Aggregate demand and supply

‘Aggregate’ means added together – the individual elements that were introduced in microeconomics. Aggregate demand and supply analysis brings together the amount that consumers wish to consume and the amount that firms wish to produce at any price level. Aggregate demand (AD) is the total planned expenditure on goods and services produced in the UK. Aggregate supply is the total planned output of goods and services. The equilibrium point where they meet determines the average price level and the equilibrium real output level. THe price level can be measured by a price index such as the CPI, and the output but real GDP.

The aggregate demand and supply model is perhaps the most useful tool for macroeconomists, because it gives reasons for changes in the important macroeconomic variables: when price levels increase this is inflation, and when output increases this is economic growth.

Aggregate demand
Aggregate demand (AD) is the total planned expenditure on goods and services produced in the UK. It comprises of consumption (C), investment (I), government spending (G), and exports (X) minus imports (M).

The AD curve is downward sloping. This is not because ‘people buy more things because they are cheaper’ – the most common misunderstanding about the AD curve. There are three ways to explain the downward sloping AD curve, any of which is adequate at AS:

  • Lower prices in an economy mean increased international competitiveness, so there are more exports and fewer imports. In other words, net exports are higher at lower prices.
  • The total amount of spending will be approximately equal whether prices are high or low because people have approximately the same amount of money to spend, so there area under the curve will be fairly constant. This is known as the real balance effect. If you plot a constant area, you will get a rectangular hyperbola.
  • At higher price levels, interest rates are likely to be raised by the monetary authorities. This means that investment, a component of aggregate demand, will fall and savings might increase.

The components of aggregate demand and their relative importance

Consumption
Consumption, or spending by household on goods and services, is the main component of aggregate demand, comprising approximately 65%. It measures the amount that consumers wish to spend at various price levels. One of the key determinants of consumption is the confidence of the consumer, both in terms of job security and in terms of future income prospects. If customers are feeling confident, they are more likely to make large purchases which they can pay for in the future.
Another determinant is interest rates. Higher interest rates not only leave consumers with less spending money after housing costs, but also increase the cost of hire purchase. A third determinant is the housing market. When price accelerate, home owners can extract more equity from their houses, as discussed in an earlier post on the Wealth effect.

Investment
There is an inverse relationship between interest rates and the level of investment that firms tend to make. This is because increases in capital stock have to be financed, and there is an opportunity cost to that finance. Firms often borrow from banks to finance investment, so if interest rates rise, the cost of borrowing rises and firms are less likely to borrow, and therefore less likely to invest. However, investments are not solely based on interest rates,and some argue that the interest elasticity of demand for investment is very low. This is because investors are sometimes driven by other factors, such as confidence in future sales patterns, what their main competitors are doing, government incentives and regulations, and the prospects for future interest rates rather than by the current rate of interest.

A change in investment will change the level of aggregate demand, but a change in aggregate demand will also change the rate of investment. This circular relationship can be analysed by the accelerator, and although this is not required knowledge for the AS examination, it is a useful way of evaluating the role of investment.

Government spending
Government spending in the UK comprises almost 40% of all spending in the economy, totalling about £590 billion. Government spending need not equal tax revenue and the difference between them is know as a budget (or fiscal) deficit or surplus. The government can deliberately manipulate aggregate demand by overspending (runnign a fiscal deficit) when there is a slowdown in the economy and vice versa in a boom. Taxing more heavily in times of abundance is a useful way of putting brakes on an economy, although sometimes governments miscalculate the start of a downturn and cut taxes too early (as in the late 1980s). Similarly, net spending can be increased in a recession, which will reverse the effects of a demand deficiency.

Another factor to consider is the national debt – the accumulation of fiscal deficits over the years. He budget needs to balance over the course of the economic cycle, otherwise the government will accrue national debt. Interest payments have to be made on this, and if government continue to overspend there will be a cost for future generations. In the short run, however, there is some flexibility with the balance of the government’s accounts.

