2.

2 Aggregate demand and supply Syllabus item: 82 Weight: 3

- Aggregate demand (AD)

IB Question
• Distinguish between the microeconomic concept of demand for a product and the macroeconomic
concept of aggregate demand.
• Construct an aggregate demand curve.
• Explain why the AD curve has a negative slope.

1. The AD curve

• Aggregate demand: the total spending on goods and services in a period of time at a given

price level

Macro Micro

Aggregate demand curve

 X-axis: total quantity of all good and services. (National output = national income =
national expenditure/ “real output” or national income (Y))

*In Macroeconomic analysis, the x-axis is commonly labeled as “real output” (meaning that

the value of national output adjusted for inflation.

 Y-axis: a measure of the average price level of all goods and services

Analysis:

• The demand curve  price of one good × demand for that one good (microeconomic),

Aggregate demand  price of all goods × demand for all goods (macroeconomic)
• The AD diagram illustrates the inverse relationship between the average price level and

the total real output demanded; at a lower average price level, a higher quantity is

demanded

• Negatively sloped because of the ‘wit’ effects: wealth, interest rate and trade effects

 Reason 1: Wealth effects  A fall in price will stimulate the consumption component

of AD since consumption usually reflects the real income

 Reason 2: Interest rate effect  A fall in price will increase the real money supply,
lower the interest rate and stimulate the investment and consumption components of

AD.

 Reason 3: Trade effects  A fall in price will, with a constant exchange rate,
increase international competitiveness so that exports increase and imports

decrease.
 Syllabus item: 83 Weight: 3

2. The components of AD

IB Question
• Describe consumption, investment, government spending and net exports as the components of
aggregate demand.

Definitions
• Export: domestic goods and services that are bought by foreigners  inflow of export revenues to the country
• Import: goods and services that are bought from foreign produces outflow of import expenditure

Aggregate demand = C + I + G + (X-M)

• Consumption (C)

 Definition: Total spending by consumers on domestic goods and services

 Consumer demand: We look at 1) durable goods: goods that are used over a period of

time) ex. Cars, computer, mobile phones, bicycles etc.

+ 2) non-durable goods: goods that are used up immediately. Ex. Rice, toilet paper etc.

• Investment (I)

 Definition: The addition of capital stock to the economy. Investment is carried out by

firms. There are two types of investment:

1) Replacement investment – occurs when firms spend on capital in order to maintain

the productivity of their existing capital

2) Induced investment – occurs when firms spend on capital to increase their output to

respond to higher demand in the economy

 The economy’s capital stock includes all goods that are made by people and are used to

produce other goods or services such as factories, machines, offices etc.

 Investment is not to be confused with buying shares or putting money in a bank — we tend

to call this “investment” in everyday English, but it is, in fact, “saving” as it is a leakage

from the circular flow

• Government spending (G)

 Definition: includes all government consumption and investment but excludes transfer

payments made by state

 Includes health, education, law and order, transport, social security, housing and

defense

 The amount of government spending depends on its policies and objectives

• Net exports (X-M)

 Definition: Domestic goods and services that are bought by foreigners. When the firms

in a country sell exports to foreigners, it results in an inflow of export revenues to the

country. Imports are goods and services hat are bought from foreign producers. When

imports are bought it results in an outflow of import expenditure.

 Export revenue – import expenditure, equivalent to (X-M)

 Positive value: Export revenues > Import expenditure (Addition to AD)

 Negative value: Import expenditure > Export revenues (Reduction to AD)

 Aggregate demand: C + I + G + (X-M) which is shown in Figure 14.2

 Syllabus item: 84 Weight: 4

IB Question
• Explain how the AD curve can be shifted by changes in consumption due to factors including
changes in consumer confidence, interest rates, wealth, personal income taxes (and hence
disposable income) and level of household indebtedness.

3. The determinants of AD or causes of shifts in the AD curve

Changes in AD: Any changes in the components of aggregate demand will cause a shift in the

demand curve as shown in figure 14.3

 Increase in any of components of AD  AD curve shift to the right

 Decrease in any of components of AD  AD curve shift to the left

1st determinant: Consumption

1) Changes in expectations/ consumer confidence

 If people are optimistic about their economic future that they are likely to spend more

now.  Ex) If they think that they are likely to get a promotion in the future due to a

booming economy and strong sales then they will feel more confident about taking a loan or

using up savings.
  The higher the consumer confidence is, the higher consumption (shift to the right) and

vice versa.

