Aggregate Demand And Supply Flashcards
What does aggregate mean
Added together, the individual elements that were introduced in microeconomics are totalled in macroeconomics.
Aggregate demand (AD) and aggregate supply (AS) analysis brings what together?
Brings together the amount that consumers wish to consume and firms wish to produce at any price level.
The equilibrium point where AD meets AS determines…
The average price level and the equilibrium real output level. The price level can be measured by a price index such as the CPI and the output by the real GDP.
Define aggregate demand
Aggregate demand (AD) is the total planned expenditure on goods and services produced in an economy over a period of time.
Define aggregate supply
Aggregate supply (AS) is the total planned output of goods and services in an economy over a period of time.
What does aggregate demand comprise of
Aggregate demand comprises of consumption (C), investment(I), government expenditure (G), and exports (X) minus imports (M)
What’s the formula for AD
AD = C + I + G + (X - M)
When the price level falls, the level of AD expands along the AD curve; when price level rises, the AD contracts.
What’s a common misunderstanding to do with why the AD curve is downwards sloping
The curve Is downwards sloping but NOT because people buy more when they are cheaper.
Tell me a reason why the AD curve is downwards sloping to do with lower prices and competitiveness
Lower prices in an economy mean increases international competitiveness, so there are more exports and fewer imports. In other words, net exports are higher at lower prices.
Tell me a way to explain why the AD curve is downwards sloping to do with the real balance effect
Total expenditure by the economy remains much the same along the AD curve. For example, when there is a fall in the price level, people still spend approximately the same amount but they buy a larger amount of goods and services. This is called the real balance effect.
Tell me a way to explain the downward sloping AD curve to do with higher price levels
At higher price levels, interest rates are likely to be raised by the monetary authorities. This means that investment - a component of AD - falls and savings might increase.
What is the main component of AD
Consumption, approximately 60%
What is consumption
Consumption is equal to spending by households on goods and services, it comprises approximately 60% of AD.
It measures the amount that consumers wish to spend at various price levels. If you ignore tax and spending on imports, a persons income is either spent (C) or saved (S). The higher the income after tax (disposable income), the more people are likely to spend, but they might spend at a slower rate as they earn more I.e - people tend to save a higher proportion of their income as their income rises.
What are the key factors that affect consumption (spend rather than save)
Amount of disposable income
Consumer confidence
Interest rates
The housing market
What’s a determinant of consumption to do with disposable income
The higher the income after tax (disposable income), the more people are likely to spend, but they might spend at a slower rate as they earn more - I.e people tend to save a higher proportion of their income as income rises.
Tell me about a determinant of consumption to do with confidence
The more people feel they need to save, the less they spend, or vice versa. One of the key determinants of consumption is confidence of the consumer. Confidence is influenced by factors such as job security and future income prospects. If consumers are feeling confident, they are more likely to make large purchases that they can pay for in the future.
Tell me about the determinant of consumption: interest rates
Higher interest rates not only leave consumers with less spending money after mortgage payments on house purchases, but they also increase the cost of borrowing.
Tell me how the housing market is a determinant of consumption
When house prices accelerate upwards, home owners can extract more equity from their houses. (Wealth effect will later be discussed dw 🐷)
There is generally a positive correlation between the growth in consumer spending and
The growth in real output
Tell me about investment as a component of AD
Investment is an increase in the capital stock. It means creating assets that will generate income in the future rather than in the immediate term. Investment firms around 10-15% of AD, but the figure depends on whether you are considering gross or net investment.
What is gross investment
Gross investment is the total amount of investment before any account is taken of depreciation of assets. Capital loses value as it wears out or becomes less efficient. Many machines become totally redundant as new methods of production are invented and the investment in these machines does not have any long term benefit on the economy.
What is net investment
It takes account of the fall in value of capital assets. It is more significant for changes in the productivity of an economy and its productive potential.
List the factors that influence the amount of investment
Interest rates
Profits of businesses
Taxation
Government policy
Exchange rate
Access to credit
New technology
Business confidence
How are interest rates a factor that influences investment
An inverse relationship between interest rates and the level of investment would be expected. This is because increases in the capital stock have to be financed and there is an opportunity cost to that finance. Firms often borrow from banks to finance investment, so if interest rates rise, the cost of borrowing rises and firms are less likely to borrow and therefore less likely to invest. The prospects for future interest rates may be more significant than the current rate of interest and many firms watch closely the decisions on interest rates made by the Monetary Policy Committee. However, some argue that the interest elasticity of demand for investment is very low because other factors are much more significant.
