MACROECONOMICS

Aggregate Demand
AD: total quantity of all goods and services, which is national
output
X axis: real output (the value of national output adjusted for
in ation) or national income. Thus, aggregate demand curve shows
the relationship between the average price level and real output.
Figure 14.1: macroeconomic demand vs microeconomic demand

AD diagram: illustrates the inverse relationship between the

average price level and the total real output demanded; at a lower
average price level, a higher quantity is demanded.
- demand from all possible sectors within the economy

Components of aggregate demand

1. Consumption
- Total spending by consumers on domestic goods and services.
- Durable goods: cars, computers, phones that are used by
consumers over a period of time.
- Non durable goods: rice, newspapers, that are used up
immediately or over a relatively short period of time

2. Investment
- Addition of capital stock to the economy, carried out by rms.
- Replacement investment: rms spend on capital in order to maintain the productivity
of their existing capital.
- Induced investment: when rms spend on capital to increase their output to respond
to higher demand in the economy.
- The economy’s capital stock includes all goods that are made by people and are used
to produce other goods or services, such as factories, machines, of ces and
computers.
3. Government spending
- Federal, state/provincial municipal/city spend on a variety of goods and services. These
include health, education, law and order, transport, social security, housing and defense.
- Amount of (G) depends on the policies and objectives of the government
4. Net exports (X-M)
- Exports: domestic goods and services that are bought by foreigners. When the rms
in a country sell exports to foreigners, it results in an in ow of export revenues to
the country.
- Imports: goods and services that are bought from foreign producers. When
importants are bought, it results in an out ow of import expenditure.
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- Net trade: export-imports (positive: exports > imports ; negative: imports > exports)
Shape of AD curve
Aggregate demand: C+I+G+(X-M)
When the average price level in the economy falls from PL1 to
PL2, the level of output demanded by consumers (C)+ rms (I)
+governments (G) and the net foreign sector (X-M) increase
from Y1 to Y2.

Changes in AD
Any changes in the price level = movement along the AD curve,
from one level of real output to another.
Change in any of AD = shift in demand curve

Causes of changes in consumption:

1. Changes in income taxes
As income rises people have more money to spend on goods and services so
consumption increases. If there is an increase in direct Income Tax, then people will have
less disposable income. Disposable income is the income that people have remaining for
spending and saving after income taxes have been paid. With less disposable income,
consumption will decrease and there will be a fall in AD. A reduction of Income-Tax
levels will lead to an increase in disposable incomes and thus an increase in
consumption.

2. Changes in interest rate

Spending on non durable goods is carried out with the day-to-day money that people
earn. But some of that money used to buy durable goods comes from money which
people borrow from the bank. When people borrow money, they must pay for the
borrowed money by paying interest to the bank. If there is an increase in the interest
rates, which is the price of borrowed money then there is likely to be less borrowing.
Therefore, consumption will fall, resulting in a fall in AD.

3. Changes in wealth
The amount of consumption depends on the amount of wealth that consumers have.
Income is the money that people earn. Wealth is made up of the assets that people own.
This includes physical assets such as houses, art, antiques or jewelry and nancial assets
like shares in companies, government bonds or bank savings.

Two main factors that change the level of wealth in the economy:
- A change in house prices: When house prices increase across the economy consumers
feel more wealthy and are likely to feel con dent enough to increase the consumption
by saving less or borrowing more.
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 - Change in the value of stocks and shares: Many consumers hold shares in companies.
Value of the shares increases when people face value their. Encourage them to spend
more. Alternatively they might sell those shares and then use the earnings and increase
consumption.

4. Changes in consumer con dence/expectations

If people are optimistic about their economic future then they are likely to spend more
now. Example, if they think that they are likely to get a promotion in the future due to a
booming economy and strong sales, then they will get more con dent by taking a loan or
using up savings. Thus, high consumer con dence is likely to lead to increased
consumption.
Consumer Expectations regarding the future price will also fact consumption. Expect the
price level to increase in the future for in ation to occur, then they will increase
consumption now, especially on durable consumer goods. In the same way if they expect
the price trouble to fall or de ation to occur then they will put of consuming now in the
belief that products will be less expensive in the future.

