2.2 Aggregate demand and supply

2.2 Aggregate demand and aggregate supply: Aggregate demand

In microeconomics demand only represents the demand for one product or service in a particular market, whereas aggregate demand in macroeconomics is the total demand for goods and services in a period of time at a given price level.

Components of AD:

AD = G+I+C+(X-M)

C= Consumption

I= Investment

G= Government spending

X= Exports

M= Imports

Negative slope: AD has a negative slope because the relationship between price level and AD is inversely proportional, meaning that as the price level increases real AD decreases.

The price level also represents inflation and real GDP also represents economic growth and employment.

Movements along the AD curve: these are a result of a change in price level.

An increase in price level reduces the purchasing power of a given level of income and so individuals cannot afford to buy as many goods and services as their real income decreases.

Inflation is likely to result in higher interest rates which will reduce AD as it makes savings more attractive and borrowing less attractive for both firms and individuals.

An increase in domestic prices makes a country’s exports less competitive on the world market and imports appear relatively cheap. This can reduce demand for exports.

Shift of the AD curve: a change in any of the components of AD, not due to a change in price level will shift the AD curve.

Factors of consumption

Consumption (C): the total spending by consumers on domestic goods and services. This is the most important component.

AD curve can be shifted by changes in consumption due to factors.

Consumption function:

C= a + bY

a = autonomous consumption – amount of money spent even if disposable income was zero in order to sustain life. This may have to come from savings or loans.

b = marginal propensity to consume – the proportion of an increase in income that is spent on domestic goods and services.

Y = disposable income – income after tax is deducted and benefits added.

Interest rates: the price of borrowing money over a period of time and the reward for saving money.

An increase in interest rates decreases consumption expenditure.

When interest rates rise, the reward for saving money increases and loans become more expensive, so there is less consumption.

When interest rates fall, the monthly repayments for flexible mortgages decrease, so there is more consumption.

Wealth effect: as the value of assets rise individuals feel more wealthy, consumer confidence increases so consumption increases.

Household debt: money owned by householders to lenders. If this increases initially consumption increases as they can consume beyond their disposable income. However, consumption the decreases when they have to repay their loans with interest.

Disposable income: there is a positive relationship between consumption and disposable income. When consumption is less than disposable income, the individual will save the remaining. In reality MPC drops as income rises because people save. The government can influence the amount of disposable income an individual has by changing the amount of taxation and benefits, which therefore changes the level of consumption in the economy.

Expectations/Consumer confidence: if people are optimistic about their economic future then they are likely to spend more now.

For instance if they feel that they are likely to get a pay rise then they are likely to feel more confident about using their savings and therefore increasing consumption.

A stable and growing economy, with low inflation and low unemployment will boast consumer confidence and increase AD.

Remember these factors of consumption with WIDER (wealth, income, debt, expectations and rates). Next you will learn that the factors of investment are very similar.

Factors of investment

Investment (I): an increase in the spending of firms on capital. Capital is any manmade good used to produce other goods and services, such as machinery, buildings. Below are the two main types of investment.

Replacement Investment (Depreciation): firms spend on capital to maintain the productivity of existing capital.

Induced Investment: firms spend on capital to increase their output, in response to higher demand in the economy.

Factors of investment:

G: Government policy

R: Rate of interest

A: Accelerator

P: Profitability

E: Expectations of future demand

T: New technology

E: Exchange rate

Government policy (G): governments may offer incentives to increase foreign and domestic investment, such as reduction in corporation tax rates, or grants towards research and development.

Rate of interest (R): cost of borrowing and reward for saving.

If firms borrow to fund investment then they will be charged interest. If firms use their retained profits then they sacrifice the interest foregone had they continued to save the money in the bank.

If the rate of interest decreases, then the cost of borrowing and rewards for saving decrease, so investment usually increases.

Investment schedule when investment is inelastic: if business confidence is low firms are unlikely to undertake investment irrespective of the rate of interest

Accelerator (A): investment is dependent upon the level of consumption and the income in an economy.

If consumption increases then they will undertake further investment, called induced investment, to produce the additional output.

Profits (P): firms with retained profits may increase investment as they have the internal funds available.

Expectations (E): if businesses have confidence that consumer demand will rise in the future, then they are likely to increase investment in new capital equipment in preparation to meet the output demanded. Business confidence is affected by:

Consumer confidence
GDP
Government optimism
Inflation

Technological changes (T): in order to keep up with advances in technology firms will increase investment.

