AGGREGATE DEMAND AND SUPPLY

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 Note Inflation used for the vertical axis follows from new thinking that Central Banks do not target the money supply but short term interest rates

AGGREGATE DEMAND CURVE

Why does it slope down from left to right? Assume RBI 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 will fall Investment will fall International competitiveness will decrease exports fall, imports rise

Therefore a rise in the price level leads to lower levels of aggregate demand

AGGREGATE DEMAND CURVE

The AD diagram: Inflation on the vertical axis assume an initial target rate of 2.0% (as measured by the WPI or CPI) Real GDP or Real National Income or Real Output on the vertical axis (shown by the initial Y)

AGGREGATE DEMAND CURVE

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

3.0%

2.0% AD
Y2 U = 7% Y1 U = 5%

Real National Income

SHIFTS IN THE AGGREGATE DEMAND CURVE

Inflation

This would cause Shifts in AD will be Any exogenous caused bynational changes in a rise in factor causing C, factors affecting C, I, income (economic G and (X-M) I or G to rise, or growth) and lead (exogenous factors) a surplus to trade a fall in e.g. increasing unemployment causes a shift (U to income tax rates = 2%) (and the right in vice AD affect consumption versa)

2.0%

AD2 AD
Y1
U = 5%

U = 2%

Y2

Real National Income

CONSUMPTION EXPENDITURE

Exogenous factors affecting consumption:

Tax rates Incomes short term and expected income over lifetime Wage increases Credit Interest rates Wealth Property Shares Savings Bonds

INVESTMENT EXPENDITURE

Spending on:

Machinery Equipment Buildings Infrastructure Expected rates of return Interest rates Expectations of future sales Expectations of future inflation rates

Influenced by:

GOVERNMENT SPENDING

Defence Health Social Welfare Education Foreign Aid Regions Industry Law and Order

IMPORT SPENDING (NEGATIVE)

Goods and services bought from abroad represents an outflow of funds from India (reduces AD)

EXPORT EARNINGS (POSITIVE)

Goods and services sold abroad represents a flow of funds into India(raises AD)

KEY VARIABLES

MACROECONOMIC POLICY

FISCAL POLICY

Government Income (taxes and borrowing) Government Spending

MONETARY POLICY

Interest Rates (RBI)

AGGREGATE SUPPLY (AS)

CAPACITY OF THE ECONOMY

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

AGGREGATE SUPPLY
Inflation AS
The shape the AS An output level of Y1 Yf represents Full increases in of capacity are This shape curve issuggest important would thein Employment Output possible but the nearer reflects a the economy to Yf, determining the economy at this point isgets working the the more problems are to outcome in the economy below full iscapacity working Keynesian view experienced with acquiring economy full and capacity there would and be of the AS curve. resources to boost cannot widespread produce any production (production more. unemployment. bottlenecks) especially
labour skills shortages. Between Y1 and Yf,

Economy starts to overheat

Y1

Yf

Real National Income

AGGREGATE SUPPLY
Inflation 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

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

SRAS 1 SRAS

SRAS 2

Real National Income

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

Yf

Real National Income

AGGREGATE SUPPLY
Inflation AS
For our analysis, we will assume the AS curve looks like this!

Real National Income

PUTTING AD AND AS TOGETHER

Inflation AS
A shift in the AD In thisto situation, the curve AD1 as a economy would bein result of a change operating at the less any or all of than capacity, there factors affecting AD would be would increase unemployment growth, reduce and the economy might unemployment but at be growing only a cost of higher slowly. inflation (a trade-off)

2.5%

2.0%

AD 1 AD

Y1

Y2

Yf

Real National Income

Putting AD and AS together

Inflation AS

3.5%
2.5%

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

AD2

2.0%

AD1 AD

Y1

Y2

Y3

Yf

Real National Income

SUSTAINED GROWTH
Inflation AS AS1
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

2.0%

AD2 AD

Y1

Y2

Real National Income