AQA Chapter 13: AS & AS Aggregate Demand

Understanding Aggregate Demand (AD) Aggregate Demand (AD) = –Total level of planned real expenditure on UK produced goods and services The components of aggregate demand Household Spending (C) Gross Fixed Capital Spending (I) Value of Change in Stocks (inventories) Government Consumption (G) Exports of Goods and Services (X) (minus) Imports of Goods and Services (M) AD sums to GDP (expenditure based)

The Aggregate Demand Curve Real National Output Price Level AD1 P1 Y1 P2 Y2 P3 Y3

An Outward Shift in Aggregate Demand RNO Price Level AD1 P1 Y1Y2 AD2

An Inward Shift in Aggregate Demand Real National Output Price Level AD4 P1 Y4Y3 AD3

Causes of Changes in Aggregate Demand Changes to Government Fiscal Policy –An increase/decrease in level of taxation –Changes in real government spending on health, education, transport –An increase in the size of the budget deficit (where government spending > tax revenue) Changes to Monetary Policy –Changes in official base interest rates by the Bank of England –Fluctuations in the exchange rate for sterling (e.g. a fall in the value of sterling against the Euro or the US dollar) Changes in Business & Consumer Confidence Fluctuations in the growth of national income and expenditure in other countries (the global economic cycle) –E.g. the effects of a recession in the United States –A cyclical recovery within the Euro Zone

The UK and Global Economic Fluctuations –Demand-side economic shocks Growth of income & demand in OECD economies –E.g. an economic recession in the United States –Asian economic downturn / financial turbulence Interest rates decisions in Europe and in the USA Performance of global stock markets - particularly in the USA Foreign Investment decisions of global multinationals –Supply-side economic shocks Fluctuations in international commodity prices

Fiscal Policy and Aggregate Demand Aggregate Demand = Consumer spending + Investment spending + Government spending + Exports - Imports = Gross Domestic Product Fiscal Policy can affect AD through several channels Direct changes in government spending (current and capital) Changes in direct taxes –Income tax / National Insurance –Corporation tax –Taxation of saving Tax incentives for R&D Changes in indirect tax –Changes in excise duties –Changes in VAT Changes in the budget deficit or surplus

Taxes and Aggregate Demand Cut in personal income tax Boost to disposable income Adds to consumer demand Cut in indirect taxes Lower prices – higher real incomes Adds to consumer demand Adds to business capital spending Cut in corporation tax Higher “post tax” profits for businesses Cut in tax on interest from saving Boost to disposable income of people with net savings Adds to consumer demand Expansionary Fiscal Policy

Monetary Policy and Aggregate Demand Expansionary Monetary Policy Lower Nominal Interest Rates Stimulates Capital Investment Spending Increase in Economic Activity Expansionary Monetary Policy Increase in Bank Loans Stimulates Household Spending Increase in Economic Activity Expansionary Monetary Policy Exchange Rate Depreciation Stimulates Net Exports Increase in Economic Activity Expansionary Monetary Policy Rise in Equity Prices Rise in House Prices Rise in Value of Household Wealth Increase in Economic Activity Interest Rate Channel Bank Lending Channel Exchange Rate Channel Wealth Effect Channel

AQA Chapter 13: AS & AS SRAS / LRAS / AD

Short Run Aggregate Supply (SRAS) SRAS is the relationship between real GDP and the price level –SRAS shows how much output the economy can generate in the short term at each price level –A rise in the price level should stimulate an expansion of supply We hold the following constant: –Wage rates for labour –Other resource prices such as raw material prices and components –Long run potential GDP (see LRAS) Changes in aggregate demand cause either a contraction or an expansion along the SRAS curve

Short Run Aggregate Supply Curve Real National Output Price Level SRAS1 P1 Y1 P2 Y2 A rise in the price level will cause an expansion of aggregate supply in the economy Producers are responding to higher prices (driven up by increased demand) Real national output will increase from Y1 to Y2

Shifts in short run aggregate supply Changes in unit labour costs (ULCs) –Unit labour costs are defined as wage costs adjusted for the level of productivity Changes to raw material costs and other components –Fluctuations in the world price of oil, copper, aluminum and other essential inputs in many production processes –These costs might be affected by movements in the exchange rate which cause fluctuations in the prices of imports Changes to producer taxes and subsidies levied by the government as part of their fiscal policy –Changes in VAT on building materials or duty on fuels

Inward Shift in SRAS Price Level SRAS1 Y2 P2 Y1 SRAS2 RNO Inward shift of SRAS Less output can be supplied at each price level

Long Run Aggregate Supply (LRAS) LRAS is located at potential GDP – it represents a level of real national output in the economy Potential GDP is assumed to be independent of the price level –The price level is fixed –Technology does not change –All resources are fully employed –The economy is on its production possibilities curve

Long Run Aggregate Supply (LRAS) Changes in potential GDP are brought about by: –Changes in full-employment labour supply available for production (i.e. more people join the labour force) –Changes in the stock of capital inputs – affected by the level of gross capital investment –Changes in the productivity of factor inputs e.g. higher labour productivity or an increase in capital productivity –Advances in the general state of technology An outward shift of LRAS signifies an increase in long-run potential “full-employment” output

Short Run (SRAS) and Long Run Aggregate Supply (LRAS) Price Level RNO Yp SRAS LRAS Potential GDP Short run GDP exceeds potential Short run GDP below potential Positive output gap Negative output gap

Inter-relationships between SRAS and LRAS General Price Level Real National Output Yp SRAS LRAS AD AD2 P1 Y2

Inter-relationships between SRAS and LRAS General Price Level Real National Output Yp SRAS LRAS AD AD2 P1 Y2 SRAS2 P2

AQA Chapter 13: AS & AS Non-linear AS (Keynesian LRAS) A different way of showing aggregate supply

The Non-Linear AS Curve Price Level LRAS Yfc Elastic supply AD AD2 AD3 ??????

An Increase in Long Run Aggregate Supply Price Level RNO LAS1LAS2LAS3 Ad1 Ad2 Ad3

Supply-Side Economic Policies Changes to the structure of taxation Measures to make markets more contestable / competitive Active labour market policies to increase the supply and efficiency of labour Policies to raise the stock of capital inputs Policies to increase spending on R&D Privatisation of state owned industries Opening up of capital markets to finance higher levels of investment