Tell me how profits of businesses is a factor that influences investment
Many businesses finance their investment from retained profits, i.e profits made in the past which have not been distributed to shareholders. If businesses have little retained profit then investment may be limited.
Tell me how taxation is a factor that influences investment
Linked with profits of businesses, is the corporation tax rate (tax of company profits). If this is high, then this might limit the funds which companies have available for investment. In 2018, corporation tax rates ranged from 8.5% in Switzerland to 30% in OECD countries. The Uks rate was 19% for the tax year 2019 - 2020.
Tell me how government policy is a factor that influences investment
If the government is following a reflationary economic policy, for example by increasing government expenditure and cutting taxes, then consumer spending will be rising and this could stimulate investment.
Tell me how the exchange rate is a factor that influences investment
A low exchange rate would make a country’s exports more competitive and so lead to an increase in demand for them. This could encourage firms to increase investment because the prospect of making profits will have increased.
Tell me how access to credit is a factor that influences investment
How keen banks are to lend and what conditions they apply to loans may have a significant impact on the ability of firms to invest.
Tell me how new technology is a factor that influences investment
If there are new technological developments which could increase productivity and reduce unit costs, then firms in that market will have a great incentive to invest.
Tell me how business confidence is a factor that influences investment
Investors are driven by factors that are likely to determine future sales. Anything that improves confidence in future sales patterns is likely to lead to a rise in investment. The indicators of this are changes in the rate of economic growth, business expectations, what their main competitors are doing, and government incentives and regulations.
How can decisions on investment be explained by a kind of irrational behaviour of humans keen to make profit or avoid losses
It was described by Keynes as animal spirits.
Keynes believed that it was not rational thinking that made people invest or sell in capital and stocks markets. Instead, there is an animal or herd instinct. A rational person would sell when prices are high and make a profit. However, Keynes stated that our irrational instincts mean we buy when we see prices are rising. We sell when prices fall because, in a state of panic, we want to avoid further losses. This behaviour explains the enormous volatility in asset priced and means that investment of all kinds tends to exaggerate trends in the business cycle. This causes bubbles (which, by their nature, burst) and means that governments would do well to intervene to try to stop the extremities that occur when markets are left to their own devices.
When was Keynes an influential commentator on economic issues
Throughout and between the world wars, and in particular through the Wall Street Crash of 1929 and the Great Depression that followed. His ideas provide an opposing view to the classical school, where humans behaviour is deemed to be rational, markets are best left to themselves (laissez faire) and governments have no discretionary or determining role in the level of AD.
Define animal spirits
The forces that make markets move in large booms and busts, as people buy and sell impulsively rather than calmly, using purely rational behaviour.
What circular relationship can be analysed using the accelerator to do with investment
A change in investment changes the level of AD, but a change in AD also changes the level of investment. This circular relationship can be analysed using the accelerator and, although this is not required knowledge for the exam, and it is a useful way of evaluating the role of investment.
How important is government expenditure (G) in the UK and AD
Government expenditure in the UK comprises over 40% of all spending in the economy, totalling about £590 billion. However, as a component of AD it accounts for only around 25% because a large part of government expenditure is paid out as transfer payments, which are really a movement of spending power from taxpayers to other consumers (so features as consumption)
What’s the main influence on government spending
The trade cycle. In a boom or period of high economic growth, government expenditure is likely to fall as there is less demand for social benefits to low income groups. Revenue from taxation is likely to rise too, so the government is expected to be able to run a budget (or fiscal) surplus during a boom.
What’s the budget
Government spending does not need to equal tax revenue and the difference between them is known as a budget or (fiscal) deficit or surplus. The government can deliberately manipulate AD by overspending (running a budget deficit) when there is a slowdown in the economy, and vice versa in a boom. This discretionary fiscal policy is seen by many Keynesians as a way to prevent AD from collapsing in a recession.
What may fiscal policy be used for
Discretionary fiscal policy is seen by many Keynesians as a way to prevent AD from collapsing in a recession. Fiscal policy may also be used to prevent bubbles in growth and markets from getting too big. Taxing more heavily in times of abundance is a useful way to put the brakes on the economy. Similarly, government spending can be increased and/or taxes cut in a recession. However, sometimes governments miscalculate the start of a downturn and cut taxes too early.
How can the debt influence government expenditure
The national debt can affect G, which is the total amount of the governments outstanding debt. Governments hope that the budget will balance over the course of the economic cycle for current spending at least (not investment), otherwise the government will accrue national debt. Interest payments have to be made on this and if the government continues to overspend there will be a cost for future generations.
What’s the Keynesian view on fiscal policy
The Keynesian view is that fiscal policy is a powerful tool in shifting AD, made much more effective by the working of the multiplier.
