2.8 - Using the aggregate demand-supply diagram to show changes in economic activity

Overview
1. When showing how demand side and supply side factors interact to alter the overall level of economic activity and living standards we use an aggregate demand-supply diagram
2. AD/AS diagram - used to illustrate the key sets of influences or factors affecting spending and productive capacity on an economy’s equilibrium level of GDP or economic activity.
  1. Macroeconomic analysis
3. looks at how the equilibrium is reached nationally across all markets and how both demand and supply interact to determine the general level of prices.
Aggregate demand line
1. negative slope
2. overall quantity demanded contracts when there is a rise in the general price level.
3. Lower prices cause expansion in their quantity of national production that would be demanded.
4. Reasons for neg sloping line; higher prices usually eat into the purchasing power of individuals, reducing how much they buy. Inflation also encourages Aus to buy cheaper imports rather than Aus products.
5. response to generally stronger demand side conditions is that buyers are prepared to purchase larger quantities of local products at all given price levels. This will cause the whole AD line to shift up and to the right
6. Weaker demand side conditions move the whole AD line down and to the left
7. Factors which move these lines are disposable incomes, consumer and business confidence, overseas economic activity, population growth, interest rates and government economic policies.
Aggregate supply line
1. When graphed Aus supply line traces the relationship between the quantity of final national production that would be made available to suppliers at different general price levels.
2. line is positive and has three sections to it.
  1. 1. Horizontal Section
    1. exists at low levels of national output or supply where there are unused productive capacity.
      1. This is where firms would find it easy to increase production levels in response to little or no rise in price.
  2. 2. Upper or vertical zone
    1. generally no unused productive capacity.
      1. National production is at its limit because all resources are fully employed.
        Large rises in the price and the offer of huge profits are not enough for an actual increase in the volume of production.
        firms cannot get hold of extra resources that they would require to lift their GDP.
  3. 3. Intermediate zone
    1. between these extremes
    2. Indicates the gradual onset of full employment where the little excess capacity remaining soon gives way to no unused capacity at all.
      1. Moving upwards into this zone means price rises are needed to make extra production and profit.
3. Rising the supply line depends on the level of unused capacity and whether there is access to extra resources
4. Production can sometimes be bottle necked and limited. Firms would generally like to supply more as it means a price rise but they cannot do this.
5. Over time the productive capacity changes and with it is the position of the line. Supply side factors are responsible for this.
6. More favourable supply side conditions improve national productive capacity causing the line to increase or more outwards.
7. less favourable supply side conditions result in a decrease in the AS line that shifts inwards. Producers here are less willing to produce more and capacity is cut.
Changes in the equilibrium level of economic activity
1. National economic conditions change to reflect the levels of AD and AS
  1. show a cyclical pattern with many ups and downs.
2. Sometimes stagflation can occur
3. The causes of all these conditions can be illustrated on the diagrams.
Equilibrium changed by new conditions affecting the level of AD
1. high or low economic activity can depend on where the AD line crosses the AS line.
2. actual position of the AD line reflects the ever changing conditions of demand affecting expenditure on Australian made production
3. Deficient AD and recession
  1. Weak demand side conditions prevail, the equilibrium level of economic activity will also be down
  2. Low or falling production will cause a rise in cyclical unemployment and perhaps a recession
4. Excessive AD and boom
  1. Strong AD side conditions rise excessively the new equilibrium will cause economic activity to rise to a higher GDP.
    1. Soaring production is present here, the problem is inflation and a boom
  2. excessive spending, production cannot keep up and the economy overheats.
    1. Shortages occur, causing a rise of prices and demand inflation.
5. Ideal AD and domestic stability
  1. AD conditions are at domestic economic stability.
  2. Equilibrium would occur near the maximum production and employment will flourish.
  3. role of AD in this ideal situation is to help decide the national level of economic activity. This does not account for the situation of stagflation
  4. AD doesn't impact in the long term as much as AS so therefore we turn to the supply side conditions.
Equilibrium changed by new conditions affecting AS
1. Conditions that affect the position of the AS line remain fixed. In the real world this is not the case
2. Favourable supply conditions
  1. favourable ~ producers keen to increase production and capacity there will be a rise in quantity supplied at all prices and the whole AS line will shift outwards.
  2. new equilibrium with be a result of an increase in AS which means there has been a rise in national output and employment in GDP.
    1. fall in price this is beneficial. The rise in the AS lines there is improved domestic economic stability and material living standards
3. Unfavourable supply conditions
  1. unfavourable~producers are less willing to expand capacity or supply goods and services, supply would fall as would production, employment and GDP.
  2. Rising production costs or falling profits force firms to lift their prices, accelerating inflation.
    1. stagflation occurs. The solution to this problem is to implement government policies to improve the supply side conditions.
Application of this model for government economic policy
1. gov aim is to make society better of and stabilise our economic activity
2. two approaches used by the federal government to grow economic activity over time
  1. Aggregate demand or macroeconomic policies and Aggregate supply policies including microeconomic reforms.
3. 1. Aggregate demand or macroeconomic policies
  1. Try to steer the level of economic activity to maximise living standards
  2. AD needs to be controlled so that it isn't too strong or too weak.
  3. We don’t want it to cause booms and recessions
4. 2. Aggregate supply policies
  1. includes microeconomic reforms, immigration, aspects of the budget and environment factors.
  2. often wish to increase AS, efficiency and productive capacity needed to be economically stable.
  3. impact of these two types of policies on economic activity can also be shown using the AD-AS diagram.

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2.8 - Using the aggregate demand-supply diagram to show changes in economic activity

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	Created by mikaela.farrugia about 10 years ago