Aggregate demand and supply using models

Learning Objectives To understand the inverse relationship between AD and the price level To understand the three reasons for the inverse relationship To understand how AD is represented on a model To understand what causes shifts in AD

Aggregate demand and the price level AD curve shows an inverse relationship between the price level (inflation) and AD In other words: Price level = AD And Price level = AD BUT the reasons are different to those for the relationship between demand for a product and price at the micro level, where a fall in price makes a product cheaper against other products

Aggregate demand and the price level Three reasons for the inverse relationship: 1.The wealth effect: Wealth = a stock of assets e.g. property, shares and money held in savings accounts Price level = wealth buys more goods & services = AD increases Price level = reduces the purchasing power of wealth – wealth buys fewer goods & services = AD contracts

Aggregate demand and the price level Three reasons for the inverse relationship: 2. The rate of interest effect: Price level = inflation. Bank of England will raise interest rates to reduce demand, as this reduces inflation (Higher interest rates = more incentive to save not spend & less disposable income if mortgage interest payments higher. Also increases cost of consumer credit) = AD contracts Price level = no need to raise interest rates, so lower rates, therefore encouraging demand = AD increases

Aggregate demand and the price level Three reasons for the inverse relationship: 3. The international trade effect: Price level = country’s products are more competitive overseas = exports rise & less demand for relatively more expensive imports = net exports increase = AD increases Price level = country’s products are less competitive internationally = exports fall & demand for relatively cheaper imports increases = net exports fall = AD contracts

Summary: 3 reasons for inverse relationship of price level & AD The WEALTH effect The INTEREST RATE effect The INTERNATIONAL TRADE effect

Aggregate demand Inverse relationship between AD / price level is shown on the model: AD curve slopes from left to right P1 – P2 (fall in price level) = Y1 – Y2 (increase in GDP

Shifts in Aggregate Demand Any change in the price level causes a movement along the AD curve. A shift in AD arises because of a change in one or more of the components of AD (C, I, G, X and/or M) and so could be caused by any of the factors which influence their level.

Shifts in Aggregate demand An increase in AD shifts the curve to the right. A decrease in AD shifts the curve to the left. AD – AD1 = decrease AD – AD2 = increase

Shifts in Aggregate demand Rightward shift = firms produce more to meet demand = increase in actual output (real GDP) and so economic growth occurs AD – AD1 = decrease AD – AD2 = increase

Shifts in Aggregate demand Leftward shift = firms produce less as reduced demand = decrease in actual output (real GDP) and so economic growth slows AD – AD1 = decrease AD – AD2 = increase

Causes of increases in AD There are many (see your notes on components of AD), but for example: Rising consumer expectations (optimism) Reduction in income tax Reduction in interest rates Fall in exchange rate (boosting exports)

Causes of decreases in AD There are many (see your notes on components of AD), but for example: Negative consumer expectations (pessimism) Increase in income tax Increase in interest rates Rise in exchange rate (making exports more expensive)

Consolidation questions Answer the consolidation questions 1-6. Complete the table looking at leakages and injections and the effect on national income. Start a key terms list using the hand out. Fill in definition for the terms covered so far.

Aggregate Supply The total output of goods and services that producers in an economy are willing and able to supply at a given price level in a given time period A change in AS means that the total output that producers are willing and able to supply at any given price level alters

Aggregate Supply

Why is the AS curve this shape? Because it shows a positive relationship between the price level and output (real GDP). Less supplied at lower price level, more at higher price level.

Aggregate Supply Low levels of output = unused resources (higher unemployment) = more output can be produced without inflationary pressure on prices. Supply is perfectly elastic = any amount can be supplied at the same price level. As more resources are used and become scarcer, factor prices will start to rise and less output is possible. Supply becomes increasingly less responsive to the price level. At full employment, no more output is possible. Supply becomes perfectly inelastic = no response of supply to a change in price level

Components of Aggregate Supply Consumer goods Capital goods – their use adds to capacity and increases economy’s ability to supply consumer goods in future Public and merit goods – produced by private firms for supply to the public sector e.g. education, healthcare, pharmaceuticals, construction Traded goods – goods for export

Aggregate Supply Shifts of AS could be caused by: Change in firms’ costs of production (important in the short run) Change in quantity / quality of factors of production (important in the long run) due to: – Inflows / outflows of workers – Better training / education – Increased productivity of workers – More / less investment in capital goods – Improved technology – More enterprise

Macroeconomic equilibrium Where AD = AS The level of output and price level where there is no pressure to change within the economy Real GDP (Output) Price Level AD AS PEPE YEYE

Macroeconomic equilibrium What happens if the macroeconomy is NOT in equilibrium? If AS > AD (AD = 0Y 1 AS = 0Y 2 ) firms have unsold stock & produce less. AS contracts & price level decreases so AD Increases. This continues until AD = AS at 0Y E (output) and OP E (price level) Real GDP (Output) Price Level AD AS PEPE YEYE Y1 Y2 P 0

Macroeconomic equilibrium What happens if the macroeconomy is NOT in equilibrium? If AS < AD then the price level is below the euilibrium. Firms find there is a shortage of goods & they expand their output responding to increased price level. This continues until equilibrium is reached. Real GDP (Output) Price Level AD AS PEPE YEYE Y1 Y2 P 0

AD and AS