AS Economics
Aggregate Demand
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Is it natural to be greedy? If yes, does that make
being greedy ok?
Aggregate Demand
• Learning Objectives for this lesson…
• 1)Define aggregate demand
• 2)Describe the components of aggregate demand
• 3) Explain what determines each of the components of aggregate demand
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Aggregate Demand
• Definition of aggregate demand
• “Aggregate demand is the total demand for a country’s goods and services at a given
price level and in a given time period”
• NB: The price level is the average of each of the prices of all products produced in an
economy.
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Aggregate Demand
• Components of aggregate demand
• Aggregate demand is made up of the following
•
•
•
•
Consumer expenditure (C)
Investment (I)
Government spending (G)
Net exports (X – M)
• Let’s look at each one…
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Aggregate Demand
• Components of aggregate demand
• Consumer expenditure (C)
• Consumer expenditure is also known as ‘consumption’
• In most countries it is the largest component of aggregate demand
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Aggregate Demand
• Components of aggregate demand
• Investment (I)
• This is spending on, for example, machines and office buildings
• This is perhaps the most volatile component of aggregate demand as it can rise and fall each
year
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Aggregate Demand
• Components of aggregate demand
• Government spending (G)
• Includes local and national spending on, for example, education, health care, policing
• Transfer of payments (i.e. benefits) are not included as benefits are not a ‘good’ or a ‘service’
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Aggregate Demand
• Components of aggregate demand
• Net exports (X-M)
• Exports (X)
• Imports (M)
• A trade surplus is when exports are greater than imports and is added to AD
• A trade deficit is when exports are less than imports and is taken away from AD
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Aggregate Demand
• How is AD calculated?
• AD = C + I + G + (X-M)
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Aggregate Demand
• Activity
• Calculate aggregate demand from the following information and decide whether a trade surplus
or trade deficit has been created
•
•
•
•
•
Consumer expenditure: £950m
Investment: £20m
Government spending (including £50m in benefits): £600m
Imports: £50m
Exports: £90m
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Aggregate Demand
• Activity answer
• C + I + G + (X-M)
• 950 + 20 + (600-50) + (90-50)
• AD = £1,560m
• Trade surplus of £40m is created and is added to AD
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Aggregate Demand
• Consumer expenditure
• There are a range of influences that affect how much consumers spend
•
•
•
•
•
•
•
Real disposable income
Wealth
Consumer confidence and expectations
Rate of interest
The age structure of the population
Distribution of income
Inflation
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Aggregate Demand
• Consumer expenditure
• Activity
• Calculate the APC given the following information
• Sarah’s wage after allowing for tax is £500 per week and of this she spends £450 per week in total
• What is the Sarah’s APC?
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Aggregate Demand
• Consumer expenditure
• Activity answer
• 450 / 500 = 0.9
• APC = 0.9
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Aggregate Demand
• Government spending
• Government spending decisions are influenced by a number of different factors…
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Aggregate Demand
• Factors which influence government spending
• 1) Government intervention level
• In countries where there is a high level of state intervention there is a positive correlation to
the amount spent by governments as a proportion of AD
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Aggregate Demand
• Factors which influence government spending
• 2) Level of economic activity
• If there is high unemployment, a government may increase spending to raise aggregate
demand and the output of the economy
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Aggregate Demand
• Factors which influence government spending
• 3) A desire to please the electorate
• Voters can put pressure on the government to spend money in certain areas, such as health
and education
• This is especially true during the run-up to the general election
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Aggregate Demand
• Factors which influence government spending
• 4) War, terrorist attacks, rises in crime
• Or the threat of these
• All these will impact on government spending
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Aggregate Demand
• Net exports
• (x-m)
• There are a number of factors that can influence net exports…
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Aggregate Demand
• Factors which influence net exports
• 1) Real disposable income abroad
• A rise is likely to result in more exports being sold
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Aggregate Demand
• Factors which influence net exports
• 2) Real disposable income in the domestic country
• A rise in income at home may result in a fall of exports, as firms will try to meet the demand
in the domestic market
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Aggregate Demand
• Factors which influence net exports
• 3) The exchange rate
• The exchange rate is defined as “the price of one currency in terms of another currency”
• A fall in a country’s exchange rate will reduce the price of exports and raise the price of imports
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Aggregate Demand
• Factors which influence net exports
• 4) Government restrictions on free trade
• A country’s net exports may rise if other countries’ governments remove trade restrictions
e.g. tariff ’s [a tax on imports]
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Aggregate Demand
• Net exports
• Remember that x-m
• Spending on imports reduces a country’s aggregate demand because the spending is going
on foreign products not domestically produced products.