5. Level of household indebtedness

If it is easy to borrow money which means easy credit and interest rates are low then it
is likely that households will take on more debt by getting loans or using that credit
cards. Spending on goods and services will rise.

Causes of changes in investment:

1. Changes in interest rates
Firms need money to invest which comes from several
sources. For example, rms use their "retained pro ts" or
they can borrow the money. Both of these are affected by the
interest rate. If the money is to be borrowed then an increase
in cost of borrowing may lead to a fall in investment. If interest
rates are higher, then rms may prefer to put their retained
pro ts in the bank to earn returns as savings rather than use
them to in past.

A decrease in interest rate, from 7% to 4% will decrease the

incentive to save and decrease the cost of borrowing, so is likely to
lead to an increase in borrowing that is likely to result in. an
increase in the level of investment from I1 to I2.

2. Changes in business taxes

If government increases taxes on business pro ts that will reduce post tax pro ts which
will mean that rms have less money to invest and so would expect to see a fall in AD.

3. Technological change
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 In any dynamic economy there is likely to be quick pace of technological change. Keep up
with the advances in technology and remain competitive rms will need to invest--
increasing AD.

4. Changes in business con dence

Businesses make decisions about the amount of investment for the future and their
con dence in the economic climate. There would be little point in investing to increase
the potential output of a form if consumer demand is likely to fall in the future. If
businesses are very con dent about the future of the economy and expect consumer
demand to rise then they will be ready to meet the increases in consumer demand by
investing to increase potential output and productivity.

5. Levels of corporate indebtedness

If it is easy to borrow money which means easy credit and interest rates are low then it
is likely that businesses will take on more debt and investment will rise. However if
interest rates rise, then businesses will have to spend more to repay their loans. In the
short run they might simply continue to borrow but ultimately the debt will have to be
paid and it will leave businesses with less money to spend on investment causing a falling
AD.

Causes of changes in government spending:

The amount and nature of government spending depends on political and economic
priorities of the government. For example if the government has made a commitment to
nancially support given industry, government spending will rise. Governments are
obliged to spend to correct market failure then government spending will rise. New
education policy might require increase public spending on schools. Thus, government
spending increases then AD will shift to the right and if it falls it will shift to the left.

Causes of changes in net exports:

1. Changes in exports
If foreign incomes tries then that consumption of imported goods and services will rise.
For example as the Chinese national income Rises, chinese people are more willing and
able to buy imported goods and services from your. Thus, European exports rise as the
Chinese economy grows. Similarly as China grows, investment in China expanse. This is
likely to involve some measure of imported capital such as increasing German exports of
capital equipment.

Changes in the value of a country's currency for the exchange rate become stronger
than it makes the country's exports relatively more expensive to foreigners. This because
quantity of exports to fall.

Changes in countries trade policies may also affect the value of a country's exports
because if a country two sides to adopt a policy of model liberalized trade then it may
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 reduce the tariffs that it charges on imports and effectively allows countries to export
more to that country.

Relative in ation rates among trading partners also affect export revenues. For example
if in ation in the US was relatively higher than Canada then you ask words would be less
competitive in Canada and made reduce the export revenues which us on from its
exports to Canada.

2. Changes in imports
As people consume more goods and services, it will cause goods and services to be
imported. Similarly as national income Rises, there is likely to be greater investment. Part
of the capital goods that are purchased will be imported. Thus as national income tries
so does the spending on imports.

An increase in exchange rate would make imported goods less expensive and depending
on the elasticity of demand for imports it could reduce import expenditure.

The type of trade policies that our country adopt will affect its level of import spending.
Country decides to adopt a more liberalize trade policy by reducing tariffs on imports,
then import expenditure would be expected to rise. However if more protectionist set
of policies were to be adopted, then import expenditure what fall.