 “Consumer confidence index” or “Consumer sentiment index”

2) Changes in interest rates

 Definition of interest rates: the price or cost of borrowing money

 Some of the money that is used to buy durable goods comes from money which people

borrow from the bank. When people borrow money they must pay for the borrowed money

by paying interest to the bank. Thus, if there is an increase in interest rates, then there is

likely to be less borrowing (because it is more expensive to borrow). Therefore consumption

will fall, resulting in a fall in AD.

 Borrowed money is usually used to buy houses. To buy a house, most consumers get a

loan for housing called a mortgage. If interest rates increase then this loan becomes more

expensive on a month-to-month basis.

 The higher the interest rate, the lower the consumption and vice versa.

 Also, a rise in the interest rate makes saving more attractive.

3) Changes in wealth

Definition of wealth: assets that people own including physical assets (ex. house, arts,

antiques) and monetary/financial assets (ex. shares in companies, government bonds, or

bank savings)

 2 main factors that can change the level of wealth in economy:

1. A change in house prices: when house prices increase across the economy, consumers

feel more wealthy and likely to fell confident enough to increase their consumption by
spending less or borrowing more

2. A change in the value of stocks or borrowing more: If the value of shares increases,

people feel wealthier. This might encourage them to spend more.

*”Income” and “Wealth” are different!!!

4) Changes in income
  Increase in income means that they have more money to spend on goods and services,

thus higher the consumption and vice versa.

5) Changes in household indebtedness

Definition of household indebtedness: the extent to which households are willing and able to

borrow money

 If it is easy to borrow money (easy credit) and interest rates are low then it is likely that

households will take on more debt by getting loans or using their credit cards other means.

 If interest rates rise, households will have to spend more to re-pay their loans and

mortages.
IB Question
• Explain how the AD curve can be shifted by changes in investment due to factors including
interest rates, business confidence, technology, business taxes and the level of corporate
indebtedness.

2nd determinant: Investment

1) Changes in interest rates

 In order to invest, firms need money. The money that firms use for investment can come

from “retained profits” or they can borrow the money. Both of these are affected by the

interest rate. If the money is to be borrowed, then an increase in the cost of borrowing

money may lead to a fall in investment. If interest rates are high, then firms may prefer to

put their retained profits in the bank to earn higher returns as savings, rather than use them

to invest.

 Inverse relationship between interest rates and the level of investment, as shown below.

 A decrease in the interest rate, from 7 to 4 percent, will decrease the incentive to save and

decrease the cost of borrowing, so it is likely to lead to an increase in borrowing that is likely to

result in an increase in the level of investment from I1 to I2, and vice versa.
2) Changes in expectations/business confidence

 If businesses are vey confident about the future of the economy and expect consumer

demand to rise then they will want to be ready to meet the increase in consumer demand by

investing to increase potential output and productivity.

3) Changes in technology

In order to keep up with advances in technology, and to remain competitive, firms will need

to invest.

4) Changes in business taxes

Business taxes can be structured to either encourage investment (shifting the AD to the

right) or discourage investment (shifting AD to the left).

5) Changes in the level of corporate indebtedness

 IB Question
• Explain how the AD curve can be shifted by changes in government spending due to factors
including political and economic priorities.

3rd determinant: Government spending

1) Changes in political and economic priorities

• Political priorities: A new education or health policy might require increased public

spending on schools or hospitals.

• Economic priorities: If the government has made a commitment to financially support a

given industry, then government spending will rise.

IB Question
• Explain how the AD curve can be shifted by changes in net exports due to factors including the
income of trading partners, exchange rates and changes in the level of protectionism.

4th determinant: Net exports

Imports Exports
perspective perspective

• Exports: goods and services that are bought by foreigners. If foreign income rise the their

consumption of imported goods and services will rise.

