Economics (9640) | Aggregate demand and aggregate supply analysis

👋 Welcome to AD and AS Analysis!

Hello future economists! This chapter is incredibly important. If macroeconomics is a giant machine, the Aggregate Demand (AD) and Aggregate Supply (AS) model is the blueprint that shows you how it works.

We are moving away from looking at individual markets (like bananas or cars) and zooming out to look at the entire national economy. By the end of these notes, you will be able to use the AD/AS diagram like a professional tool to explain economic problems like inflation, unemployment, and economic growth.

3.2.2.3 Determinants of Aggregate Demand (AD)

What is Aggregate Demand (AD)?

Aggregate Demand (AD) is the total planned spending on goods and services produced within an economy at a given price level and in a given time period.
Think of it as the total spending power of everyone in the country.

The AD Curve and the Price Level

The AD curve shows an inverse relationship between the overall price level and the total amount of output demanded (Real National Income or Real GDP). This means the curve slopes downwards.

A change in the general price level causes a movement along the AD curve. Why does it slope downwards?

• The Wealth Effect (or Real Balances Effect): If the price level falls, the real value of your savings and assets increases. You feel wealthier and spend more.
• The Interest Rate Effect: A lower price level often leads to lower interest rates (as Central Banks might respond to low inflation), encouraging more borrowing, investment, and consumption.
• The International Trade Effect: If domestic prices fall while foreign prices stay the same, our goods become relatively cheaper. Exports increase (X↑) and imports decrease (M↓), increasing net exports (X-M).

Components of Aggregate Demand: The C+I+G+(X-M) Formula

AD is made up of four main components. You must know this equation: \[AD = C + I + G + (X - M)\]

1. Consumption (C): Spending by households on consumer goods and services (like food, holidays, new phones).
2. Investment (I): Spending by firms on capital goods (like new machinery, factories, research and development). Note: This is NOT financial investment like buying shares.
3. Government Spending (G): Spending by the government on goods and services (like hospitals, schools, defence). This excludes transfer payments (like unemployment benefits).
4. Net Exports (X - M): The value of exports (X, sales to foreign buyers) minus the value of imports (M, purchases from foreign suppliers).

Determinants of the AD Components (The Shifts)

A shift in the AD curve (outward/right = increase; inward/left = decrease) happens when one of the components changes for a reason *other than* the price level.

1. Determinants of Consumption (C) and Savings

Consumption (C) is heavily influenced by factors affecting household wealth and confidence.

• Income (Y): Higher disposable income usually means higher consumption.
• Consumer Confidence: If households expect good economic times, they spend more today.
• Interest Rates: Higher interest rates increase the cost of borrowing (dampening C) and increase the reward for saving (which is a withdrawal from the circular flow).
• Wealth: If housing or stock market prices rise, people feel wealthier and spend more (Wealth Effect).
• Marginal Propensities: These determine how much consumption changes following a change in income:
  • MPC: The fraction of extra income consumed.
  • MPS: The fraction of extra income saved.
  • MPT: The fraction of extra income paid in taxes.
  • MPM: The fraction of extra income spent on imports.

2. Determinants of Investment (I)

Investment (I) is driven by expected returns and costs.

• Business Confidence: If firms are optimistic about future demand, they invest in expansion.
• Interest Rates: Higher rates increase the cost of borrowing for new projects, leading to lower investment.
• The Accelerator Process: (Conceptual understanding required). A rise in National Income (output) can lead to a *proportionally larger* rise in investment, as firms rush to increase capacity to meet the sustained higher demand.
• Technology: New technology encourages replacement and modernization investment.

Did you know? There's a vital difference between saving and investment. Saving is income not spent (a withdrawal); investment is spending on capital goods (an injection). If saving is high but firms lack confidence, investment might still be low.

3. Determinants of Government Spending (G)

• Fiscal Policy: The government deliberately changes spending (G) or taxation (T) to influence the economy. An increase in G shifts AD right.
• Political Objectives: Spending priorities (e.g., healthcare vs. defence).

4. Determinants of Net Exports (X - M)

• Exchange Rate: A depreciation of the domestic currency makes exports cheaper and imports more expensive, usually increasing Net Exports (AD shifts right).
• Real Income Abroad: If trading partners experience economic growth (higher income), they buy more of our exports (X↑).
• Domestic Real Income: If our economy grows, we buy more imports (M↑), which reduces net exports (AD shifts left).

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3.2.2.5 & 3.2.2.6 Aggregate Supply (AS) Analysis

Aggregate Supply (AS) is the total quantity of goods and services that firms in an economy are willing and able to supply at a given price level.

Short-Run Aggregate Supply (SRAS)

The SRAS curve shows the relationship between the price level and the total output when the costs of production (especially wages) are fixed or slow to change.

• Slope: SRAS slopes upwards.
• Why? In the short run, if the price of goods and services rises (P↑), but key costs like money wage rates stay fixed, firms' profit margins increase. This gives them an incentive to produce more output.
• Main Determinants: The SRAS is primarily determined by the price level and the costs of production.

Factors that Shift the SRAS Curve (Changes in Costs)

A shift in the SRAS curve occurs when the underlying costs of production change. If costs rise, SRAS shifts left (inward); if costs fall, SRAS shifts right (outward).

