AD & AS Flashcards
National income
National income is the flow of new output produced by an economy in a particular time period. The flow of new output is real national income which comprises the actual goods and services produced. Nominal national income measures the flow of output at the current price level in the economy
The role of real national income as an indicator of economic growth
The level of real national income is an indicator of current living standards within the economy, and it’s rate of change measures the economic growth (or decline) in the economy. Actions, income = national output = national expenditure
The circular flow of income
Households supply labour and other factor services in exchange for goods and services produced by firms. These real flows generate money flows of income and expenditure. Not all income received by households is spent on consumption as some can be withdrawn as saving and investment can be injected into firms rather than spending all profit on income to the households. In an open economy, the withdrawals involve taxation and imports, injections involve gov expenditure and exports
Equilibrium national income
The level of income at which withdrawals from the circular flow of income equal injections into the flow. It is also the level of output at which AD equals AS. saving + taxation + imports=investment + gov expenditure + exports.
Full employment income
The level of income when the economy is producing on its production possibility frontier (PPF), with no spare capacity
The effect of savings in the circular flow model
Savings can be hoarded, meaning a fraction of income is not spent. This can lead to deficient AD in economy- too little demand to buy the output the economy is capable of producing. This is because they cannot sell some of the goods/services produced so firms reduce their output and national income falls. If savings are lent, for other firms and consumers to borrow and spend, planned saving may end up equalling planned investment and national income remains in equilibrium. However, as households and firms have different saving and investment decisions, there is no reason for planned saving to equate to planned investments
Aggregate Demand and Supply
AD- Total planned spending on real output in the economy at different price levels. C + I + G +(x-m)
AS- Level of real national output that producers are prepared to supply at different avg price levels. Upward slope explained by nature of firms: all firms aim to profit maximise, in short run the cost of producing extra units of output increases as firms produce more output.
Reflationary policies
Policies that increase aggregate demand with the intent to increase real output and employment
Factors that shift the AD and AS curve
If either AD or AS shift, there is a change in price levels. The AD curve will shift if there is a change in value of any components in ‘C + I + G +(x-m)’. This could be changes in gov spending, taxation, exchange rate, interest rates etc. The AS curve is constructed under the assumption that all determinants of AS other than price level remain unchanged. If these determinants change then AS will shift, such as changes in resource prices, wage costs, labour productivity, business taxes and subsidies, external shocks etc.
What causes a change in a nations potential GDP
Changes in labour supply available for production.
Changes in the stock of capital inputs
Changes in the efficiency of allocation of factor inputs
Advances in state tech
Improvements in institutions such as banking system
Shifts in the LRAS curve
An underlying rate of growth or trend growth rate is the long-run avg growth rate for a country over a period of time. This is determined by the same factors that determine the position of the PPF and position of LRAS curve. An increase in quantity of available factors of production including labour, and improvements in tech that increase productivity of labour, capital or land. These can shift the LRAS curve
Demand-side and supply-side economic shocks
A sudden unexpected event hitting the economy, disturbing either aggregate demand or aggregate supply. In some cases an outside shock may affect both, a good example would be covid which affect AS and for AD, the global financial crisis
The determinants of consumption
Interest rates- rewards savers for sacrificing consumption and the higher the interest the greater the reward, cost of borrowing also rises which reduces AD further.
Level of income- Keynes believed that as income rises while absolute consumption rises, consumption falls as a fraction of total income, while the fraction of savings increases. This can also involves expected future income.
Wealth- raising wealth can account for more savings as it is assets you own therefore people who are more wealthy tend to save less income and consume more.
Availability of credit- if available easily and cheaply, consumption increases as people supplement current income by borrowing on credit created by the banking system.
Consumer confidence- people’s views on expected income and changes in personal wealth. When consumer optimism rises, households tend to spend more and save less, gov try to boost consumer and business confidence to try raise economic growth. Fall in confidence could be expecting interest rates to fall so you wait and do not borrow to spend knowing the cost of borrowing may fall. Or expectations of future inflation
Determinants of saving
When consumers decide whether or not to spend they are also simultaneously deciding whether or not to spend so determinants of consumption are also determinants of saving. Ignoring taxation and spending on imports, Savings = Income - Consumption.
The determinants of investment
Relative prices of capital and labour- when price of capital rises or interest rates rise, in the long run firms adopt more labour intensive methods of production, substituting labour for capital which reduces investment, opposite if capital prices fall or interest rates fall.
Nature of technical progress- technical progress can make machinery out of date and firms may have to replace it early, before the end of its technical life.
Supply of investment funds- banks have been criticised for favouring short-term investments while firms investing in fixed capital goods need long term investments that yield most of their expected income several years into the future, gov may also help, with less supply from financial institutions, they are likely to supply less
The accelerator process
A change in the level of investment in new capital goods induced by a change in national income or output. The size of the accelerator depends on the economy’s capital-output ratio
AD and economic activity
Economic activity is the production and consumption of goods and services together with the employment of labour, capital and other inputs that produce output. When AD rises and real output rises, firms generally have to employ more workers to produce additional output and the opposite means less labour is required
National income multiplier
Measures the relationship between an initial change in a component of AD, such as gov spending or private sector investment, and the resulting generally larger change in the level of national income.
Multiplier= change in national income/ initial change in gov spending.
Multiplier= 1/marginal propensity to save
Marginal propensity to consume and save
Consume- the fraction of any increase in income which people plan to spend on the consumption of domestically produced goods/services
Save- the fraction of any increase in income which people plan to save rather than spend
The value of a multiplier formula
1/(1-MPC) or 1/MPS
Determinants of short-run AS
Price levels and production costs: (rightward shifts)
A fall in businesses’s costs of production which includes costs of imported raw materials and energy.
A fall in unit labour costs, fall in wage costs or increase in labour productivity.
Reduction in indirect taxes such as VAT imposed on firms.
An increase in subsidies granted to firms by gov.
Technical progress which improves the quality and productivity of capital goods.
Leftward shift caused by the opposite of all these
Determinants of LRAS
Unlike short run, long run isn’t affected by price levels and is at the economy’s production potential. Involves:
The state of technical progress
The quantities of the factors of production in the economy
The mobility of the factors of production, particularly labour
Productivity of the factors of production
People’s incentive to work hard
Personal enterprise, emergence of a large number of risk taking entrepreneurs
Institutional structure of the economy
Normal capacity level of output
The level of output at which the full production potential of the economy is being used, located where the LRAS curve is
The importance of the institutional structure of the economy with AS
Involves factors like rule of law and efficiency of the banking system. Contract law is particularly important. If contracts are not legally enforceable, normal economic activity can break down, which shifts the position of the LRAS curve to the left. As the financial crisis and onward showed, the inability of the banking systems to provide finance also shifted the LRAS curve leftwards. Efficient contract law and banking system promotes long run economic growth and an outwards shift of the economy’s PPF and LRAS curve
Keynesian AS curve
An inverted L-shape of the AS curve. Keynes argued that a depressed economy can settle into an under-full-employment equilibrium, that without a purposeful intervention from the gov, an economy could display permanent demand deficiency. Market forces would fail to adjust automatically and achieve full employment. If the gov could shift AD right, the existence of spare capacity would lead to a growth in real output without an increase in price level, and eventually the LRAS becomes vertical when normal capacity is achieved.
Open and Closed economy
Closed- an economy with no international trade
Open- an economy open to international trade
Saving
Income which is not spent
Withdrawal
A leakage of income out of the circular flow, can be savings, taxation, imports
Investment
Total planned spending by firms on capital goods produced within the economy
Injection
Spending entering the circular flow can be through investment, government spending, exports
