Aggregate Demand (AD)Aggregate Demand (AD)

Definition: AD is the total demand Definition: AD is the total demand (total spending) for a country’s goods (total spending) for a country’s goods and services at a given price level in and services at a given price level in a given time period.a given time period.

The Aggregate Demand Curve and Price The Aggregate Demand Curve and Price levellevel

The AD curve shows the relationship The AD curve shows the relationship between the average price level and real between the average price level and real output. output. Price level

0

p

yReal GDP/National Income/National output/Real output

AD

Aggregate Demand (AD) is often Aggregate Demand (AD) is often expressed as:expressed as:

AD = C + I + G + ( X – M)AD = C + I + G + ( X – M)

Components of ADComponents of AD

Consumption (C) :Consumption (C) : 65% of the AD component 65% of the AD component

Total spending by consumers on Total spending by consumers on domestic goods and services. domestic goods and services.

For example durable goods such as cars, For example durable goods such as cars, mobile phones,(long period) and non mobile phones,(long period) and non durable goods such as rice, newspaper, durable goods such as rice, newspaper, toilet paper. (short period)toilet paper. (short period)

What causes changes in consumption:What causes changes in consumption:

Changes in incomeChanges in income

Changes in interest ratesChanges in interest rates

Changes in wealthChanges in wealth

Changes in expectations and consumer Changes in expectations and consumer confidenceconfidence

Investment (I):Investment (I):

Represents addition of capital stock Represents addition of capital stock (factories, machines, computers) to (factories, machines, computers) to

the the economy.economy.

Represents investments carried out by Represents investments carried out by firms, firms, for example: replacement for example: replacement investment and investment and induced investmentinduced investment

What causes changes in investment?What causes changes in investment?

Interest ratesInterest rates Changes in the level of national incomeChanges in the level of national income Technological changesTechnological changes Expectations and business confidenceExpectations and business confidence

For example, the diagram for investment For example, the diagram for investment shows:shows:

Government spending:Government spending:

Government spending represents the variety of goods and services spent on health, education, transport, law and order, social security, housing and defence.

What causes changes to government What causes changes to government spending?spending?

Commitment to financial support to Commitment to financial support to industryindustry

Spending to correct market failureSpending to correct market failure New education or health policy – new New education or health policy – new

schools or hospitalsschools or hospitals

Net Export: (X-M)Net Export: (X-M)X = export:X = export:

Export are domestic goods and services Export are domestic goods and services bought by foreigners.bought by foreigners.

M = import:M = import: Imports are goods and services Imports are goods and services

bought bought from foreign producers.from foreign producers. Imports is also an outflow of import Imports is also an outflow of import

expenditure.expenditure. When export revenue exceeds import When export revenue exceeds import

expenditure, this is positive. Increase AD.expenditure, this is positive. Increase AD. When import expenditure exceeds export When import expenditure exceeds export

revenue, this is negative. Reduce AD.revenue, this is negative. Reduce AD.

When price in the economy falls from p to When price in the economy falls from p to p1, p1,

C+I+G+(X-M) increases from Y to Y1.C+I+G+(X-M) increases from Y to Y1.

AD = C+I+G+(X-M)

P

0

P

P1

Y Y1 Real output

Changes in AD:Changes in AD:

Changes in price causes a Changes in price causes a movementmovement along the AD curve, from one level of real along the AD curve, from one level of real output to anotheroutput to another

Changes in the components of AD will Changes in the components of AD will cause a cause a shiftshift in the demand curve. in the demand curve.

Shift in Aggregate Shift in Aggregate DemandDemand

..

A change in AD is caused by a A change in AD is caused by a change in an influence on AD other change in an influence on AD other than a change in price level;than a change in price level;

An increase in AD is a rise in planned An increase in AD is a rise in planned spending and is represented by a spending and is represented by a shift to the right of the AD curve;shift to the right of the AD curve;

A decrease in AD is shown by a shift A decrease in AD is shown by a shift to the left of the AD curveto the left of the AD curve

Possible causes of an increase in Possible causes of an increase in ADAD

– An increase in An increase in government spendinggovernment spending, , which may occur in a deliberate attempt which may occur in a deliberate attempt to increase AD;to increase AD;

– An increase in An increase in consumption consumption arising arising from an increase in wealth, an increase from an increase in wealth, an increase in the money supply, a cut in taxation, a in the money supply, a cut in taxation, a rise in population, increased optimism rise in population, increased optimism (‘feel-good factor’) etc.(‘feel-good factor’) etc.

– An increase in An increase in investment investment due to due to change in technology, a rise in change in technology, a rise in expectation, a fall in the rate of interest;expectation, a fall in the rate of interest;

– An increase in An increase in exportexport because of a rise because of a rise in quality, a fall in the country’s in quality, a fall in the country’s exchange rate, a rise in income abroad.exchange rate, a rise in income abroad.

I

7%

4%

0 I1 I2 Investment

Interest rate

The relationship between investment and interest rate shows when interest rate Decreases, there is no incentive to save, and lead to increase in borrowing, which increases investment from I1 to I2. Increase in interest rate will have the oppositeEffect.

What causes changes in net export?What causes changes in net export?