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Aggregate Demand
• The relationship between aggregate demand and the price level
• AD is inversely related to the price level:
• A rise in price level causes a fall in AD (contraction)
• A fall in the price level results in a rise in AD (extension)
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Aggregate Demand
Price
Level
Aggregate Demand
Real GDP
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Aggregate Demand
• Do not confuse the aggregate demand curve with the demand curve
• The demand curve shows the demand for a single product, which alters as its
relative price changes
• The aggregate demand curve total demand altering as the price level changes
• Remember to label the axis correctly
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Aggregate Demand
Price
Level
Aggregate Demand
Real GDP
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Aggregate Demand
• Why does the demand curve slop from left to right?
• 3 main reasons…
• 1) The wealth effect – a fall in price level increases the amount of goods and services that
wealth can buy
• 2) The rate of interest effect – if interest rate rises there will be less consumption and the
price level will fall, which in turn will increase demand
• 3) The international trade effect – a rise in the price level will make the country’s products
less competitive and people may buy from abroad, which will cause a contraction
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Aggregate Demand
• Movement along the aggregate demand curve
• The only factor that will cause a movement along the aggregate demand curve is the
price
• Let’s take a look…
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Aggregate Demand
Price
Level
As price level rises, AD
falls
This is a movement
along the AD curve
Aggregate Demand
Real GDP
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Aggregate Demand
• Shift of the aggregate demand curve
• A change in any other factor will cause a shift along the aggregate demand curve
• Such as…
•
•
•
•
Changes in expectations
Government policy
Changes in exchange rates
Changes in populations size
• Let’s take a look…
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Shifts in Aggregate Demand
Price
Level
If Consumption has increased, then
this will shift AD outwards
(expansion)
AD 2
AD 1
Real GDP
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Aggregate Demand
• For each of the following, sketch the AD line and show what would happen to the
line (fully label your diagram and show the direction of the change):
•
•
•
•
•
1) Consumer expenditure has decreased
2) The price level has increased
3) The population has decreased
4) Consumer expectations are low
5) The government has cut the rate of income tax
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Aggregate Demand
• Review of last lesson…
• 1) To recognise that aggregate demand and the price level are inversely
related
• 2) To be able to explain why the aggregate demand curve may shift
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Aggregate Supply and Equilibrium
• Definition of aggregate supply
• “Aggregate supply is the total output of goods and services that producers
in an economy are willing and able to supply at different price levels in a
given time period”
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Aggregate Supply and Equilibrium
• There are two versions of the AS curve
• The short-run aggregate supply curve (SRAS)
• The long-run aggregate supply curve (LRAS)
• We will consider the SRAS curve
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Aggregate Supply and Equilibrium
• What does the supply curve show?
• Same axis as AD: Price level and Real GDP
• Low level of supply means that unemployment is high and the price level will be low (because of the availability of
resources)
• High level of supply means that unemployment is low (as output increases) and the price level will be higher (because of
scarce resources and production inefficiencies)
• Let’s take a look…
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Aggregate Supply and Equilibrium
• Wait….
• One more thing….
