Aggregate demand and supply using models

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

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

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

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

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

Summary: 3 reasons for inverse relationship of price level & AD

• The WEALTH effect• The INTEREST RATE effect• The INTERNATIONAL TRADE effect

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

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.

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

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

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

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)

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)

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.

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

Aggregate Supply

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.

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

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

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

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

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

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

• AD and AS