Aggregate supply and demand

• AD= C+I+G+(X-M)
• Consumption ​is consumer spending on goods and services; it makes up about 60% of AD, so is the biggest part.
• • Investment is spending by businesses on capital goods, such as new equipment and buildings as well as working capital e.g. stocks and work in progress; it makes up about 15-20% of AD. Most investment is by the private sector (about 75%) but there is also investment by the government.
• Government spending is spending by the government on providing goods and services, generally public and merit goods, both on wages and salaries of public sector workers and on investment goods like new roads and schools.

  • This will change year on year as governments decides how much they spend. Transfer payments such as pensions and jobseekers’ allowances aren’t included in the figure as money is just transferred from one group to another. Government spending tends to be around 18-20% of GDP.
• Net exports is exports minus imports: when imports are higher than exports this is a minus figure as more money leaves the UK than comes in. The UK has a large trade deficit, but this minor figure and is the least significant part of AD at around 5%.
• the AD curve is ​downward sloping as a rise in prices causes a fall in real GDP and there are four key reasons for this:

  • income effect
  • substitution effect
  • real balance effect
  • interest rate effect
• Income effect: As a rise in prices is not matched straight away by a rise in income, people have lower real incomes so can afford to buy less, leading to a contraction demand.
• • Substitution effect: If prices in the UK rise, less foreigners will want to buy British exports and more UK residents will want to buy imported foreign goods because they are cheaper. The rise in imports and fall of exports will decrease net exports so AD will contract.
• • Real balance effect​: A rise in prices will mean that the amount people have saved up will no longer be worth as much and so will offer less security. As a result, they will want to save more and so reduce their spending, causing a contraction in AD.
• • Interest rate effect: Rising prices mean firms have to pay their workers more and so there is higher demand for money. If supply stays the same, then the ‘price of money’ i.e. interest rates will rise because of this higher demand. Higher interest rates mean that more people will save and less will borrow and will also mean that businesses invest less, so AD will contract.
• Disposable income (Y) is the ​money consumers have left to spend​, after taxes have been taken away and any state benefits have been added. This means that disposable income is affected by government taxation as well as wages.
• MPC= ​change in consumption / change in income
• MPS= ​change in savings / change in income
• APS= ​total savings / total income
• Other influences on consumer spending:

  • interest rates
  • consumer spending
  • wealth effect
  • distribution of income
• Investment is the ​addition of capital stock to the economy i.e. machines and factories used to produce other goods and services. It is only seen as investment if real products are created so buying a share in a company would be saving but buying new machinery is investment.
• Machinery depreciates (loses its value) over time as it wears out or gets used up. ​Gross investment is the amount of investment carried out and ignores the level of depreciation, whilst ​net investment​ is gross investment minus the value of depreciation.
• Influences on investment:

  • rate of economic growth
  • business expectations and animal spirits
  • demand for exports
  • interest rates
  • influence of government and regulations
  • access to credit
  • retained profit
  • technological change
  • costs
• 1. The government has a very significant part to play in the level of AD, through spending. They spend money on defence, education, the NHS etc.
• Influences on government expenditure:

  • the trade cycle - decisions over government expenditure may be made in order to manage AD, and therefore regulate the trade cycle. In a recession, the government may increase spending in order to increase demand to reduce unemployment.
  • fiscal policy
  • age distribution - ​An ageing population leads to increased government expenditure on pensions, social care etc. 
• Exporting goods abroad brings money into the country as there is an increase in AD whilst importing goods means money leaves the country. Net trade is the ​total exports minus the total imports.
• Influences on net trade balance:

  • real income
  • exchange rates
  • state of world economy
  • degree of protectionism
  • Prices
• Aggregate supply is the ​volume of goods and services produced within the economy at a given price level. It indicates the ability of an economy to produce goods and services and shows the relationship between the ​real GDP​ and the ​average price levels​.
• Factors influencing Short AS:

  • Changes in costs of raw materials and energy​
  • Changes in exchange rates
  • Changes in tax rates
• Factors influencing Long run AS:

  
  

  • Technological advances
  • Changes in relative productivity
  • Changes in education and skills
  • Changes in government regulations
  • Demographic changes and migration
  • Competition policy
• In the short run, supply can be increased by offering overtime but in the long run ​there will be a limit on how much supply can be increased. There is a limit on the number of people and machines that are available and once labour productivity is maximised, supply cannot be increased any further. On the LRAS curve, unlike the SRAS curve, wage rates are variable and can change.
• Competition policy: The government can promote competition between businesses and markets which will force them to improve the quality of their goods or lower prices.
• Demographic changes and migration: ​If immigration is higher than emigration, the population will grow and so therefore there will be more workers which will increase the LRAS. The value and importance of this immigration will depend on the age of the immigrants and their skills. 
• Classical

  In the long run, AS is ​independent of the price level and is ​determined by the level of all factors of production and the quality of technology​. The LRAS is a measure of a country’s potential output and the concept is linked to the idea of PPF; it shows the productive potential of the economy. 
• classical LRAS

  • In the short run it is possible for an economy to ​exceed the maximum potential LRAS by allowing factors of production to ​work overtime or not allow time for maintenance of machinery etc. However, this is ​not possible in the long run as machines will eventually stop and workers will want a break.
• Classical LRAS

  The vertical AS curve is based on the classical view that ​markets tend to correct themselves fairly quickly. This means although an economy can be in disequilibrium at any moment in time it will naturally move towards equilibrium position where all resources are employed and the economy is producing at its productive potential; on its PPF. This means LRAS is vertical.
• Keynesian: ​The classical view of the LRAS curve was agreed until the 1930s when Keynes expressed the view that if the economy can be in disequilibrium for 20-30 years, it can’t be correct to imply the AS curve is vertical. Keynes came up with his own LRAS curve.
• • Keynes thought this was true to an extent but wages tend to be ​‘sticky downwards’​. They will not fall below a certain level because:
  • businesses are unwilling to risk demotivation of their staff by offering low wages
  • there may be full employment in one area and unemployment in another area due to lack of labour mobility
  •  the minimum wage means wages cannot fall below a certain level.
• what will happen in the long run to real output if aggregate demand increases? using classical long run AS curve

  • There will be no change in real output
  • They believe that the economy will be at full employment
• explain the likely impact of aggregate demand of a fall in average house prices ?

  • creates a negative wealth effect
  • Assets depreciate lead to consumers losing confidence and reduce consumption
• why is the classical long run as curve shaped like that

  • assumes full employment
  • due to wages and prices are seen as sensible
• what is meant by spare capacity in keynes lras curve

  • Economy is not operating at a full capacity
  • there is a negative output gap in the economy.
• influence on consumer spending

  • Interest rates
  • consumer confidence
  • Wealth effects
  • Disposable income
• influence on investment

  • Rate of economic growth
  • Business expectations and confidence
  • Keynes and animal spirits
  • Demand for exports
  • Interest rates
  • access to credit
  • Government regulations / deregulations
• government expenditure

  • trade cycle
  • fiscal policy