Higher interest rates encourage saving, discourage borrowing, and shift the AD curve leftward
• Wealth: Refers to assets including property, bonds, and shares
• Rising asset prices boost aggregate demand, as people feel wealthier and spend more
• Personal Taxes: Lower income taxes increase disposable income, leading to increased consumption
• Household Indebtedness: High debt levels constrain long-term consumption as individuals repay debts
• Expectations of Future Price Level: Expectations of rising prices (inflation) encourage present spending, shifting the AD curve rightward
• Expectations of falling prices (deflation) encourage saving and reduce spending

Tools to Manage an Economy

• Fiscal Policy: Involves taxing and spending
• Monetary Policy: Involves interest rates and money supply

Fiscal Policy and Aggregate Demand

• Definition: Government policies related to government spending and taxation rates
• Expansionary Fiscal Policy: Aims to increase AD
• Decreasing taxes increases AD
• Increasing government spending increases AD
• Contractionary Fiscal Policy: Aims to decrease AD
• Increasing taxes decreases AD
• Decreasing spending decreases AD
• Government spending and consumption are both affected

Monetary Policy and Aggregate Demand

• Definition: Official policies governing money supply and interest rates
• Expansionary Monetary Policy: Aims to increase AD
• Decreasing interest rates increases AD
• Increasing money supply increases AD
• Contractionary Monetary Policy: Aims to decrease AD
• Increasing interest rates decreases AD
• Decreasing money supply decreases AD

Aggregate Supply

• The total quantity of goods/services all industries in an economy produce at a given price level

• The sum of all microeconomic supply curves within the economy

• Distinctions between Short-Run and Long-Run: -Considered temporary as it can bounce back to full capacity

• Long-Run Aggregate Supply: Represents maximum capacity

• Short-Run Aggregate Supply: Reflects the current economy and may not be at full capacity

• Production Possibility Curve (PPC): Illustrates that production cannot exceed an economy's capacity

Two Schools of Thought on Aggregate Supply

• Neoclassical View:
  • Relies on Monetarists and "supply-side" economists from the "Austrian school"
  • Market force efficiency and minimal government intervention
  • Long-run aggregate supply curve is perfectly inelastic
• Keynesian View:
  • Associated with John Maynard Keynes
  • "Spare-capacity" exists, so new factories are unnecessary
  • Factories can re-employ workers
  • There is no long run

Short-Run Aggregate Supply (SRAS) Curve

• Illustrates the relationship between the average price level and national output, assuming constant production costs
• Movement along the SRAS: Change in average price level
• Shift of SRAS: Change other than average price level results in "supply side shock"
• Supply Side Shocks: Factors changing production costs, shifting the SRAS curve
• The supply curve shows how increased costs arise with increased output

Supply-Side Shocks

• Fits the Neoclassical view
• Changes in Costs of Factors of Production:
• Increased wage rates (minimum wage) cause an inward shift
• Increased raw material costs (oil prices) increase production costs
• Increased prices of imports cause inward shift
• Government indirect taxes or subsidies:
• Taxes lead to price drops and cause an outward shift of AS

Factors of Production Improvement

• Land
  • Land reclamation
  • Irrigation systems
  • Technological advancements
  • Environmental protection policies
• Labor
  • Immigration policies for skilled workers
  • Investment in training programs
  • Investment in healthcare
  • Supporting families
• Capital
  • Tax incentives
  • Infrastructure investment
  • Policies that encourage saving and investing
• Entrepreneurship
  • Financing new ventures
  • Intellectual property protection
  • Decreasing barriers to starting businesses

(LEDCs) vs Developed Nations

• Greater population/growth means more workforce available and opportunities for employment
• Ability to learn from ‘developed' nations issues and not repeat critical errors
• Capital stock has more room for growth and modernization
• More available land
• Lower expectations on both consumer and labour side

Keynesian And Free Market Economists

• improvements to LRAS are more effective than demand-side policies in growing a nation's economy.
• LRAS improvements create sustainable growth
• Improvements in LRAS look at fundamental productive capacity compared to only looking at spending
• Growth on supply side tends to be increasingly permanent and has the ability to sustain itself

Government's Focus On Improving Production Factors

• Reluctant due to time lags
• The time LRAS policies require to show results is significantly shorter than the common political cycle
• Voters/citizens expect immediate results and/or economic improvements
• Economic problems that are short-term or seemingly more relevant may be prioritised
• Uncertainty of long term solutions may deter people from investing in this route

Supply-Side Policies

• The overarching goal is to increase the output of the economy by increasing the quantity of factors of production and/or by improving the Quality of the factors of production

Interventionist Supply-Side Policies

• Based on the idea that the government has a fundemental role to play to actively encourage economic growth
• Investment in human capital
  • Constant and needed increase in the quality/productivity of a country labor force is required & training needs to be available
• Research and development
  • Firms are able to stay up to date with modern developments, new production techniques, and to constantly seek improved methods of production
• Provision and maintenance of infrastructure
  • Infrastructure may be defined as large scale capital, usually provided by the government, which is necessary for economic activity to take place
• Direct support for business/industrial policies
  • Governments have agencies or ministries who are responsible for developing policies that support and encourage the development of industry

Market Based Supply-Side Policies

• Focus on allowing markets to operate more freely, with minimal government intervention
• Incentive based
• Designed to increase the incentives for labor to work harder and more productively
• Designed to increase the incentives for firms to invest and to increase productivity
• Reduction in household income taxes: if income taxes are reduced, so that people are not taxed more for working more, then they might have the incentive to work harder and to become more productive, thus increasing the potential output of the economy(reduction in progressive income taxes)
• Institutional changes
  • Often described as institutional changes as they affect the structures, institutions, and rules that govern economic stakeholders
• Labor market reforms
  • Reduction in trade union power power

Policy Goals

• Policies designed to increase the long-run aggregate supply (LRAS) in the economy by increasing the quantity and/or the quality of factors of production. They are intended to shift the AS/LRAS curve to the right

Main Goals

• Achieve long term economic growth by increasing the productive capacity of the economy
• Improve competition and efficiency
• Reduce labour costs and unemployment through increased labour market flexibility Reduction in household income taxes When people work more and begin to earn more, it is likely they will start to have to pay a higher level of tax on their higher level of income. his may disincentivize people to work as people would prefer to have more leisure time over more work ho