Aggregate Demand
Aggregate demand (AD) is the total demand for final goods and services in the economy (Y) at a given time and price level .It is the amount of goods and services in the economy that will be purchased at all possible price levels. This is the demand for the gross domestic product of a country when inventory levels are static. It is often called effective demand, though at other times this term is distinguished.
Components
An aggregate demand curve is the sum of individual demand curves for different sectors of the economy. The aggregate demand is usually described as a linear sum of four separable demand sources.
AD=C+I+G+(X-M)
where
- C is consumption
- I is Investment,
- G is Government spending,
- X is total exports, and
- M is total imports
· C Consumers' expenditure on goods and services: This includes demand for durables & non-durable goods.
· I Gross Domestic Fixed Capital Formation - i.e. investment spending by companies on capital goods. Investment also includes spending on working capital such as stocks of finished goods and work in progress.
· G General Government Final Consumption. i.e. Government spending on publicly provided goods and services including public and merit goods. Transfer payments in the form of social security benefits (pensions, job-seekers allowance etc.) are not included as they are not a payment to a factor of production for output produced. A substantial increase in government spending would be classified as an expansionary fiscal policy.
· X Exports of goods and services - Exports sold overseas are an inflow of demand into the circular flow of income in the economy and add to the demand for UK produced output. When export sales from the UK are healthy, production in exporting industries will increase, adding both to national output and also the incomes of those people who work in these industries.
· M Imports of goods and services. Imports are a withdrawal (leakage) from the circular flow of income and spending in the economy. Goods and services come into the economy - but there is a flow of money out of the economic system. Therefore spending on imports is subtracted from the aggregate demand equation.
The Aggregate Demand Curve
Aggregate demand normally rises as the price level falls. This can be explained in three main ways:
Real money balances effect
As the price level falls, the real value of money balances held increases. This increases the real purchasing power of consumers.
Prices and interest rates
A lower price level increases the real interest rate - there will be pressure on the monetary authorities to cut nominal interest rates as the price level falls. Lower nominal interest rates should encourage an increase in consumer demand and planned investment.
International competitiveness
If the UK price level is lower than other countries (for a given exchange rate), UK goods and services will become more competitive. A rise in exports adds to aggregate demand and therefore boosts national output.
A change in one of the components of aggregate demand will cause a shift in the aggregate demand curve. For example there might be an increase in export demand causing an injection of foreign demand into the domestic economy. The government may also increase its own expenditure and businesses may raise the level of planned capital investment spending.
Aggregate Supply
Aggregate supply (AS) measures the volume of goods and services produced within the economy at a given price level. In simple terms, aggregate supply represents the ability of an economy to produce goods and services either in the short-term or in the long-term. It tells us the quantity of real GDP that will be supplied at various price levels. The nature of this relationship will differ between the long run and the short run
- In the long run, the aggregate-supply curve is assumed to be vertical
- In the short run, the aggregate-supply curve is assumed to be upward sloping
Short run aggregate supply (SRAS) shows total planned output when prices in the economy can change but the prices and productivity of all factor inputs e.g. wage rates and the state of technology are assumed to be held constant.
Long run aggregate supply (LRAS): LRAS shows total planned output when both prices and average wage rates can change – it is a measure of a country’s potential output and the concept is linked strongly to that of the production possibility frontier
short-run aggregate supply curve
Shifts in the AS curve can be caused by the following factors:
- changes in size & quality of the labour force available for production
- changes in size & quality of capital stock through investment
- technological progress and the impact of innovation
- changes in factor productivity of both labour and capital
- changes in unit wage costs (wage costs per unit of output)
- changes in producer taxes and subsidies
- changes in inflation expectations - a rise in inflation expectations is likely to boost wage levels and cause AS to shift inwards
In the diagram above - the shift from AS1 to AS2 shows an increase in aggregate supply at each price level might have been caused by improvements in technology and productivity or the effects of an increase in the active labour force.
