L8 - Aggregate Demand Flashcards
What causes AE to shift?
- Price
- Net Exports
What is Keynes view on Consumption?
Consumption depends on level of disposable income
What is Friedman’s and Modigliani’s view on consumption?
Friedman’s permanent income hypothesis
Modligliani’s life time income (spending changes based on age)
What is the link between changes in private consumption and the price level?
The link between these changes is Non-bank private sector (NBPS) wealth
What is NBPS wealth?
NBPS Wealth consists of cash,bank deposits and bonds which are denominated in money terms
What is wealth denoted as?
A
That’s it
What happens to real wealth as prices rise?
Real Wealth falls
As measured by A/P
Rise in prices reduce real value of assets
What is Insider Wealth?
• Some nbps wealth is inside wealth; i.e. an asset issued by an agent in the private sector (say a firm) and held by another agent (say a household) in the same sector.
- Rise in P raises the real wealth of the bond-issuer, who will have to part with less purchasing power when the bond is redeemed;
- Lowers the real value to the bond holder who receives less in real terms on redemption
- If both issuer and holder are in the same (private) sector then the effect on nbps wealth is zero
What is Outsider Wealth?
- Outside wealth is where assets are held by agents in private sector of the domestic economy but issued by those from outside that sector i.e Government sector or overseas sector
- no offsetting within-sector effects, so a rise in P does reduce the real outside wealth of the nbps
Assume all NBPS Wealth to be Outside wealth
What is the modified consumption function including the real wealth ratio (A/P)
C=f(Yd,A/P)
What happens if P rises within the Income Expenditure diagram?
As P rises, for a given stock of nominal outside wealth (A), real wealth will fall and C will fall, which will lead to a fall in the AE-line.
SHOWN IN DIAGRAM
What happens if P falls within the Income Expenditure Diagram?
As P falls, for a given A, (A/P) will rise and C will rise, shifting the AE-line upwards.
How can Net Exports shift AE?
When the domestic price level (P) falls, domestically produced goods become cheaper compared to foreign goods, whose prices (P*) are assumed to be unchanged
Change in relative prices causes domestic consumers to increase their purchases of domestically produced goods and to reduce their purchases of foreign goods (assuming a constant exchange rate)
Leads to both the NX-line and the AE-line shifting up
SHOWN IN DIAGRAM
What is the total effect of a change in P on AE?
The total effect of a rise (fall) in P on AE is to reduce (raise) consumption via the fall (rise) in nbps outside wealth and to reduce (increase) NX as domestic competitiveness declines (improves)
Both of these effects operate in the same direction and so a rise (fall) in P leads to a fall (rise) in AE and a shift down (up) in the desired expenditure schedule, from AE0 to AE1
How do you derive the AD Diagram?
The summing of points of the equilibrium on the AE line.
DIAGRAM ON NOTES
What does it mean if there are points to the left of the Aggregate Demand Curve?
Points to the left of the AD curve show combinations of P and GDP where AE>Y;
thus there is pressure on Y to rise because firms could sell more than current
output
DIAGRAM ON NOTES
What does it mean if there are points to the right of the Aggregate Demand Curve?
Points to the right of AD show combinations of P and GDP where AE
What are shifts in AD caused by?
caused by changes in any variables other than P, that shift the AE-line
i.e. autonomous consumption (a), taxation (t0), net exports (x0), or investment (I), government spending (G), the rate of interest (r), the exchange rate or foreign price level (P*E)
Any variable which shifts AE up, will shift AD to the right; and any variable which shifts AE down, will shift AD to the left
How does AD and the Multiplier interact?
multiplier measures the magnitude of the change in ‘equilibrium’ GDP in response to a change in autonomous spending at a given price level
context of the AD-curve this same magnitude is measured by the horizontal shift of the AD curve
Just causes shifts in AD
DIAGRAM ON NOTES
What is Aggregate Supply?
Total output of goods and services that firms wish to produce, assuming they can sell all they wish to sell at the going price level.
What is SRAS?
SRAS shows desired quantity firms wish to produce based on assumption all input prices remain constant
What is LRAS?
LRAS is the desired quantity firms wish to produce after price level and input prices fully adjusted to any demand shock
What are the factors determining AS?
Output prices,
- wage rates,
- other input costs, such as oil and raw materials
- productivity of labour
- Wage costs will depend, in part, on the general level of employment
What does the slope of the AS curve depend on?
- How production costs are related to output
- How goods prices and output are related
What’s the Problem of Supply and Demand Analysis?
Labour market NOT a perfectly competitive market, but rather a market where bargaining takes place. Thus the standard demand and supply framework is not an appropriate tool of analysis.
