Aggregate Demand and Supply Saturday, 8 September 2018 Aggregate Demand - Aggregate demand in macroeconomics is the total demand for goods and services in a period of time at a given price level or its GDP. - AD = G+I+C+(X-M) - C= Consumption - I= Investment - G= Government spending - X= Exports - M= Imports - Inverse relationship between price and AD. Thus curve is negative and downward sloping. Factors of downward sloping demand curve: Wealth Effect : Higher price levels reduce purchasing power or real value of the nations households wealth and savings. The public feels poorer at higher price levels and thus demands a lower quantity. On the other hand, at lower price levels people feel wealthier and thus demand more. Similar to income effect. Interest Rate Effect : In response to a rise in the price level, banks raise interest rates on loans, this is because banks know firms and individuals may need to borrow more money to spend. At higher interests rates, the quantity demanded decreases as people rather save than spend. Vice versa for low interest rates. The Net Export Effect : As the price level of a country falls (deflation), ceteris paribus, goods and services produced in that country become more attractive to foreign consumers. Likewise domestic consumers find imports less attractive as they now appear relatively more expensive. Vice versa for inflation in an economy. Substitution effect, but for imports and exports. Shifts in AD curve There will be a shift in AD as a result of a change in any of the four components. Consumption, Investment, Government Spending or Exports-Imports 1
Factors of consumption Consumption (C): the total spending by consumers on domestic goods and services. This is the most important component. AD curve can be shifted by changes in consumption due to factors. Level of national income: as national income rises, the level of consumption of a nations household rises and as national income falls, consumption falls. - Real Interest rates: the price of borrowing money over a period of time and the reward for saving money. Real IR is subtracting rate of inflation from nominal interest rates. - If inflation is anticipated, banks will charge higher nominal interest rates to borrows. This is because banks must rise rates to maintain profits, since inflation errodes value of money and a borrower would be paying back money worth less than the original sum of money borrowed. - However, if not anticipated then real interest rate is lower and households are induced to spend on durable goods, due to opportunity cost of holding money( inflation) increases while the opportunity cost of spending money(nominal interest rates) remains the same. - An increase in interest rates decreases consumption expenditure. - When interest rates rise, the reward for saving money increases and loans become more expensive, so there is less consumption. - When interest rates fall, the monthly repayments for flexible mortgages decrease, so there is more consumption. Wealth effect: as the value of assets rise individuals feel more wealthy, consumer confidence increases so consumption increases. Household debt: money owned by householders to lenders. If this increases initially consumption increases as they can consume beyond their disposable income. However, consumption the decreases when they have to repay their loans with interest. Degree to which credit is available affects consumption. Disposable income: there is a positive relationship between consumption and disposable income. When consumption is less than disposable income, the individual will save the remaining. In reality MPC drops as income rises because people save. The government can influence the amount of disposable income an individual has by changing the amount of taxation and benefits, which therefore changes the level of consumption in the economy. 2
Expectations/Consumer confidence: if people are optimistic about their economic future then they are likely to spend more now. - For instance if they feel that they are likely to get a pay rise then they are likely to feel more confident about using their savings and therefore increasing consumption. - A stable and growing economy, with low inflation and low unemployment will boast consumer confidence and increase AD. Remember these factors of consumption with WIDER (wealth, income, debt, expectations and rates). Next you will learn that the factors of investment are very similar. Factors of investment: Investment (I): an increase in the spending of firms on capital. Capital is any manmade good used to produce other goods and services, such as machinery, buildings. Below are the two main types of investment. - Replacement Investment (Depreciation): firms spend on capital to maintain the productivity of existing capital. - Induced Investment: firms spend on capital to increase their output, in response to higher demand in the economy. Factors of investment: 1. G: Government policy 2. R: Rate of interest 3. A: Accelerator 4. P: Profitability 5. E: Expectations of future demand 6. T: New technology 7. E: Exchange rate Government policy (G): governments may offer incentives to increase foreign and domestic investment, such as reduction in corporation tax rates, or grants towards research and development. Rate of interest (R): cost of borrowing and reward for saving. 3
