Aggregate Demand and Supply
Aggregate Demand

The sum of all expenditure in the economy over a period
of time
Macro concept – WHOLE economy
 Formula:

◦
◦
◦
◦
AD = C+I+G+(X-M)
C= Consumption Spending
I = Investment Spending
G = Government Spending
(X-M) = difference between spending on imports and
receipts from exports (Balance of Payments)
Aggregate Demand Curve

Shows the overall level of spending at different
price levels

Note – Inflation used for the vertical axis
(Assumes Central Banks do not target the
money supply but short term interest rates)
Aggregate Demand Curve

Why does it slope down from left to right?
◦ Assume Bank of England sets short term interest rates
◦ Assume a rise in the price level will be met by a rise in
interest rates
◦ Any increase in interest rates will raise the cost of
borrowing:
 Consumption spending will fall
 Investment will fall
 International competitiveness will decrease – exports fall,
imports rise

Therefore – a rise in the price level leads to lower levels
of aggregate demand
Aggregate Demand Curve
The AD diagram:
 Inflation on the vertical axis – assume an
initial ‘target rate’ of 2.0% (as measured
by the HICP or CPI)
 Real GDP or Real National Income or
Real Output on the vertical axis (shown
by the initial Y)

Aggregate Demand Curve
At a lower
higher rate
of of
The
level
This level of output will
inflation
(3.0%)
risingof
National
Income
Atassociated
an inflation
level
be
with
a
interest
rates
mean
that
requires
fewer
units
2%, the AD
curve
particular
level
of gives
C,
I andof
(X-M)
of
labour
– allofhave
a level
output
Y1we
unemployment
which
negative effects on rises
AD –
unemployment
will call U = 5%
NY7%
fallsshown
to Y2 by U =
to
7%
Inflation
3.0%
2.0%
AD
Y2
U = 7%
Y1
U = 5%
Real National Income
Shifts in the Aggregate Demand Curve
This would cause
Shifts
AD will be
Anyinexogenous
a
rise in national
caused
factor
causing
by
changes
in factors C,
income
(economic
affecting
I,rise,
G and
I or G C,
toand
or a
growth)
lead
(X-M)
to
a fall
in
trade
surplus
(exogenous factors)
unemployment (U
e.g.
increasing
income
causes
a shift
totax
=
2%)
(and
vice
rates affect consumption
the
right in AD
versa)
Inflation
2.0%
AD2
AD
Y1
U = 5%
Y2
U = 2%
Real National Income
Consumption Expenditure
affected by
◦
◦
◦
◦
◦
◦
Tax rates
Incomes – short term and expected income over lifetime
Wage increases
Credit
Interest rates
Wealth
Investment Expenditure

Spending on:
◦
◦
◦
◦
Machinery
Equipment
Buildings
Infrastructure
Influenced by:
◦
◦
◦
◦
Expected rates of return
Interest rates
Expectations of future sales
Expectations of future inflation rates
Government Spending
Defence
 Health
 Social Welfare
 Education
 Foreign Aid
 Regions
 Industry
 Law and Order

Import Spending (negative)

Goods and services bought from abroad – represents an
outflow of funds from the UK (reduces AD)
Export Earnings (Positive)

Goods and services sold abroad – represents a flow of
funds into the UK (raises AD)
Key variables
Macroeconomic policy
Fiscal Policy


Government Income (taxes and borrowing)
Government Spending
Monetary Policy

Interest Rates (Bank of England)
Aggregate Supply (AS)
Capacity of the Economy








Costs of Production
Technology
Education and Training
Incentives
Tax regime
Capital stock
Productivity
Labour Market
Aggregate Supply
Inflation
AS
Economy starts to overheat
Y1
Yf
Between
and
Yf
An
represents
output Y1
level
‘Full
of Yf,
Y1
increases
in
capacity
The
ofOutput
the
Employment
would
suggest
theAS –
Thisshape
shape
are
possible
but
the
is important
in
atcurve
economy
this
point
is
working
the
reflects
a
nearer
the
economy
determining
the and
economy
below
fulliscapacity
working
to
gets
to
Yf,
the
more
Keynesian
view
outcome
full
there
capacity
wouldare
be
and
problems
in
ofthe
theeconomy
AS curve.
cannot
widespread
produce
any
experienced
with
more
unemployment
acquiring resources to
boost production
(production
bottlenecks) especially
labour skills shortages.
Real National Income
Aggregate Supply
Inflation
AS1
AS2
Increases in
capacity can
occur as a result
of a shift in AS
(akin to a shift
outwards of the
Production
Possibility
Frontier) (PPF)
Yf1
Yf2
Real National Income
Aggregate Supply
Inflation
LRAS
Yf
This is because they
Classical
economists
believe that
in the
long
run,the
there
assume
longwill
runbe
no unemployment of
aggregate
supply
resources because
curve
(LRAS)
is
markets
will clear,
thus whatever
the
vertical
(perfectly
rate
of inflation, firms
inelastic).
will supply the
maximum capacity of
the economy.
Real National Income
Aggregate Supply
Inflation
AS
For our analysis,
we will assume
the AS curve
looks like this!
Real National Income
Putting AD and AS together
AS
Inflation
2.5%
2.0%
A shift in the AD
In
thisto
situation,
curve
AD1 as athe
economy
bein
result of awould
change
operating
at the
less
any or all of
than
capacity,
there
factors
affecting
AD
would
be
would increase
unemployment
growth, reduce and
the
economy might
unemployment
but at
be
growing
only
a cost of higher
slowly.
inflation (a trade-off)
AD 1
AD
Y1
Y2
Yf
Real National Income
Putting AD and AS together
AS
Inflation
3.5%
Further increases in
AD would lead to
successively
smaller increases in
growth and
employment at the
cost of ever higher
inflation.
AD2
2.5%
2.0%
AD1
AD
Y1
Y2
Yf
Y3
Real National Income
Sustained Growth
Inflation
AS
AS1
Sustained growth
(not to be
confused with
sustainable
economic
growth) occurs
when AS and AD
rise at similar
rates – national
income can rise
without effects
on inflation
2.0%
AD2
AD
Y1
Y2
Real National Income
Research - Homework

Research the following indicators (get sources) for Kazakhstan and
prepare a presentation on the Kazakh Economy.
How well is the Kazakh Economy Doing?
You may use one or more of the following indicators, or another
indicator to best answer the above questions.




GDP
GNP
NNP (Net National Development Index)
HDI (Human Development Index)
Possible sources
 http://hdrstats.undp.org/en/countries/profiles/KAZ.html
 www.stat.gov.kz