Aggregate demand and supply analysis Flashcards
What is aggregate demand and supply analysis?
This is the main theory about how the economy works.
Define Aggregate Demand [4]
Aggregate demand refers to the total level of spending in the economy, and is made up of 4 main parts:
1 - Consumer expenditure (on goods and services)
2- Business investment expenditure
3-Government spending
4- (Exports) - (Imports)
Equation for AD
(Consumer Expenditure) + (Investment Expenditure) + (Gov Spending) + (Exports - Imports)
The AD Curve
This shows the relationship between the total level of spending in the economy and the rate of inflation.
The AD curve will be downwards sloping i.e. the lower inflation, the more goods and.services people will buy. There are 2 main reasons for this:
1- People will buy more goods if prices are lower - when inflation os low - people can afford to buy more therefore spending within the economy will increase
2- If prices and inflation are low in this country, it means for foreigners, our goods and services will be cheaper to buy, meaning exports will increase. (And imports will likely decrease)
Changes in AD. (Aggregate demand and supply analysis)
If theres a change in any of the factors, which influences any of the components of AD, that will lead to a parallel shift in the position of the AD Curve.
An increase In AD, for example the government has reduced taxes, will shift the AD curve outwards.
A decrease in AD, for example a recession, will lead to an inwards shift of the curve.
Define Aggregate Supply [3]
Aggregate supply refers to the total output the economy is producing. This is influenced by 3 main factors:
1)Quantity of resources that we have available within the economy e.g. Workforce
2- The quality of resources available to the economy e.g. education, skills, technology
3 - How well we use those resources - largely down to entrepreneurs and management
What is the full employment level of output? (Aggregate demand and supply analysis)
This refers to the maximum output the economy could produce if it is making full use of its resources, and is on its PPF (Where the LRAS curve is first vertical)
The aggregate supply curve
This will show the relationship between output and inflation in the economy. There are two views on the AS curve
1- The Keynesian view (In AS macro as LRAS curve) - Keynesian economists believe the AS curve is divided into 3 main parts:
a) Horizontal line(Real output increases without affecting inflation)
b) Curve (Both inflation and real output change)
c) Vertical line (Inflation increases)
2 - The Monetarist view - vertical - any changes the gov makes will lead to higher inflation
Changes in LRAS (Aggregate demand and supply analysis)
If theres a change in any of the factors which influences the output in the economy
Example - an increase in resources in the economy would increase FE level of output, causing an outwards shift , and the opposite would happen if theres a decline in resources (curve shifts left and right)
If theres a change in businesses costs, for example wages have increased
2-Example - More expensive to produce their output, they will have to increase their prices shifting the curve up. A fall in costs will do the opposite.
Equilibrium output (Aggregate demand and supply analysis)
This is where the level of output that the economy produces depends upon the level of spending. i.e. businesses will not produce anything unless they think they can sell it. Therefore, the economy will be in equilibrium where the level of AD is exactly equal to the level of AS. The point for Keynesian economists is that this can occur at any level of output, and theres no guarantee that it will operate at full employment.
Using the LRAS graph we can show that AD can cross well below full employment, at full employment and even above, at which inflation will increase.
Ideally, the government wants spending to be in between where the LRAS curve first curves up and where full employment first hits, and Keynesian economists believe the government should use their fiscal and monetary policies to try and keep spending as close to this point as possible.
Fiscal policy
Involves the use of taxes and government spending
Monetary policy
Involves interest rates
What should the government do (Keynesian) if the economy at AD is in a recession?
Reduce interest rates to encourage spending
Reduce taxes to increase what households have available to spend
Increase Government spending
The effects of changes in AD
The effects of changes in AD and AS in the economy will largely depend on the previous position of the economy.
Suppose spending is initially low, the economy is in a recession. Unemployment will be high and there will be a lot of spare capacity. In this case, an increase in spending will only increase output, and businesses will have no problem keeping up with demand, it should have no effect on inflation.
However if spending (AD) is already at FE, an increase in spending will create difficulties as businesses will not as easily be able to increase demand without offering higher wages, and inflation will increase.
The effects of changes in AS
Again, the effects depend upon the previous position of the economy.
If already at full employment, an increase will be beneficial and lower inflation, but a decrease will increase inflation and real output will fall.