Assessing the impact of an imbalance in the flow of government income
The Keynesian view is that fiscal policy – that is, the deliberate manipulation of government spending and taxation in order to change aggregate demand – is a powerful tool in shifting aggregate demand, made much more effective by the working of the multiplier. In contrast, the classical economist’s view is that overspending by the government has a similar effect to printing more money – it is purely inflationary.

There is now some consensus that deliberate fiscal manipulation has a short-run impact, but only if wage demands and other cost pressures are kept in check. There is also much consensus that it is only really through supply-side policies that long-term improvements in equilibrium employment will be achieved, as the AS curves shift to the right. But as Keynes would say, ‘in the long run we are all dead’ that is by the time the unemployed become employable they will be past working age.

Net exports
Exports represent an injection into the circular flow of income, in that the money paid for goods and services sold abroad enters the domestic flow of income. Imports mean that there is an outflow of money, and exports minus imports gives the total movement of funds known as net exports. (If the value of imports is greater than the value of exports, this will be a negative figure, as in the UK). There are several reasons why the value of net exports might change.

First, consider a change in the exchange rate. If the exchange rate increases in value against other currencies, imports become cheaper and exports more expensive on world markets. Over time, people respond to these relative price movements and the demand for exports falls and the demand for imports rises. A stronger currency will worsen net exports , whereas a weaker currency will improve the figure.

However, in the short run the price elasticity of supply for exports and imports tends to be low – inelastic. This might be because contracts have been signed for specific deals in international trade, or because traded components are a very small percentage of firms’ overall costs. For example, an Italian importer of BMW Minis will agree a price in advance of delivery from the UK. If the pound gets stronger against the Euro, the price of the cars will still remain the same as per the contract. Price elasticity of demand may also be low because of a lack of available substitutes, as in the case of oil. Owing to the low price elasticity of demand of exports and imports, the initial impact of a change in exchange rate may in fact be opposite to the one described above.

A second major cause of changes in the value of net exports is changes in the global economy. For example, if there is a recession the USA, but the UK does not suffer a slowdown, the USA will buy fewer exports from the UK, and will be attempting to export more. Similarly, if there is inflation in the Uk, but not in other countries, net exports from the UK will worsen as UK goods become increasingly uncompetitive. A collapse in a stock market in another part of the world may also have direct effects on UK exports via wealth effects.

Thirdly, non-price factors, such as quality and after-sales service, are major determinants if net exports. Germany, for example, cannot compete effectively on price, bu the value of its exports exceeds that of any other country owing to its high quality of design and manufacture.

In summary, wh any of the components C, I, G or X rises, the AD curve shifts to the right. The same happens if imports fall. As a useful evaluation point, it is wise to consider the above analysis involves levels rather than rates. In the UK these components do not usually fall, but they many rise more slowly during an economic slowdown, which means the AD curve will still shifty to the right but by ever decreasing amounts.

[diagram on page 34]

Aggregate supply

Aggregate supply is the amount that firms are willing to produce at various price levels. It is largely influenced by productivity, which in turn is influenced by factors such as the costs of production, the level of investment, the availability and efficiency of factors of production and supply side policies.

There are two views of aggregate supply. The classical view is that in the long run an economy will operate at full capacity and there will be no unemployed resources in the economy: that is, the AS curve is vertical – perfectly inelastic. If there are any unemployed resources, the prices of these factors will fall until the surplus disappears.

By contrast, the Keynesian view is that the equilibrium level of output can occur below the employment level of output. According to this view, the AS curve has a backward bending L shape, with three distinct sections: spare capacity, bottlenecks, and full employment. The assumption behind this analysis is that an economy can be in equilibrium when not at full employment. In other words, demand deficiency means that unemployed resources such as labour will not find work if the economy is left to its own devices.