Export:Export:

If foreign income rises, this leads to more If foreign income rises, this leads to more imported goods and services being imported goods and services being consumed.consumed.

Import:Import:

When national income grows, this leads When national income grows, this leads to an increase in consumption. As more to an increase in consumption. As more goods and services are being consumed, goods and services are being consumed, some of these will be imported goods.some of these will be imported goods.

Government policies affecting AD:Government policies affecting AD:

Fiscal policy – taxesFiscal policy – taxes Expansionary fiscal policyExpansionary fiscal policy Monetary policy – interest ratesMonetary policy – interest rates

Aggregate Supply (AS)Aggregate Supply (AS) Aggregate supply is the total Aggregate supply is the total

quantity of goods and services firms quantity of goods and services firms are willing and able to sell at a given are willing and able to sell at a given price level in a given period of time.price level in a given period of time.

The Short Run Aggregate Supply (SRAS) CurveThe Short Run Aggregate Supply (SRAS) Curve

The Short Run Aggregate Supply The Short Run Aggregate Supply (SRAS) curve is drawn on the (SRAS) curve is drawn on the assumption that the prices of all assumption that the prices of all factors of production are fixed;factors of production are fixed;

The curve slopes up from left to The curve slopes up from left to right, this is because higher output is right, this is because higher output is likely to raise the cost per unit likely to raise the cost per unit produced and therefore to supply produced and therefore to supply more, firms have to charge a higher more, firms have to charge a higher price;price;

A rise in the price level is likely to A rise in the price level is likely to encourage firms to raise output in encourage firms to raise output in the short run;the short run;

Influences other than a change in the Influences other than a change in the price level cause firms to change price level cause firms to change how much they wish to supply the how much they wish to supply the different values of the price level and different values of the price level and shiftshift the SRAS. the SRAS.

Causes of a shift in the SRAS are:Causes of a shift in the SRAS are:

– A change in weather conditionA change in weather condition– A change in raw material costsA change in raw material costs– A change in wage ratesA change in wage rates– A change in corporation taxA change in corporation tax

The Long Run Aggregate Supply (LRAS) The Long Run Aggregate Supply (LRAS) CurveCurve

In the long run, wage rates and the prices In the long run, wage rates and the prices of other inputs can change.of other inputs can change.

There are two main views on the shape of There are two main views on the shape of LRAS Curve.LRAS Curve.

The New Classical ViewThe New Classical View

The New Classical view is that the The New Classical view is that the LRAS curve is vertical.LRAS curve is vertical.

Reason:Reason: The classical view believes The classical view believes that if there is unemployment, wages that if there is unemployment, wages will fall to restore full employment, will fall to restore full employment, therefore in the long run the therefore in the long run the economy will operate at full economy will operate at full employment hence the vertical employment hence the vertical supply curve.supply curve.

The Keynesian ViewThe Keynesian View

The Keynesian view is that the shape The Keynesian view is that the shape of the long run aggregate supply of the long run aggregate supply (LRAS) curve can be perfectly elastic (LRAS) curve can be perfectly elastic at low levels of economic activity, at low levels of economic activity, less elastic at higher levels and less elastic at higher levels and perfectly inelastic when full perfectly inelastic when full employment is reached.employment is reached.

Reasons:Reasons: Keynesians believe that at low Keynesians believe that at low

output, and hence low levels of output, and hence low levels of employment, the LRAS curve will be employment, the LRAS curve will be horizontal due to considerable spare horizontal due to considerable spare capacity in the economy and output capacity in the economy and output can be increased without raising cost can be increased without raising cost per unit produced;per unit produced;

Keynesians also believe that as Keynesians also believe that as pressure begins to be placed on pressure begins to be placed on capacity and shortages in skilled capacity and shortages in skilled labour occur, unit costs begin to rise labour occur, unit costs begin to rise and the LRAS curve slopes upwards;and the LRAS curve slopes upwards;

Once the full employment level is Once the full employment level is reached, it is not possible to raise reached, it is not possible to raise output and the LRAS curve becomes output and the LRAS curve becomes vertical.vertical.

Note:Note: The New Classical economists The New Classical economists and the Keynesian economists both and the Keynesian economists both agree that, if full employment is agree that, if full employment is reached, the LRAS curve will be reached, the LRAS curve will be vertical.vertical.

A change in LRAS is a change in the A change in LRAS is a change in the production potential of the economy;production potential of the economy;

An increase in the LRAS is shown by An increase in the LRAS is shown by a shift to the right of the LRAS and a a shift to the right of the LRAS and a decrease by a shift to the left;decrease by a shift to the left;

LRAS will shift to the right LRAS will shift to the right if:if:

The quantity of factors of productionThe quantity of factors of production increases due to increases due to

1.1.an increase in investment, an increase in investment, 2.2.discovery of new materials, discovery of new materials, 3.3.an increase in the size of the labour an increase in the size of the labour

force;force;The quality of factors of productionThe quality of factors of production

increases due to:increases due to:1 improvement in education and training, 1 improvement in education and training, 2. technological progress, this will raise 2. technological progress, this will raise

productivity (output per worker hour).productivity (output per worker hour).