• In the short-run…
• The PRICES OF FACTORS OF PRODUCTION are assumed to be fixed…
• Now let’s take a look…
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Aggregate Supply and Equilibrium
Price
Level
Aggregate Supply
Upward sloping as firms will
increase output if the price they
receive increases
Real
GDP
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Aggregate Supply and Equilibrium
• Shifts in the AS curve
• A change in AS means that the total output that producers are willing and able to supply, at any given price
level, alters
• A decrease in supply is represented by a shift to the left of the AS curve
• A increase in supply is represented by a shift to the right of the AS curve
• Let’s take a look…
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Shifts in SRAS
Price
Level
Aggregate Supply
Real
GDP
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Aggregate Supply and Equilibrium
• What causes a shift in the supply curve?
• Changes in the cost of production
• Wages
• Raw materials
• The quality and quantity of the factors of production will cause a shift of the supply curve in the
long run e.g.
•
•
Quantity of labour: immigration, raise in retirement age,
Quality of labour: education increases productivity
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Aggregate Supply and Equilibrium
• Please complete the following worksheet
• “Aggregate Supply – Basic Concepts”
• Then we will move on to Macroeconomic Equilibrium
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Aggregate Supply and Equilibrium
• Learning Objectives for this lesson…
• 1) Define what is meant by equilibrium in the macroeconomy
• 2) Explain how the macroeconomic equilibrium is determined.
• 3) Explain why the macroeconomic equilibrium may change.
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Aggregate Supply and Equilibrium
• Definition on macroeconomic equilibrium:
• “Macroeconomic equilibrium occurs when aggregate demand and aggregate supply are
equal and there is no reason for the economy’s output or the price level to change”
• We will consider the short-run equilibrium
• Remember……at equilibrium AD = SRAS
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Short-run Equilibrium
AD = SRAS
Let’s take a look….
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Short-run Equilibrium
Price
Level
SRAS
Equilibrium
Price Level
AD
Real GDP
Equilibrium
Real GDP
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Aggregate Supply and Equilibrium
• If there is excess demand (i.e. AD > AS) then this means there is a shortage of goods and
services
• Firms would find their stocks declining
• The excess demand would encourage them to expand their output until firms could meet
the demand
• Finally, the market would be back in equilibrium
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Aggregate Supply and Equilibrium
• If there is excess supply (AS > AD) then this means there is a surplus of goods and services
• Firms would find their stocks increasing
• The excess supply would encourage them to contract their output until they achieved the
right supply level to meet demand
• Finally, the market would be back in equilibrium
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Aggregate Supply and Equilibrium
• The equilibrium price level is “the only price which will lead to suppliers
producing exactly the right output to satisfy the demands from consumers,
investors, the Government and overseas consumers”
• Activity…
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Aggregate Supply and Equilibrium
•
Activity…
•
•
Draw 4 axis (which are fully labelled)
For each one, draw a AD and AS curve and show the effect of the following:
•
An increase in demand
•
A decrease in demand
•
An increase in supply
•
A decrease in supply
•
Fully label you diagram and include arrows to show the direction of change for GDP, Price Level and Equilibrium
•
Be prepared to draw your answers on the board
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LRAS
• LRAS is located at potential GDP – it represents a level of real national output in
the economy
• Potential GDP is assumed to be independent of the price level
• The price level is fixed
• Technology does not change
• All resources are fully employed
• The economy is on its production possibilities curve
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LRAS
• Changes in potential GDP are brought about by:
• Changes in full-employment labour supply available for production (i.e. more people
join the labour force)
• Changes in the stock of capital inputs – affected by the level of gross capital
investment
• Changes in the productivity of factor inputs e.g. higher labour productivity or an
increase in capital productivity
