The Determination of Level of Output and Price: The Economy's Big Picture
Hey everyone! Welcome to one of the most important topics in macroeconomics. Ever wonder why sometimes prices in Hong Kong seem to be going up all the time (inflation), or why sometimes the news talks about a "recession"? This chapter is all about understanding the forces that decide the overall price level and the total amount of goods and services (output) our entire economy produces.
Think of it as zooming out from individual markets (like the market for bubble tea) to look at the entire economy all at once. It might sound big and complicated, but we'll break it down step-by-step. You've got this!
Section 1: Aggregate Demand (AD) - The Whole Economy's Shopping List
What is Aggregate Demand?
In simple terms, Aggregate Demand (AD) is the total amount of all final goods and services that households, firms, the government, and foreigners are willing and able to buy at different overall price levels. It's the demand for EVERYTHING produced in the economy.
The AD curve shows the relationship between the price level (like the average price of everything) and the quantity of real GDP (output) demanded. And just like a regular demand curve, it slopes downwards.
Why is the AD Curve Downward Sloping?
Don't worry if this seems tricky at first! It's different from why a single product's demand curve slopes down. There are three main reasons for the AD curve's shape. Let's use an analogy: imagine the entire economy is one giant supermarket.
1. The Wealth Effect (or Real Balances Effect)
If the price level in our giant supermarket falls, the money you have in your wallet or bank account can suddenly buy more stuff. Your $100 note is now "more powerful". You feel wealthier, even though the number of dollars you have hasn't changed. Because you feel richer, you are likely to buy more goods and services.
In short: Lower Price Level → Higher Real Wealth → Higher Consumption (C) → Higher Quantity of Real GDP Demanded.
2. The Interest Rate Effect
When the price level falls, you don't need to hold as much cash to buy your daily necessities. You'll likely save more or put the extra money in a bank. This increases the supply of loanable funds in banks, which causes the interest rate (the price of borrowing money) to fall. When interest rates are lower, it's cheaper for businesses to borrow money to invest in new machinery (Investment, I) and for you to borrow for a big purchase like a new phone (Consumption, C).
In short: Lower Price Level → Lower Interest Rate → Higher Investment (I) and Consumption (C) → Higher Quantity of Real GDP Demanded.
3. The Exchange Rate Effect (or International Trade Effect)
If the price level in Hong Kong falls, our goods and services become cheaper compared to those from other countries. This makes our exports more attractive to foreigners, so they buy more from us (Exports, X, increase). At the same time, foreign goods are now relatively more expensive for us, so we buy fewer of them (Imports, M, decrease). Since Net Exports = Exports - Imports (NX = X - M), our net exports increase.
In short: Lower Price Level → Cheaper Exports & More Expensive Imports → Higher Net Exports (NX) → Higher Quantity of Real GDP Demanded.
Quick Review: Downward Sloping AD
- Wealth Effect: Feel richer, buy more.
- Interest Rate Effect: Cheaper borrowing, more investment and consumption.
- Exchange Rate Effect: Cheaper exports, more net exports.
Shifts in the Aggregate Demand Curve
A change in the price level causes a movement along the AD curve. But what if something else changes? That causes the entire curve to shift left or right. The easy way to remember the shifters is to think of the GDP formula: AD = C + I + G + NX.
Anything (other than the price level) that changes these components will shift the AD curve.
- Shift to the Right (Increase in AD): People want to buy more at ANY price level.
- Example: The government cuts income taxes, giving people more disposable income to spend (C increases).
- Example: Businesses become very optimistic about the future and invest in new factories (I increases).
- Example: The government decides to build a new bridge (G increases).
- Example: The economy of a major trading partner booms, and they buy more of our exports (NX increases).
- Shift to the Left (Decrease in AD): People want to buy less at ANY price level.
- Example: People become worried about losing their jobs and start saving more (C decreases).
- Example: Interest rates rise, making it more expensive for firms to borrow (I decreases).
- Example: The government cuts its spending on education (G decreases).
- Example: Our currency appreciates, making our exports more expensive for foreigners (NX decreases).
Key Takeaway for AD
Aggregate Demand is the total spending in the economy. It slopes down due to the wealth, interest rate, and exchange rate effects. The entire curve shifts when there are changes in Consumption (C), Investment (I), Government Spending (G), or Net Exports (NX).
Section 2: Aggregate Supply (AS) - The Economy's Production Power
What is Aggregate Supply?
Aggregate Supply (AS) is the total quantity of goods and services that all firms in an economy are willing and able to produce and sell at different overall price levels.
To understand AS properly, we need to look at it in two different time frames: the short run and the long run.
Short-Run Aggregate Supply (SRAS)
The Short-Run Aggregate Supply (SRAS) curve is upward sloping.
Why? The Sticky Wage/Price Idea.
In the short run, many of the costs of production for firms are "sticky" – they don't change quickly. The most important sticky cost is wages. Many workers have contracts that fix their salary for a year or more.
So, imagine the overall price level in the economy rises. Firms can now sell their products for higher prices. However, their biggest cost – the wages they pay their workers – is still stuck at the old, lower level. This means their profit margin per item increases, giving them a strong incentive to produce and sell more output.
In short: Higher Price Level + Sticky Input Prices (like wages) → Higher Profits → Higher Quantity of Real GDP Supplied.
Long-Run Aggregate Supply (LRAS)
The Long-Run Aggregate Supply (LRAS) curve is a vertical line.
