1. Aggregate Demand and Supply

3. Aggregate Demand (AD)

4. Aggregate Demand The sum of all expenditure in the economy over a period of time The sum of all expenditure in the economy over a period of time Macro concept – WHOLE economy Macro concept – WHOLE economy Formula: Formula: AD = C+I+G+(X-M) C= Consumption Spending C= Consumption Spending I = Investment Spending I = Investment Spending G = Government Spending G = Government Spending (X-M) = difference between spending on imports and receipts from exports (Balance of Payments) (X-M) = difference between spending on imports and receipts from exports (Balance of Payments)

5. Aggregate Demand Curve Shows the overall level of spending at different price levels Shows the overall level of spending at different price levels Note – Inflation used for the vertical axis – follows from new thinking on the derivation of AD curves from the likes of David Romer @ University of California – Assumes Central Banks do not target the money supply but short term interest rates Note – Inflation used for the vertical axis – follows from new thinking on the derivation of AD curves from the likes of David Romer @ University of California – Assumes Central Banks do not target the money supply but short term interest rates

6. Aggregate Demand Curve Why does it slope down from left to right? Why does it slope down from left to right? Assume Bank of England sets short term interest rates Assume Bank of England sets short term interest rates Assume a rise in the price level will be met by a rise in interest rates Assume a rise in the price level will be met by a rise in interest rates Any increase in interest rates will raise the cost of borrowing: Any increase in interest rates will raise the cost of borrowing: Consumption spending will fall Consumption spending will fall Investment will fall Investment will fall International competitiveness will decrease – exports fall, imports rise International competitiveness will decrease – exports fall, imports rise Therefore – a rise in the price level leads to lower levels of aggregate demand Therefore – a rise in the price level leads to lower levels of aggregate demand

7. Aggregate Demand Curve The AD diagram: The AD diagram: Inflation on the vertical axis – assume an initial ‘target rate’ of 2.0% (as measured by the HICP or CPI) Inflation on the vertical axis – assume an initial ‘target rate’ of 2.0% (as measured by the HICP or CPI) Real GDP or Real National Income or Real Output on the vertical axis (shown by the initial Y) Real GDP or Real National Income or Real Output on the vertical axis (shown by the initial Y)

8. Aggregate Demand Curve Inflation Real National Income AD 2.0% Y1 At an inflation level of 2%, the AD curve gives a level of output of Y1 This level of output will be associated with a particular level of unemployment which we will call U = 5% U = 5% 3.0% Y2 At a higher rate of inflation (3.0%) rising interest rates mean that C, I and (X-M) all have negative effects on AD – NY falls to Y2 U = 7% The lower level of National Income requires fewer units of labour – unemployment rises to 7% shown by U = 7%

9. Shifts in the Aggregate Demand Curve Inflation Real National Income AD 2.0% Y1 U = 5% Shifts in AD will be caused by changes in factors affecting C, I, G and (X-M) (exogenous factors) e.g. increasing income tax rates affect consumption AD2 Y2 U = 2% Any exogenous factor causing C, I or G to rise, or a trade surplus causes a shift to the right in AD This would cause a rise in national income (economic growth) and lead to a fall in unemployment (U = 2%) (and vice versa)

10. Consumption Expenditure Exogenous factors affecting consumption: Exogenous factors affecting consumption: Tax rates Tax rates Incomes – short term and expected income over lifetime Incomes – short term and expected income over lifetime Wage increases Wage increases Credit Credit Interest rates Interest rates Wealth Wealth Property Property Shares Shares Savings Savings Bonds Bonds

11. Investment Expenditure Spending on: Spending on: Machinery Machinery Equipment Equipment Buildings Buildings Infrastructure Infrastructure Influenced by: Influenced by: Expected rates of return Expected rates of return Interest rates Interest rates Expectations of future sales Expectations of future sales Expectations of future inflation rates Expectations of future inflation rates

12. Government Spending Defence Defence Health Health Social Welfare Social Welfare Education Education Foreign Aid Foreign Aid Regions Regions Industry Industry Law and Order Law and Order

13. Import Spending (negative) Goods and services bought from abroad – represents an outflow of funds from the UK (reduces AD) Goods and services bought from abroad – represents an outflow of funds from the UK (reduces AD)

14. Export Earnings (Positive) Goods and services sold abroad – represents a flow of funds into the UK (raises AD) Goods and services sold abroad – represents a flow of funds into the UK (raises AD)

15. Key variables

16. Macroeconomic policy

17. Fiscal Policy Government Income (taxes and borrowing) Government Income (taxes and borrowing) Government Spending Government Spending

18. Monetary Policy Interest Rates (Bank of England) Interest Rates (Bank of England)

19. Aggregate Supply (AS)

20. Capacity of the Economy Costs of Production Costs of Production Technology Technology Education and Training Education and Training Incentives Incentives Tax regime Tax regime Capital stock Capital stock Productivity Productivity Labour Market Labour Market

21. Aggregate Supply Inflation Real National Income The shape of the AS curve is important in determining the outcome in the economy AS Yf This shape reflects a Keynesian view of the AS curve. Yf represents ‘Full Employment Output – at this point the economy is working to full capacity and cannot produce any more Y1 An output level of Y1 would suggest the economy is working below full capacity and there would be widespread unemployment Economy starts to overheat Between Y1 and Yf, increases in capacity are possible but the nearer the economy gets to Yf, the more problems are experienced with acquiring resources to boost production (production bottlenecks) especially labour skills shortages.

22. Aggregate Supply Inflation Real National Income AS1AS2 Yf1 Yf2 Increases in capacity can occur as a result of a shift in AS (akin to a shift outwards of the Production Possibility Frontier) (PPF)

23. Aggregate Supply Inflation Real National Income SRAS Short run aggregate supply (SRAS) assumes firms only able to increase output at higher costs (e.g. overtime payments) thereby pushing up price level SRAS 1 SRAS 2 SRAS assumes costs such as overall wage rate remain fixed, changes in such costs cause a shift in the SRAS curve (exogenous shocks – input costs)

24. Aggregate Supply Inflation Real National Income LRAS Classical economists assume the long run aggregate supply curve (LRAS) is vertical (perfectly inelastic). This is because they believe that in the long run, there will be no unemployment of resources because markets will clear, thus whatever the rate of inflation, firms will supply the maximum capacity of the economy. Yf

25. Aggregate Supply For our analysis, we will assume the AS curve looks like this! Inflation Real National Income AS

26. Putting AD and AS together Inflation Real National Income AS Yf AD 2.0% Y1 In this situation, the economy would be operating at less than capacity, there would be unemployment and the economy might be growing only slowly. AD 1 Y2 2.5% A shift in the AD curve to AD1 as a result of a change in any or all of the factors affecting AD would increase growth, reduce unemployment but at a cost of higher inflation (a trade-off)

27. Putting AD and AS together Inflation Real National Income AS Yf AD 2.0% Y1 AD1 Y2 2.5% AD2 3.5% Further increases in AD would lead to successively smaller increases in growth and employment at the cost of ever higher inflation. Y3

28. Sustained Growth Inflation Real National Income AD AS 2.0% Y1 AS1 Y2 AD2 Sustained growth (not to be confused with sustainable economic growth) occurs when AS and AD rise at similar rates – national income can rise without effects on inflation