• Advances in the general state of technology
• An outward shift of LRAS signifies an increase in long-run potential “full-employment”
output
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Price Level
LRAS
SRAS
Short run GDP exceeds
potential
Potential GDP
Yp
RNO
Price Level
LRAS
SRAS
Short run GDP exceeds
potential
Potential GDP
Yp
RNO
Price Level
LRAS
SRAS
Short run GDP exceeds
potential
Potential GDP
Short run GDP below potential
Yp
RNO
Price Level
LRAS
SRAS
Positive output gap
Short run GDP exceeds
potential
Potential GDP
Short run GDP below potential
Yp
RNO
LRAS
Price Level
SRAS
Positive output gap
Short run GDP exceeds
potential
Negative
output gap
Potential GDP
Short run GDP below potential
Yp
RNO
General
Price Level
LRAS
SRAS
AD
Yp
Real National Output
General
Price Level
LRAS
SRAS
P1
AD2
AD
Yp
Y2
Real National Output
General
Price Level
LRAS
SRAS
P1
AD2
AD
Yp
Y2
Real National Output
General
Price Level
LRAS
SRAS2
SRAS
P2
P1
AD2
AD
Yp
Y2
Real National Output
General
Price Level
LRAS
SRAS2
SRAS
P2
P1
AD2
AD
Yp
Y2
Real National Output
The Keynesian non-Linear Supply Curve
Price Level
LRAS
Yfc
The Non-Linear Supply Curve
LRAS
Price Level
SRAS1
AD2
AD
Elastic
supply
Yfc
The Non-Linear Supply Curve
LRAS
Price Level
AD4
SRAS1
AD3
AD2
AD
Elastic
supply
Yfc
The Non-Linear Supply Curve
LRAS
Price Level
AD6
AD5
AD4
SRAS1
AD3
AD2
AD
Elastic
supply
Yfc
An Outward Shift in Short Run Aggregate
Supply
LRAS
Price Level
SRAS1
Fall in production costs boosts
Short run aggregate supply at each
price level
SRAS2
Yfc
RNO
Price Level
An Inward Shift in SRAS
LRAS
SRAS3
SRAS1
SRAS2
Yfc
RNO
An Increase in Long Run Aggregate Supply
Price Level
LRAS
LRAS2
LRAS3
Real National
Output
The Multiplier
• Definition of the multiplier
• “The multiplier effect is the process by which any change in a component of
aggregate demand results in a greater final change in real GDP”
• Confused? What does this mean?
• Let’s consider it…
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The Multiplier
• When injections exceed leakages, aggregate demand will increase
• We know this already
• This rise in aggregate demand (because of net injections) will have a greater
final effect on the economy)
• Why?...
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The Multiplier
• …because when people spend money, that expenditure becomes the income of those who
sell them the products…
• …they in turn will spend some of the money they receive…
• …so there is a knock-on effect, with AD rising more than the initial amount…
• …THIS IS CALLED THE MULTIPLIER EFFECT (when AD rises more than the initial
amount of net injections)
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The Multiplier
• The concept…
• “£100 of investment will increase
aggregate demand in the economy by
more than £100”
• Let’s see how…
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The Multiplier
Firm invests
£100
wages
profits
Households
receive £100
Spend £90
Firms receive
£90
wages
profits
Save £10
• As long as households do not save all their money the
increase in Investment will increase Consumption.
• The less the Consumer saves, the less the leakage and
the larger the multiplier is
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The Multiplier
• Let's assume that all people in our society tend to save 10% of what they
earn. Thus, their marginal propensity to consume (MPC) is 90%. That would
mean that our MPC is equal to 0.9. Let us also assume that the government
spends £2,500.00 on a an increase in a teacher’s salary. Thus, our change in
aggregate demand is £2,500.00. Let's explore how much this initial
expenditure will influence the economy at large...
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The Multiplier
• CHANGE IN GDP = £2,500.00 x 1___
1 - 0.9
• CHANGE IN GDP = £2,500.00 x 10
• CHANGE IN GDP = £25,000
• MULTIPLIER = 25,000 / 2,500 = 10
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The Multiplier
• By the way…
• You won’t need to remember the formula to calculate the multiplier…
• But it is still useful to be able to work it out
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The Multiplier
• Why is the multiplier useful?
• The existence of the multiplier effect means that a government has to recognise that any
change in government spending will have a knock-on effect on the economy
• If government wants to raise real GDP by £10billion and the multiplier has been estimated
at 2, it would have to raise spending by £5billion
• Try an example that you will need to know how to do…
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The Multiplier
• If the multiplier is 2.5 and the government wants to raise real GDP by £150
billion, how much would it have to raise spending by?
