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
