Aggregate Demand and Supply

Aggregate demand and supply determining

major macro economic variables

Output
Money (real GDP)
Spending and Taxes
Other forces Aggregate
demand
Interaction of Employment
agg. demand &
& unemployment
agg. supply
Price level & costs Aggregate
Potential output supply Prices &
Capital, labor, technology inflation

Foreign
trade
 Definitions :

Aggregate demand :refers to the total amount that different

sectors in the economy ( consumers, governments,
businesses) willingly spend in a given period.
Depends on level of prices, monetary policy fiscal policy
and other factors.

Aggregate supply: refers to the total quantity of goods and

services that the nation’s businesses are willing to produce
and sell in a given period.
Depends on price level, productive capacity and the
level of costs.
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

 Shows the overall level of spending at

different price levels

Aggregate Demand Curve
 Why does it slope down from left to right?
 Assume Bank of India 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 CPI)
 Real GDP or Real National Income or
Real Output on the vertical axis
(shown by the initial Y)
 Aggregate Demand Curve
Inflation The lower level of
National Income requires
fewer units of labour –
unemployment rises to
7% shown by U = 7%
3.0%

2.0%

AD

Y2 Y1 Real National Income

 Shifts in the Aggregate Demand Curve
This would cause a rise
in national income
Inflation
(economic growth) and
lead to a fall in
unemployment (U =
2%) (and vice versa)

2.0 %

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
 Credit
 Interest rates
 Wealth
 Property

 Shares

 Savings

 Bonds
Investment Expenditure
 Spending on:
 Machinery
 Equipment
 Buildings
 Infrastructure
 Influenced by:
 Expected rates of return
 Interest rates
 Expectations of future sales
 Expectations of future inflation rates
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 the UK (reduces AD)
Export Earnings (Positive)
 Goods and services sold abroad –
represents a flow of funds into the UK
(raises AD)
Impact on aggregate demand

Monetary policy : Increase in money supply

lowers interest rates and improves credit
conditions, inducing higher levels of investment
and consumption of durable goods

Fiscal policy : Increases in expenditures on

goods and services directly increase spending;
tax reductions or increases in transfers raise
income and induce higher consumptions
 Impact on aggregate demand

Foreign o/p : Output growth abroad leads to an

increase in net exports.
Asset values : stock-price or housing price produces
greater household wealth and thereby increases
consumption and also increases investment
Oil-price decrease : higher oil production decreases
oil price hence consumption and investment
increases
Advances in technology : opens new opportunities
for investment.
Aggregate Supply (AS)
Capacity of the Economy
 Costs of Production
 Technology
 Education and Training
 Incentives
 Tax regime
 Capital stock
 Productivity
 Labour Market
 Aggregate Supply
Between Y1 and Yf,
increases in capacity are
possible but the nearer
Inflation AS the economy gets to Yf,
the more problems are
experienced with acquiring
resources to boost
production (production
bottlenecks) especially
labour skills shortages.
Economy starts to overheat

Y1 Yf
Real National Income
 Aggregate Supply
Increases in
capacity can
occur as a result
AS1 AS2 of a shift in AS
Inflation (akin to a shift
outwards of the
Production
Possibility
Frontier) (PPF)

Yf1 Yf2
Real National Income
 Aggregate Supply
SRAS assumes
costs such as
overall wage
Inflation rate remain
fixed, changes
in such costs
SRAS1 cause a shift in
the SRAS curve
(exogenous
shocks – input
SRAScosts)

SRAS2

Real National Income

 Aggregate Supply
This is because they
believe that in the long
Inflation LRAS 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

Real National Income

 Aggregate Supply

AS For our analysis, we

Inflation will assume the AS
curve looks like this!

Yf

Real National Income

 Putting AD and AS together

A shift in the AD
curve to AD1 as a
Inflation AS 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)

2.5%

2.0%
AD1

AD

Y1 Y2 Yf

Real National Income

 Putting AD and AS together

Further increases in
AD would lead to
Inflation AS successively
smaller increases in
growth and
employment at the
cost of ever higher
3.5% inflation.

2.5%

2.0%
AD1

AD

Y1 Y2 Y3 Yf
Real National Income
 Sustained Growth
Sustained growth
(not to be
Inflation AS confused with
AS1
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
 Impact on aggregate supply

Potential o/p : it assumes unemployment of labor and other

resources at lowest level with stable inflation. Growth of
inputs increases potential output and aggregate supply
Technology and efficiency: Innovation and technological
improvements can increase level of potential output.
Wages : lower wages gives lower production costs which means
that quantity supplied will be higher at every price level.
Import prices : decline in foreign prices and exchange rate,
import prices will fall which leads to lower production and
raises aggregate supply.
Other i/p costs : lower oil prices , lowers production costs and
raises aggregate supply.
 When output is less than full-
employment, the primary impact of
an increase in aggregate demand
will be an increase in output.
 When output is at or beyond the full-
employment level, the primary
impact of an increase in demand will
be higher prices.
 Market forces may fail to restore full
employment quickly. During a serious
recession, excess capacity and
pessimism about the future are likely to
slow the adjustment process.
 The responsiveness of aggregate
supply to changes in demand will be
directly related to the availability of
unemployed resources.
 Fluctuations in aggregate demand are
an important source of business
instability.
 The problem faced by China and India was, in fact,
higher inflation as a result of higher GDP growth of
more than 9 per cent in the past few years,
warranting a tight monetary policy rather than lower
interest regimes.

 However, the export of the US crisis has resulted in

abrupt withdrawal of western investments to meet
their own needs, which resulted in a stock market
crash, leading to contraction of capital needed to oil
the continued the growth process, and the resultant
liquidity crisis.
 It is, therefore, obvious that while growth may
contract, the opportunities posed by the lower
valuations of assets as an outcome of the stock
market crash and bursting of the real estate bubble
will lead to a revival of domestic investment. The next
boom will be from Asian economies, which are
expected to fuel the growth of the world economy.
Key Variables
Macroeconomic Policy
Fiscal Policy
 Government Income (taxes and
borrowing)
 Government Spending
Monetary Policy
Monetary policy is the government or
central bank process of managing money
supply to achieve specific goals—such as
constraining inflation, maintaining an
exchange rate, achieving full employment or
economic growth. Monetary policy can
involve changing certain interest rates,
either directly or indirectly through open
market operations, setting reserve
requirements, or trading in foreign exchange
markets
Types of Monetary policies and objectives

Inflation Targeting

Target market variable : Interest rate

on overnight debt

Long term objective : A given rate

of change in the CPI
Types of Monetary policies and objectives

Price Level Targeting

Target market variable : Interest rate

on overnight debt

Long term objective : A specific CPI

number
Types of Monetary policies and objectives

 Monetary Aggregates

Target market variable : The growth in

money supply

Long term objective : A given rate of

change in the CPI
Types of Monetary policies and objectives

Gold Standard

 Target market variable :The spot

price of gold

 Long term objective : Low

inflation as measured by the
gold price
Types of Monetary policies and objectives

 Mixed Policy

Target market variable : Usually interest

rates

Long term objective : Usually

unemployment + CPI change
 Monetary policy

expansionary policy contractionary policy,

increases the total supply decreases the total

money money supply in the
economy

traditionally used to has the goal of raising

combat unemployment in interest rates to combat

a recession by lowering inflation

interest rates