UBEA 1013: ECONOMICS 1 CHAPTER 12: AGGREGATE DEMAND-SUPPLY MODEL 12.1 Aggregate Demand Curve 12.2 Aggregate Supply Curve 12.3 Equilibrium & Changes

UBEA 1013: ECONOMICS Aggregate Demand Curve Aggregate Demand (AD) is the total demand for all goods & services in the economy. AD curve plots aggregate demand against price (P). But aggregate demand is not only influence by price but other factors as follow: a. Federal Budget (Fiscal policy) i) Government spending ii) Taxes b. Money supply (Monetary policy) Shift in AD curve

UBEA 1013: ECONOMICS 3 To derive the aggregate demand curve, we examine what happens to aggregate output (income) (Y) when the price level (P) changes, assuming no changes in government spending (G), net taxes (T), or the monetary policy variable (M s ). The aggregate demand (AD) curve is a curve that shows the negative relationship between aggregate output (income) and the price level. Movement Along the AD curve: P & Y Relationship

UBEA 1013: ECONOMICS 4 The Impact of an Increase in the Price Level on the Economy – Assuming No Changes in G, T, and M s

UBEA 1013: ECONOMICS 5 Generally: A higher price level causes the demand for money to rise, which causes the interest rate to rise. Then, the higher interest rate causes aggregate output to fall. Reason for a downward slopping AD curve: The consumption link: P ↑ »» r ↑ »» C ↓ »» Y ↓ Note: Interest rate reflects the cost of borrowing & negative relationship with consumption (Refer 10.1B)

UBEA 1013: ECONOMICS 6 Reason for a downward slopping AD curve: The real wealth effect: P ↑ »» real wealth (W) ↓ »» C ↓ »» Y ↓ Note: Positive relationship between wealth & consumption (Refer 10.1B) Therefore: Change in P »» movement along the AD curve BUT change in G, T or M S »» shifting the AD curve

UBEA 1013: ECONOMICS 7 Shift of Aggregate Demand Curve: An increase in the quantity of money supplied (M S ) at a given price level shifts the aggregate demand curve to the right. An increase in government purchases/demand (G) or a decrease in net taxes shifts the aggregate demand curve to the right.

UBEA 1013: ECONOMICS 8 Factors That Shift the Aggregate Demand Curve Expansionary monetary policy M s AD curve shifts to the right Contractionary monetary policy M s AD curve shifts to the left Expansionary fiscal policy G AD curve shifts to the right Contractionary fiscal policy G AD curve shifts to the left T AD curve shifts to the right T AD curve shifts to the left

UBEA 1013: ECONOMICS 9 Aggregate Expenditure & Aggregate Demand: At every point along the aggregate demand curve, the aggregate quantity of output demanded is exactly equal to planned aggregate expenditure. Y = C + I + G equilibrium condition

UBEA 1013: ECONOMICS Aggregate Supply Curve Aggregate Supply (AS) is the total supply for all goods & services in the economy. In the short run, the aggregate supply curve (the price/output response curve) has a positive slope. AD curve shows the relationship between the aggregate quantity of output supplied by all firms in an economy and the overall price level. Movement Along the AS curve: P & Y Relationship

UBEA 1013: ECONOMICS 11 At low levels of aggregate output, the curve is fairly flat. As the economy approaches capacity, the curve becomes nearly vertical. At capacity, the curve is vertical. As the economy approaches maximum capacity, firms respond to further increases in demand only by raising prices (e.g. from C to D) When the economy is operating at low levels of output, an increase in aggregate demand is likely to result in an increase in output with little or no increase in the overall price level (e.g. from A to B)

UBEA 1013: ECONOMICS 12 But aggregate supply is not only influence by price but other factors that shift the AS curve as follow: Bad weather, natural disasters, destruction from wars Good weather Public policy waste and inefficiency over-regulation Public policy supply-side policies tax cuts deregulation Stagnation capital deterioration Economic growth more capital more labor technological change Higher costs higher input prices higher wage rates Lower costs lower input prices lower wage rates Shifts to the Left Decreases in Aggregate Supply Shifts to the Right Increases in Aggregate Supply Factors That Shift the Aggregate Supply Curve Shift of Aggregate Supply Curve:

