3.2 Aggregate Demand & Aggregate Supply (components, determinants, shifts, alternative views, equillibrium) Flashcards
aggregate demand
value of total demand for all goods and services in the economy, per time period
reasons for inverse relationship between general price level and aggregate demand
- pigou wealth effect
- keynes’ interest rate effect
- Mundell - Flemmings exchange rate effect
pigou wealth effect
for any given nominal value of income, a lower price level enables households, firms and the government to have greater purchasing power
keynes interest rate effect
fall in general price level causes interest rates to drop, thus boosting the demand for money resulting in greater spending and investment
Mundell- Flemings exchange rate effect
as general price level falls, interest rates also tend to fall, resulting in depreciation of the exchange rate which increases demand for exports and decreases demand for imports
Mundell- Flemings exchange rate effect
as general price level falls, interest rates also tend to fall, resulting in depreciation of the exchange rate which increases demand for exports and decreases demand for imports
components of aggregate demand
- consumption expenditure
- investment expenditure
- government spending
- export earnings - import expenditure
- AD =C + I + G +(X-M)
net exports
measures the difference between the value of the country’s export earnings and import expenditure
difference between AD and GDP
AD = planned/ expected expenditure GDP = actual expenditure
determinants of consumption (AD)
- consumer confidence
- interest rates
- wealth
- income tax
- level of debt
- expectations of future price level
consumer confidence and AD
- more confident consumers = greater consumption level
- changes with business cycle
interest rates and AD
- higher interest rates = lower AD bc less demand for money + more saving, higher loan repayments = less disposable income for consumption and investment
- lower interest rates = demand for money increases
wealth and AD
positive correlation between household wealth and GDP
income and business tax and AD
- higher tax = less income available for consumption and investment
level of debt and AD
- high debt = less money for consumption and investment
expectatioons of future price level and AD
- expect prices to rise = increased AD and vice versa
determinants of investment (AD)
- interest rates
- business confidence
- technology
- business taxes
- level of corporate indebtedness
components of Aggregate demand
- consumption
- investment
- government spending
- net exports
determinants of net exports
- income of trading partners ( downturn in trading partners = fewer export sales and cheaper imports)
- exchange rates (high exchange rates increases demand for imports)
- Trade policies
Aggregate supply
- total amount of goods and services that firms within an economy are willing and able to supply at a given time and at an overall price level
- measures an economy’s potential output
SRAS curve
- total planed national output at different price levels
- holding productivity and costs of factor inputs constant
- relatively price elastic due to flexibility of raw materials and labour
determinants of SRAS
- costs of factors of production
2. indirect taxes
determinants of the costs of factors of production ( AS)
- labour costs
- raw material costs
- exchange rates (rise in exchange rate makes imports less expensive = lower cost of production)
- bureaucracy and admin ( strict policies decrease supply)
slope of the SRAS curve
- depends on degree of spare capacity in the economy
- steeper curve = few underutilized resources
- as national output expands and economy heads towards productive capacity, supply bottlenecks appear making SRAS more inelastic
monetarist/ new classical view of LRAS
- LRAS curve is vertical at the full employment level of output in the long run
- aggregate supply independent of price level in the long run ( perfectly inelastic)
- Any attempt to increase AD at LRAS is purely inflationary
Keynesian view of the LRAS curve
- 3 distinct sections owing to varying degrees of spare capacity in the economy
- argue that economy can be below full employment in the long run
- refer to keynes AS curve as “keynesian aggregate supply”
section 1 of the KAS curve
- AS is horizontal
- perfectly elastic due to plenty of spare capacity
- increase in AD has no inflationary effect
section 2 of KAS curve
- relatively price elastic due to pressure of scarce resources
- increase in general price level incentivizes more output as a whole
- slight inflationary effect
section 3 of KAS curve
- Vertical
- perfectly price inelastic
- no spare capacity in the economy
- any increase in AD is inflarionary
- full employment output
inflationary gap
- AKA positive output gap
- exists when national output exceeds full employment
- economy operates beyond the full employment level due to excess aggregate demand
- increases general price level
Deflationary gap
- AKA recessionary gap
- real national output equilibrium is below the full employment level of output
- actual growth is below trend rate of growth
- caused by low levels of aggregate demand
factors leading to Shifts of the AS curve in the long run
- changes in quantity/quality of the factors of production
- improvements in technology
- increase in efficiency
- change in institutions ( legal, financial, health, infrastructure, education, trade regulations)
Assumptions and implications of Keynesian Aggregate Supply
- assumes wage inflexibility
- implies the need for government intervention
assumptions and implications of the monetarist/ new classical LRAS model
- assumes natural unemployment
- LRE occurs at the full employment level of output
- assumes labour flexibility
- implies no need for government intervention
- implies some amount of unemployment is acceptable and inevitable
- implies supply-side policies are more effective and demand side are inflationary
Flaws of the LRAS model
- difficult to precisely measure the level of output
- impractical for every firm to operate at 100% capacity
- difficult to clearly determine number of people in natural unemployment
sticky downwards
a situation in which a variable is resistant to change, thereby reducing the effectiveness of the market
expansionary fiscal policy
tax cuts/ increased government spending to stimulate more economic spending
expansionary monetary policy
- lower interst rates to encorage consumption and investment
short run macroeconomic equilibrium
- SRAS = AD
- any change in AD or SRAS will change equilibrium position
- NOTE: consider price elasticity (AD change will have higher impact on price level if AS is price elastic)
macroeconomic equilibrium in the new classical model
- long run equilibrium occurs at full employment
- automatic adjustments of AD and AS forces restore equilibrium in the long run
- assumes prices and wages are flexible
- assumes economy will reach full employment in the long run
full employment
- all those who are willing and able to work at the prevailing market wage rate are able to find a job
- impossible to increase output as resources are fully utilized
- attempts to increase demand will be inflationary
- natural unemployment still present
components of natural unemployment
- frictional unemployment
- seasonal unemployment
- structural unemployment
process of restoring an inflationary gap to macro equilibrium
1) increase in AD increases general price level
2) increase in output beyond capacity puts strain on scarce resources
3) Increased production costs cause supply to decrease
4) supply decreases, increasing general price level, thereby reducing quantity demanded and restoring equilibrium
process of restoring deflationary gap to macro equilibrium
1) fall in AD reduces price level
2) Lower price level reduces production costs and labour costs over time
3) lower production costs increases AS and restores macro equilibrium
equilibrium in the Keynesian model
- economy can always maintain equilibrium at the full employment level
- persistent recessionary gaps as equilibrium level of output may not equal the full employment in the long run
- government intervention rewuired to prevent prolonged negative output gaps
- increases in AD do not necessarily cause inflation