Aggregate Supply
Aggregate supply is the total amount of goods and
services that all industries in the economy will produce at
every given price level. It is essentially the sum of supply
curves of all the industries in the economy.

Short run aggregate supply

Graphically the short run aggregate supply is upward
sloping. There is a positive relationship between the price
level and the amount of output that country's industries
will supply.

The supply curves usually called and gets steeper as price

rises. Thus, the SRAS curve would be the same since it is a
horizontal summation of all the micro economics supply
curves. It would look like the SRAS curve in gure 15.1. It
is drawn in a straight line for convenience.

At any given price level, industries will supply a certain

level of output. In macroeconomics short run is de ned as
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 the period of time when the prices of all the factors of production do not change. Most
importantly the price of labour or the wage rate is xed.

If a larger level of output is to be produced rms are likely to face higher average costs
of production. Sample in order to produce more, forms will have to provide incentives
two workers to produce a larger amount. This is done by paying overtime wages. Law of
diminishing returns means that marginal and average cost will rise as output increases in
the short run.In the short run an increase in output will be accompanied by an increase
in average cause. Industries will pass on an increase in costs in the form of a higher price
level. This explains why the SRAS curve is upward sloping. In gure 15.2, an increase in
the level of output from Y1 to Y2, will be accompanied by an increase in the price level
from P1 to P2.

Shifts in the SRAS curve

A change in anything other than the price will lead to a shift
in the whole curve. A change in any of the factors other than
the price level will result in a shift in the SRAS curve. This
might be referred supply side shocks. These are factors that
cause changes in the costs of production. Decrease and costs
leads to an increase in aggregate supply and increase in cost
results in a decrease in aggregate supply.

Examples of changes in the costs of production:

- Change in wage rates: An increase in wages for result in an
increase in the costs of production to rms and therefore
a fall in aggregate supply. For example the government
raised the legal minimum wage, it was increased labour costs.
If labor unions in manufacturing industries whose priority is usually to ensure good
wages and conditions for workers, were to negotiate for higher wages for
manufacturing workers, then this would lead to fall in the SRAS.

- Changes in costs of raw materials: An increase in the price of rubber which is raw
material would affect industries that use rubber as a factor but this might not be
signi cant enough to affect the aggregate supply noticeably. A change in price of oil
would impact Industries as oil is widely used in most production processes.

- Change in the price of imports: If the capital or raw materials used by a country's
industries are imported, then a rise in import prices will increase the costs of
production. This can occur due to changes in the exchange rate of a country's
currency. For example, if the value of the euro falls then this makes the import price
of raw materials and capitals used by the European producers relatively more
expensive. Their costs of production increase.
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 - Change in the government indirect taxes or subsidies:
An increase in indirect taxes effectively increases the cost of production to rms and
therefore a fall in the SRS curve. Since subsidies are a payment from governments to
rms. An increase in government subsidies reduce rms cost of production leading to a
decrease in the SRAS curve. This happens only if a product is essential, otherwise
subsidies have a minimal impact.

Long run aggregate supply

New classical LRAS:

New classical economists include monetarists, supply side
economists and economists from the Austrian school.
These economics have a shared belief in the ef ciency of
market forces and in their view, there should be the very
minimum of government intervention in the allocation of
resources in the economy.

In this view, the LRAS curve is perfectly inelastic or vertical at

the full employment level of output. Full employment level of
output represents the potential output that could be
produced if the economy were operating at full capacity and
is annotated as Yf on a macroeconomic diagram.

This view asserts that the potential output is based entirely on the quantity and quality
of factors of production and not on the price level. The LRAS is independent of the price
level, illustrated in gure 15.5. The price level might rise from P1 to P2, but the level of
output does not change.

Keynesian AS:
The shape of the curve that is known as Keynesian AS shows
three possible phases that does not really distinguish
between short run and long run, shown in gure 15.6 in
region 1, 2 and 3.

