Inflation Lesson Two Reflection – Inflation Lesson One Understand Aggregate Demand and Supply Illustrate Inflation on the: Aggregate Demand and Supply Curve

Aggregate Demand and Supply The Aggregate Demand (AD) and Aggregate Supply (AS) model is used to: – Provide insights into the operation of an economy. – Aid in understanding changes in the price level (inflation), real output (GDP), employment, and unemployment.

Deflationary (Recessionary) Gap What is this economic model telling us?

Deflationary (Recessionary) Gap This economic model is telling us: – Equilibrium income is below the full employment (YF). – Equilibrium real income, output, and employment (Y) and the equilibrium price level (PL) is established where the AD and AS curves intersect.

Inflationary Gap What is this economic model telling us?

Inflationary Gap Equilibrium income is above the full employment level of income (the AD and AS curves intersect at a point beyond full employment). Situation is likely to be a temporary situation because the economy is operating at a level of output beyond its long-run capacity. For a while firms may produce the required quantity by working longer hours and paying overtime to workers. However, wages will be forced upwards as firms compete for scarce labour, causing the AS curve to shift upwards to AS 1. This will move the economy onto the long run AS curve or vertical at YF, eliminating the inflationary gap.

Overview of AD and AS

What is Aggregate Demand?! Aggregate Demand (AD) represents all demand for goods and services in an economy. It is called “Economic Activity” Aggregate Demand consists of: – Total consumption spending by consumers. – Investment spending by firms. – Spending by Government. – Net exports [exports – imports].

Total Consumption Spending by Consumers Who are consumers? What goods and services do consumers by? What have you bought in the last few days/weeks?

Investment Spending by Firms What do we mean by investment? What would firms invest in and why?

Government Spending What would Government spend money on and why? Financial Statements of the New Zealand Government. Treasury Website Article About Government Spending.

Government Spending

Net Exports [Exports – Imports] What are the major goods that New Zealand exports? What are the major goods that New Zealand imports? What are the advantages of New Zealand exporting and importing?

Summary of Aggregate Demand (AD) Aggregate Demand (AD) represents all demand for goods and services in an economy. AD can be represented on an economic model. Aggregate Demand consists of: – Total consumption spending by consumers. – Investment spending by firms. – Spending by Government. – Net exports [exports – imports].

Calculating Aggregate Demand (AD) C + I + G + (X-M) C = Total Consumption Spending I = Investment Spending by Firms G = Government Spending X = Exports M = Imports

Aggregate Demand on an Economic Model Looks very similar to your standard Demand curve.

Shifts in the Aggregate Demand (AD) Curve The AD curve shifts to the left or the right, just like the standard demand curve. Can you think of reasons why the Aggregate Demand curve will shift? Think about… – Consumer Behaviour – Investing Behaviour – Government Policy – Interest Rates

Shifts in the Aggregate Demand (AD) Curve The AD curve will shift to the left if: – Consumption spending decreases (consumers could be saving their money or paying higher income tax or there is a reduction in transfer payments. – Investment spending decreases (firms have low business confidence, or an increase in interest rates will reduce the likelihood of firms investing) – Government has a budget surplus (spends less than it receives in revenue also known as a net withdrawal) – Imports are higher than exports.

Important Features of Shifts in the Aggregate Demand (AD) Curve Shifts of the AD curve depend on the level of ‘spending’ by major sectors of the economy. Interest rate changes have a major impact on the AD curve because they influence the level of spending by households and investment by firms. Inclusive of: – Changes in income tax rates or savings. – Expectations about future inflation levels. – Decisions about levels of Government spending and transfer payments.

Sample Exam Question On Graph One below, show how an increase in petrol prices could affect inflation. Fully label the changes. Graph One: AS/AD model of the New Zealand Economy Give a detailed explanation of the changes you made in (b).

Sample Exam Answer AS1 PL2 Answer: Transport prices would increase, which would increase the costs of production for most firms. Hence, the AS curve would shift left and the general price level would increase as firms increase prices to maintain profit margins. Marking Schedule (Merit Question): AS curve shifted with increase in price level shown plus detailed explanation of why an increase in petrol prices would increase inflation. Must have reference to profit. How, me, your awesome teacher marks your effort!