Aggregate demand and supply using models

1. Aggregate demand and supply using models

2. Learning Objectives • To understand the inverse relationship between AD and the price level • To understand the three reasons for the inverse relationship • To understand how AD is represented on a model • To understand what causes shifts in AD

3. Aggregate demand and the price level • AD curve shows an inverse relationship between the price level (inflation) and AD • In other words: Price level = AD • And Price level = AD • BUT the reasons are different to those for the relationship between demand for a product and price at the micro level, where a fall in price makes a product cheaper against other products

4. Aggregate demand and the price level Three reasons for the inverse relationship: • The wealth effect: • Wealth = a stock of assets e.g. property, shares and money held in savings accounts • Price level = wealth buys more goods & services = AD increases • Price level = reduces the purchasing power of wealth – wealth buys fewer goods & services = AD contracts

5. Aggregate demand and the price level Three reasons for the inverse relationship: 2. The rate of interest effect: • Price level = inflation. Bank of England will raise interest rates to reduce demand, as this reduces inflation (Higher interest rates = more incentive to save not spend & less disposable income if mortgage interest payments higher. Also increases cost of consumer credit) = AD contracts • Price level = no need to raise interest rates, so lower rates, therefore encouraging demand = AD increases

6. Aggregate demand and the price level Three reasons for the inverse relationship: 3. The international trade effect: • Price level = country’s products are more competitive overseas = exports rise & less demand for relatively more expensive imports = net exports increase = AD increases • Price level = country’s products are less competitive internationally = exports fall & demand for relatively cheaper imports increases = net exports fall = AD contracts

7. Summary: 3 reasons for inverse relationship of price level & AD • The WEALTH effect • The INTEREST RATE effect • The INTERNATIONAL TRADE effect

8. Aggregate demand Inverse relationship between AD / price level is shown on the model: AD curve slopes from left to right P1 – P2 (fall in price level) = Y1 – Y2 (increase in GDP

9. Shifts in Aggregate Demand • Any change in the price level causes a movement along the AD curve. • A shift in AD arises because of a change in one or more of the components of AD (C, I, G, X and/or M) and so could be caused by any of the factors which influence their level.

10. Shifts in Aggregate demand • An increase in AD shifts the curve to the right. • A decrease in AD shifts the curve to the left. AD – AD1 = decrease AD – AD2 = increase

11. Shifts in Aggregate demand • Rightward shift = firms produce more to meet demand = increase in actual output (real GDP) and so economic growth occurs AD – AD1 = decrease AD – AD2 = increase

12. Shifts in Aggregate demand • Leftward shift = firms produce less as reduced demand = decrease in actual output (real GDP) and so economic growth slows AD – AD1 = decrease AD – AD2 = increase

13. Causes of increases in AD • There are many (see your notes on components of AD), but for example: • Rising consumer expectations (optimism) • Reduction in income tax • Reduction in interest rates • Fall in exchange rate (boosting exports)

14. Causes of decreases in AD • There are many (see your notes on components of AD), but for example: • Negative consumer expectations (pessimism) • Increase in income tax • Increase in interest rates • Rise in exchange rate (making exports more expensive)

15. Consolidation questions • Answer the consolidation questions 1-6. • Complete the table looking at leakages and injections and the effect on national income. • Start a key terms list using the hand out. Fill in definition for the terms covered so far.

16. Aggregate Supply • The total output of goods and services that producers in an economy are willing and able to supply at a given price level in a given time period • A change in AS means that the total output that producers are willing and able to supply at any given price level alters

17. Aggregate Supply

18. Aggregate Supply • Why is the AS curve this shape? • Because it shows a positive relationship between the price level and output (real GDP). Less supplied at lower price level, more at higher price level.

19. Aggregate Supply • Low levels of output = unused resources (higher unemployment) = more output can be produced without inflationary pressure on prices. Supply is perfectly elastic = any amount can be supplied at the same price level. • As more resources are used and become scarcer, factor prices will start to rise and less output is possible. Supply becomes increasingly less responsive to the price level. • At full employment, no more output is possible. Supply becomes perfectly inelastic = no response of supply to a change in price level

20. Components of Aggregate Supply • Consumer goods • Capital goods – their use adds to capacity and increases economy’s ability to supply consumer goods in future • Public and merit goods – produced by private firms for supply to the public sector e.g. education, healthcare, pharmaceuticals, construction • Traded goods – goods for export

21. Aggregate Supply • Shifts of AS could be caused by: • Change in firms’ costs of production (important in the short run) • Change in quantity / quality of factors of production (important in the long run) due to: • Inflows / outflows of workers • Better training / education • Increased productivity of workers • More / less investment in capital goods • Improved technology • More enterprise

22. Macroeconomic equilibrium • Where AD = AS • The level of output and price level where there is no pressure to change within the economy Price Level AS PE AD YE Real GDP (Output)

23. Macroeconomic equilibrium • What happens if the macroeconomy is NOT in equilibrium? If AS > AD (AD = 0Y1 AS = 0Y2) firms have unsold stock & produce less. AS contracts & price level decreases so AD Increases. This continues until AD = AS at 0YE (output) and OPE (price level) Price Level AS P PE AD 0 Y1 YE Y2 Real GDP (Output)

24. Macroeconomic equilibrium • What happens if the macroeconomy is NOT in equilibrium? If AS < AD then the price level is below the euilibrium. Firms find there is a shortage of goods & they expand their output responding to increased price level. This continues until equilibrium is reached. Price Level AS P PE AD 0 Y1 YE Y2 Real GDP (Output)

25. AD and AS