Aggregate Demand (AD) and Aggregate Supply (AS) Analysis Changes in price level are shown by movements up and down the AD/AS curves Distinguish between the factors which shift the AD/AS curves in the short and long run Economic growth is shown by a shift right of the Long Run AS curve Use AD/AS Analysis to illustrate changes in price level, demanddeficient (cyclical) unemployment and economic growth
The Specification
Candidates should be able to define aggregate demand and explain and analyse the determinants of aggregate demand, i.e. the determinants of consumption, investment, government spending, exports and imports. In the context of investment, there should be an elementary understanding of the accelerator process.
Note: candidates will not be required to undertake any calculations to illustrate the operation of the accelerator.
Candidates should be able to explain and analyse the determinants of savings, and to appreciate the difference between saving and investment.
The Determinants of Aggregate Demand
Total demand in the economy, made up of consumption, investment, government expenditure and net exports Known as:
AD = C + I + G + (X-M) consumption + investment + gov spending + (exports-imports)
Aggregate Demand
Price Level
Notice the difference in axis labelling compared to microeconomics. You will be penalised in the exam if you do not label in this way.
AD
Real Output
Low prices – less rationing
Low prices of UK goods/services = more exports, also imports will appear more expensive, increasing demand domestically
Expectations – if consumers expect prices to increase in the future they will buy now, if they expect prices to fall in the future they will postpone their buying
Why does the curve slope from left to right?
Price Level Increase in AD
AD1
Decrease in AD AD2
AD
Real Output Shifts of the AD Curve – increases/decreases in AD due to a factor other than a change in the price level
Increase in AD
Decrease in AD
C + I + G + (X-M) consumption + investment + gov spending + (exports-imports)
Causes of Increases and Decreases in AD
Factors that affect level of Investment:
Interest rate – if it is low it will encourage borrowing to invest
Business expectations – positive expectations will encourage investment In the short term an increase in investment shifts AD to the right (increases it). rate of progress will Rate of technical progress – a high encourage updating In the long term what do you think it will do to the supply curve Rate of change of income – why? if demand is increasing and firms and are already producing at near to or at full capacity firms are likely to invest. This will create a large injection into the circular flow and create the multiplier effect. This reaction of investment to the rate of change of income is called the accelerator effect and coupled with the multiplier effect could lead to sizeable fluctuations in demand.
Investment: spending by firms on buildings, machinery and improving the skills of the labour force Multiplier Effect: where an increase or decrease in spending leads to a larger than proportional change in the national income
1.
Explain what is meant by the multiplier effect
2.
Explain what is meant by the accelerator effect
3.
Explain how the 2 are related
Task
Mainly on public, merit and local government goods
Has fallen over last 50 years due to the privatisation of many industries
This fall has also enabled a fall in taxation
Increases in government spending will shift the AD curve to the right
A cut in government spending will shift the AD curve to the left
Government Expenditure
Factors that affect Net Exports Nb. For high AD we want high eXports and low iMports
Levels of demand in the economies of trading partners (tend to be within the EU). High demand from overseas = high exports = high AD
Value of the pound sterling – if the value falls our goods become cheaper to overseas buyers and exports will rise, if the value rises those goods become more expensive and exports will fall Low £ value = high exports = high AD Similarly, if the value of the pound is high the buying power of UK consumers abroad increases resulting in higher imports High £ value = high imports = low AD
If the UK economy is growing and incomes are rising consumers are more likely to spend more on imports Rising incomes = high imports = low AD
Net Exports (X-M)
Write a paragraph explaining the factors which determine AD ◦ Try to build in analysis of their determining factors e.g. net exports is heavily influenced by the exchange rate
Task
Multichoice
The determinants of AD AD and the level of economic activity
Aggregate Supply
Price Level
AS
The Keynesian AS curve
Aggregate Supply
Real Output
Shows the total output the economy can produce using available factors of production at a given price level
As prices increase firms will increase output and while there is still labour available prices will increase at a slow rate
As the labour becomes scarce and the market becomes tight prices begin to increase at a higher rate
Eventually maximum employment is reached and the supply curve becomes vertical (perfectly inelastic)
Explaining the Keynesian AS Curve
Price Level
Price Level
LRAS
SRAS
Real Output
The Classical AS Curve
