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Aggregate Demand

Introduction

Aggregate means ‘total’ and in this case we use the term to measure how much is being spent by all consumers, businesses, the government and people and firms overseas.

Components of aggregate demand

Aggregate demand (AD) = total spending on goods and services

AD = C + I + G + (X-M)

  • C: Consumers’ expenditure on goods and services : Also known as consumption, this includes demand for durables e.g. audio-visual equipment and motor vehicles & non-durable goods such as food and drinks which are “consumed” and must be re-purchased.
  • I: Capital Investment – This is spending on capital goods such as plant and equipment and buildings to produce more consumer goods in the future. Investment also includes spending on working capital such as stocks of finished and semi-finished goods.
  • Capital investment spending in the UK accounts for between 16-20% of GDP in any given year. Of this investment, 75% comes from private sector businesses such as Tesco, British Airways and British Petroleum and the remainder is spent by the government – for example building new schools or in improving railway or road networks. So a mobile phone company such as O2 spending £100 million on extending its network capacity and the government allocating £15 million of funds to build a new hospital are both capital investment. Investment has important effects on the supply-side as well as being an important component of AD. A small part of investment spending is the change in the value of stocks –i.e. unsold products. Producers may find either than demand is running higher than output (i.e. stocks will fall) or that demand is weaker than expected and less than current output (in which case the value of unsold stocks will rise.)

 

  • G: Government Spending – This is spending on state-provided goods and services including public goodsand merit goods . Decisions on how much the government will spend each year are affected by developments in the economy and the political priorities of the government.
  • Government spending on goods and services is around 18-20% of GDP but this tends to understate the true size of the government sector in the economy. Firstly some spending is on investment and a sizeable slice goes on welfare state payments. Transfer payments in the form of benefits (e.g. state pensions and the job-seekers allowance) are not included in current government spending because they are a transfer from one group (i.e. people in work paying income taxes) to another (i.e. pensioners drawing their state pension having retired from the labour force, or families on low incomes).
  • X: Exports of goods and services – Exports sold overseas are an inflow of demand (an injection) into our circular flow of income and spending adding to aggregate demand.
  • M: Imports of goods and services. Imports are a withdrawal of demand (a leakage) from the circular flow of income and spending.
  • Net exports measure the value of exports minus the value of imports. When net exports are positive, there is a trade surplus (adding to AD); when net exports are negative, there is a trade deficit (reducing AD). E.g. The UK has been running a large trade deficit for several years now.

Aggregate Demand in the Economy

The main components of aggregate demand are shown in the table above Remember that AD = C + I + G + X – M

The change in the value of stocks is a small component of the equation, it relates to changes in how much investment businesses are making in stocks (unsold products) to be consumed at a later stage.

  • Recession: 2009 was a year of recession – what happened to each of the components of aggregate demand in 2009 compared to 2008?
  • Recovery: The British economy started to recover in 2010; using the table can you explain why this happened?

Shocks to aggregate demand

  • Many unexpected events can happen which causes changes in the level of demand, output and employment
  • Headwinds can alter direction with great speed leading to uncertainty about where the economy is heading
  • These events are called “shocks”. Some of the causes of AD shocks are as follows:
  • A big rise or fall in the exchange rate – affecting export demand and having follow-on effects on output, employment, incomes and profits of businesses linked to export industries.
  • A recession in one or more of our main trading partners which affects demand for our exports of goods and services.
  • A slump in the housing market or a big change in share prices.
  • An event such as the credit crunch (global financial crisis) – involving a fall in the amount of credit available for borrowing by households and businesses.
  • An unexpected cut or an unexpected rise in interest rates or change in government taxation and spending – for example the shock of deep cuts in state spending expected in 2011 and beyond.

These shocks will bring about a shift in the aggregate demand curve – and we turn to this next.

The Aggregate Demand Curve

The AD curve shows the relationship between the general price level and real GDP.

