1. AS Economics Aggregate Demand 1

2. Is it natural to be greedy? If yes, does that make being greedy ok?

3. Aggregate Demand Learning Objectives for this lesson… 1)Define aggregate demand 2)Describe the components of aggregate demand 3) Explain what determines each of the components of aggregate demand 3

4. Aggregate Demand Definition of aggregate demand “Aggregate demand is the total demand for a country’s goods and services at a given price level and in a given time period” NB: The price level is the average of each of the prices of all products produced in an economy. 4

5. Aggregate Demand Components of aggregate demand Aggregate demand is made up of the following Consumer expenditure (C) Investment (I) Government spending (G) Net exports (X – M) Let’s look at each one… 5

6. Aggregate Demand Components of aggregate demand Consumer expenditure (C) Consumer expenditure is also known as ‘consumption’ In most countries it is the largest component of aggregate demand 6

7. Aggregate Demand Components of aggregate demand Investment (I) This is spending on, for example, machines and office buildings This is perhaps the most volatile component of aggregate demand as it can rise and fall each year 7

8. Aggregate Demand Components of aggregate demand Government spending (G) Includes local and national spending on, for example, education, health care, policing Transfer of payments (i.e. benefits) are not included as benefits are not a ‘good’ or a ‘service’ 8

9. Aggregate Demand Components of aggregate demand Net exports (X-M) Exports (X) Imports (M) A trade surplus is when exports are greater than imports and is added to AD A trade deficit is when exports are less than imports and is taken away from AD 9

10. Aggregate Demand How is AD calculated? AD = C + I + G + (X-M) 10

11. Aggregate Demand Activity Calculate aggregate demand from the following information and decide whether a trade surplus or trade deficit has been created Consumer expenditure: £950m Investment: £20m Government spending (including £50m in benefits): £600m Imports: £50m Exports: £90m 11

12. Aggregate Demand Activity answer C + I + G + (X-M) 950 + 20 + (600-50) + (90-50) AD = £1,560m Trade surplus of £40m is created and is added to AD 12

13. Aggregate Demand Consumer expenditure There are a range of influences that affect how much consumers spend Real disposable income Wealth Consumer confidence and expectations Rate of interest The age structure of the population Distribution of income Inflation 13

14. Aggregate Demand Consumer expenditure Activity Calculate the APC given the following information Sarah’s wage after allowing for tax is £500 per week and of this she spends £450 per week in total What is the Sarah’s APC? 14

15. Aggregate Demand Consumer expenditure Activity answer 450 / 500 = 0.9 APC = 0.9 15

16. Aggregate Demand Government spending Government spending decisions are influenced by a number of different factors… 16

17. Aggregate Demand Factors which influence government spending 1) Government intervention level In countries where there is a high level of state intervention there is a positive correlation to the amount spent by governments as a proportion of AD 17

18. Aggregate Demand Factors which influence government spending 2) Level of economic activity If there is high unemployment, a government may increase spending to raise aggregate demand and the output of the economy 18

19. Aggregate Demand Factors which influence government spending 3) A desire to please the electorate Voters can put pressure on the government to spend money in certain areas, such as health and education This is especially true during the run-up to the general election 19

20. Aggregate Demand Factors which influence government spending 4) War, terrorist attacks, rises in crime Or the threat of these All these will impact on government spending 20

21. Aggregate Demand Net exports (x-m) There are a number of factors that can influence net exports… 21

22. Aggregate Demand Factors which influence net exports 1) Real disposable income abroad A rise is likely to result in more exports being sold 22

23. Aggregate Demand Factors which influence net exports 2) Real disposable income in the domestic country A rise in income at home may result in a fall of exports, as firms will try to meet the demand in the domestic market 23

24. Aggregate Demand Factors which influence net exports 3) The exchange rate The exchange rate is defined as “the price of one currency in terms of another currency” A fall in a country’s exchange rate will reduce the price of exports and raise the price of imports 24

25. Aggregate Demand Factors which influence net exports 4) Government restrictions on free trade A country’s net exports may rise if other countries’ governments remove trade restrictions e.g. tariff’s [a tax on imports] 25

26. Aggregate Demand Net exports Remember that x-m Spending on imports reduces a country’s aggregate demand because the spending is going on foreign products not domestically produced products. 26

27. Aggregate Demand The relationship between aggregate demand and the price level AD is inversely related to the price level: A rise in price level causes a fall in AD (contraction) A fall in the price level results in a rise in AD (extension) 27

