How the macroeconomy works 2.2.5 Determinants of short-run aggregate supply What are the 4 factors of production? How easy is it to increase the availability of each in the short-run? How the macroeconomy works

Animal spirits “Even apart from the instability due to speculation, there is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than mathematical expectations, whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits—a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.”

Paradox of thrift https://www.youtube.com/watch?v=qrHyDztQlB Y

2.2.5 Determinants of short-run aggregate supply The price level and production costs are the main determinants of the short-run AS Changes in costs, such as: money wage rates, raw material prices, business taxation and productivity, will shift the short-run AS curve

Aggregate Supply: A Definition Questions What is the shape of a normal supply curve? Why is it upward sloping? What does ‘aggregate’ mean? “The total value of output of the economy at a given price level at a given point in time.”

The Short-Run Aggregate Supply Curve Building diagrams: Axis? AS Curve? Price Level Real National Output SRAS P Y

What is meant “Short-Run”? In economics, we differentiate between the short-run and long-run It is important not to think of this in terms of a specific time period, as the short and long run is more of a concept to be applied In the short-run it is assumed that all factors of production are fixed The only exception to this is that firms may be able to hire more labour, or make existing labour and other existing resources work harder, in order to meet aggregate demand

Movements Along the SRAS Curve A rise in the price level leads to an expansion in short-run aggregate supply . Changes in aggregate demand lead to movements along the SRAS curve e.g. if AD increases, firms will hire more labour and make resources work harder in order to boost supply as they see an opportunity to increase profits. Price Level SRAS P1 P P2 A fall in the price level leads to a contraction in short-run aggregate supply. Y2 Y Y1 Real National Output

Factors Affecting SRAS (1) Money wage rates do not take into account inflation. Real wages are money wages adapted for inflation. Short-run aggregate supply can shift when there is a change in the costs of production. These could be: Wages If wage rates increase, then firms may substitute labour for capital (assuming they are able to do so), or employ less labour to maintain profit margins The price of raw materials Higher raw material prices, e.g. oil, metals, increase the firms costs of production and will reduce SRAS Productivity The productivity of land, labour and capital can change in the short run. For example, a good harvest will increase output of foodstuff shifting SRAS to the right

Factors Affecting SRAS (2) Taxes and subsidies An increase in business tax rates e.g. Corporation tax will increase costs of production and SRAS will decrease An increase in business subsidies will lower costs of production and SRAS will increase Exchange rates and imports Many businesses will import raw materials or components for the production process If the currency strengthens, this makes purchasing those raw materials relatively cheaper and SRAS will increase

The annual yuletide food survey by Good Housekeeping magazine found that the cost of the cheapest set-piece meal on Christmas Day – for 8 people and including 11 ingredients from turkey to fresh vegetables and cranberry sauce – had risen from £19.82 to £23.53, or from £2.48 a head to £2.94. The Good Housekeeping basket comprises of a whole turkey weighing at least 3.5kg, at least 880g each of potatoes, sprouts, carrots and parsnips; stuffing mix; a jar of cranberry sauce; at least 900g of Christmas pudding, Christmas cake, at least eight mince pies and a jar of brandy butter. Nine of the 11 cheapest items cost more than last year, including turkey, which is now £8.99 from last year’s £8, and sage and onion stuffing mix, which has increased from 30p to 34p. Good Housekeeping said the increased cost was due to the pound’s fall since last year’s referendum, which has pushed up the cost of food imports, and an inflation rate that has hit 3%.

Shifts of the SRAS Curve An increase in costs of production will lead to a shift from SRAS to SRAS2. SRAS2 Price Level SRAS SRAS1 P A decrease in costs of production will lead to a shift from SRAS to SRAS1. Y2 Y Y1 Real National Output

Multiple Choice 1 SRAS1 Price Level SRAS2 Real National Output The shift of the short-run aggregate supply curve from SRAS1 to SRAS2 can be explained by a fall in the price level the world price of oil the trend rate of growth productivity Can you explain your answer? Price Level Real National Output SRAS1 SRAS2 B

Multiple Choice 2 The short-run aggregate supply curve is drawn on the assumption that investment in the economy is constant the prices of factors of production are constant the money supply is constant consumption expenditure by households is constant Can you explain your answer? B

AS: 3.2.2 How the macroeconomy works 2.2.2 Aggregate demand and aggregate supply analysis Important note: It is recommended that this unit is covered as the last unit in the section i.e. following units 2.2.1 and 2.2.3-2.2.6 What is meant by the term aggregate demand? What is meant by the term aggregate supply? What is the difference between short-run and long-run? AS: 3.2.2 How the macroeconomy works

