Http:// Copyright 2005 – Biz/ed Aggregate Demand and Supply.

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Copyright 2005 – Biz/ed

Aggregate Demand and Supply



Aggregate Demand (AD)



Aggregate Demand• 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 CurvePriceLevel

Real National Income

AD

P1

Y1

At the price level P1, 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%

P2

Y2

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

U = 7%

The lower level of National Income requires fewer units of labour – unemployment rises to 7% shown by U = 7%



Shifts in the Aggregate Demand CurvePrice

Level


AD

P1

Y1U = 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

Y2U = 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)



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 SupplyPriceLevel


The shape of the AScurve 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.



Aggregate SupplyPriceLevel


AS1 AS2

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)



Putting AD and AS togetherPriceLevel


AS

Yf

AD

P1

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

P2

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)



Putting AD and AS togetherPriceLevel


AS

Yf

AD

P1

Y1

AD1

Y2

P2AD2

P3

Further increases in AD would lead to successively smaller increases in growth and employment at the cost of ever higher inflation.

Y3



Sustained GrowthPriceLevel


AD

AS

P1

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

Http:// Copyright 2005 – Biz/ed Aggregate Demand and Supply.

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