In section A of the next diagram, there is spare capacity. The economy can increase output without any cost pressures. This is because there an unused resources such as factories not working at full capacity, or unemployed labour. In this section, aggregate demand may shift to the right – for example, through fiscal policy – and equilibrium real output would increase without causing an increase in the price level. The situation is comparable to that of Japan over the last two decades, where there is a lot of scope for increased production byt unemployment persists in the long run.

[diagram on page 35]

Section B in the diagram is the bottlenecks section, where some constrictions in the supply chain cause cost and wage pressures to build up in some areas of the economy. This usually involves a certain type of labour which when in short supply can have its price bid upwards. An example concerns the shortage of construction workers associated with the 2012 Olympic Games. If aggregate demand expands in this section of the graph, then while economy with still grow, there will be some inflation.

Section C illustrates full capacity in the economy, All viable workers have to work, so if a form wants to take on more workers it will have to entice the away from other jobs by increasing wages. In this section of the diagram, if aggregate demand increases, although in the short run there may be extra spending, the long term effect will be increased inflation and no increased output.

According the the classical view, section C is the only part of the AS curve that occurs. The economy cannot be in equilibrium while there is unemployment. So, if unemployment does exist, it can only result from a short-run failure of the market or from mismanagement by government.

Shifts in the aggregate supply curve
Shifts in the aggregate supply curve occur when factors change which will affect most firms. Such factors might relate specifically to the cost of workers (labour market) or the way in which firms compete (product market). Let’s consider how changes in both markets might produce a rightward shift of the AS curve.

Labour market
In the labour market, a rightward shift in the aggregate supply curve could occur in the following ways:

  • Productivity gap closes. Productivity is output per unit of input, and if it increases relative to a country’s main trading partners then the productivity gap is said to be closing. For example, the gap is currently closing between the UK and France, so while the UK has a lower productivity than that of France, its productivity is increasing over time, which means that costs of production are becoming relatively less expensive in the UK compared to France. However, the gap is widening between the UK and the rest of its trading partners.
  • Education and skills improve. Increased spending on education and training should mean that a country’s workforce can produce more output per worker.  Education increases the value of the potential output. However, not all education achieves this end. It is not clear that a BA in MAdonna Studies, or a BSc in Surf Science has a major impact on the costs of production in the UK.
  • Health spending increases. An increase in resources in the health sector should mean that workers have less days off sick and are actie for longer – often beyond traditional retirement ages. However, spending on health might be absorbed into wage increases for staff in the health service, which would have little overall effect on the level of healthcare. Similarly, the majority of healthcare spending goes on the elderly or very young, neither of which are economically active.

Product market
In the product market, a rightward shift in the AS curve could occur in the following ways:

  • Sources of raw materials change. In a developed country like the UK most raw materials are imported, and if global competition increases, UK costs will fall. The costs of the imports depends on global demand pressres from other parts of the world as well as supply. If there is a global increase in demand for oil, for example, this will cause the costs of production to increase in the UK because oil is a major production cost in all UK firms.
  • Exchange rates fall. If the Euro fell in value relative to the pound, many costs would fall in the UK, meaning that aggregate supply in the UK increases.
  • International trade increases. As a country opens up to more trade, competition drives down prices and inefficient domestic firms give way to overseas firms with a comparative advantage. So, as globalisation develops, aggregate supply increases.
  • Technological advantages. Innovation and investment in new ideas tend to reduce costs for all firms. For example, widespread access to the internet increases competition among forms and also means that firms can be more streamlined. Buying a book, for instance, is now much cheaper online as there are fewer expensive retail outlets to maintain.
  • Regulation changes. There are many regulations in the UK economy which have been imposed to try and maintain a disciplined economy, for example in the post and telecommunications service. However, such industries have been increasingly deregulated over the past two decades to increase competition, which in turn imposes its own form of discipline. The net effect is that parcel postage and phone services – costs faced by all firms – have reduced in real terms, shifting aggregate supply to the right.
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