Aggregate demand curve

Aggregate Demand and the Price Level

There are several explanations for an inverse relationship between AD and the price level in an economy. These are summarised below:

  • Falling real incomes: As the price level rises, so the real value of people’s incomes fall and consumers are less able to buy the items they want or need. If over the course of a year all prices rose by 10 per cent whilst your money income remained the same, your real income would have fallen by 10%
  • The balance of trade: A persistent rise in the price of level of Country X could make foreign-produced goods and services cheaper in price terms, causing a fall in exports and a rise in imports. This will lead to a reduction in net trade and a contraction in AD
  • Interest rate effect: if the price level rises, this causes inflation and an increase in the demand for money and a consequential rise in interest rates with a deflationary effect on the economy. This assumes that the central bank (in our case the Bank of England) is setting interest rates in order to meet a specified inflation target

Shifts in the AD Curve

  • A change in the factors affecting any one or more components of aggregate demand i.e. households (C), firms (I), the government (G) or overseas consumers and business (X) changes planned spending and results in a shift in the AD curve.

Consider the diagram below which shows an inward shift of AD from AD1 to AD3 and an outward shift of AD from AD1 to AD2. The increase in AD might have been caused for example by a fall in interest rates or an increase in consumers’ wealth because of rising house prices.

Shifts in the AD Curve

Factors causing a shift in AD
Changes in ExpectationsCurrent spending is affected by anticipated income and inflation The expectations of consumers and businesses have a powerful effect on spendingWhen confidence falls, we see an increase in saving and businesses postpone investment projects because of worries over weak demand and lower expectedprofits.
Changes in Monetary Policy – i.e. a change ininterest rates If interest rates fall – this lowers the cost of borrowing and the incentive to save, encouraging consumption. Lower interest rates encourage firms to borrow and investThere are time lags between changes in interest rates and the changes in aggregate demand.
Changes in Fiscal PolicyFiscal Policy refers to changes in government spending, welfare benefits and taxation, and the amount that the government borrows The Government may increase its expenditure e.g. financed by a higherbudget deficit – this directly increases ADIncome tax affects disposable income e.g. lower rates of income tax raise disposable income and should boost consumption.An increase in transfer payments increases AD – particularly if welfare recipients spend a high % of the benefits they receive.
Economic events in the international economyInternational factors such as the exchange rate and foreign income (e.g. the economic cycle in other countries) A fall in the value of the Sing Dollar ($) (a depreciation) makes imports dearer and exports cheaper – the net result should be that Singapore AD rises. The impact depends on the price elasticity of demand for imports and exports and also the elasticity of supply of SG exporters in response to exchange rate depreciation.An increase in overseas incomes raises demand for exports. In contrast a recession in a major export market will lead to a fall in exports and an inward shift of aggregate demand.
Changes in household wealth Wealth is the  value of assets owned e.g. houses and shares A fall in the value of share prices or a slump in the housing market can lead to a decline in household financial wealth and a fall in consumer demand. Declining asset prices also have a negative effect on consumer confidence / a fall in expectations
Changes in the supply of credit The availability of credit is vital for the smooth functioning of most modern economies. We have seen in recent years how the bursting of the credit bubble in countries such as the UK and the USA has created many problems for businesses and individualsMany banks and other lenders are now more reluctant to lend

Interest rates on different loans have become more expensive

Instead of taking out new loans, in recent times businesses have been paying back debt. In the 5 years before the financial crisis UK companies borrowed £107m from banks every day. Since then they’ve been repaying £5.8m a day.

 

 

Aggregate Supply

Introduction

What do we mean by aggregate supply?

Aggregate supply (AS) measures the volume of goods and services produced within the economy at a given price level.

AS represents the ability of an economy to deliver goods and services to meet demand

The nature of this relationship will differ between the long run and the short run

  1. Short run aggregate supply (SRAS) shows total planned output when prices in the economy can change but the prices and productivity of all factor inputs e.g. wage rates and the state of technology are held constant.
  1. Long run aggregate supply (LRAS):  LRAS shows total planned output when both prices and average wage rates can change – it is a measure of a country’s potential output and the concept is linked to theproduction possibility frontier

In the long run, the LRAS curve is assumed to be vertical (i.e. it does not change when the general price level changes)

In the short run, the SRAS curve is assumed to be upward sloping (i.e. it is responsive to a change in aggregate demand reflected in a change in the general price level)

The short run aggregate supply curve

The short run aggregate supply curve

A change in the price level brought about by a shift in AD results in a movement along the short run AS curve. If AD rises, we see an expansion of SRAS; if demand falls we see a contraction of SRAS.