• 150/2.5
• £60 bn
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The Multiplier
• Review of the learning objective…
• Show a general awareness of the multiplier effect
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The Multiplier
• Review of last lesson…
• Show a general awareness of the multiplier effect
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Increase in AD
SRAS
Price Level
P2
P1
AD2
AD1
GDP1
GDP2
Real GDP
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Decrease in AD
SRAS
Price Level
P1
P2
AD1
AD2
GDP2
GDP1
Real GDP
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Increase in SRAS
SRAS1
Price Level
SRAS 2
P1
P2
AD
GDP1 GDP2
Real GDP
88
Decrease in SRAS
SRAS2
Price Level
SRAS 1
P2
P1
AD
GDP2 GDP1
Real GDP
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Output, Unemployment and Inflation: Changes
in AD/AS
• Now, we shall consider the following;
• Changes in aggregate demand
• Changes in aggregate supply
• Changes in both AD and AS
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Output, Unemployment and Inflation: Changes
in AD/AS
• 1) Changes in AD
• To evaluate a change in AD, we need to consider;
• the actual change in AD
• the initial AD level in the economy
• the size of the multiplier
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Output, Unemployment and Inflation: Changes
in AD/AS
• 1) Changes in AD
• An increase in AD in an economy which has considerable share capacity is likely to;
• Raise output
• Reduce unemployment
• Perhaps leave the price level unchanged
• If the economy is already operating at full capacity and full employment, then any increase
in AD is purely inflationary
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Output, Unemployment and Inflation: Changes
in AD/AS
• 2) Changes in AS
• The effect of a change in AS will depend on;
• The size of the change
• The initial level of economic activity
• An increase in AS occurring when the economy is at, or close to, full capacity will
raise output and lower the price level (refer to Fig. 4.14 in your books on p99)
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Output, Unemployment and Inflation: Changes
in AD/AS
• 2) Changes in AS
• There is a possibility that an increase in AS will have no impact on the economy and
could happen if;
• The economy is operating at a low output level, AND
• There is a high level of unemployed resources.
• …potential output would increase but actual output would remain the same as with the price
level (refer to Fig 4.15 on p99 of your text book)
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Output, Unemployment and Inflation: Changes
in AD/AS
• Changes in both AD and AS
• Over time in most countries, both AD and AS increase
• AD can increase because of a rise in population
• AS can increase because of advances in technology and improved education
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Output, Unemployment and Inflation: Changes
in AD/AS
• Changes in both AD and AS
• If increases in AS can match AD, the economy can enjoy higher output without
encountering inflationary pressure
• If AD grows more rapidly than AS, this is called overheating and will result in
inflation
• The result is higher output but at a cost of higher prices
• There needs to be more AS to settle the inflation
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Output, Unemployment and Inflation: Changes
in AD/AS
• Changes in both AD and AS
• Example of a shift in both curves…
• Immigration of people of working age and government spending on training that raises
workers’ productivity…this will shift both curves
• Sketch the above using an ADAS graph. Label your diagram and explain in full what
has happened and why.
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Output, Unemployment and Inflation: Changes
in AD/AS
• The Output Gap
• Definition of the output gap;
• “The output gap is the difference between an economy’s actual and potential GDP
• Output Gap = Actual Output – Potential Output
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Output, Unemployment and Inflation: Changes
in AD/AS
• The Output Gap
• A negative output gap occurs when the economy’s output is below its potential
output
• A positive output gap arises when an economy’s actual output is above that of its
potential output
• Can there be a positive output? Let’s see….
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Output, Unemployment and Inflation: Changes
in AD/AS
• The output gap
• A positive output gap may seem impossible and it is certainly unsustainable for long
periods of time, but…
• In the short-term, workers can work overtime, people enter the labour force that wouldn’t
otherwise enter it, and machines continue operating without downtime
• Indeed, countries with positive output gaps usually experience inflation
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