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Aggregate Demand and Supply
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Aggregate Demand and Supply
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Aggregate Demand (AD)
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Aggregate Demand
The sum of all expenditure in the economy over a period of time
Macro concept WHOLE economy Formula:
AD = C+I+G+(X-M) C= Consumption Spending I = Investment Spending G = Government Spending (X-M) = difference between spending on imports and receipts from exports (Balance of Payments)
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Aggregate Demand Curve
Shows the overall level of spending at different price levels Note Inflation used for the vertical axis follows from new thinking on the derivation of AD curves from the likes of David Romer @ University of California Assumes Central Banks do not target the money supply but short term interest rates
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Aggregate Demand Curve
Why does it slope down from left to right? Assume Bank of England sets short term interest rates Assume a rise in the price level will be met by a rise in interest rates Any increase in interest rates will raise the cost of borrowing:
Consumption spending will fall Investment will fall International competitiveness will decrease exports fall, imports rise
Therefore a rise in the price level leads to lower levels of aggregate demand
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Aggregate Demand Curve
The AD diagram: Inflation on the vertical axis assume an initial target rate of 2.0% (as measured by the HICP or CPI) Real GDP or Real National Income or Real Output on the vertical axis (shown by the initial Y)
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Aggregate Demand Curve
Inflation The level level of At a higher output This lower ofrate of At be associated National Income inflation (3.0%) will an inflation level of 2%, fewer requiresthe AD units rising particular with a interest rates curve gives of labour mean that level of C,aIlevel and of output of Y1 (X-M) all have unemployment rises to 7% shown call U negative will by U which weeffects on = 7% AD = 5%NY falls to Y2
3.0%
2.0% AD
Y2 U = 7% Y1 U = 5%
Real National Income
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Shifts in the Aggregate Demand This would cause Shifts in AD will be a Curve Any exogenous Inflation
caused national rise in by changes in factor affecting C,C, factors causing I, income (economic G or G to rise, or I and (X-M) lead growth) and (exogenous factors) a trade in to a fall surplus e.g. increasing unemployment to causes a shift (U income tax rates = 2%) (and vice the right in AD affect consumption versa)
2.0%
AD2 AD
Y1
U = 5%
U = 2%
Y2
Real National Income
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Consumption Expenditure
Exogenous factors affecting consumption:
Tax rates Incomes short term and expected income over lifetime Wage increases Credit Interest rates Wealth Property Shares Savings Bonds
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Investment Expenditure
Spending on:
Machinery Equipment Buildings Infrastructure Expected rates of return Interest rates Expectations of future sales Expectations of future inflation rates
Influenced by:
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Government Spending
Defence Health Social Welfare Education Foreign Aid Regions Industry Law and Order
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Import Spending (negative)
Goods and services bought from abroad represents an outflow of funds from the UK (reduces AD)
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Export Earnings (Positive)
Goods and services sold abroad represents a flow of funds into the UK (raises AD)
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Key Variables
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Macroeconomic Policy
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Fiscal Policy
Government Income (taxes and borrowing) Government Spending
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Monetary Policy
Interest Rates (Bank of England)
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Aggregate Supply (AS)
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Capacity of the Economy
Costs of Production Technology Education and Training Incentives Tax regime Capital stock Productivity Labour Market
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Aggregate Supply
Inflation AS
Between Y1 and Yf, The output of theof are Yf represents Full Y1 An shape level increases in capacity This shape AS curve issuggest thein Employment Output would important possible but the nearer reflects is the thethis point working determining gets to Yf, at economya economy the more problems are to outcome in capacity economy is the view below full working Keynesian experienced would be economy with full capacity and and there of theproduce any AS curve. acquiring resources to cannot widespread boost production more. unemployment. (production bottlenecks) especially labour skills shortages.
Economy starts to overheat
Y1
Yf
Real National Income
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Inflation
Aggregate Supply
AS1 AS2
Increases in capacity can occur as a result of a shift in AS (akin to a shift outwards of the Production Possibility Frontier) (PPF)
Yf1
Yf2
Real National Income
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Aggregate Supply
Inflation SRAS 1 SRAS SRAS 2
SRASrun Short assumes costs such as aggregate supply (SRAS) assumes overall wage firms remain to rate only able increase output at fixed, changes higher costs (e.g. in such costs overtime cause a shift in payments) the SRAS curve thereby pushing (exogenous up price level shocks input costs)
Real National Income
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Aggregate Supply
Inflation LRAS
This is because they Classical in the believe that economists will be long run, there no unemployment of assume the long resources because run aggregate markets will clear, supply curve thus whatever the rate of inflation, firms (LRAS) is vertical will supply the (perfectly maximum capacity of inelastic). the economy.
Yf
Real National Income
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Aggregate Supply
Inflation AS
For our analysis, we will assume the AS curve looks like this!
Real National Income
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Putting AD and AS together
Inflation AS
A shift in the AD In thisto AD1 as a curve situation, the economya change in result of would be operating of the any or all at less than capacity, there factors affecting AD would be would increase unemployment and growth, reduce the economy might at unemployment but be growing only a cost of higher slowly. (a trade-off) inflation
2.5% 2.0%
AD 1 AD Y1 Y2 Yf Real National Income
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Putting AD and AS together
Inflation AS 3.5% 2.5% 2.0% AD1 AD Y1 Y2 Y3
Yf Further increases in AD would lead to successively smaller increases in growth and employment at the cost of ever higher inflation.
AD2
Real National Income
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Sustained Growth
Inflation AS AS1
Sustained growth (not to be confused with sustainable economic growth) occurs when AS and AD rise at similar rates national income can rise without effects on inflation
2.0%
AD2 AD Y1 Y2
Real National Income
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