- If firms borrow to fund investment then they will be charged interest, that will have to be paid back at a later date with profits. If firms use their retained profits then they sacrifice the interest foregone had they continued to save the money in the bank. In this manner, interest rates can determine long term or short term opportunity cost of a firm/household. - At higher interest rates the amount of investment in the economy declines for the following reasons: 1. Firms have an incentive to save earnings. Firms, being profit maximising, will be less likely to invest when returns are greater on saving. 2. Households will prefer to save. 3. Cost of borrowing is higher and thus higher costs and smaller profits. 4. Fewer investments in capital with expected rate of return equal or greater than rate of interest. 5. To borrow or spend has higher opportunity cost of the revenue lost in the saving. - At lower interest rates the amount of investment in an economy increases for the following reasons: - Opportunity cost of buying new capital falls and firms are more likely to invest revenues earned from their sales in new capital equipment in order to expand output. - Vice versa for above. Investment schedule when investment is inelastic: if business confidence is low firms are unlikely to undertake investment irrespective of the rate of interest. Thus, knowing the responsiveness of firms and households to changes in interest rates is very important to the government when setting policies and determining future AD. - If consumption increases then they will undertake further investment, called induced investment, to produce the additional output. Profits (P): firms with retained profits may increase investment as they have the internal funds available. Expectations (E): if businesses have confidence that consumer demand will rise in the future, then they are likely to increase investment in new capital equipment in preparation to meet the output demanded. Business confidence is affected by: Consumer confidence 4
If consumption and consumer confidence is falling, investment will fall as well. Less investment reduces firms demand for capital and labour leading to higher unemployment and further leads to a fall In disposable income and consumption. This is often the first sign of a recession. GDP Inflation If there is deflation and price level is falling, firms and households are more likely to save their revenues and postpone investments until prices start to rise, in order to save more money. On the other hand, if prices are rising firms would invest to take advantage of the higher prices they can sell goods at in the future. Technological changes (T): in order to keep up with advances in technology firms will increase investment. - Best example of this is mid 1990s following creation of world wide web. Dot com bubble saw trillions of dollars of investment in companies. Creation of new industries can lead to new makers for consumers to invest in. Exchange rates (E): the price of one currency in terms of another, determined by the demand and supply of the currency. When the value of the country s currency falls the volume of investment will increase. Factors of government spending Government current expenditure: day-to-day spending on things such as salaries or civil servants, drugs for health service etc. Government capital expenditure: spending on manmade goods used to produce other goods and services, i.e. Public Sector Investment. - Governments spend in order to ensure that adequate amounts of public and merit goods and services are consumed such as defence, education and health services and to influence the level of economic activity and distribution of income. Fiscal policy: use of government spending (and taxation) to influence the level of aggregate demand (economic activity). - The amount spent depends upon the political and economic priorities. 5
Factors of net exports Export: a flow of money in to the country and is an injection in to the circular flow of income. Import: a flow of money out of the country and is a leakage for the circular flow of income. Net exports = exports imports Change in protectionism: if a country suddenly increases the level of protectionism, for example introduces a tax or quota in imports, then this will increase that value of X-M as the level of imports in to a country falls. Income of trading partners: if foreign incomes rise then the demand for goods and services produced by a given country will increase and this will lend a rise in the value of AD as X increases. And vice versa. Example: In 2008 when incomes in the US fell, Canadas exports fell by 30%. The exchange rate: if the exchange rate becomes stronger, then exports from that country appear relatively expensive while imports appear relatively cheap. This can lead to a fall in the value of net exports particularly if the demand for imports and exports is elastic. Important to note that even if exports are a key part of a nations economy, it many only account for a small % of the economies GDP. For example. Switzerland 6
