Aggregate Demand & Aggregate Supply

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1 Business Environment.2 Week 4 Aggregate Demand & Aggregate Supply 1

2 Objectives To appreciate how a change in the price level affects aggregate demand and aggregate supply. To understand how aggregate supply reacts to a change in aggregate demand To understand the significance of wage and price flexibility for the supply response To appreciate the significance of the Philips curve for the derivation of aggregate supply curve 2

3 Aggregate Demand It is the total level of spending in the economy and consists of four elements: consumer spending (C), private investment (I), government expenditure on goods and services (G) and expenditure on exports (X) less expenditure on imports (M). Thus: AD= C + I + G + X M 3

4 Aggregate Demand Lower prices increase demand, this is the key idea in microeconomics. However, we are dealing (here in macroeconomics) with the general level of prices in the economy. 4

5 Aggregate Demand Suppose that all prices in the economy fell by 50% Goods and services are now half the price they were before The value of all goods and services produced in the economy has also halved Incomes have fallen in line with prices Given this, people cannot buy more with their income Sloman explains that not all incomes will change by the same amount and so aggregate demand might alter 5

6 Aggregate Demand Other reasons why demand will increase if all prices in the economy fall: The demand for exports may increase, stimulating aggregate expenditure. The value of any money that people have in their possession will rise. This may encourage people to buy more. (this is known as the real balance effect) These reasons suggest that aggregate demand will increase as prices fall. 6

7 AD curve The aggregate demand curve shows how much national output (GDP) will be demanded at each level of prices. But why does the AD curve slope downwards? Why will people demand fewer products as prices rise? There are two effects that can cause this: Income effects Substitution effects 7

8 Income effects Thus for consumers there has been an income effect of the higher prices. The rise in price leads to a cut in real incomes and thus people will spend less. Aggregate demand will fall. The AD curve will be downward sloping, as in figure

9 Substitution effects In the microeconomic situation, if the price of one good rises, people will switch to alternative goods. This is the substitution effect of that price rise and helps to explain why the demand curve for a particular good will be downward sloping. But how can there be a substitution effect at a macroeconomic level? If prices in general go up, what can people substitute for spending? There are in fact three ways in which people can switch to alternatives. 9

10 Substitution effects If prices in general go up, what can people substitute for spending? There are in fact three ways in which people can switch to alternatives. The first, and most obvious, concerns imports and exports. Higher prices for our country's goods will discourage foreign residents from buying our exports (which are part of aggregate demand) and encourage domestic residents to buy imports (which are not part of aggregate demand). Thus higher domestic prices will lead to a fall in aggregate demand (i.e. cause the AD curve to be downward sloping). 10

11 Substitution effects The second is known as the real balance effect. If prices rise, the value (i.e. the purchasing power) of people's balances in their bank and building society accounts will fall. But many people will be reluctant to reduce the real value of their balances too much, and will thus probably cut back on their spending also. This desire by people to protect the real value of their balances will thus also cause aggregate demand to fall. 11

12 Substitution effects The third reason why people may switch away from spending concerns changes in interest rates. With higher prices to pay by consumers, and higher wages to pay by firms, there will tend to be a greater demand for money. With a given supply of money in the economy, there will be a shortage of money. As a result, banks will tend to raise interest rates. These higher rates of interest will have dampening effect on spending: after all, the higher the rates of interest people have to pay, the more expensive it is to buy things on credit. Again aggregate demand is likely to fall. 12

13 Aggregate Demand & Supply Fig

14 The shape of the AD curve We have seen that both income and substitution effects of a rise in the general price level will cause the aggregate demand for goods and services to fall. Thus, the AD curve is downward sloping. The bigger the income and substitution effects, the more elastic will the curve be. 14

15 Shifts in the AD curve The AD curve can shift inwards (to the right) or outwards (to the left). A rightward shift represents an increase in aggregate demand, whatever the price level; A leftward shift represents a decrease in aggregate demand, whatever the price level. 15

16 Shifts in the AD curve A shift in the AD curve will occur if there is a change in any of its component parts, independent of a change in the price level. Let us look briefly at what might cause a rightward shift. The components of Aggregate Demand are: Consumption Investment Government expenditure on goods and services Exports minus imports 16

17 Aggregate Supply The AS curve shows the output that firms are willing to supply at different price levels. Higher prices (other things being equal) will make it more profitable to produce and so firms will increase their output. If firms produce more, their costs of production will rise because firms need to employ more workers. This increased demand for workers will put pressure on wages to rise. The faster wages rise, the less profitable it is to increase output. If wages rose as fast as the price level, there would be no incentive to produce more and so the aggregate supply curve would be vertical. 17

18 Aggregate Supply There are other explanations: One is that given an excess demand for goods and services, producers will produce more. This will increase the demand for labour, putting pressure on wages to rise. It is this increase in wage rates that then causes prices to rise. This is a different explanation but still gives an upward sloping 18

19 The aggregate supply curve. The short-run aggregate supply curve slopes upwards, as shown in figure 4.1. In other words, the higher the level of prices, the more will be produced. The reason is simple. Because we are holding wages and other input prices fixed, then as the prices of their products rise, firms profitability at each level of output will be higher than before. This will encourage them to produce more. But what limits the increase in aggregate supply in response to an increase in prices? In other words, why is the aggregate supply curve not horizontal? There are two main reasons: 19

20 The aggregate supply curve. Why is the aggregate supply curve not horizontal? There are two main reasons: Diminishing returns Growing shortages of certain variable factors 20

21 The aggregate supply curve. Rising costs explain the upward-sloping aggregate supply curve. The more steeply costs rise as production increases, the less elastic will the aggregate supply curve be. It is likely that, as the level of national output increases and firms reach full-capacity working, the aggregate supply curve will tend to get steeper. 21

22 Shifts in the aggregate supply curve The aggregate supply curve will shift if there is a change in any of the variables that are held constant when we plot the curve. Several of these variables, notably technology, the labour force and the stock of capital, change only slowly normally shifting the curve gradually to the right. The wage rate (and other input prices) can change significantly in the short run, however, and are thus the major causes of shifts in the short-run supply curve. 22

23 Equilibrium Equilibrium in the macro-economy occurs when aggregate demand and aggregate supply are equal. In figure 4.1, this is at the price level Pₑ and a level of national output (GDP) of Qₑ. At any other combination of the price level and GDP the economy is out of equilibrium. When this occurs, changes will take place to move the economy towards equilibrium. 23

24 Equilibrium Fig

Building a Model of Aggregate Demand and Aggregate Supply *

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