In contrast, the Classical economists view is that overspending by the government has a similar effect to printing more money - it is purely inflationary.
What is the consensus on deliberate fiscal manipulation
There is some consensus that deliberate fiscal manipulation has a short run impact, but only if wage demands and other cost pressures are kept in check. Until the credit crunch and recession hit the economy in general in 2008, there was much consensus that it is only really through supply side policies that long term improvements in equilibrium employment will be achieved, as the AS curve shifts to the right. With the prospect of a repeat of the economic depression that followed the 1929 crash, Keynesian expansionary budgets again became popular. As Keynes would say, ‘in the long run we are all dead’: that is by the time the unemployed become employable, they will be past employment age, and sometimes the government must not sit by and let the economy go into a deep slump, but instead stimulate the circular flow through fiscal policy.
A loose or expansionary fiscal policy means
Government spending is greater than taxation. This might mean an increase in government spending or a reduction in taxation, or that government spending is rising more quickly than taxation.
Define fiscal policy
The deliberate manipulation of government spending and taxation in order to influence the level of AD in the economy.
Tell me about Net trade (X -M) as a component of AD
Exports represent an injection into the circular flow of income, in that the money paid for goods and services abroad enters the domestic flow of income. Imports mean that there is an outflow of money. Exports minus imports gives the total movement of funds, known as net exports. (If the value of imports is greater than the value of exports, this will be a negative figure, as in the UK). There are several reasons why the value of net exports might change.
Tell factors that may influence Net trade (X - M)
Changes in real income
Changes in the exchange rate
Changes in the global economy
The degree of protectionism
Non-price factors
Tell me how changes in real incomes influences net trade (X-M)
This is an important factor influencing net exports. For example, if real incomes are rising more rapidly in the UK than in other countries then there is likely to be an increase in consumer expenditure, some of which will be spent on imports. This would result in a deterioration in net exports.
Tell me how changes in the exchange rate influences net trade (X-M)
If this increases in value against another currencies, imports become cheaper and exports more expensive on world markets. Over time, people respond to these relative price movements and the demand for exports falls and the demand for imports rises. A stronger currency worsen net exports, whereas a weaker currency improves the figure. However, in the short run the price elasticity of demand for exports and imports tends to be low. This may be because contracts have to be signed for specific deals in international trade or because the traded components are a small percentage of firms overall costs. For example, an Italian importer of BMW minis will agree a price in advance of delivery from the UK. If the pound gets stronger against the euro, the price of the cars remains as per contract. Price elasticity of demand may also be low because of a lack of available substitutes, as in the case of oil. Owing to the low price elasticity of demand for exports and imports, the initial impact of a change in the exchange rate may be the opposite of the one described above.
Tell me how changes in the global economy influences net trade (X-M)
For example, if there is a recession in the USA but the UK does not suffer a slowdown, the USA will buy fewer exports from the uk and will attempt to export more. Similarly, if the rate of inflation is higher in the uk than it’s major competitors, net exports from the uk will worsen as uk goods become increasingly uncompetitive. A collapse in a stock market in another part of the world may also have direct effects on UK exports via wealth effects.
Tell me how the degree of protectionism influences net trade (X-M)
For example, if the USA imposes tariffs on uk steel then there will be a fall in exports and the net exports will fall.
Tell me how non price factors influences net trade (X-M)
Non price factors, such as quality and after-sales service, are major determinants of exports. Germany, for example, cannot compete effectively on price, but the value of its exports exceeds that of many other countries because of high quality and design of its manufactured goods.
What happens to AD when imports fall
The curve shifts to the right, as when any of the components of AD rises.
A useful evaluation point, is wise to consider that the changes involved with AD shifting involves levels rather than rates. In the UK these components do not usually fall, but they may rise more slowly during an economic slowdown. This means that the AD curve will still shift to the right but by increasingly smaller amounts.
What is aggregate supply
Aggregate supply (AS) is the amount that firms are willing to produce at various price levels. It is largely influenced by productivity, which in turn is influenced by factors such as the costs of production, the level of investment, the availability and efficiency of factors of production and supply side policies.
When does a movement along the AS curve occur
There is a movement along the AS curve when the average price level changes. For example, if AD shifts to the right and the AS curve is relatively elastic, firms will be willing to produce more at the higher price level.
When will the whole AS curve shift
The AS curve will shift if there is a change in the costs of production faced by all firms. This might be because there is a change in the cost of raw materials, wages exchange rates, indirect tax rates (short run) or changes in productive potential, for example because there are new fertilisers to make land more productive, workers are better educated, there is improved technology or there is investment in efficient capital assets (long run)
What does SRAS stand for
Short-run aggregate supply
What does the SRAS curve look like
Shows that in the short run, when price level rises, the level of AS expands along the SRAS curve, and when the price level falls, the level of SRAS contracts. It’s a straight line like the normal supply curve from theme 1.