• Imports:

1) Changes in income of trading partners

 If foreign incomes rise then their consumption of imported goods and services will rise
 Ex) As the Chinese national income rises, Chinese people are more willing and able to
buy imported goods and services from Europe. Thus, European exports rise as the Chinese

economy grows.

2) Changes in exchange rates

 Changes in the value of a country’s currency (its exchange rate) can affect a country’s

exports.  If a country’s exchange rate becomes stronger, then this makes the country’s

exports relatively more expensive to foreigners.

Ex) As an example, let’s say that it takes 90 Japanese Yen to buy one US dollar. If the value of

the yen relative to the dollar change from 100 Yen to buy one US dollar, this will decrease the

amount that Japanese citizens will buy in the US, and increase the amount that US citizens can

buy in Japan.  Cause net exports to fall and the AD curve to shift to the left.

3) Changes in the level of protectionism

 Trade protection or commercial policy refers to any policy that governments may implement

to discriminate against foreign supplies.

Ex) trading partners lift trade barriers (for example if they decrease tariffs, which are taxes on

imports; or eliminate quotas, which are quantitative restrictions on imports) then exports will

increase and so will AD.

C = f (IR, CC, W, PIT, Hd,…)

I = f (Ir, BC, T, BT, CD,…)
NX / (X-M) = f (Yfm ER, CP,…)
 ★ Government policies affecting aggregate demand

Fiscal policy and monetary policy

1) Fiscal policy
 Definition: The set of a government’s policies relating to its spending and taxation rates
 Ex) Direct taxes (taxes on income) and indirect taxes 0taxes on goods and services)
 Government use expansionary fiscal policy to increase aggregate demand and contractionary,
or deflationary, fiscal policy to reduce aggregate demand

<Expansional fiscal policy>

• If a government would like to encourage greater consumption, then it can lower income

taxes to increase disposable income. This is likely to increase AD.

• If a government would like to encourage greater investment, then it can lower corporate

taxes so that firms enjoy higher after-tax profits that can be used for investment. This is

likely to increase AD.

• Governments have major investment projects themselves and may increase their

spending in order to improve or increase public services. This directly impacts upon AD.

2) Monetary policy
 The set of official policies governing the supply of money in the economy and the level of
interest rates in an economy
2.2 Aggregate demand and supply Syllabus item: 85 Weight: 3
- Aggregate supply (AS)

1. The meaning of aggregate supply

IB Question
• Describe the term aggregate supply.
• Explain, using a diagram, why the short-run aggregate supply curve (SRAS curve) is upward
sloping.

• Aggregate supply: total amount of goods and services that all industries in the economy will
produce at every given price level (the sum of the supply curves of all industries in the economy)

<Short-run aggregate supply (SRAS)>

• Short-run in this case means: the period of time when the prices of the f.o.p do not

change. Price of labour – the wage rate – is fixed.

• Positive relationship between the price level and the amount of output that a country’s

industries will supply which is shown below

(Movement along the SRAC curve)

• In the short-run, recalling that the LDMR means that marginal and average costs will rise

as output increases in short-run, an increase in output will be accompanied by an increase

in average costs. Industries will pass on an increase in costs in the form of a higher price

level  SRAS curve is upward sloping

• In short-run, firms respond to price increases by supplying more goods but in the long-run,

supply may not always respond to an increase in price level.

IB Question
• Explain, using a diagram, how the AS curve in the short run (SRAS) can shift due to
factors including changes in resource prices, changes in business taxes and subsidies and
supply shocks.

<Shifts in Short Run Average Supply (SRAS)>

A change in any of the factors other than price level will result in a shift in the SRAS curve 

“Supply-side shock”

• A decrease in costs results in an increase in aggregate supply, while an increase in costs

results in a decrease in aggregate supply

1) Changes in resource prices

Changes in the price of resources such as price of oil, equipment, capital goods etc. affect

the SRAS curve. An increase in the price of resource shifts the SRAS curve to the left as it
will increase production costs.

2) Changes in business taxes and subsidies

Business taxes are taxes on firms’ profits, and are treated by firms like costs of production.

Therefore, higher taxes on profits are like increases in production costs and so shift the

SRAS curve to the left.