Phase 1: Aggregate supply will be perfectly elastic at low levels

of economic activity. Economy can raise the price levels of
output without encouraging high average costs because of
the existence of spare capacity in the economy. Is there are
high levels of induced factors such as unemployed labour and
underutilized capital. Should there be a need for Greater
output, these can be used to the fullest capacity at constant
average costs.
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Phase 2: As an economy approaches its potential output and the spare capacity is used
up, economies available factors of production become increasingly scarce. As producers
continue to try to increase output they will have to bid for increasingly scarce factors.
Higher prices for the factors of production mean higher costs for the producers, and the
price level will rise to compensate for the higher costs.

Phase 3: When an economy reaches its full capacity it is impossible to increase output
any further because of all factors of production are fully employed. This suggests that AS
is perfectly inelastic, shown in region 3. This third range corresponds exactly to the LRAS
of the new classical economist. At this stage of output cannot be increased without an
increase in the quantity or improvement in the quality of factors of production

Shift in the AS and LRAS curves

An outward shift of a country's AS/LRAS means that its productive potential has
increased. A shift in the AS/LRAS curve can be linked to an outward shift of the PPC. This
is an illustration of potential economic growth.

An outward shift of a country's AS/LRAS means that its productive potential has
increased. A shift in the AS/LRAS curve can be linked to an outward shift of the PPC. This
is an illustration of potential economic growth.
MACROECONOMIC EQUILIBRIUM
The actual level of output, and its corresponding price level, is determined by the
interaction between aggregate demand and aggregate supply.

Equilibrium level of national income is where the AD = AS

Short-run equilibrium
=> AD = SRAS, producing an output level of Y at the price level of P
The output produced by the economy is exactly equal to the total
demand in the economy and so there is no reason for producers to
change their levels of output. Because AD=AS, there is no upward or
downward pressure on the price level—no in ationary or de ationary
pressure.
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 Long -run equilibrium
New classical perspective:
According to the new classical economists, the economy will
always move towards its long-run equilibrium at the full-
employment level of output. Thus, the long-run equilibrium is
where AD meet the vertical long-run AS in gure 16.2.

Impact of any changes in AD will be on the price level on. This is

illustrated in gure 16.3, where increase in AD is from AD1 to
AD2 causing an increase in the price level from P1 to P2 without
any increase in the level of real output.

*the monetarists believe that economy will always move

automatically to its long-run equilibrium. The word automatically
means without government intervention and illustrates the
signi cance that the new classical economists place on free
markets.
*in their view, there may be a short-run increase in output if
there is an increase in AD, but the economy will always return to
its long-run equilibrium.

In ationary gap:
The new classical perspective showing a combination of the short
run and long run: gure 16.4 and 16.5. Initially, the economy is at its
long run equilibrium at Yf. If there is an increase in AD, AD1 to AD2,
in the short run, there will be an increase in output from Yf to Y1.
In this case, the economy would be experiencing what
is known as an in ationary gap, where the economy is
in equilibrium at a level of output that is greater that
the full employment level of output— gure 16.4

However, according to the new classical economists, this is only

possible in the short run. It is possible for output to increase along
the short run aggregate by paying existing workers overtime wages
as a short-term solution. But as the economy is originally at full
employment level of output, there are no unemployed resources. In
their effort to increase the output, rms in the economy are
competing for increasing scarce labour and capital and as the
diagram shows, the increase in aggregate demand results in the
increase in price from P1 to P2 as shown in gure 16.5. The
increase in the average price level means, that on average, all prices
in the economy have risen as the rms bid up the prices of the
factors of production in order to increase the output. The rise in
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the price level means an increase in the costs to rms as the
prices of the factors of production have risen. At this point, if the
costs of production rise, the result is a shift in the short run
aggregate supply from SRAS1 to SRAS2. Although rms were
willing to supply a higher level of output due to higher prices they
were receiving in the short run, that higher costs of production
result in no real gain, so that produce output back to Yf. The nal
result is that output returns to its fullest employment level, but at
a higher price of P3.