exports 70% of its GDP value but when imports are also considered, exports only account for a total of 5% of GDP. Saturday, 8 September 2018 Tastes and preferences of consumers: TOnce a country has developed a strong reputation in the global marketplace, that country can count on steady demand from abroad for its output. German cars are known to be better around the world. Keynesian Multiplier Effect An increase in injections (G, I or X) to the circular flow of income leads to a more than proportionate increase in national income. An increase in government spending on infrastructure, increases employment as a workforce is needed to fulfil the investment. Therefore, income levels, consumer confidence, consumer spending and, investment spending by firms would increase. Governments consider the multiplier effect when considering the benefits of aggregate demand stimulus. What level of stimulus is required to increase the overall level of output. The diagram shows how an increase in government spending on an infrastructure project will create new jobs, which provide workers with income. The workers will spend their income in local stores and as a result the income level of the store holders will increase. As a result of increased incomes the store owners may increase investment which may increase the number of jobs available. The multiplier effect will be higher the more of the increase in income that is spent i.e. the higher the value of MPC. In addition, the less money that is saved, spent on taxes and imports the bigger the final effect on the national income. Aggregate Supply Aggregate supply: the planned level of output at different price levels over a given period of time. This refers to the total amount of goods and services willing and able to be produced. However, there are competing theories on the possible response to a nations producers to changes in the price level. 7
Positive slope: AS has a positive slope because the price level and AS have a direct relationship. The price level increases real AS increases. a relatively low level of output. On the Keynesian AS curve, producers are responsive to the higher price and increase their output. AS is relatively elastic when the nation is producing at In neo-classical model of aggregate supply, a change in the average price level of the nations good has no effect on level of output. Regardless of price, nations producers will always produce at the level of output at which all the nations resources are fully employed. AS is perfectly inelastic at nations full employment level of output. Keynesian AS curve is considered to be the SRAS curve and the Neo-classical is understood as the LRAS curve. Movement along the supply curve: an increase in price will cause an increase in the price level which leads to an increase in output in the short run, as an increase in prices will make it more profitable to produce. SRAS Keynesian curve - SRAS curve is horizontal (relatively elastic ) at levels of output below full employment. - SRAS curve is vertical at levels of output beyond full employment. SRAS curve is horizontal (relatively elastic ) at levels of output below full employment. In the short run firms are very responsive to a decrease in the demand for national output. SRAS is relatively elastic when AD declines and the price levels falls. A fall in AD will lead to a small decrease in the price level but a relatively learge decrease in total output. 8
Yi: The quantity is the full employment level of output. The nation experiences very low unemployment, stable prices, and the nations resources are generally being used efficiently and near full capacity towards the production of goods and services. Yf: A decrease in AD cause. Ill in the price level. As the average price level of goods falls, firms respond by reducing their output and laying off workers. In the short run, the decrease in the price level is proportionally smaller than the decrease in output. Yr: If AD continues to fall, firms must once again reduce employment and output. Therefore leading to a fall in price level and output. However due to highly elastic nature, the decline in output is larger. The decline in the short run equilibrium output and employment is explained by the fact that in the short run wages and prices are downwardly inflexible. The short run is referred to as the fixed wage period. Firms find it difficult or impossible to adjust wages in short run due to these reasons: 1. Worker Contracts A contract may include a guaranteed wage, as a legally binding agreement making it hard for firms to slash wages in times of falling demand. 2. Minimum Wage Laws Minimum wage lows may make it difficult for employers of low skilled workers to reduce costs without laying off workers when demand falls. The existence of the price floor prevents firms from decreasing price levels and adjusting to lower demand. This is because firms are unable to make a profit with the higher costs of production, causing unemployment to be potentially higher than it usually would during week AD. 3. Wage Agreements with Labour Unions 9