3) Changes in supply shocks

Supply shocks are events that have a sudden and strong impact on short-run aggregate

supply. Some supply shocks directly affect aggregate supply. For example, a war or violent
 Syllabus item: 86 Weight: 4
conflict can result in destruction of physical capital and disruption of the economy, leading to

lower output produced and a leftward shift in the SRAS curve.

2. Alternative views of aggregate supply

IB Question
• Explain, using a diagram, that the monetarist/new classical model of the long-run aggregate
supply curve (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.

<LRAS>

New classical LRAS

• LRAS curve is perfectly inelastic at “full employment level of output”.

(there is some unemployment though, referred to as natural (or ‘normal’) unemployment

• It represents the potential output that could be produced if the economy were

operating at full capacity and is annotated as Y1 below

• LRAS curve is vertical

 Because in the long-run, money wages will have adjusted and matched the increase in

prices so firms’ profitability will not have changed

 It shows that in the long-run, when all adjustments have been made, an economy will

produce whatever its resources and technology normally allow it to produce

• Potential output is based entirely on the quantity and quality of f.o.p

 LRAS is independent of price level

IB Question
• Explain, using a diagram, that the Keynesian model of the aggregate supply curve has three
sections because of “wage/price” downward inflexibility and different levels of spare capacity
in the economy.

<Long-run aggregate supply>

Keynesian AS

Three possible phases:

1. In region 1, the LRAS is perfectly elastic, implying that higher level of output can and will be

produce without the average price level rising. Producers in the economy can raise their

level of output without higher average costs, because of ‘spare capacity’ in the economy.

2. In region 2, as the economy approaches its potential output (Y f), and the spare capacity is

used up, the available factors in the economy become more scarce. As producers increase

output, they bid for the increasingly scarce factors and prices begin to rise.
3. In region 3, when the economy is at full capacity, all factors are being used and so output

cannot increase. Thus, LRAS is perfectly inelastic.

 4. Shifting the aggregate supply curve over the long-term

IB Question
• Explain, using the two models above, how factors leading to changes in the quantity and/or
quality of factors of production (including improvements in efficiency, new technology, reductions
in unemployment, and institutional changes) can shift the aggregate supply curve over the long
term.

• A Shift in LRAS can be shown below.

(a) Keynesian perspective (b) The new classical perspective

(However, Keynes was not interested in the long-run in his analysis of the workings of an

economy)

• An outward shift of a country’s LRAS curve means that its productive potential has
increased. (A shift in the LRAS can be likened to an outward shift of PPC)
• The LRAS curve will shift to the right if there is an improvement in the quality of f.o.p or

increase in the quantity of the f.o.p.

F.o.p Increase in quantity Improvement in quality (increase in

productivity)

Land (all natural resources) • Land reclamation • Technological advancements tat

• Increased access to allow for increased access to

supply of resources resources or the discovery of new

• Discovery of new resources

resources • Fertilisers

• Irrigation

Labour + entrepreneurship • Increase in birth rate • Education

• Immigration • Training

• Decrease in the • Re-training

natural rate of • Apprenticeship programmes

unemployment

Capital • Investment • Technological advancements that

contribute to more efficient capital

• Research and development

 4. Short-run equilibrium

IB Question
• Explain, using a diagram, the determination of short-run equilibrium, using the SRAS curve.
• Examine, using diagrams, the impacts of changes in shortrun equilibrium.

Short-run equilibrium

• The economy is in short-run equilibrium where AD = SRAS

• Short-run equilibrium: output level of Y at the price level of P

• The output produced by the economy = total demand in the economy

(So there is no reason for producers to change their level of output)

• Any shifts in AD will induce a change in the equilibrium average price and output levels in

the same direction as the change in AD

• Any shifts in SRAS will induce a change in the equilibrium average price and output

levels in the opposite direction as the change in AD

 5. Equilibrium in monetarist/new classical

IB Question
• Explain, using a diagram, the determination of long-run equilibrium, indicating that long-run
equilibrium occurs at the full employment level of output.

Long-run equilibrium

• It is where AD = vertical LRAS

<New classical perspective>

• The impact of any changes in AD will be on the price level only

• The LRAS curve is vertical at the full employment level of output

 The economy produces potential GDP in the LR

• The economy will always move ‘automatically’ (without government intervention) to its

long-run equilibrium.

