Download - Aggregate demand and supply using models
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Aggregate demand and supply using models
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Learning Objectives
• To understand the inverse relationship between AD and the price level
• To understand the three reasons for the inverse relationship
• To understand how AD is represented on a model
• To understand what causes shifts in AD
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Aggregate demand and the price level• AD curve shows an inverse relationship
between the price level (inflation) and AD• In other words: Price level = AD• And Price level = AD
• BUT the reasons are different to those for the relationship between demand for a product and price at the micro level, where a fall in price makes a product cheaper against other products
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Aggregate demand and the price level
Three reasons for the inverse relationship:1. The wealth effect: • Wealth = a stock of assets e.g. property, shares
and money held in savings accounts• Price level = wealth buys more goods &
services = AD increases• Price level = reduces the purchasing power
of wealth – wealth buys fewer goods & services = AD contracts
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Aggregate demand and the price levelThree reasons for the inverse relationship:2. The rate of interest effect: • Price level = inflation. Bank of England will raise
interest rates to reduce demand, as this reduces inflation (Higher interest rates = more incentive to save not spend & less disposable income if mortgage interest payments higher. Also increases cost of consumer credit) = AD contracts
• Price level = no need to raise interest rates, so lower rates, therefore encouraging demand = AD increases
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Aggregate demand and the price level
Three reasons for the inverse relationship:3. The international trade effect: • Price level = country’s products are more
competitive overseas = exports rise & less demand for relatively more expensive imports = net exports increase = AD increases
• Price level = country’s products are less competitive internationally = exports fall & demand for relatively cheaper imports increases = net exports fall = AD contracts
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Summary: 3 reasons for inverse relationship of price level & AD
• The WEALTH effect• The INTEREST RATE effect• The INTERNATIONAL TRADE effect
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Aggregate demand
Inverse relationship between AD / price level is shown on the model: AD curve slopes from left to right
P1 – P2 (fall in price level) = Y1 – Y2 (increasein GDP
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Shifts in Aggregate Demand
• Any change in the price level causes a movement along the AD curve.
• A shift in AD arises because of a change in one or more of the components of AD (C, I, G, X and/or M) and so could be caused by any of the factors which influence their level.
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Shifts in Aggregate demand
• An increase in AD shifts the curve to the right.• A decrease in AD shifts the curve to the left.
AD – AD1 = decrease AD – AD2 =
increase
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Shifts in Aggregate demand• Rightward shift = firms produce more to meet
demand = increase in actual output (real GDP) and so economic growth occurs
AD – AD1 = decrease AD – AD2 =
increase
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Shifts in Aggregate demand• Leftward shift = firms produce less as reduced
demand = decrease in actual output (real GDP) and so economic growth slows
AD – AD1 = decrease AD – AD2 =
increase
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Causes of increases in AD
• There are many (see your notes on components of AD), but for example:
• Rising consumer expectations (optimism)• Reduction in income tax• Reduction in interest rates• Fall in exchange rate (boosting exports)
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Causes of decreases in AD
• There are many (see your notes on components of AD), but for example:
• Negative consumer expectations (pessimism)• Increase in income tax• Increase in interest rates• Rise in exchange rate (making exports more
expensive)
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Consolidation questions
• Answer the consolidation questions 1-6.• Complete the table looking at leakages and
injections and the effect on national income.• Start a key terms list using the hand out. Fill in
definition for the terms covered so far.
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Aggregate Supply
• The total output of goods and services that producers in an economy are willing and able to supply at a given price level in a given time period
• A change in AS means that the total output that producers are willing and able to supply at any given price level alters
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Aggregate Supply
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Aggregate Supply• Why is the AS curve this shape?• Because it shows a positive relationship
between the price level and output (real GDP). Less supplied at lower price level, more at higher price level.
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Aggregate Supply
• Low levels of output = unused resources (higher unemployment) = more output can be produced without inflationary pressure on prices. Supply is perfectly elastic = any amount can be supplied at the same price level.
• As more resources are used and become scarcer, factor prices will start to rise and less output is possible. Supply becomes increasingly less responsive to the price level.
• At full employment, no more output is possible. Supply becomes perfectly inelastic = no response of supply to a change in price level
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Components of Aggregate Supply
• Consumer goods • Capital goods – their use adds to capacity and
increases economy’s ability to supply consumer goods in future
• Public and merit goods – produced by private firms for supply to the public sector e.g. education, healthcare, pharmaceuticals, construction
• Traded goods – goods for export
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Aggregate Supply• Shifts of AS could be caused by:• Change in firms’ costs of production (important in the
short run)• Change in quantity / quality of factors of production
(important in the long run) due to:– Inflows / outflows of workers– Better training / education– Increased productivity of workers– More / less investment in capital goods– Improved technology– More enterprise
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Macroeconomic equilibrium
• Where AD = AS• The level of output and price level where
there is no pressure to change within the economy
Real GDP (Output)
Price Level
AD
AS
PE
YE
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Macroeconomic equilibrium
• What happens if the macroeconomy is NOT in equilibrium?
If AS > AD (AD = 0Y1 AS = 0Y2)firms have unsold stock & produce less. AS contracts& price level decreases so ADIncreases. This continues until AD = AS at 0YE (output) and OPE
(price level) Real GDP (Output)
Price Level
AD
AS
PE
YEY1 Y2
P
0
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Macroeconomic equilibrium
• What happens if the macroeconomy is NOT in equilibrium?
If AS < AD then the price level is below theeuilibrium. Firms find thereis a shortage of goods & they expand their output responding to increased price level. This continues until equilibrium is reached. Real GDP
(Output)
Price Level
AD
AS
PE
YEY1 Y2
P
0