Aggregate Demand and Supply

Aggregate Demand
1. C+I+G+(X-M)
  1. Consumption 60%
  2. Investment 20%
  3. Government Spending 25%
  4. Exports - Imports -5%
2. Consumption
  1. Spending on consumer goods and services over a period of time by households or anyone else
    1. Influences of consumer spending
      1. Income, Interest Rates, Confidence, Wealth, Inflation
    2. More consumption in free market economies where there is more choice than in command economies where there is no temptation
  2. Consumption function shows the relationship between consumption of households and determinants of consumption (main one is disposable income)
    1. The APC is the ratio of consumption to income and is expressed as C/Y. The APC declines income increases because the proportion of income spent consumption decrease.
      1. As income rises both APC and MPC declines, but the decline in MPC is more than the decline in APC, as income falls both APC and MPC rises but APC rises at a slower, rate than MPC.
        MPC is useful in short-period where as APC is useful in long period. In the short period there is no change in MPC and MPC<APC. In the long period APC=MPC.
    2. The MPC is the ratio of change in consumption to change in income. MPC= ∆C/∆Y. It is defined as the rate of change in the average propensity at income changes.
      1. MPC is measured as the gradient of the consumption curve. MPC is greater than zero but less than one because expenditure must increase with the increase in income but the total increase in income is not consumed - a part of it is saved.
        MPC falls with the fall in income because as the communities grow richer, it tends to consume smaller percentage of each increment to its income. Because of this tendency as it moves from left to right.
    3. Different theories about consumption
      1. Keynes
        Consumption planned in accordance with current disposable income
      2. Modigliani
        Consumption is based on what households think their income will be over their lifetime
      3. Friedman
        Households base spending on their permanent income (average over their life)
  3. Saving
    1. The proportion of a household's disposable income which is not spent over a period of time
    2. The savings function is the relationship between the saving of households and the factors which determine it
      1. MPS= ∆S/∆Y
      2. APS = S/Y
    3. Y=C+S
3. Investment
  1. Investment is the addition to the capital stock. Investment can be into physical capital like factories or machines, or it can be into human capital like training schemes. The value of capital will diminish over time (depreciation). Net investment is positive if gross investment is greater than depreciation
    1. main influences of investment - interest rates/ confidence/ risk/ government and regulations
    2. Positive net investment will push the PPF out. Maintenance investment will maintain the PPF where it is
4. Government Spending
  1. main influences - deliberate manipulation of economy through fiscal policy and economic cycle
  2. Total expenditure by government and local authorities
    1. Usually has a multiplier effect
    2. The gov sets out its plans for spending and taxation in the budget. It is exogenous - does not vary with the price level. If spending is greater than tax revenue, the gov runs a budget deficit. The shortfall will have to be borrowed and accumulates into national debt. On the other hand, if it is less than tax revenue, there is a budget surplus.
      1. budget does not have to balance in the short run
      2. assess the impact of an imbalance on the flow of income
      3. The use of gov expenditure and taxation to influence the level of AD is called fiscal policy
    3. Transfers are not included as AD is REAL economic activity
    4. Increase
      1. Change in gov policy
      2. Increased public sector wages
      3. War - spending on defence increases
      4. Political views, Conservatives spend less, Labour spend more - different schools of economics
      5. Increased tax revenue in boom years - more people employed, more pay taxes, consumption increases so VAT revenue rises, firms produce more so more excise duties charged
    5. Decrease
      1. Increased unemployment
        Transfer payments make up a larger proportion of budget. Also reduced tax revenue therefore lower budget
      2. Recession/Austerity measures
5. Exports - Imports
  1. impact on the current account - a change in the exchange rate/changes in the state of the world economy/non-price factors
    1. EVALUATION
      1. a change in the exchange rate might have opposite effects in the short and long run
      2. a stronger currency makes exports uncompetitive and imports cheap
        Decrease AD as X falls but M rises
      3. the price elasticity of demand for exports and imports may be very low meaning that the stronger currency worsens the current account in the short run
    2. Exchange Rate
      1. If interest rates were to rise, there would be more hot money flowing into the UK, therefore greater demand for £s so Demand shifts out. Same with confidence - greater confidence means more investment therefore demand shifts out. In Greece and Spain, confidence fell, currency was sold ie money was removed from the countries' accounts and demand shifted in while supply shifted out. the exchange rate fell
        Demand of £s comes from exports to overseas customers and FDI to the UK
        Supply of £s comes from imports by Britons
  2. Types of Competition
    1. Quantity (price)
      1. Wages, trade tariffs etc
    2. Quality (non-price)
      1. Skills, organisation, speed, transportation, customer care
  3. Ad will increase as a result of decreased corporation tax, reduced income tax, increased benefits and increased investment, but will fall due to a reduction in tariff barriers because the government wants to deter imports, so they tax imports and the price of imports rises. If the tax is reduced, the imports will be cheaper, our demand will increase and net trade will decrease as X-M will be lower and AD will shift inwards
    1. X-M will increase
      1. fall in the exchange rate (depreciation) - exports become more competitive while imports become more expensive
      2. Improvement in the quality of domestically made goods - increases competitiveness of our exports
    2. X-M will decrease
      1. Incomes in trade partner countries fall e.g. in the 2008 crash, incomes in Spain and Ireland fell so demand for UK exports decreased and this was significant since 50% of our exports are to the EU
        Gov trying to diversify - selling to the BRICs avoids dependence on the EU and also increases exports
      2. Higher price level in the UK - exports become less competitive and imports become cheaper.
      3. Exchange rate increases (£ strengthens)
      4. Incomes abroad increase - export more
        Incomes in the UK fall, import less
        High propensity to import - significant effect
      5. We specialise in services but most of these aren't traded so we naturally export less
  4. Negative for the UK, positive for South Korea, China and Germany
6. Causes of Shifts
  1. Confidence/Expectations
  2. Changes in Monetary and Fiscal Policy - There are time lags between policy changes and the affects on AD.
  3. Economic events in the international economy e.g. exchange rates/incomes
  4. Changes in household wealth
7. Why does AD slope downwards - causes of movements along
  1. Real value of assets/savings increases when the price level falls, people feel better off and spend more, so consumption increases
  2. International price competitiveness is greater when the price level falls because our exports are cheaper and imports more expensive so X-M increases
  3. When the price level falls, the interest rate is reduced.
    1. Increases Consumption due to more disposable income due to lower monthly repayments
    2. Increases investment because the opportunity cost of reinvesting rather than saving is lower so investment is encouraged, and returns on investments are likely to be higher
8. AD is total spending in the economy by the 3 main economic agents (households, firms and the government) on real economic activity
Aggregate Supply
1. the factors influencing how much firms are able and willing to supply at various prices - costs of production, level of investment, availability of factors of production
2. Illustrate spare capacity
3. Factors that might cause a shift in AS - changing costs of raw materials/change in the level of international trade or exchange rates/technological advances/relative productivity changes/education and skills changes/regulation changes

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Aggregate Demand and Supply

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	Created by Kati Christova over 10 years ago