The Aggregate Demand & Supply Model

Question 1

Define Aggregate Demand and list its components:

Answer 1

Aggregate Demand (AD) - the total demand for all goods and services in an economy
AD = C + I + G + (X-M)

Components of AD (types of spending):

• Consumption (C) - spending by consumers on durable/non-durable products
• Investment (I) - change in the capital stock of an economy (machinery etc)
• Government Spending (G) - gov spending on goods and services, not transfer payments
• Net Exports (X-M) - demand from overseas minus demand for foreign products

Question 2

Define Consumption and explain what it depends on: (7)

Answer 2

Consumption (C) - spending by consumers on durable/non-durable products
Depends on:
- The level of disposable income (ie after tax, social security): ↑Y ->↑C However it depends on ‘marginal propensity to consume’ (MPC) - the proportion of extra income ‘consumed’ = ∆C/∆Y
- The Price Level/Inflation: ↑PL ->↓Real Y ->↓C
- Population: ↑population -> ↑C (depends on the demographics - young people tend to spend more, older - save)
- The savings ratio: the % of people’s income they choose to save
- Interest rates: ↑i -> more expensive to borrow/greater incentive to save ->↓C
- Consumer confidence: if people expect the economy/their situation to worsen then they may ↓C to save for the future
- Wealth: the value of assets people own. The ‘wealth effect’ says when wealth increases so does C. This is because people feel ‘richer’ and more confident, so save less. It may also allow ‘equity release’ (second mortgage). The main asset people own is housing, so ↑house prices creates a wealth effect. The other asset many people own is shares (often via pension schemes) so a ‘stock market crash’ may cause a negative wealth effect

Question 3

Define Investment and explain what it depends on: (5)

Answer 3

Investment (I) - is a change in capital stock of an economy (eg machinery, equipment etc however it also includes stocks)
Depends on:
- Profit of firms: firms us retained profit for I. So more profit -> ↑I . However it depends on “marginal efficiency of capital” (MEC) - the annual profit from the I, divided by the initial cost, shown as percentage
- Interest rates: if i(rates) > MEC it makes no sense to invest, as if the firms borrow, the cost of borrowing is greater than the profit of I and if they have cash then the return on savings is greater than profit of I. So ↑i -> ↓I
- Business confidence: if firms are confident and expect a high return they are more likely to invest
- Changes in GDP/Y: if C (or X) increases, firms will need to ↑output to meet the extra demand. This may mean they invest. This is the “accelerator effect”: ∆I = a*∆Y, where a=accelerator (a constant)
- Cost and Efficiency of capital goods: the better the I is (cheaper ↑π) the more likely it will occur

Question 4

Define and explain Government spending

Answer 4

Government Spending (G) - gov spending on goods/services ... not transfer payments
G = Tax + Borrowing
In this model of the economy G is assumed to be independent of economic variables. It is determined by the political decisions of the government. Does not include transfer payments (benefits etc)

Question 5

Define and explain Net Exports

Answer 5

Net Exports (X-M) - demand from overseas minus demand for foreign products
↑value € ->↓Pm ->↑M ->↓(X-M)
↑value € ->↑Px ->↓X ->↓(X-M)

The level of Net Exports (NX) (X-M) is determined by:

• Exchange rate (value of 1 currency in terms of another): if a currency gets stronger it means a foreigner will have to pay more in their currency to buy the exported product, so demand falls and so does the value of exports. The reverse it true for imports (↑P€ -> more $ per € ->↓Pm); SPICED = WPIDEC
• Level of ‘protectionism’: trade barriers, such as tariffs, which discourage imports (but other countries will retaliate and so exports fall as well). Tariff - a tax on imported goods. Quota - a physical limit on the quantity of a good imported
• Relative economic growth: if your country has economic growth then people get rich so imports rise. If the RoW has economic growth exports rise. So if growth is faster than elsewhere Net X worsens (↓(X-M). This depends on the ‘marginal propensity to import’ - how much of any extra income is spent on imports
• Relative levels of inflation: if UK has inflation, prices rise, foreigners buy less, exports fall. If RoW has inflation, imports fall - So impact on Net X depends on relative UK inflation
• Non-Price Factors: price is not the only factor to consider when we X or M

Question 6

Explain the Multiplier Effect:

Answer 6

When one component of AD increases, AD as a whole increases by more than the value of the original increase. This is because one person’s spending is another person’s income. The multiplier is not infinite because we do not spend all of our extra income. Money we don’t spend goes into savings, tax and imports
multiplier = 1/(1-MPC)
MPC + MPW(Marginal Propensity to Withdraw) = 1
MPW = MPS(to save) + MRT(rates of tax) + MPM(to import)

Question 7

Define Aggregate Supply and the 2 different types of it

Answer 7

Aggregate Supply (AS) - the total supply of all goods and services in an economy. 
There are w different AS curves in the LR(LRAS) and in the SR(SRAS), where the SR is the period of time in which prices may vary, but the costs of FoPs (especially labour) are fixed

Question 8

Explain LRAS and shifts in it

Answer 8

The LRAS is perfectly inelastic. This is because in the LR all factor markets are in equilibrium and thus there is a set amount of labour etc employed. This set amount of labour can produce a set amount of output. This is sometimes called the full employment level of Y(Yfe)
Shifts in LRAS:
1. Increase in the quantity of labour/FoPs (immigration, change in retirement age, investment…)
2. Increase in quality/efficiency of labour/FoPs (better skills, new technologies, more competition…). These are usually linked to increased productivity

Question 9

Explain SRAS and shifts in it

Answer 9

The SRAS slopes upwards. This is because ↑real Y ->↑D labour (derived demand) ->↑W(op) ->↑costs of production -> ↑prices (ie PL)
BUT “↑W(op)” is overtime pay etc as in SR W is fixed
Shifts in SRAS:
Since we consider the costs of FoPs/labour fixed in the SR, any change in these costs can not be shown on the SRAS and we need a new SRAS
ie ↑costs of FoPs ->↓SRAS