UBEA 1013: ECONOMICS 13 A cost shock, or supply shock, is a change in costs that shifts the aggregate supply (AS) curve. Shift of Aggregate Supply Curve:

UBEA 1013: ECONOMICS Equilibrium & Changes The equilibrium price level is the point at which the aggregate demand and aggregate supply curves intersect. P 0 and Y 0 correspond to equilibrium in the goods market and the money market and a set of price/output decisions on the part of all the firms in the economy. Equilibrium: AD = AS

UBEA 1013: ECONOMICS 15 Price level increase implied inflation Inflation that is caused by an increase in aggregate demand is called “demand – pulled inflation”. (AD curve shift) Inflation that is caused by an increase in costs is called “costs – pushed inflation”. (AS curve shift) Changes in Equilibrium: Policy Effectiveness & Inflation Shift in AD or AS due to fiscal or monetary policy causes changes in equilibrium. However, the effectiveness of respective policies depends on the slope of the AD curve or (especially) AS curve

UBEA 1013: ECONOMICS 16 Recap: Inflation is an increase in the overall price level. Sustained inflation occurs when the overall price level continues to rise over some fairly long period of time. Stagflation occurs when output is falling at the same time that prices are rising. One possible cause of stagflation is an increase in costs. Hyperinflation is a period of very rapid increases in the price level.

UBEA 1013: ECONOMICS 17 Changes in Equilibrium: Demand – Pull Policy Effectiveness & Demand – Pull Inflation Expansionary policy works well when the economy is on the flat portion of the AS curve, causing little change in P relative to the output increase. AD can shift to the right for a number of reasons, including an increase in the money supply, a tax cut, or an increase in government spending. In this case, policy effective: Output increase with low inflation.

UBEA 1013: ECONOMICS 18 When the economy is operating near full capacity, an increase in AD will result in an increase in the price level with little increase in output. On the steep portion of the AS curve, expansionary policy does not work well. The multiplier is close to zero. In this case, policy ineffective: Output increase with high demand – pulled inflation.

UBEA 1013: ECONOMICS 19 If the AS curve is vertical (in the long run), neither monetary policy nor fiscal policy has any effect on aggregate output. The multiplier effect of a change in government spending or taxes on aggregate output is zero. Expansionary policy or further increase in demand will cause hyperinflation.

UBEA 1013: ECONOMICS 20 Costs – Push Changes in Equilibrium: Costs – Push Inflation Those factors could reduce the output while pushing the price up or causing inflation. AS can shift to the left for a number of reasons, including higher costs, a tax increase, natural disaster, or destruction from war. The steeper the AD curve (less responsive of output change to change in price level), the greater the effect those factors to inflation.

UBEA 1013: ECONOMICS 21 Costs – Push Changes in Equilibrium: Costs – Push Inflation Recall that if output fall while price level rising (inflation), it is a stagflation situation. If inflation is caused by an increase in cost (especially cost shock), it could be referred as “costs – push inflation” or “supply – side inflation”. Cost shocks are bad news for policy makers. The only way to counter the output loss is by having the price level increase even more than it would without the policy action.

UBEA 1013: ECONOMICS 22 Case Study Changes in Equilibrium: Case Study Case 1: Currently, oil shock happened (crude oil price above US$60 per barrel) If government practices expansionary policy, inflation can be expected but can prevent economic recession (fall in output)

UBEA 1013: ECONOMICS 23 Case 2: If economic growth (AS↑) due to FDI (more capital) >> Y ↑ & P ↓ If government practices expansionary policy, output can increase further without limited inflation problem. If wages increase, wealth increase, C ↑, AD ↑ & output can increase further. Therefore, FDI is a good way to boost economy growth. END