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3.2 Aggregate Demand and Aggregate Supply
3.2.1 Aggregate demand 3.2.2 Determinants of aggregate demand components 3.2.3 Aggregate supply
Terms in this set (17)
What is aggregate demand and why is the curve downward sloping?
AD is the total spending of goods and services in a period of time at a given price level. (C+G+I+(X-M))
1. The wealth effect; as the average price level falls, the wealth of participants in the economy increases in real terms as their ability to purchase goods and services improves
2. The interest rate effect; when price levels decrease
3. The net-balance effect; a lower price level makes goods and services relatively cheaper for foreign countries to buy, so the demand for exports rises, increasing the net trade balance.
What determinants impact the component of consumption?
1. Real interest rates; when taking out sums it includes interest, so when interest rates fall, this makes it easier for people to borrow money and spend, as the repayment on that borrowing becomes lower. Low interest rates also discourage saving, which is a leakage to the circular flow. Lower savings and increased borrowing can both result in a rightward shift of the AD.
2. Personal taxes; the amount that we have to pay in tax to the government varies, but when income tax increases, we have less disposable income to spend on other things, shifting AD leftward.
3. Expectations of future price level; consumers may decide to spend more and save less if they expect inflation. If they expect price levels to fall, they may choose to save more which which shift AD leftwards.
What determinants impact the component of investment?
1. Interest rates; firms borrow to finance large-scale investment because it is easier to manage repayments in smaller amounts rather than saving money and spending it all at once. Lower interest rates may encourage borrowing and investment (AD shifts rightward)
2. Business confidence; if prices are rising rapidly or a recession is looming, firms are unlikely to spend or plan for expansion. They will cut their costs (causing AD to shift leftward)
3. Technology; improvements in technology reduce the need for using more resources than are necessary and decrease production costs, causing AD to shift rightward
4. Business taxes; Raising business taxes reduces the amount left for investment and causes leftward shift of AD
What causes a shift in government spending?
Government spending largely depends on their political and economic priorities.
The government has powers over government expenditure, such as how much tax is levied, different sectors of society will be prioritised, such as education, healthcare, defence, welfare and so on.
Economic priorities are dependent on the health of the economy. They may change depending on current and future predictions of how the economy is doing at achieving macroeconomic goals, such as employment or low and stable inflation.
What determinants impact the component of net exports?
1. Income of trading partners; the growth of large emerging consumer markets provide large boosts in the exports for developed markets like German, Japan and the USA. As incomes have risen in the emerging markets, a greater demand for the exports of the developed markets has resulted in a rightward shift of AD. A slowdown in consumption in one economy can result in a leftward shift of AD in another, as consumers become less willing or able to purchase the exports.
2. Exchange rates; values of currencies determine the relative prices of goods and services traded. When exchange rates increase, more of one currency is required to purchase another, making the exports less competitive, but also makes it cheaper to import goods and services, which will cause a leftward shift of AD.
3. Changes in trade policies; can affect the way that countries interact with other economies. They might impose trade restrictions like tariffs, quotas or increase levels of protectionism. If imports decrease and exports increase, AD will shift rightwards.
Case study: Australia's reliance on Exports
- The Australian economy is highly dependent on exports of mined natural resources which account for roughly 6% of GDP
- 3.7% of that comes from coal
The demand for natural resources, such as fossil fuels like coal from Australia, has increased due to the expansion of emerging economies like China and India
- 24% of exported coal goes to China
- In 2019, it was reported that the Chinese government was turning towards natural gas in order to generate electricity
- They planned to curb imports of coal to support the domestic coal industry, shifting Australia's GDP inwards
What are the two types of government policies that affect aggregate demand?
1. Fiscal policy - relating to spending and taxation rates
2. Monetary policy - money supply and interest rate levels
How can expansionary fiscal policy be used to increase AD?
- Lower taxes to increase disposable income, which is likely to increase AD
- Lower corporate taxes so that firms can enjoy higher after-tax profits that can be used for investment
- Increase government spending through major investment projects that can improve or increase public services, which directly impacts upon AD
How can monetary policy be used to increase AD?
- The central bank is the ultimate authority in control of the money supply in an economy, with the primary responsibility of maintaining a low and stable rate of inflation
- The central bank's base rate impacts all borrowing and lending in the economy
- To increase AD, the base rate should be lowered, which reduces the cost of borrowing and leads to increases in both consumption and investment
What is aggregate supply? Define the term 'short-run'.
AS is the total quantity of goods and services produced in an economy over a specific time period at different price levels.
The short-run is the period during which resource prices or costs of production remain relatively constant, especially wages.
There is a positive relationship between the output that firms are willing and able to provide and the selling price of goods and services in the economy. As firms receive higher prices for the goods that they sell, they will be more willing and able to produce output, as long as their costs of production, especially wages, remain constant in the short run.
What are the determinants of SRAS?