(There may be a short-run increase in output if there is an increase in AD but it will always

return to its long-run equilibrium.)

IB Question
• Explain why, in the monetarist/new classical approach, while there may be short-term
fluctuations in output, the economy will always return to the full employment level of output in
the long run.
• Examine, using diagrams, the impacts of changes in the long-run equilibrium.

• The impact of any changes in AD will be on the price level only:

• The economy will always move automatically (“without government intervention”) to its

long-run equilibrium.

• Only the price level changes, leaving the equilibrium level of real GDP unchanged at

potential output, Yp.

 6. Equilibrium in the Keynesian model

IB Question
• Explain, using the Keynesian AD/AS diagram, that the economy may be in equilibrium at any
level of real output where AD intersects AS.
• Explain, using a diagram, that if the economy is in equilibrium at a level of real output below the
full employment level of output, then there is a deflationary (recessionary) gap.

<Keynesian perspective>
• Equilibrium level of output: AD=AS

However, in Keynesian perspective, they believe that the economy may be in long-run

equilibrium of a level of output below the full employment level of national income (Yf)

• In this case, the equilibrium level of output is below the full employment level of output

 Deflationary gap (Output gap)

 Whereby the level of AD in the economy is not sufficient to buy up the potential output

that could be produced by the economy at the full employment level of output
IB Question
• Discuss why, in contrast to the monetarist/new classical model, the economy can remain stuck
in a deflationary (recessionary) gap in the Keynesian model.
• Explain, using a diagram, that if AD increases in the vertical section of the AS curve, then there
is an inflationary gap.
• Discuss why, in contrast to the monetarist/new classical model, increases in aggregate demand
in the Keynesian AD/AS model need not be inflationary, unless the economy is operating close to,
or at, the level of full employment.

• AD can increase such that there is an

increase in the level of real output,

without any consequent increase in the

price level (Because of the existence of

spare capacity in the economy)

• If AD increases further to AD3, then the economy starts to experience inflationary pressure

as available f.o.p becomes scarcer and their prices bid up.

• This happens when the economy is

operating at full employment and there

is an increase in AD (“Purely

inflationary”)

There is only an increase in price level

• “Inflationary gap”, whereby the level of

AD cannot be satisfies given the existing

resources. As a result, the price rises to

allocate the scarce resources among

the competing components of AD,

i.e. consumers, producers, producers,

the government, and the foreign sector

 7. The Keynesian multiplier

IB Question
• Explain, with reference to the concepts of leakages (withdrawals) and injections, the nature and
importance of the Keynesian multiplier.
• Calculate the multiplier using either of the following formulae.
• Use the multiplier to calculate the effect on GDP of a change in an injection in investment,
government spending or exports.
• Draw a Keynesian AD/AS diagram to show the impact of the multiplier.

• Changes in any of the components of AD (e.g. investment) may have a larger effect on

GDP than just the value of the change. This is known as the multiplier effect. This is

because an injection of extra income leads to more spending, which creates more income,

and so on.

The Keynesian multiplier

It states that the change in income s a multiple of the change in any injection:

It follows that if any two terms are given you can solve for the third one.

In addition,

MPC is the additional spending on domestic goods from additional income. So, if you are told
that from an extra dollar (which has 100 cents) people spend 80 cents it follows that

It also follows that the remain in 20 cents were paid in tax saved and/ or spent but on imports.

The multiplier may therefore be written as:

MRT is the marginal tax rate (the extra tax paid out of an extra dollar earned), MPS is the
additional savings out of an additional dollar earned and MPM is the additional spending on

imports out of an additional dollar earned:

And MPW is the marginal propensity to withdraw, or

Continuing the previous example, if people are taxed 12 cents, save 3 cents and spend on

imports 5 cents out of each additional dollar earned then:

So that MPW = 0.20 (their sum).

The multiplier k is thus equal to:

Or using the MPW figure directly:

If the government increases spending by 150 billion, then national income will increase by

(5×150) =750 billion. Or if, for example, the government wants national income increase by 1.2

trillion then government expenditures should rise by

Key points--------------------------------------------------------------------------------------- -