2.2.2 Aggregate demand and aggregate supply analysis Changes in the price level are represented by movements along the aggregate demand (AD) and aggregate supply (AS) curves The various factors that shift the AD curve and the short-run AS curve The factors which affect long-run AS and distinguish them from those which affect short-run AS Underlying economic growth is represented by a rightward shift in the long-run AS curve How to use AD/AS diagrams to illustrate macroeconomic equilibrium How both demand-side and supply-side shocks affect the macroeconomy Students should be able to use AD and AS analysis to help them explain macroeconomic problems and issues. For example, they should be able to use AD and AS diagrams to illustrate changes in the price level, demand- deficient (cyclical) unemployment and economic growth Students should also understand how global economic events can affect the domestic economy

Macroeconomic Equilibrium We will now be putting the two concepts of aggregate demand (AD) and aggregate supply (AS) together to explain and analyse the economy in more detail Using AD/AS analysis is an important skill and part of the ‘economists toolkit’ that will help you to identify, explain and analyse economic problems To begin with, it is important to note that macroeconomic equilibrium occurs where: AD = AS

Short-Run Equilibrium Building diagrams: Axis? AD Curve? SRAS Curve? Price Level Real National Output SRAS P Y AD

Any change in the components of AD Shifts in AD and SRAS You should have an understanding of the factors that shift AD and SRAS: Aggregate Demand Any change in the components of AD Recall the AD formula: C + I + G + (X-M) Short-run Aggregate Supply Any change in the costs of production

Short-Run Shifts Example (1) 1) Begin with the equilibrium position. 2) What will happen if there is an increase in consumption? Price Level SRAS 3) AD will shift to the right. P1 4) There will be an expansion along the SRAS curve resulting in a new equilibrium price level of P1 and output of Y1. P AD1 AD Y Y1 Real National Output

Short-Run Shifts Example (2) 1) Begin with the equilibrium position. 2) What will happen if there is an increase in the cost of raw materials used in the production process? Price Level SRAS1 SRAS 3) SRAS will shift to the left. P1 P 4) There will be a contraction along the AD curve. There will be a new equilibrium price level of P1 and output of Y1. AD Y1 Y Real National Output

For each of the following examples, identify the impact on an AD/SRAS and draw a new diagram to show the new equilibrium position. Scenario 1 The Government increase the rate of income tax 2 There is a rise in the national minimum wage 3 The Government injects £2bn into a new house building programme 4 The price of oil falls on global markets 5 There is a fall in the exchange rate

Classical Long-Run Equilibrium Building diagrams: Axis? AD Curve? Classical LRAS Curve? Price Level Real National Output LRAS P Y AD

Shifts in AD and Classical LRAS You should have an understanding of the factors that shift AD and SRAS: Aggregate Demand Any change in the components of AD Recall the AD formula: C + I + G + (X-M) Long-run Aggregate Supply Any change in the quantity, quality or productivity of factors of production

Long-Run Shifts Example (1) 1) Begin with the equilibrium position. 2) What will happen if there is an increase in exports? Price Level 3) AD will shift to the right. LRAS 4) There will be an expansion along the LRAS curve resulting in a new equilibrium price level of P1. Crucially, real national output will remain at Y, because all factor resources have been employed and remain unchanged. Therefore, any increase in AD will only cause inflation. P1 P AD1 AD Y Real National Output

Long-Run Shifts Example (2) 1) Begin with the equilibrium position. 2) What will happen if there is a discovery of new primary raw materials? 3) LRAS will shift to the right. Economic growth will occur. Price Level LRAS LRAS1 4) There will be an expansion along the AD curve resulting in a new equilibrium price level of P1. This time, real national output increases to Y1 because there has been an increase in the quantity of factor resources. Therefore, the economy now benefits from a higher level of real national output and lower price level. P P1 AD Y Y1 Real National Output

For each of the following examples, identify the impact on an AD/Classical LRAS and draw a new diagram to show the new equilibrium position. Scenario 1 Tax breaks are given to firms who invest profits in research and development 2 There is an increase in imports 3 New laws are passed that block the construction of new oil pipelines 4 There is an increase in consumer confidence 5 The government injects £5bn into widening training course availability for the unemployed

Macroeconomic Policy Implications Classical economists would advocate and support economic policies that improve long-run aggregate supply That is not to say aggregate demand is unimportant, but if AD increases with no attention given to improving the quality and quantity of factor resources, then inflation (rising price levels) will occur and damage economic growth