1. Resource prices; the price of inputs relating to production can have a significant impact on a firm's productive capacity and ability. Economies highly depend on energy. Any changes to the price of energy can have a significant impact on the price of all the goods and services we buy. If the price of electricity doubled then the short-term production capability of firms, as well as the number of firms in the economy, decreases, shifting AD leftwards.
2. Government intervention; Governments can choose to increase or decrease the amount of regulation firms in the economy face. This allows firms to retain or spend more of their revenue to meet those regulations. Lowering business taxes for firms can also allow them to keep a greater share of their profit. This means that they can reinvest their money to increase the number or efficiency of the factors of production that they use.
3. Supply shocks; A supply shock refers to what happens to the overall aggregate supply in a country when it is affected by an event. During the 1970s oil embargo by OPEC, the Western world experienced a supply shock as the prices of oil rose sharply. Supply shocks can also occur if there are large-scale natural or human-made disasters that delay or destroy the regular production of a business in the short run. This will all shift AD leftward.
What causes a shift in SRAS vs. what causes a shift in LRAS?
The SRAS curve shifts due to changes in costs of production.
The LRAS curve represents the potential capacity of an economy's factors of production and if shifted by changes in the quantity of factors of production or quality of factors of production.
How can you increase the quantity/improve the quality of the factors of production?
Land: the natural resources and inputs that a country has available
- Reclamation of land, increased access to supply of resources, the discovery of new resources
- Improvements in technology to use it more efficiently, unconventional methods of extraction, fertilisers and irrigation to increase yield
Labour: the people that make up the labour force of the country
- Immigration or domestic birth rates can increase the quantity of labour that is available
- Improve the skill and education of the human capital (the workforce), improvements in technology improving the productivity of workers, apprenticeship programmes
Capital: the tools and machinery that are used in economic production
- Construct more infrastructure like roads, factories and railways
- Change the productivity of the capital by retrofitting them to become more energy-efficient, or faster with new technology, R&D
What are the 2 types of government policies that can help to increase the potential output of the economy?
1. Interventionist supply-side policies; the government has a role to play in encouraging economic growth
2. Market-based supply side policies; allows markets to operate more freely with minimal government intervention
Describe interventionist supply-side policies to increase the quantity or quality of the factors of production:
1. Investment in human capital; education and training need to be available to improve the quality of the labour workforce. It is a positive externality because the benefits are felt by the people who receive the education and felt across the economy. This involves providing the skills/knowledge that people need to know to enter the labour workforce and also the retraining of workers to keep up with changing economic circumstances. Methods include schools, unis, apprenticeship programmes etc.
2. Research and Development (R&D); involves any pending directed towards the innovation and improvement of products and processes. Governments can encourage R&D by firms by offering tax incentives, such as tax credits (firms don't have to pay tax on the profit made by that R&D). They can also guarantee intellectual property rights like patents and copyrights.
3. Provision and maintenance of infrastructure; infrastructure is defined as large scale capital, and is necessary for economic activity to take place. Education/health systems and the legal framework of a country are also a type of infrastructure.
4. Support for industrial policies; targeted government interventions to drive the development of specific economic sectors. This increases the productivity of specific industries and helps them to grow. The government also helps them to improve the competitive nature through anti-monopoly laws. A common policy is import substitution where the government targets a particular industry with the goal to switch production from abroad to the domestic economy.
Describe the new classical LRAS view:
- This view primarily believes in the power of the market
- It believes that resource prices should be fully flexible both upwards and downwards, like wages
- Markets can correct any shortages or surpluses without need for government intervention
- The LRAS curve is perfectly inelastic/vertical, and is known as the full employment level of output, which represents the potential output that could be produced if the economy were operating at full capacity
- This view suggests that the potential output is based purely on the factors of production, and is independent of price level because price level rising does not increase output
Describe the Keynesian LRAS view:
- The Keynesian curve believes that government intervention is needed when the economy gets stuck in a short-run position
- This is because when there is spare capacity in the economy, firms cannot just cut down wages due to sticky wages (downwardly inflexible as workers' earnings don't adjust quickly to changes)
- Rather than just adjusting to lower prices and coming back to full employment, the economy can remain operating below its full potential
The curve is separated into 3 sections:
1. Flat portion; the AS curve is perfectly elastic during low levels of economic activity, and producers can raise their levels of output without incurring higher average costs because of the existence of spare capacity in the economy (high levels of unused factors like unemployed labour)
2. Upwards sloping portion; the economy approaches its potential output and the spare capacity is used up, so the economy's available factors of production become increasingly scarce and producers have to bid for them. Higher prices for factors of production mean higher costs for producers, so price levels rise to compensate
3. Vertical portion; The economy reaches full capacity and it is impossible to increase output any further as all FOPs are fully employed
Recommended textbook explanations
Principles of Economics
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Campbell R. McConnell, Sean M. Flynn, Stanley L. Brue
Economics: Principles in Action
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