28. Aggregate Demand 28 Price Level Real GDP Aggregate Demand

29. Do not confuse the aggregate demand curve with the demand curve The demand curve shows the demand for a single product, which alters as its relative price changes The aggregate demand curve total demand altering as the price level changes Remember to label the axis correctly 29

30. 30 Aggregate Demand Price Level Real GDP Aggregate Demand

31. Why does the demand curve slop from left to right? 3 main reasons… 1) The wealth effect – a fall in price level increases the amount of goods and services that wealth can buy 2) The rate of interest effect – if interest rate rises there will be less consumption and the price level will fall, which in turn will increase demand 3) The international trade effect – a rise in the price level will make the country’s products less competitive and people may buy from abroad, which will cause a contraction 31

32. Aggregate Demand Movement along the aggregate demand curve The only factor that will cause a movement along the aggregate demand curve is the price Let’s take a look… 32

33. 33 Aggregate Demand Price Level Real GDP Aggregate Demand As price level rises, AD falls This is a movement along the AD curve

34. Aggregate Demand Shift of the aggregate demand curve A change in any other factor will cause a shift along the aggregate demand curve Such as… Changes in expectations Government policy Changes in exchange rates Changes in populations size Let’s take a look… 34

35. 35 Shifts in Aggregate Demand Price Level Real GDP AD 1 AD 2 If Consumption has increased, then this will shift AD outwards (expansion)

36. Aggregate Demand For each of the following, sketch the AD line and show what would happen to the line (fully label your diagram and show the direction of the change): 1) Consumer expenditure has decreased 2) The price level has increased 3) The population has decreased 4) Consumer expectations are low 5) The government has cut the rate of income tax 36

37. Aggregate Demand Review of last lesson… 1) To recognise that aggregate demand and the price level are inversely related 2) To be able to explain why the aggregate demand curve may shift 37

38. Aggregate Supply and Equilibrium Definition of aggregate supply “Aggregate supply is the total output of goods and services that producers in an economy are willing and able to supply at different price levels in a given time period” 38

39. Aggregate Supply and Equilibrium There are two versions of the AS curve The short-run aggregate supply curve (SRAS) The long-run aggregate supply curve (LRAS) We will consider the SRAS curve 39

40. Aggregate Supply and Equilibrium What does the supply curve show? Same axis as AD: Price level and Real GDP Low level of supply means that unemployment is high and the price level will be low (because of the availability of resources) High level of supply means that unemployment is low (as output increases) and the price level will be higher (because of scarce resources and production inefficiencies) Let’s take a look… 40

41. Aggregate Supply and Equilibrium Wait…. One more thing…. In the short-run… The PRICES OF FACTORS OF PRODUCTION are assumed to be fixed… Now let’s take a look… 41

42. 42 Aggregate Supply and Equilibrium Price Level Real GDP Aggregate Supply Upward sloping as firms will increase output if the price they receive increases

43. Aggregate Supply and Equilibrium Shifts in the AS curve A change in AS means that the total output that producers are willing and able to supply, at any given price level, alters A decrease in supply is represented by a shift to the left of the AS curve A increase in supply is represented by a shift to the right of the AS curve Let’s take a look… 43

44. 44 Shifts in SRAS Price Level Real GDP Aggregate Supply

45. Aggregate Supply and Equilibrium What causes a shift in the supply curve? Changes in the cost of production Wages Raw materials The quality and quantity of the factors of production will cause a shift of the supply curve in the long run e.g. Quantity of labour: immigration, raise in retirement age, Quality of labour: education increases productivity 45

46. Aggregate Supply and Equilibrium Please complete the following worksheet “Aggregate Supply – Basic Concepts” Then we will move on to Macroeconomic Equilibrium 46

47. Aggregate Supply and Equilibrium Learning Objectives for this lesson… 1) Define what is meant by equilibrium in the macroeconomy 2) Explain how the macroeconomic equilibrium is determined. 3) Explain why the macroeconomic equilibrium may change. 47

48. Aggregate Supply and Equilibrium Definition on macroeconomic equilibrium: “Macroeconomic equilibrium occurs when aggregate demand and aggregate supply are equal and there is no reason for the economy’s output or the price level to change” We will consider the short-run equilibrium Remember……at equilibrium AD = SRAS 48

49. Short-run Equilibrium AD = SRAS Let’s take a look…. 49

50. 50 Short-run Equilibrium Price Level Real GDP SRAS AD Equilibrium Price Level Equilibrium Real GDP