Keynesian Long-Run Equilibrium Building diagrams: Axis? AD Curve? Keynesian LRAS Curve? LRAS Price Level Keynes believed the economy could settle in equilibrium below the full employment level of output. Therefore, the distance Y-FE represents spare capacity in the economy. P AD It follows that there is likely to be unemployment because of a deficiency of AD. Y FE Real National Output FE = Full Employment

Shifts in AD and Keynesian LRAS This is the same as previously outlined However, of critical importance is the original equilibrium position of the economy

Keynesian Long-Run Shifts Example (1) 1) Begin with the equilibrium position. 2) What will happen if there is an increase in consumption? LRAS Price Level 3) AD will shift to the right. 4) There will be an expansion along the LRAS curve. The price level will increase to P1 as the economy gets closer to full employment and resources become more scarce. Real national output increases to Y1, but spare capacity of Y1-FE remains. P1 P AD1 AD Y Y1 FE Real National Output

Keynesian Long-Run Shifts Example (1) Continued 5) If AD continues to increase.... LRAS Price Level 6) ....without any increases in LRAS P2 7) At some point FE equilibrium will be reached.... P1 P AD2 AD1 8) ...and any increases in AD above AD2 will be purely inflationary. AD Y Y1 FE Real National Output

Keynesian Long-Run Shifts Example (1) Continued 2 9) If however AD is depressed at AD3.... 10) ....and AD increases to AD4 LRAS 11) the price level would be unchanged because there remains a significant amount of spare capacity in the economy. Increases in AD can be absorbed without increases in the price level. Price Level 12) Therefore, any policies to increase LRAS would simply enhance spare capacity and leave the equilibrium level of employment unchanged. P AD4 AD3 Y3 Y4 FE Real National Output Keynesian Long-Run Shifts Example (1) Continued 2

Keynesian Long-Run Shifts Example (2) 1) Begin with the equilibrium position. 2) What will happen if there is an increase in capital efficiency? LRAS LRAS1 Price Level 3) LRAS will shift to the right 3) There will be an expansion along the AD curve. The price level will decrease as available factor resources are increased and scarcity reduces. Real national output increases to Y1 and maximum productive potential increases to FE1, indicating economic growth. P P1 AD Y FE Y1 FE1 Real National Output Keynesian Long-Run Shifts Example (2)

Macroeconomic Policy Implications Keynesian economists would therefore advocate and support economic policies that improve and manage aggregate demand That is not to say long-run aggregate supply is unimportant, but if the economy is operating significantly below its full potential e.g. in a recession, Keynesian economists would focus attention on policies that stimulate the components of aggregate demand (C, I, G, X, M)

How demand-side and supply-side shocks affect the macroeconomy The UK economy operates within a global framework Events in other countries impact on UK economic performance This has a significant effect on the strength of the UK economy Shocks will be felt to a larger extent by ‘open’ economies such as the UK These are more integrated into the global economy so there is a greater impact when major global events take place Watch the video discussing global shocks on the UK economy https://www.youtube.com/watch?v=bPWAWOAvTA4&feature=youtu.be

Multiple Choice 1 Price Level SRAS AD1 AD Real National Output The shift in the aggregate demand curve from AD to AD1 could have been caused by an increase in imports labour productivity household savings the government budget deficit Price Level Real National Output SRAS AD AD1 D Can you explain your answer?

Multiple Choice 2 Can you explain your answer? Price Level SRAS E AD The diagram shows the AD and SRAS curves for an economy. Equilibrium is at point E. Which one of the following would be likely to lead to a new equilibrium position, with a fall in the price level? A fall in exports An increase in government spending A fall in productivity An increase in wage rates Price Level SRAS E A AD Real National Output Can you explain your answer?

Multiple Choice 3 Can you explain your answer? Which one of the following combination of events, A, B, C or D is most likely to have bought about the change in equilibrium output from 0Y to 0Y1? SRAS Price Level SRAS1 A The level of investment rises Money wages in the economy rise B The level of exports decreases Business taxes increase C The level of consumption falls The cost of oil and other imported raw materials decrease D Government spending on welfare benefits falls Average productivity falls P C P1 AD AD1 Y Y1 Real National Output Can you explain your answer?

Multiple Choice 4 Can you explain your answer? Price Level LRAS SRAS X The diagram shows the AD curve and SRAS and LRAS curves of an economy. The economy is currently operating at point X. At this point, the economy must be experiencing inflation caused by excess demand. inflation caused by increasing costs. unemployment of labour. a low rate of economic growth. Price Level LRAS SRAS X C AD Real National Output Can you explain your answer?