Chapter 8 - Theory of Aggregate Demand and Aggregate Supply Flashcards
Define Aggregate demand (AD)
Aggregate demand is the total demand by households, firms, government and foreign sectors for the final goods and services that is domestically produced in the economy at various price levels.
It is the total value of goods and services demanded in an economy at a given price.
What are the components of AD?
- Consumption expenditure (C)
- Investment expenditure (I)
- Government expenditure (G)
- Net Exports (X-M)
- AD = C + I + G + (X-M)
Define consumption expenditure
Consumption expenditure is the total expenditure of households on final goods and services in the economy. It is part of the national income that is spent on consumer goods.
What are the determinants of consumption expenditure?
- Level of interest rates (i/r): lower cost of borrowing; savings become less attractive; opp cost of current consumption is lower -> encourage consumption
- Government policy & disposable income: policies that raise purchasing power (e.g. transfer payments and expansionary fiscal policy by lowering direct tax) encourage spending
- Accessibility of credit: higher access to credit, higher level of autonomous consumption; households tempted to spend
- Price expectations: expect future higher prices, spend more now, vice versa
- Savings: rise in savings lead to fall in consumption exp; sacrifice current consumption to save more (give income constant); periods of high economic uncertainty result in more people saving
What is investment expenditure?
Investment expenditure are expenditure on capital goods such as equipment, plants as well as additions to stocks of raw materials and intermediate goods.
What determines investment expenditure?
Generally, more profits means more investment
* Level of interest rates: lower of cost of borrowing raise investments; account for marginal efficiency of investments (MEI) (investments interest elastic/inelastic)
* Business expectations: Higher expected ROI, higher investment exp; optimistic about future; good/bad business sentiments
* Government policy: Policies that affects profits affects investment level (e.g. tax holidays, lowering corp tax raise profits and hence investment)
* Technological improvement: tech improvement lead to new production techniques which lowers COP and raise profits, hence investment rises too
* Changes in infrastructure: good infrastructure (like communication and transport network) lowers COP, raise profits and investment; provision of research facilities encourage local and foregin investments
Define government expenditure
Government expeniture is the amount of spending by the government on goods and services
What determines government expenditure?
It is affected by govt budget policies and not by changes in national income. It is assumed independent of changes in national income. It should not include expenditure on transfer payments (otherwise double counting)
What is export revenue?
Export revenue refers to revenue received from the sale of goods and services to trading partners
What are the determinants of export revenue?
- Trading partner’s real national income: when trading partner RNY increase, they will import more, which raise export revenue of domestic country
- Exchange rate: Depreciation of domestic currency makes it cheaper for trading partner to import, hence raise export revenue of domestic country (vice versa)
- Inflation rate: Inflation raises export price, assuming PED exports price elastic, there is fall in export revenue
What is import expenditure?
Import expenditure refers to expenditure incurred due to purchases of goods and services from a country’s trading partner
What are the determinants of import expenditure?
- Domestic real national income: when domestic incomes rise, more is spent on imports and import expenditure rise
- Exchange rate: Depreciation of domestic currency makes it more more expensive to import, people may turn to locally produced substitutes, import expenditure falls (assume PED imports elastic); net exports rise since export revenue rise at the same time
- Inflation rate: Inflation in domestic country makes price of imports relatively cheaper, hence demand for import rise and import exp rise; net exports fall as export rev. falling at the same time
What is aggregate supply (AS)?
Aggregate supply (AS) is the total output that firms in the economy are willing and able to supply at different price levels in a given time period.
It is the total value of goods and services produced in an economy at a given price level.
What are the 2 types of AS?
- Short-run AS: output which will be supplied at different price levels in a period of time
- Long-run AS: output which firms would produce after the price level adn factor prices have fully adjusted
What are the 3 ranges on the AS curve?
- Keynesian range: high level of unemployed resources where firms do not have to pay higher prices to compete for resources
- Intermediate range: less resources become available and shortages occur; firms need to offer higher prices to get more resources ➡️raises COP
- Classical range: all resources fully employed and firms cannot go on raising output; full employment level of national income Yf is reached
What are the types of factors that shift AS?
- Factors which affect COP: Shift AS curve up/downwards (Yf unchanged)
- Factors which affect productive capacity: Shift AS curve left/rightwards
What are the types of factors that shift AS?
- Factors which affect COP: Shift AS curve up/downwards (Yf unchanged)
- Factors which affect productive capacity: Shift AS curve left/rightwards
What are the factors which affect COP (SRAS)?
- Increases in the prices of factor inputs: higher factor price, higher COP
- Increases in wages: applies when wage costs are increased without a corresponding increase in productivity (affects productive capacity)
- Increase in indirect taxation: raise cost of supplying the good as fikrms have to consider tax (like GST) when supplying the goods
- Decrease in government subsidies: COP increase
What are the factors which affect productive capacity (LRAS)?
Increase in quantity and quality of FOP:
- Increase in quantity of labour: population size (birth rates, immigration and emigration); labour participation rate (women)
- Increase in quality of labour: level of knowledge and skill; productivity (e.g. foreign talent, higher education and retraining)
- Increase in quality of capital: facilitates growth; can be facilitated by increase in R&D to find cheaper and better methods of production
- Increase in quantity of capital: e.g. safe and positive business environment encourages investments; subsidies increase rate of capital formation
- Increase in quantity and quality of natural resources: e.g. discovery of new resource deposits
Level of technology: increase in application of new scientific knowledge in the form of inventions and innovations
How does productive capacticity affect COP?
Rise in productivity capacity would lead to fall in COP (note: productivity capacity can fall due to natural disasters etc.)
How does productive capacticity affect COP?
Rise in productivity capacity would lead to fall in COP (note: productivity capacity can fall due to natural disasters etc.)
How does COP affect productive capacity?
Changes in COP does not affect level of tech or quantity and quality of FOP (productive capacity)
What is the relationship between AS curve and PPC?
- Rise in productive capacity leads to rightward shift of PPC
- Changes in COP has no effect on PPC
What are withdrawals?
Leakages that goes out of circular flow of income e.g. Taxes, savings and imports
What are injections?
Additions of money to circular flow of income e.g. Government expenditure on Goods and Services, investment expenditure and export revenue
What is induced consumption?
Induced consumption refers to consumption induced or generated by changes in income
What are the assumptions of the multiplier process (to run its full impact)?
- General price levels are fixed
- Economy is able to meet any rise in expenditure
- Economy is operating at spare capacity on Keynesian range (otherwise damped multiplier)
What is the formula for multiplier process?
🔺Y = k🔺AD
What is the formula for size of multiplier k?
k = 1/(MPS+MPM+MPT) = 1/(1-MPC) = 1/MPW
Define marginal propensity to consume (MPC)
Marginal propensity to consume measures the extent of change in consumption due to a change in national income (aka induced consumption)
Define marginal propensity to save (MPS)
Marginal propensity to save measures the change in savings due to change in national income
Define marginal propensity to tax (MPT)
Marginal propensity to tax measures the change in tax revenue collected due to a change in national income
Define marginal propensity to import (MPM)
Marginal propensity to import measures the change in import expenditure due to a change in national income
Define marginal propensity to withdraw (MPW)
Marginal propensity to withdraw measures the change in all withdrawals in the economy due to a change in income, which is also the sum of MPS, MPT and MPM