51. Aggregate Supply and Equilibrium If there is excess demand (i.e. AD > AS) then this means there is a shortage of goods and services Firms would find their stocks declining The excess demand would encourage them to expand their output until firms could meet the demand Finally, the market would be back in equilibrium 51

52. Aggregate Supply and Equilibrium If there is excess supply (AS > AD) then this means there is a surplus of goods and services Firms would find their stocks increasing The excess supply would encourage them to contract their output until they achieved the right supply level to meet demand Finally, the market would be back in equilibrium 52

53. Aggregate Supply and Equilibrium The equilibrium price level is “the only price which will lead to suppliers producing exactly the right output to satisfy the demands from consumers, investors, the Government and overseas consumers” Activity… 53

54. Aggregate Supply and Equilibrium Activity… Draw 4 axis (which are fully labelled) For each one, draw a AD and AS curve and show the effect of the following: An increase in demand A decrease in demand An increase in supply A decrease in supply Fully label you diagram and include arrows to show the direction of change for GDP, Price Level and Equilibrium Be prepared to draw your answers on the board 54

55. 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 55

56. 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 56

57. Price Level RNO Yp SRAS LRAS Potential GDP Short run GDP exceeds potential

58. Price Level RNO Yp SRAS LRAS Potential GDP Short run GDP exceeds potential

59. Price Level RNO Yp SRAS LRAS Potential GDP Short run GDP exceeds potential Short run GDP below potential

60. Price Level RNO Yp SRAS LRAS Potential GDP Short run GDP exceeds potential Short run GDP below potential Positive output gap

61. Price Level RNO Yp SRAS LRAS Potential GDP Short run GDP exceeds potential Short run GDP below potential Positive output gap Negative output gap

62. General Price Level Real National Output Yp SRAS LRAS AD

63. General Price Level Real National Output Yp SRAS LRAS AD AD2 P1 Y2

64. General Price Level Real National Output Yp SRAS LRAS AD AD2 P1 Y2

65. General Price Level Real National Output Yp SRAS LRAS AD AD2 P1 Y2 SRAS2 P2

66. General Price Level Real National Output Yp SRAS LRAS AD AD2 P1 Y2 SRAS2 P2

67. The Keynesian non-Linear Supply Curve Price Level LRAS Yfc

68. The Non-Linear Supply Curve Price Level LRAS Yfc SRAS1 Elastic supply AD AD2

69. The Non-Linear Supply Curve Price Level LRAS Yfc SRAS1 Elastic supply AD AD2 AD3 AD4

70. The Non-Linear Supply Curve Price Level LRAS Yfc SRAS1 Elastic supply AD AD2 AD3 AD4 AD5 AD6

71. An Outward Shift in Short Run Aggregate Supply Price Level RNO LRAS SRAS1 SRAS2 Yfc Fall in production costs boosts Short run aggregate supply at each price level

72. An Inward Shift in SRAS Price Level RNO LRAS SRAS1 SRAS2 Yfc SRAS3

73. An Increase in Long Run Aggregate Supply Price Level Real National Output LRAS LRAS2 LRAS3

74. The Multiplier Definition of the multiplier “The multiplier effect is the process by which any change in a component of aggregate demand results in a greater final change in real GDP” Confused? What does this mean? Let’s consider it… 74

75. The Multiplier When injections exceed leakages, aggregate demand will increase We know this already This rise in aggregate demand (because of net injections) will have a greater final effect on the economy) Why?... 75

76. The Multiplier …because when people spend money, that expenditure becomes the income of those who sell them the products… …they in turn will spend some of the money they receive… …so there is a knock-on effect, with AD rising more than the initial amount… …THIS IS CALLED THE MULTIPLIER EFFECT (when AD rises more than the initial amount of net injections) 76

77. The Multiplier The concept… “£100 of investment will increase aggregate demand in the economy by more than £100” Let’s see how… 77

78. The Multiplier 78 Firm invests £100 wages profits Households receive £100 Save £10 Spend £90 Firms receive £90 wages profits As long as households do not save all their money the increase in Investment will increase Consumption. The less the Consumer saves, the less the leakage and the larger the multiplier is

79. The Multiplier Let's assume that all people in our society tend to save 10% of what they earn. Thus, their marginal propensity to consume (MPC) is 90%. That would mean that our MPC is equal to 0.9. Let us also assume that the government spends £2,500.00 on a an increase in a teacher’s salary. Thus, our change in aggregate demand is £2,500.00. Let's explore how much this initial expenditure will influence the economy at large... 79