Why? Prices are Fully Flexible.
In the long run, those "sticky" wages and other input prices have had time to adjust. If the price level doubles, eventually workers will demand double the wages, and suppliers will charge double for raw materials. Because both output prices and input costs change proportionally, the price level has no effect on firms' profits or their incentive to produce.
So what determines production in the long run? The economy's real production capacity, which depends on:
- Its stock of labour
- Its stock of capital (machinery, factories)
- Its natural resources
- Its level of technology
This vertical LRAS is positioned at the Full-Employment Level of Output (Yf), also known as potential GDP. This is the maximum sustainable level of output an economy can produce.
Did you know?
The Full-Employment Level of Output doesn't mean 0% unemployment! It means unemployment is at its "natural rate," which includes people who are temporarily between jobs or have skills that don't match available jobs.
Shifts in the Aggregate Supply Curves
Just like with AD, we need to know what shifts the AS curves.
- Shifting SRAS only: Caused by a change in the costs of production.
- Example (Shift Left - Decrease): A sudden rise in world oil prices (a negative supply shock) increases production costs for almost all firms.
- Example (Shift Right - Increase): A new government subsidy for businesses reduces their production costs.
- Shifting LRAS (which also shifts SRAS with it): Caused by a change in the economy's fundamental production capacity.
- Example (Shift Right - Increase): A major technological breakthrough like the invention of the internet.
- Example (Shift Right - Increase): An increase in the size of the labour force due to immigration.
- Example (Shift Right - Increase): A discovery of new natural resources.
Key Takeaway for AS
SRAS is upward sloping because of sticky input prices. LRAS is vertical because, in the long run, all prices are flexible, and output depends only on real factors like technology and resources. Changes in production costs shift SRAS, while changes in the economy's potential shift LRAS.
Section 3: Putting It All Together - Macroeconomic Equilibrium
Now for the exciting part! We combine the AD and AS curves to see how the economy's output and price level are determined.
Short-Run and Long-Run Equilibrium
Short-Run Equilibrium occurs where the AD curve intersects the SRAS curve. This point gives us the current price level (Pe) and the current level of real GDP (Ye).
Long-Run Equilibrium is a special case where the AD, SRAS, and LRAS curves all intersect at the same point. Here, the economy is producing at its full-employment potential (Ye = Yf), and the price level is stable.
Analysing Changes in the Economy
This is the key skill for your exams! When something happens in the world, how does it affect the economy? We use a technique called comparative statics to figure this out.
A 4-Step Guide to Analysing Economic Events:
Let's use an example: The government launches a major infrastructure project, increasing its spending significantly.
- Start at Long-Run Equilibrium. Always assume the economy begins in this stable state. Draw your AD, SRAS, and LRAS curves all intersecting at one point (P1, Yf).
- Identify the Shock. Does the event affect total spending (AD) or production (AS)? Government spending is a component of AD (it's the 'G' in C+I+G+NX). An increase in G is a positive AD shock.
- Shift the Curve. The increase in G shifts the AD curve to the right (from AD1 to AD2).
- Find the New Short-Run Equilibrium. The new equilibrium is where AD2 intersects the original SRAS curve. We can see that the price level rises (to P2) and output increases (to Y2). Because Y2 is greater than Yf, the economy is experiencing an inflationary gap.
From Short Run to Long Run: The Self-Correction Mechanism
The economy doesn't stay in a gap forever. It has a way of "self-correcting" back to the long-run equilibrium (Yf).
Correcting an Inflationary Gap (Output > Yf)
Continuing our example, the economy is "overheating". Output is high, and unemployment is very low. Firms find it hard to hire workers and must compete for them by offering higher wages. These higher wages are an increase in the cost of production.
- Higher input costs cause the SRAS curve to shift to the left.
- This shift continues until the economy returns to the long-run output level, Yf.
- The final result: Output is back at Yf, but the price level is even higher (P3).
Correcting a Recessionary Gap (Output < Yf)
Now imagine the opposite: a stock market crash causes people to spend less, shifting AD to the left. In the short run, output falls and the price level drops. We have a recessionary gap.
- In this situation, unemployment is high. Workers are more willing to accept lower wages (or prevent their wages from rising).
- Lower wages mean lower input costs for firms.
- Lower input costs cause the SRAS curve to shift to the right.
- This brings the economy back to Yf, but at a new, lower price level.
Common Mistake Alert!
When asked to analyse a change, first find the short-run effect (the shift of AD or SRAS). Only discuss the long-run self-correction (the SRAS shifting back) if the question asks what happens "in the long run".
Section 4: The Link Between Output and Employment
This is a simple but crucial connection. The amount of output an economy produces is directly related to how many people have jobs.
- When Real GDP (Output) increases, firms need to hire more workers to produce the extra stuff. Therefore, employment rises and unemployment falls.
- When Real GDP (Output) decreases, firms don't need as many workers. Therefore, employment falls and unemployment rises.
This is why we care so much about those gaps!
- An inflationary gap (Y > Yf) means unemployment is below its natural rate. The economy is working beyond its sustainable capacity.
- A recessionary gap (Y < Yf) means unemployment is above its natural rate. Resources (including workers) are being wasted.
Final Key Takeaway
The AS-AD model is our main tool for understanding the macroeconomy. By finding where AD and AS intersect, we can determine the price level and output. By shifting these curves, we can analyse how real-world events cause inflation, recessions, and economic growth, and understand the crucial link between a country's output and its job market.