When do shifts in aggregate supply generally occur
They occur when factors change that affect most firms. In the short run these changes simply affect firms costs of production and not the amount that they are willing and able to produce.
Short run shifts are often called external shocks and causes SRAS to shift up or down rather than right or left (which indicates a change in capacity)
Short run supply shifts are often called what?
External shocks
List me causes of short run aggregate supply shifts
Changes in the cost of raw materials and energy
Changes in exchange rates
Changes in tax rates
These factors might relate specifically to the cost of workers (labour market) or the way in which firms compete (product market)
Tell me how changes in costs of raw materials and energy may cause a shift in the SRAS curve
In a developed country like the UK, most raw materials are imported and, if global supply increases, or global demand falls, costs of production to uk firms will fall. In contrast, if there is a global increase in the price of oil then this causes the costs of production to increase in the UK because oil is major production cost to almost all UK firms.
Tell me how changes in exchange rates may cause a shift in the SRAS curve
If the euro falls in value relative to the pound, many costs will fall in the uk, meaning the SRAS in the UK will increase (shift to the right)
Tell me how changes in tax rates may cause a shift in the SRAS curve
If there is an increase in indirect taxes, there will be an increase in costs for almost all firms in the UK. A rise in employers national insurance contributions, for example, is likely to cause all prices to increase as firms try to pass on these extra costs to the consumer. An increase in taxes will, therefore, cause a decrease in SRAS, i.e push it upwards/leftwards. By contrast, a cut in the tax on petrol prices causes an increase in SRAS.
What are the two views on the long run aggregate supply curve (LRAS)
There are two views of AS, the Classical view and the Keynesian view
Tell me about the Classical view of LRAS
The Classical view is that in the long run an economy will operate at full capacity and there will be no unemployed resources in the economy, I.e the LRAS curve is vertical. If there are any unemployed resources, the prices of these factors will fall until the surplus disappears.
Tell me about the Keynesian view of LRAS
The Keynesian view is that the equilibrium level of output can occur below the full employment level of output. According to this view, the AS curve has a backward bending L shape, with three distinct sections: spare capacity, bottlenecks and full capacity. The assumption behind this analysis is that an economy can be at equilibrium when it is not at full employment. In other words, demand deficiency may mean that unemployed resources such as labour will not find work if the economy is left to its own devices.
Explain to me the shape of the Keynesian LRAS curve - looks like a backwards L
At the section to the left, where the line is horizontal, there is spare capacity. So the economy can output without any cost pressures. This is because there are unused resources such as factories not working at full capacity or unemployed labour. In this section of the curve, AD may shift to the right, eg through fiscal policy, and equilibrium real output would increase without causing an increase in the price level. The next section is where the line starts to go from horizontal towards vertical but is not vertical yet. It is known as the bottleneck section, where some constrictions in the supply chain cause cost and wage pressures to build up in some areas of the economy. This usually involves a shortage of a particular type of labour which would case a rise in wages. An example concerns the limited availability of construction workers associated with the High Speed (HS2) rail link. If AD expands in this section of the graph, then although the economy will still grow, there will be some inflation. This occurs because the construction companies will have to raise wages in order to attract enough workers with the appropriate skills from other occupations. Where the LRAS becomes vertical, towards the right of the diagram, there is full capacity in the economy. All resources, including labour, are fully employed. Therefore, if a firm wants to take on more workers it will have to entice them away from other jobs by offering higher wages. In this section if the diagram, if AD increases, although in the short run there may be some extra spending, the long term effect will be increased inflation and no increased output.
According to the Classical view, this last vertical section is the only part of the AS curve that occurs. The economy cannot be in equilibrium while there is unemployment. So, if unemployment does exist, it can only result from a short run failure of the market or from mismanagement by the government.
Tell me the factors that influence the LRAS in the labour market (would cause a rightward shift)
Changes in relative productivity
Changes in education and skills
Demographic changes and migration
Health spending increases
Tell me the factors that influence the LRAS in the product market
Technological advances
Changes in government regulation
Competition policy and reduction in barriers to international trade.
In the labour market, tell me how the following factor influences the LRAS: changes in relative productivity
Productivity is output per unit of input and, if it increases relative to a country’s main trading partners, the productivity gap is said to be closing. For example, the gap is currently closing between the UK and France, so although the uk has lower productivity than France, it’s productivity is increasing over time. This means that the costs of production are becoming relatively less expensive in the uk compared to France. However, the gap is widening between the uk and the rest of its partners. An increase in productivity may cause a rightward shift in the LRAS.
