Aggregate Demand
Aggregate demand is planned expenditure, in real terms, in domestically produced output. AD is not the same as the
demand for final goods & services as it excludes imports and includes exports.
3 reasons why the AD curve is downward sloping:1) International substitution effect
Assumes the exchange rate is fixed
 A decrease in domestic price level, relative to foreign price level, will increase competitiveness of domestic firms
 Exporter market share increases on foreign markets
 Increases market share of firms competing with imports
 An increase in X-M so an increase in AD ( AD = C+I+G+(X-M) )
2) Real Balance effect
Assumes you hold a portion of your savings in cash
 A decrease in the price level will give an increase in household wealth & might give rise to an increase in
consumption.
 A decrease in price level means that the purchasing power of our wealth increases; you can buy more goods &
services with the same money so therefore likely to feel you can consume more
 An increase in consumption means an increase in AD ( AD = C+I+G+(X-M) )
3) InterTemporal Substitution effect
High interest rates mean high cost of borrowing money, which also leads to people postponing consumption.
Rea value of money stock = money supply
=
MS .
Price level
PL
An increase in the price level causes a decrease in money stock
PL => MS
PL
However, a decrease in the price level causes a increases in the money stock
PL => MS
PL
Assume the economy is in equilibrium
 Public holding the desired level of cash
 A decrease in Price Level means the public hold excess cash
 Therefore savings increase causing Interest rates to go down which in turn increases AD as people consume
increases
ALL 3 effects show that as price level decrease, AD increases
POTENTIAL GNP (GNP*)
GNP* is the level of output that could be produced in the economy given the state of technology, size of labour force
and without accelerating inflation
GNP* means that :firms are operating at full capacity
There is full employment
Factors that influence GNP* growth
 Growth of the labour force ( skill & motivation )
 Growth of capital stock & technological progress
 New technology is found in equipment
 High level of investment is vital to sustain a high growth rate of GNP*
 Supply of raw materials
 International trade
CLASSICAL MODEL
th
th
Emerged from 18 & 19 century British economists. They believed Advocate a non-interventionist, laissez-faire view of the economy
 That in the long run, the economy tends automatically, towards full employment
 Unemployment was only a transitory caused by external shocks
 Persistent unemployment was due to market rigidities
They believe that government expenditure should be set solely on the grounds of economic efficiency & independently
of output levels or price level.
ASSUMPTIONS
 Wages & prices are flexible ( short & long run )
 Hence, in the long run there’s no excess or demand
 In the long run all factors of production are fully employed
 No spare capacity
 LRAS & SRAS is a vertical line at GNP*
CONTRACTIONARY FISCAL POLICY
This is when government raise taxes (
T) and cut spending (
G) causing AD decrease
A change in AD will cause a change in Price level but not a change in output or employment
As decrease in AD will lower prices but not real GNP in the long run
EXPANSIONARY FISCAL POLICY
Expansionary fiscal policy is where the government increases expenditure ( G) and/or cut taxes ( T). Either of these
activities results in the increase of consumer spending power& will raise the level of economic activity.
A change in AD will cause a change in the price level but no change in output or employment
An increase in AD will increase the price level but not change real GNP in the long run
KEYNESIAN MODEL
Keynes believed that the classical model was incapable of explaining the great depression
Keynesian’s believe:Unemployment persists beyond the short run
That prices & wages are downwards rigid
Advocates an active management of the economy by government, to aid the self correcting mechanisms of the market.
Therefore
 If the economy is in a recession with high unemployment & plenty of unused capacity, government should
pursue a expansionary fiscal policy ( cut taxes, raise spending ).
This would increase economic activity & lower unemployment
 If the economy is in a boom, where output is above full employment, the government should pursue a
contractionary fiscal policy ( raise tax, cut expenditure )
Fiscal policy is cast in the role of stabilising output around its trend growth by manipulating the balance between
government spending & taxation
ASUMPTIONS
 Wages are inflexible downwards
 Hence in the long run there could be excess supply / demand
 There will be unemployment & recessions until full employment is reached ( GNP* )
 When GNP* is reached there is no spare capacity
 The LRAS is initially relatively flat & then becomes positively sloped as we reach GNP*
CONTRACTIONARY FISCAL POLICY during a recession
Contractionary fiscal policy will reduce the level of economic activity, shifting the AD curve to the left, from AD1 to AD2.
The economy will move from A to B, the price level will move from PL1 to PL2 and GNP from GNP1 to GNP2.
Thre has been a much greater decrease in the level of GNP than the in price level, threofre the contractionary fiscal
policy was effective in changing the level of GNP.
If the economy was in a deep recession then the LRAS would be horizontal, hence a contractionary fiscal policy would
cause a drop in AD which would cause a fall in real GNP but the prices stay the same.
However, if the economy is at full employment level of GNP ( GNP* ), the AS curve is vertical & AD falls. It is possible that
real GNP will stay the same but prices will fall.
EXPANSIONARY FISCAL POLICY during a recession
An expansionary fiscal policy is where the government cuts taxes / raises expenditure. This will increase the level of
economic activity, shifting the AD curve out to the right, from AD1 to AD2.
The economy will move from point A to B. At point B, the price level has increased from PL1 to PL2 and GNP from GNP1
to GNP2. However, there was a much greater increase in the level of GNP than in the price level; therefore the
expansionary fiscal policy was effective at changing the level of GNP.
If the economy was in a deep recession the LRAS would be horizontal and a expansionary fiscal policy would cause a rise
in AD which would cause a rise in real GNP but prices would stay the same.
However, if the economy was at full employment ( GNP*) the AS curve would be vertical & AD falls, it is possible that
real GNP will stay the same but prices will rise.
BOOM
If the Economy is in a boom, or is at/near enough to full employment ( GNP* ) then the starting point would be at A.
Keynes would recommend pursuing a contractionary fiscal policy. A contractionary fiscal policy is the government raises
taxes / cuts spending which lowers economic activity also shifting the AD curve in to the left from AD1 to AD2.
This lowers GNP from GNP* to GNP1 and the price level from PL1 to PL2.
However it is possible as the AS curve is vertical & AD falls that real GNP can stay the same but price level lowers.
This would be demonstrated in a economic movement from Point A to C and price level from PL1 to PL3.
However, if the starting point is B, the Keynes would recommend pursuing a expansionary fiscal policy to achieve GNP*
resulting in a movement to point A.