Originally, the economy is at its long-run equilibrium where the

AD1 intersects with SRAS1, at output Yf and the price level P1. A
fall in the AD from AD1 to AD2, due to changes in any of the
components in AD, results in a fall in the level of national output Yf
to Y1 and a decrease in the price level. In this case, the economy
would be experiencing what is known as a de ationary gap, where
the economy is in equilibrium at a level of output that is less than
the full-employment level of output.

In the short run, take on we will produce at less than full

employment of output; however, this de ationary gap will not
persist. The fall in the price level means that prices of the
economy’s factors of production have fallen. This is shown in gure
16.7. This means that rms’ cost of production fall and this results
in a shift in the SRAS1 to SRAS2. As the diagram shows, economy
returns to its long run equilibrium at the full employment level of
output, at a lower price level.

In conclusion, the long-run equilibrium level of output = full employment level of income
and that the economy will move towards the this equilibrium without any government
intervention as a result of three market forces. According to this model and increase
and aggregate demand will be purely in ationary in the long run they would recommend
leaving the economy to market forces rather than using government policies and thus
there is no role for government to play in trying to deliberately steer the economy
towards full employment. Although, there may be deviations from full employment in the
short run, new classical economists would see no role for government in lling the gaps.
They would recommend leaving the economy to market forces, rather than using
government policies to manage the level of aggregate demand.
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 Keynesian perspective:
In both new classical and Keynesian analysis, the equilibrium level
of output is where AD=LRAS. According to the Keynesian
economist, however this equilibrium level of output may occur
at different price levels. Signi cantly, they believe that the
economy may be in long run equilibrium at a level of output
below the full employment level of national income (Yf). This will
be the case if the economy is operating at level where there is
spare capacity. In this view, the equilibrium level of output
depends mainly on the level of aggregate demand in the
economy. Figure 16.8 illustrates this important view of the
Keynesian perspective.

If aggregate demand is at a level shown in gure 16.8, then

equilibrium will occur at a real output level of Y, with the price
level of P. As the aggregate supply can be perfectly elastic
because of the existing of spare capacity, with high levels of
unused factors of production such as unemployed workers or
underutilized capital.
It is important to observe that in this case the equilibrium level
of output is below the full employment level of output. There is
a de ationary gap whereby the level of aggregate demand in the
economy is not suf cient to buy the potential output that could
be produced by the economy at full employment level of output.
This may also be referred to as an output gap and though, not
easily measurable, could be shown as the distance from a point
inside a country's production possibility curve to a point on the
curve as shown in gure 16.9.

In the condition view, aggregate

demand can increase such that
there is an increase in the level of
real output, without any
consequent increase in the price
level. This is shown in gure
16.10.
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 If there is an increase in aggregate demand from
AD1 to AD2, then there will be an increase in real
output from Y1 to Y2, but no change in the price
level. Due to the existence of spare capacity in the
economy. Producers can employ THE unused
factors of production to increase output with no
increase in costs. Thus, there is no in ationary
pressure.

If the AD further increases to AD3, as in gure

16.11, then the economy starts to experience
in ationary pressure as available factors of
production become scarer and their prices are bid
up. The price level rises from P1 to P2 to
compensate producers for their higher costs.

If the economy is operating at full employment and

there is an increase in the aggregate demand, then
the outcome will be purely in ationary. That is,
there is no increase in output and the only change is
an increase in the price level. This is because, it is
impossible for the economy to produce any further
in output in long run, given the existing factors of
production. This is illustrated in gure 16.12. An
increase in aggregate demand from AD1 to AD2
results in no change in output as the economy
cannot produce output beyond the full employment
of level of output. The only impact is an increase in
the price level from P1 to P2 to allocate scarce resources among the competing
components of aggregate demand like consumers, produces, the government and the
foreign sector.

Credits:

Blink, Jocelyn & Dorton, Ian, 2020. "IB Economics Course Book: Oxford IB Diploma
Programme," OUP Catalogue, Oxford University Press, edition 2
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