In the labour market, tell me how the following factor influences the LRAS: changes in education and training
Increased spending on education and training should mean that a country’s workforce can produce more output per worker. Education increases the value of potential output. However, not all education achieves this end. It is not clear that a BA in Madonna Studies or a BSc In surf science has a major impact on costs of production in the uk.
In the labour market, tell me how the following factor influences the LRAS: demographic changes and migration
A decreasing birth rate and increasing life expectancy in the UK will have a long lasting impact on the labour force, and changes in the supply of labour shift the LRAS curve as the costs and quality of labour change. The UK population has been rising - it was approximately 67 million in 2018, an increase of over 9 million since 2000. Just over half of this increase in population is explained through net migration, I.e. more people have come to live in the uk than have left it. The extent to which migrants impact on the labour force determines whether firms costs will change as a whole.
In the labour market, tell me how the following factor influences the LRAS: health spending increases
An increase in resources in the health sector should mean that workers have fewer days off sick and are active for longer - often beyond traditional retirement ages. However, spending on health might be absorbed into wage increases for staff in the health service, which would have little overall effect on the level of healthcare. Similarly, the majority of healthcare spending goes on the elderly or very young, neither of which are economically active.
In the product market, a rightward (or downward) shift in the AS curve could occur in the following ways, list them
Technological advances
Changes in government regulation
Competition policy and reduction in barriers to international trade
In the product market, tell me how the following factor influences/ can cause a shift in the LRAS curve: technological advances
Innovation and investment in new ideas tend to reduce costs for all firms. For example, widespread access to the internet increases competition among firms and means that firms can be more streamlined. Buying a book, for example, is now much cheaper online because there are fewer expensive outlets to maintain.
In the product market, tell me how the following factor influences the LRAS: changes in government regulation
There are many regulations in the UK economy that have been imposed to try to maintain a disciplined economy, such as the postal and telecommunications services. However, such industries have been increasingly deregulated over the past two decades to increase competition, which in turn imposes its own form of discipline. The net effect is that parcel postage and phone services - costs faced by all firms - have reduced in real terms, shifting the AS to the right (or down)
In the Product market, tell me how the following factor influences the LRAS: competition policy and reduction in barriers to international trade
As a country opens up to more trade, competition drives down prices and inefficient domestic firms give way to overseas firms with a comparative advantage. Therefore, as globalisation develops, AS increases.
Why do shifts in the SRAS curve occur
Because there is a change in costs of production, but the overall productive capacity remains unchanged. The short run means that there is at least one fixed factor and firms cannot change their overall output unless the factors of production are variable. So short run changes in AS might feed through to long term changes.
What does LRAS show
It shows the productive potential of firms when all factors are variable. In the long run, the ability of an economy to produce goods and services to meet demand is based on the state of production technology, the country’s infrastructure and the quantity and quality of factors of production such as labour.
Short run ‘supply side shocks’ cause a shift in….
The SRAS curve. Examples include changes in the price of oil or exchange rates.
Changes in the quantity or quality of factors of production feed through into a shift in the…
LRAS curve.
What is AD
The total amount that is planned to be spent in an economy at any price level
What is AS
The output that all firms are willing to supply at any price level
What is equilibrium real output and price level
It occurs where AD meets AS
What are the components of AD
C + I + G + (X - M) and a change in any one of these will shift the AD curve, with multiplier effects.
If AD increases, the price level is likely to…
rise and output may rise, depending on the price elasticity of the the AS curve.
Increases in AS tend to…
lower prices or curb rises in prices. Real output is likely to increase, although this depends on the elasticities where the AD and AS curves cross.
When house prices rise, is AD likely to rise or fall
AD tends to rise because of the wealth effect
Identify four factors that could cause a fall in investment
A fall in investment may be caused by a fall in business confidence, eg if there are expectations that the economy is going to slow down, a rise in interest rates (because this makes borrowing more expensive); a fall in profits (because firms will have less money available for investment); and an increase in the value of the pound against other currencies (because this will make exports more expensive)
How would an increase in the UKs trade deficit affect the AD curve
It would cause the AD curve to shift to the left
Do all economists draw the AS curve as upward sloping
No, if there is no spare capacity in the economy, the AS curve will be vertical, and classical economists draw the AS curve as entirely vertical in the long run situation. Keynesians draw the AS curve as a combination of horizontal (spare capacity), upward sloping (some bottlenecks) and vertical (full capacity).