Labour Unions make threaten firms with walk outs or strikes by unionised workforces in order to prevent firms from decreasing wages. This may result in firms to lay off entire workforce when demand is weak. Labour unions have become less powerful in all industries apart from primary sectors and low skilled jobs. Even then due to high supply, it is unlikely that they have the funds and power to fund such drastic measures. 4. Government Regulations such as mandating fringe benefits and certain wages make it hard to cut wages. Because of inflexible nature of wages, firms instead lay off workers and reduce output in response to falling demand. In a nation, prices are slow to adjust in the short run due to labour market rigidities making it hard for firms to cut costs quickly. This SRAS model is referred to as the stick wage price model of the AS. Since wages are inflexible in the short run firms must respond to a decline in demand by reduce their output and laying off workers to reduce their costs and avoid shutting down. SRAS is vertical at levels of output beyond full employment. - Increases in AD cause the demand curve to shift, resulting in short run equilibrium levels of output beyond the full employment level. -According to the SRAS model above, it is possible to produce at a level past LRAS. Notice that a small increase In output leads to increasing prices at a higher rate. - The inflexibility of wages in the short run helps explain the decreasing elasticity of SRAS beyond the full employment level of output. - A nation producing at the LRAS point is very close to the frontier of the PPC and that all the nations land labour capital are engaged in the production of goods and services. - Full employment is when level of unemployment is low and stable. When workers who are willing and able to work, work. 10
- Does not consider natural rate of unemployment (frictional unemployment) and structural unemployment. - When AD rises, firms wish to respond the higher demand and the higher prices it brings by increasing the production. Since wages are fixed, firms have to bargain to hire more workers, often paying more. However, as output grows supply of labour decreases and firms must compete for a limited supply of labour. And example of this is coders in silicon valley. - Output will begin increasing at a decreasing rate when AD rises beyond full employment level. - As AD continues to increase, increasing output and proaction becomes nearly impossible. Unemployment falls causing a tight labour market as firms find it harder to meet the rising demands from their customers. The result Is a SRAS that small increases in GDP(output) are met with larger increases in the price level and inflation. Evaluative Points Relies on fiscal policy and government intervention to bring economy out of recession. Which causes budget deficits. Due to downwardly inflexible wages, workers will not accept lower wages when an economy is producing below full employment and often the economy will slump into a recession. Lots of opportunity cost. The US has been using expansionary fiscal policy since 2008, fed rate has been near 1%, and the economy has been growing constantly, successful example of this. However they run a 3 trillion budget deficit that Is growing. Keynesian polices has merit with economies in recession, due to it being created in great depression The biggest downside of Keynesian economics is the existence of cost push inflation when both high inflation and unemployment exist. Demand side policies would only worsen inflation and contractionary policy would make unemployment worse and lead the economy into a recession. A recent example of where this occured is Venezuela where unemployment had risen to 8% and in return government tried to stimulate economy and ended up having hyper inflation of 1 million %. 11
Long Run Aggregate Supply in Neo-Classical Model Saturday, 8 September 2018 - The fundamental assumption being this model is that wages and prices are perfectly flexible and will therefore adjust to the level of demand to ensure that output always remains at its full employment level. - No involuntary unemployment because workers who might lose their jobs as demand falls, will always accept lower wages. - Therefore allowing firms to maintain their output and employment while lowering their prices in resin to decline demand. - If workers are unwilling to work at lower wage rate then they are voluntary unemployment, which is natural in an economy at any level of AF and therefore not a concern. - This is highly hard to be implemented in the short run because wages tent be to highly inflexible in short run. - As AD falls, in the short run we would expect unemployment to rise,output to fall and only a slight decrease I price level. Similar to SRAS model. - However, In the long run as unemployment rises and demand remains week, workers will begin to accept the lower wages offered by firms in order to get back to working. - AS a result employment and output will return to full employment level while prices in the economy simply adjust downward. - As AD rises, firms scramble to hire workers to increase profits but as labor markets tighten and workers become more scarce, there is upward pressure on wages. This will lead to firms cutting employment and reducing their output in repose to the rising costs of productions that the higher wages cause. - This model shows that in the long run, there is no trade off between the level of demand in an economy and the level of output. Changes in the demand lead only to changes in wage rate and the price level as workers and consumers adjust their expectations and behaviour. - Recessions, are only likely if wages and prices are inflexible, and in the short run. Assuming they are flexible in long run, economy can self correct as wages and prices will become lower and firms hire workers to increase output until economy is producing at full employment once more. - Long run economic growth cannot be achieved by an increase in AD beyond the firms full employment because overtime higher wages in a tight labour market will lead to higher costs and a reduced output. 12