Exchange rates (E): the price of one currency in terms of another, determined by the demand and supply of the currency. When the value of the country’s currency falls the volume of investment will increase.

Factors of government spending

Government current expenditure: day-to-day spending on things such as salaries or civil servants, drugs for health service etc.

Government capital expenditure: spending on manmade goods used to produce other goods and services, i.e. Public Sector Investment.

Governments spend in order to ensure that adequate amounts of public and merit goods and services are consumed such as defence, education and health services and to influence the level of economic activity and distribution of income.

Fiscal policy: use of government spending (and taxation) to influence the level of aggregate demand (economic activity).

The amount spent depends upon the political and economic priorities.

Factors of net exports

Export: a flow of money in to the country and is an injection in to the circular flow of income.

Import: a flow of money out of the country and is a leakage for the circular flow of income.

Net exports = exports – imports

Change in protectionism: if a country suddenly increases the level of protectionism, for example introduces a tax or quota in imports, then this will increase that value of ‘X-M’ as the level of imports in to a country falls.

Income of trading partners: if foreign incomes rise then the demand for goods and services produced by a given country will increase and this will lend a rise in the value of AD as ‘X’ increases.

The exchange rate: if the exchange rate becomes stronger, then exports from that country appear relatively expensive while imports appear relatively cheap. This can lead to a fall in the value of net exports particularly if the demand for imports and exports is elastic.

The multiplier effect

An increase in injections (G, I or X) to the circular flow of income leads to a more than proportionate increase in national income.

An increase in government spending on infrastructure, increases employment as a workforce is needed to fulfil the investment. Therefore, income levels, consumer confidence, consumer spending and, investment spending by firms would increase.

The diagram shows how an increase in government spending on an infrastructure project will create new jobs, which provide workers with income. The workers will spend their income in local stores and as a result the income level of the store holders will increase. As a result of increased incomes the store owners may increase investment which may increase the number of jobs available.

The multiplier effect will be higher the more of the increase in income that is spent i.e. the higher the value of MPC. In addition, the less money that is saved, spent on taxes and imports the bigger the final effect on the national income.

Increase in AD from AD1 to AD2 represents the initial increase in spending. However, increase AD from AD2 to AD1 represents the multiplied increase in national income.

The multiplier can be calculated by two different formulae.

Multiplier = 1 / (sum of the propensity to save + tax + import)

= 1 / (1 - marginal propensity to consume)

Aggregate supply

Aggregate supply: the planned level of output at different price levels over a given period of time. This refers to the total amount of goods and services willing and able to be produced.

Positive slope: AS has a positive slope because the price level and AS have a direct relationship. The price level increases real AS increases.

Movement along the supply curve: an increase in price will cause an increase in the price level which leads to an increase in output in the short run, as an increase in prices will make it more profitable to produce.

Shift in the short run aggregate supply curve: when factors of production change.

Factors of SRAS:

Changes in business taxation
Changes in the availability of resources
Changes in wage levels
Supply-side shocks (war, natural disasters, famine)
Changes in the price level of crucial imported factors of production (e.g. oil)

Factors leading to a permanent shift of AS:

Increase our factors of production. E.g. find new oil reserves, have a larger population that can work
Increase the quality of our factors of production. E.g. education, training, efficiency
Increase technology. E.g. new harvesting machinery

Alternative views of aggregate supply

Monetarist/new classical model of LRAS: this is a free market economy view that 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.

Keynesian model of the LRAS: unemployment can exist in an economy in the long-run and therefore at a given time there can be a large availability of the factors of production (share capacity) in the economy.

Spare capacity: the resources (land, labour, capital and enterprise) are not fully employed. It is possible to increase output without expecting an increase in costs and price level will remain constant.

Approaching full employment: as the economy approaches full employment shortages start to occur in the economy they have the effect of bringing up the price/cost of the resources.

Full employment: all resources are being used fully and it is not possible to increase output. Any attempt to increase output will simply result in higher prices.

The Keynesian economists believe that unemployment can exist in the long-run in an economy as the labour market does not always reach equilibrium resulting in unemployment.

A decrease in demand for goods and services results in a decrease in demand for labour, however, if the wage rate does not decrease to meet the new equilibrium, unemployment will exist.

The wages are ‘sticky downwards’ because…

Trade unions prevent wages falling
A minimum wage exists
Unemployment benefits prevent workers from accepting a continual cut to their wages.

A shift in the LRAS is due to the same factors of production that shift the possibility production curve to the right, including improvements in efficiency, new technology, reductions in unemployment, and institutional change.