Aggregate Demand and Supply

Aggregate Demand and Supply

Aggregate Demand (AD)

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

Aggregate Demand Curve Shows the overall level of spending at different price levels

Aggregate Demand Curve Why does it slope down from left to right? Assume RBNZ sets short term 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: Consumption spending (C) will fall Investment (I) will fall International competitiveness will decrease because $NZ will appreciate– exports fall, imports rise Therefore – a rise in the price level leads to lower levels of aggregate demand

Aggregate Demand Curve The AD diagram: Price Level on the vertical axis – assume an initial ‘target rate’ of P1 (as measured by the CPI) Real GDP or Real National Income or Real Output on the vertical axis (shown by the initial Y)

Aggregate Demand Curve Price Level This level of output will be associated with a particular level of unemployment which we will call U = 5% The lower level of National Income requires fewer units of labour – unemployment rises to 7% shown by U = 7% At the higher Price Level of P2, rising interest rates mean that C, I and (X-M) all have negative effects on AD – NY falls to Y2 At the price level P1, the AD curve gives a level of output of Y1 P2 P1 AD Y2 Y1 Real National Income U = 7% U = 5%

Shifts in the Aggregate Demand Curve Price Level This would cause a rise in national income (economic growth) and lead to a fall in unemployment (U = 2%) (and vice versa) Any exogenous factor causing C, I or G to rise, or a trade surplus causes a shift to the right in AD 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 P1 AD2 AD Y1 Y2 Real National Income U = 5% U = 2%

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

Investment Expenditure Spending on: Machinery Equipment Buildings Infrastructure Influenced by: Expected return on investment Interest rates Business confidence (expected future revenues) Expected inflation rates (inflationary expectations)

Government Spending Defence (Army, Navy, etc) Health Education Law and Order Regions Industry

Import Spending (negative) Goods and services bought from abroad – represents an outflow of funds from NZ (reduces AD)

Export Earnings (Positive) Goods and services sold abroad – represents a flow of funds into NZ (raises AD)

Aggregate Supply (AS)

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

Aggregate Supply This shape reflects a Keynesian view of the AS curve. Price Level AS 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. Yf represents ‘Full Employment Output’ – at this point the economy is working to full capacity and cannot produce any more. The shape of the AS curve is important in determining the outcome in the economy An output level of Y1 would suggest the economy is working below full capacity and there would be widespread unemployment. This shape reflects a Keynesian view of the AS curve. Economy starts to overheat Y1 Yf Real National Income

Aggregate Supply Price Level AS1 AS2 Increases in capacity can occur as a result of a shift in AS (akin to a shift outwards of the Production Possibility Frontier) (PPF) Yf1 Yf2 Real National Income

Putting AD and AS together 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) In this situation, the economy would be operating at less than capacity, there would be unemployment and the economy might be growing only slowly. Price Level P2 P1 AD 1 AD Y1 Y2 Yf Real National Income

Putting AD and AS together Further increases in AD would lead to successively smaller increases in growth and employment at the cost of ever higher inflation. Price Level P3 AD2 P2 P1 AD1 AD Y1 Y2 Yf Y3 Real National Income

Sustained Growth Price Level AS AS1 P1 AD2 AD Y1 Y2 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 P1 AD2 AD Y1 Y2 Real National Income