Evaluation of Neo Classical - Workers will accept lower wages in the long run as incomes dwindle. This can be seen In Venezuela amidst economic and political turmoil: While minimum wage laws sit at $41 dollars due to asymmetric information along with other market failures such as labour immobility and lack of enforcement, workers resort to working for $1 in the back market. - However, the economy does not always self correct and often even if workers are willing to work, market failures such as asymmetric information and labour immobility render can prevent workers from finding out about employment opportunities. - Furthermore, a recession many encourage business to outsource. Many business may choose to invest in developing countries where wage laws are flexible or non existent such as Bangladesh. - An example of this is Nike along with several other clothing companies, outsourcing their work to factories overseas. Shifts in Aggregate Supply Apart from changes in wage rate other factors that can affect SRAS/LRAS: 1. Investment tax credits/corporate tax 2. Changes in the availability of resources 3. Supply-side shocks (war, natural disasters, famine) 4. Changes in the price level of crucial imported factors of production (e.g. oil) 5. Reduction in minimim wage 6. Government subsidies 7. Reduction in trade union power. 8. Stronger currency (making imports cheaper) 9. Increase our factors of production. E.g. find new oil reserves, have a larger population that can work. Better infrastructure. 10. Increase the quality of our factors of production. E.g. education training, efficiency. Productivity. 11. Increase in technology. E.g. new harvesting machinery 13
However an improvement in the quality In one of these things will not necessary increase LRAS, for example in Venezuela even thought new oil supplies are discovered daily, due to lack of infrastructure and ill/ corrupt management the economy has stagnated. Thus signalling that in many cases, a combination of the above factors must be implemented. An improvement in any of the above will shift the SRAS to the right, increasing level of output and putting downward pressure on prices. If an economy is an demand deficient revision, an increase in SRAS does not necessary increase LRAS as the economy must return to full employment before its long run level fo output can expand. If an economy is producing at full employment level and any of the above increase then SRAS and LRAS curve shift to the right, increasing nations maximum output. - Increase in resource costs - Increase in trade union power - Increase in minimum wage - Higher business tax - Weaker currency making imports more expensive If the any of the factors of the above happen then the curve shifts to the left, leading to an increase in price level and a fall in output. If the economy producing at full employment and any of the above change it will result in both inflation and recession. Neo Classical view believes that there is little need for government to manage AD because economy will always achieve full employment if the market is left to itself. Monetarist/new classical model of LRAS: this is a free market economy view that LRAS is vertical at the level of potential output (full employment output) because aggregate supply in the long run is independent of the price level. Keynesian model of the LRAS: unemployment can exist in an economy in the longrun and therefore at a given time there can be a large availability of the factors of production (share capacity) in the economy. 14
Spare capacity: the resources (land, labour, capital and enterprise) are not fully employed. It is possible to increase output without expecting an increase in costs and price level will remain constant. Approaching full employment: as the economy approaches full employment shortages start to occur in the economy they have the effect of bringing up the price/cost of the resources. Full employment: all resources are being used fully and it is not possible to increase output. Any attempt to increase output will simply result in higher prices. - The Keynesian economists believe that unemployment can exist in the long-run in an economy as the labour market does not always reach equilibrium resulting in unemployment. - A decrease in demand for goods and services results in a decrease in demand for labour, however, if the wage rate does not decrease to meet the new equilibrium, unemployment will exist. The wages are sticky downwards because Trade unions prevent wages falling A minimum wage exists Unemployment benefits prevent workers from accepting a continual cut to their wages. A shift in the LRAS is due to the same factors of production that shift the possibility production curve to the right, including improvements in efficiency, new technology, reductions in unemployment, and institutional change. 15