80. The Multiplier CHANGE IN GDP = £2,500.00 x 1___ 1 - 0.9 CHANGE IN GDP = £2,500.00 x 10 CHANGE IN GDP = £25,000 MULTIPLIER = 25,000 / 2,500 = 10 80

81. The Multiplier By the way… You won’t need to remember the formula to calculate the multiplier… But it is still useful to be able to work it out 81

82. The Multiplier Why is the multiplier useful? The existence of the multiplier effect means that a government has to recognise that any change in government spending will have a knock-on effect on the economy If government wants to raise real GDP by £10billion and the multiplier has been estimated at 2, it would have to raise spending by £5billion Try an example that you will need to know how to do… 82

83. The Multiplier If the multiplier is 2.5 and the government wants to raise real GDP by £150 billion, how much would it have to raise spending by? 150/2.5 £60 bn 83

84. The Multiplier Review of the learning objective… Show a general awareness of the multiplier effect 84

85. The Multiplier Review of last lesson… Show a general awareness of the multiplier effect 85

86. 86 Increase in AD SRAS AD1 Price Level Real GDP AD2 GDP 1 GDP 2 P1P1 P2P2

87. 87 Decrease in AD SRAS AD2 Price Level Real GDP AD1 GDP 2 GDP 1 P2P2 P1P1

88. 88 Increase in SRAS SRAS1 AD Price Level Real GDP GDP 1 P1P1 SRAS 2 P2P2 GDP 2

89. 89 Decrease in SRAS SRAS2 AD Price Level Real GDP GDP 2 P2P2 SRAS 1 P1P1 GDP 1

90. Output, Unemployment and Inflation: Changes in AD/AS Now, we shall consider the following; Changes in aggregate demand Changes in aggregate supply Changes in both AD and AS 90

91. Output, Unemployment and Inflation: Changes in AD/AS 1) Changes in AD To evaluate a change in AD, we need to consider; the actual change in AD the initial AD level in the economy the size of the multiplier 91

92. Output, Unemployment and Inflation: Changes in AD/AS 1) Changes in AD An increase in AD in an economy which has considerable share capacity is likely to; Raise output Reduce unemployment Perhaps leave the price level unchanged If the economy is already operating at full capacity and full employment, then any increase in AD is purely inflationary 92

93. Output, Unemployment and Inflation: Changes in AD/AS 2) Changes in AS The effect of a change in AS will depend on; The size of the change The initial level of economic activity An increase in AS occurring when the economy is at, or close to, full capacity will raise output and lower the price level (refer to Fig. 4.14 in your books on p99) 93

94. Output, Unemployment and Inflation: Changes in AD/AS 2) Changes in AS There is a possibility that an increase in AS will have no impact on the economy and could happen if; The economy is operating at a low output level, AND There is a high level of unemployed resources. …potential output would increase but actual output would remain the same as with the price level (refer to Fig 4.15 on p99 of your text book) 94

95. Output, Unemployment and Inflation: Changes in AD/AS Changes in both AD and AS Over time in most countries, both AD and AS increase AD can increase because of a rise in population AS can increase because of advances in technology and improved education 95

96. Output, Unemployment and Inflation: Changes in AD/AS Changes in both AD and AS If increases in AS can match AD, the economy can enjoy higher output without encountering inflationary pressure If AD grows more rapidly than AS, this is called overheating and will result in inflation The result is higher output but at a cost of higher prices There needs to be more AS to settle the inflation 96

97. Output, Unemployment and Inflation: Changes in AD/AS Changes in both AD and AS Example of a shift in both curves… Immigration of people of working age and government spending on training that raises workers’ productivity…this will shift both curves Sketch the above using an ADAS graph. Label your diagram and explain in full what has happened and why. 97

98. Output, Unemployment and Inflation: Changes in AD/AS The Output Gap Definition of the output gap; “The output gap is the difference between an economy’s actual and potential GDP Output Gap = Actual Output – Potential Output 98

99. Output, Unemployment and Inflation: Changes in AD/AS The Output Gap A negative output gap occurs when the economy’s output is below its potential output A positive output gap arises when an economy’s actual output is above that of its potential output Can there be a positive output? Let’s see…. 99

100. Output, Unemployment and Inflation: Changes in AD/AS The output gap A positive output gap may seem impossible and it is certainly unsustainable for long periods of time, but… In the short-term, workers can work overtime, people enter the labour force that wouldn’t otherwise enter it, and machines continue operating without downtime Indeed, countries with positive output gaps usually experience inflation 100