Shifts in Short Run Aggregate Supply (SRAS)

Shifts in Short Run Aggregate Supply (SRAS)

The main cause of a shift in the supply curve is a change in business costs – for example:

  • Changes in unit labour costs: Unit labour costs are wage costs adjusted for the level of productivity. A rise in unit labour costs might be brought about by firms paying higher wages or a fall in the level of productivity
  • Commodity prices: Changes to raw material costs and other components e.g. the prices of oil, copper, rubber, iron ore, aluminium and other inputs will affect a firm’s costs
  • Exchange rates: Costs might be affected by a change in the exchange rate which causes fluctuations in the prices of imported products. A fall (depreciation) in the exchange rate increases the costs of importing raw materials and component supplies from overseas
  • Government taxation and subsidies:
    1. An increase in taxes to meet environmental objectives will cause higher costs and an inward shift in the SRAS curve
    2. Lower duty on petrol and diesel would lower costs and cause an outward shift in SRAS
  • The price of imports:
    1. Cheaper imports from a lower-cost country has the effect of shifting out SRAS
    2. A reduction in a tariff on imports or an increase in the size of an import quota will also boost the supply available at each price level
    3. The exchange rate affects how much a business must pay for imported raw materials and components

Long Run Aggregate Supply (LRAS)

In the long run, the ability of an economy to produce goods and services to meet demand is based on the state of production technology and the availability and quality of factor inputs.

Growth and size of economy

“Seemingly small differences in growth rates can have a large impact over a period of many years. For example, if an economy grew by 2 per cent every year, it would double in size within 35 years; if it grew at 2½ per cent a year, it would double in size after 28 years – seven years earlier”

 

A long run production function for a country is often written as follows:

 

Y*t = f (Lt, Kt, Mt)

  • Y* is a measure of potential output
  • t is the time period
  • L represents the quantity and ability of labour input available
  • Kt represents the available capital stock
  • Mt represents the availability of natural resources

LRAS is determined by the stock of a country’s resources and by the productivity of factor inputs (labour, land and capital). Changes in the technology also affect potential real national output.

Causes of shifts in the long run aggregate supply curve

Any change in the economy that alters the natural rate of growth of output shifts LRAS. Improvements in productivity and efficiency or an increase in the stock of capital and labour resources cause the LRAS curve to shift out. This is shown in the diagram below.

Policies to increase LRAS

  1. Expanding the labour supply – e.g. by improving work incentives and relaxing controls on inward labour migration. In the long term many countries must find ways of overcoming the effects of an ageing population and a rising ratio of dependents to active workers
  2. Increase the productivity of labour – e.g. by investment in training of the labour force and improvements in the quality of management of human resources. Productivity can be measured in several ways including output per person employed and output per hour worked
  3. Improve mobility of labour to reduce certain types of unemployment for example structural unemployment caused by occupational immobility of labour. If workers have more skills and flexibility, they will find it easier to get work. Conversely when unemployment remains high, the economy loses out on potential output and there is a waste of scarce resources
  4. Expanding the capital stock – i.e. increase investment and research and development
  5. Increase business efficiency by promoting greater competition within markets
  6. Stimulate invention and innovation – to promote lower costs and improvements in the dynamic efficiency of markets. Innovation creates new goods and services and encourages investment

For most advanced nations it is the growth of productivity that is critical to raising the long term growth of real GDP.

Aggregate Supply Shocks

Aggregate supply shocks might occur when there is

A sudden rise in oil prices or other essential inputs such as foodstuffs used in food-processing industries. Foodstuffs are an example of intermediate products – items that are used up in manufacturing goods for consumers to buy

Vulnerable economies “The inter-connectedness of the global economy makes it more vulnerable to major shocks……these shocks include cyber attacks, pandemics, geomagnetic storms, social unrest and financial crises.”

Source: OECD Report on Future Global Shocks, June 2011

The invention and diffusion of a new production technology

  • A major change in the movement of migrant workers from one economy to another

Shocks and long run aggregate supply

  • The effects of supply-side shocks are normally to cause a shift in the SRAS curve. For example changes in the world prices of foodstuffs, oil and gas and minerals.
  • There are occasions when changes in production technologies or step-changes in the productivity of factors of production that were not expected, feed through into a shift in the long run aggregate supply curve.
  • Natural disasters and political conflicts including civil wars can also have a significant effect on a country’s productive potential and therefore affect the LRAS although it is often difficult to measure accurately just how damaging these events have been.

An example of volatile commodity prices – the US dollar price of Brent Crude Oil

brent crude oil price