Real Output
A distinction between the short and long run In the short run wages remain constant and the price of all other factors in the economy remain fixed hence a predictable and gradual increase in price level as real output increases
A shift in the SRAS curve is caused by a change in costs ◦ ◦
An increase in costs will cause a shift from SRAS to SRAS1 A decrease in costs will cause a shift in SRAS to SRAS2
Price Level
An increase in wages will create a leftwards shift An increase in interest rates will create a leftwards shift An increase in the cost of imported materials (perhaps due to a fall in the value of the £) will create a leftwards shift An increase in corporation tax will create a leftwards shift, whereas a tax cut would create a rightwards shift
Shifts in the SRAS
SRAS1
SRAS
SRAS2
Real Output
The LRAS curve will become vertical (perfectly inelastic) before all factors of production are fully employed
This is because a certain proportion of the labour force opt to remain unemployed rather than work for low wages
These are referred to as the voluntary unemployed
This level of output when the LRAS Curve becomes vertical is called the natural rate of unemployment
Price Level
LRAS
Real Output
This corresponds to the vertical part of the Keynesian AS Curve and shows that the economy is working on its PPB
The LRAS
Increased capital equipment will shift the LRAS rightwards, perhaps caused by an interest rate fall
Natural disasters will shift the LRAS leftwards
Advancements in technology will create a rightward shift as capital equipment becomes more productive and labour productivity increases
Increases in labour productivity due to increased investment in education and training, more efficient working practices and better managerial techniques can create a rightwards shift
An entrepreneurial culture can create a rightwards shift, low taxation and social security benefits encourage this kind of culture
Persuading a larger proportion of the labour force to work can create a rightwards shift, by reducing income tax and social security benefits
Productivity increases will create a rightwards shift
Shifts of the LRAS
Price Level
LRAS2
LRAS
LRAS1
Real Output
A rightward shift shows rising real output and increasing economic growth
Price Level
AD
SRAS
Real Output
Macroeconomic Equilibrium When AD = AS
Any increase in C, G, I or X-M will shift the AD rightwards As a result output will increase and prices will rise Employment will rise However, as the SRAS Curve becomes more inelastic, and eventually perfectly inelastic, the rate of increase in output will reduce and eventually be 0, and the effect of increased demand will be purely increased prices When increases in demand cause an increase in the price level this is called Demand Pull Inflation To solve this problem the government may try to reduce AD by cutting government spending, increasing taxation or leave it to the MPC to increase interest rates (the latter is most likely)
Increases in AD
Price Level
AD2
SRAS
AD1 AD
Real Output
A fall in C, G, I or X-M leads to a fall in AD The price level falls (deflationary pressure on price) Output falls This causes demand deficient unemployment The government could respond by increasing government spending, reducing taxation or leaving it to the MPC to reduce interest rates (the latter is most likely)
Price Level
AD1
SRAS
AD
Real Output
Decreases in AD
This shows an increase in SRAS This will be caused by a reduction in costs The result is that more is produced and the price level falls This would make the UK economy more competitive to its trading partners
Price Level
SRAS AD
In contrast a supply-side shock such as an increase in the price of oil would shift the SRAS Curve to the left, increasing the price level and reducing output This would lead to increased unemployment coupled with rising prices
Shifts in the SRAS Curve
SRAS1
Real Output
An increase in the LRAS represents an increase in ECONOMIC GROWTH or a shift outwards of the PPB
Causes of a shift outwards of the PPB: ◦
Finding new economic resources
◦
Improving technology
◦
Investment in capital goods
Measures to increase AS have been targeted by governments since the late 1970s to accelerate GDP
A natural disaster will lead to a shift left of the LRAS Curve, this leads to an increase in the price level and reduced employment, increased inflationary pressure and thus an economy that is less competitive internationally
Price Level
LRAS
LRAS1
AD
Shifts in the LRAS Curve
Real Output
Is Point X possible? Why?
Multi choice qns
Determinants of SRAS Determinants of LRAS
ECON 2 PAST 12 MARKERS
Pg. 156 Activity
Pg 160 Examination Style Questions
Past Exam Questions
Keynesian: the views of John Maynard Keynes, a very influential economist (1883-1946) who suggested how governments could cure mass unemployment Long run aggregate supply: the economy’s productive potential Natural rate of unemployment: the rate of unemployment that is consistent with a stable rate of inflation
Demand deficient unemployment: unemployment created due to a lack of AD Monetary Policy Committee (MPC): a committee of economists and central bankers who meet monthly to decide whether or not to change the rate of interest
Key Terms