Memory Aid: W-R-I-P for SRAS Shifts (Wages, Raw materials, Indirect taxes, Productivity):

1. Money Wage Rates: The largest cost for many firms. If unions successfully negotiate higher nominal wages, SRAS shifts left.
2. Raw Material Prices: If the price of inputs (like oil, gas, or steel) rises globally (a supply-side shock), SRAS shifts left.
3. Indirect Taxes/Subsidies: Higher indirect taxes (e.g., VAT) increase costs, shifting SRAS left. Subsidies decrease costs, shifting SRAS right.
4. Productivity: An increase in productivity (output per worker) means lower average costs, shifting SRAS right.

Long-Run Aggregate Supply (LRAS)

The LRAS curve shows the economy's maximum potential output when all resources are fully and efficiently employed. This potential output is often called the normal capacity level of output.

In the long run, costs (like wages) are flexible and will adjust to changes in the price level.

The Classical View (Vertical LRAS)

• Shape: The LRAS is assumed to be vertical at the full employment level of output.
• Significance: In the long run, output is determined purely by the quantity and quality of factors of production, not by the price level or AD. A rise in prices simply causes an equivalent rise in costs, leaving real output unchanged.

The Keynesian View (Below Capacity)

Don't worry if this seems tricky at first—this just offers an alternative viewpoint!

The syllabus mentions that students should understand the Keynesian view: an economy can get stuck producing well below its normal capacity level of output for many years. In this scenario, AD can influence real output even in the long run if the economy is depressed.

Factors that Shift the LRAS Curve (Underlying Economic Growth)

A rightward shift in the LRAS curve represents long-run economic growth, meaning the productive capacity of the economy has permanently increased.

LRAS shifts are driven by improvements in the quantity or quality of the four factors of production (Land, Labour, Capital, Enterprise):

• Capital Stock: Increased investment in new machinery and infrastructure.
• Technology: Advancements in technology allow firms to produce more output with the same inputs.
• Working Population: An increase in the size or health of the labour force.
• Productivity: Higher productivity due to better education, training, or worker attitudes (human capital).
• Enterprise & Incentives: Policies that encourage entrepreneurship, innovation, and risk-taking.
• Factor Mobility: If resources (like labour or capital) can move easily between industries, the economy is more efficient.

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3.2.2.2 Macroeconomic Equilibrium and Shocks

Macroeconomic Equilibrium occurs where the aggregate demand (AD) curve intersects with the aggregate supply (AS) curve. This intersection determines the equilibrium price level and the Real National Output (Y).

Illustrating Changes using AD/AS Diagrams

When an economy faces a sudden, unexpected change, we call it a shock.

1. Demand-Side Shocks (Shifts in AD)

A positive demand shock (AD shifts right) could be caused by a sudden rise in consumer confidence or a large government infrastructure project.

• Effect: Higher Real GDP (economic growth), but also a higher Price Level (demand-pull inflation).
• Connection: If the output level remains below the LRAS curve, this growth helps reduce demand-deficient (cyclical) unemployment.

2. Supply-Side Shocks (Shifts in SRAS or LRAS)

A negative SRAS shock (SRAS shifts left) could be caused by a rapid increase in global oil prices.

• Effect: Lower Real GDP (recession/slowdown), and a higher Price Level. This dangerous combination is known as stagflation.

Global Economic Events

Global events constantly affect the domestic economy, usually via AD through Net Exports (X-M), or via AS through raw material costs.

• Example AD Shock: If the US economy (a major trading partner) enters a deep recession, US citizens buy fewer of our exports (X↓). This causes AD to shift left.
• Example AS Shock: Global sanctions cause the price of microchips (a key input) to spike. This increases production costs for domestic firms, causing SRAS to shift left.

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3.2.2.4 The Multiplier Process: The Snowball Effect

Role of AD in Economic Activity

A shift in AD plays a key role in influencing the short-run level of economic activity (output, employment, and inflation). However, the initial impact of a change in spending is often magnified. This is the Multiplier Process.

Understanding the Multiplier

The multiplier concept explains why an initial change in expenditure (like an increase in government spending or investment) can lead to a larger final change in local or national income (Real GDP).

Analogy: Imagine a stone dropped in a pond. The initial splash (initial spending) creates ripples (further rounds of spending) that spread far wider than the initial splash itself.

Step-by-step Process:

1. The government spends \( \$\text{1 million} \) on building a new road (Initial Injection, \(\Delta J\)).
2. The construction workers receive this \( \$\text{1 million} \) as income.
3. They do not spend it all; they save, import, or pay taxes on some of it. The part they spend is determined by the MPC (Marginal Propensity to Consume).
4. If MPC = 0.8, they spend \( \$\text{800,000} \).
5. This \( \$\text{800,000} \) becomes income for other businesses and workers (like cafes or retailers).
6. These recipients, in turn, spend 80% of the \( \$\text{800,000} \), and so on.

The final increase in national income will be much greater than the initial \( \$\text{1 million} \).

Calculating the Multiplier (k)

The value of the multiplier (\(k\)) depends on how much of the new income leaks out of the circular flow. These leakages are known as withdrawals (W): Saving (S), Taxation (T), and Imports (M).

We use the marginal propensities we defined earlier (MPS, MPT, MPM).

The formula for the multiplier is: \[k = 1 / (1 - MPC)\] OR, using the leakages (propensity to withdraw, MPW): \[k = 1 / (MPS + MPT + MPM)\] \[k = 1 / MPW\]

Example Calculation:

If MPC = 0.6, then the multiplier \(k = 1 / (1 - 0.6) = 1 / 0.4 = 2.5\).
If the government spends \( \$\text{10 billion} \), the total increase in national income will be \( \$\text{10 billion} \times 2.5 = \$\text{25 billion} \).