An inward shift in AS (from AS1 to AS3) causes a fall in supply at each price level. This might have been caused by higher unit wage costs, a fall in capital investment spending (capital scrapping) or a decline in the labour force.
Long run aggregate supply is determined by the productive resources available to meet demand and by the productivity of factor inputs (labour, land and capital).
In the short run, producers respond to higher demand (and prices) by bringing more inputs into the production process and increasing the utilization of their existing inputs. Supply does respond to change in price in the short run.
In the long run we assume that supply is independent of the price level (money is neutral) - the productive potential of an economy (measured by LRAS) is driven by improvements in productivity and by an expansion of the available factor inputs (more firms, a bigger capital stock, an expanding active labour force etc). As a result we draw the long run aggregate supply curve as vertical.
Factor That Influence Aggregate Demand
Aggregate demand is the relation between aggregate expenditure,or total spending, and the price level. Aggregate expenditure are the sum of expenditure of each sector of the economic: households (consumption),business firms(investment),government and the rest of the world(net exports).
Consumption
How much households spend depends on their income, their wealth, expectation about future prices and incomes, demographics like the age distribution of the population, and taxes.
§ Income: If current income rises, households purchase more goods and services.
§ Wealth: Wealth is different from income. It is the value of assets owned by a household, including homes, cars, bank deposits, stocks, and bonds. An increase in household wealth will increase consumption.
§ Expectation : Expectation regarding future changes in income or wealth can affect consumption today.
§ Demographics : Demographic change can affect consumption in several different ways.
§ Taxes : Higher taxes will lower the disposable income of households and decrease consumption, while lower taxes will raise disposable income and increase consumption. Government policy may change taxes and thereby bring about a change in consumption.
Investment
Investment is business spending on capital goods and investment. Factors affecting the expected profitability of business projects include the interest rate, technology, the cost of capital goods, and capacity utilization.
§ Interest rate : Investment is negatively related to the interest rate. The interest rate is the cost of borrowed funds.
§ Technology : New production technology stimulates investment spending as firms are forced to adopt new production methods to stay competitive.
§ Cost of capital goods : If machines and equipment purchased by firms rise in price, then the higher costs associated with investment will lower profitability and investment will fall.
§ Capacity utilization : The more excess capacity there is available, the more firms can expand production without purchasing new capital goods, and the lower investment is. As firms approach full capacity, more investment spending is required to expand output further.
Government Spending
Government spending may be set by government authorities independent of current income or other determinants of aggregate expenditures.
Net Exports
Net exports are equal to exports minus imports.
Income : As domestic income rises and consumption rises, some of this consumption includes goods produced in other countries.
Prices : Other things being equal, higher (lower) foreign prices make domestic goods relatively cheaper (more expensive) and increase ( decrease ) net exports.
Exchange Rate : Other things being equal, a depreciation of the domestic currency on the foreign exchange market will make domestic goods cheaper to foreign buyers and make foreign goods more expensive to domestic residents, so that net exports will rise. An appreciation of domestic currency will have just the opposite effects.
Government Policy : Net exports may fall if foreign governments restrict the entry of domestic goods into their countries, reducing domestic exports. If the domestic government restricts imports into the domestic economy, net exports may rise.
Aggregate Expenditures
The sum of all spending on U.S. goods and services, must depend on prices, income, and all of the other determinants discussed in the previous sections. As with the demand curve for a specific good or service, we want to classify the factors that influence spending into the price and the nonprice determinants for the aggregate demand curves as well. The components of aggregate expenditures that change as the price level changes will lead to movements along the aggregate demand curve-changes in quantity demanded-while changes in aggregate expenditures caused by nonprice effects will cause shifts of the aggregate demand curve-changes in aggregate demand.
Aggregate Demand and Supply Equilibrium
Short-Run Equilibrium
The equilibrium in the short-run is shown by the intersection of the Aggregate Demand (AD) curve and the Short-Run Aggregate Supply (SAS) curve. When either AD or SAS shifts, the equilibrium point is changed. For example, in Graph 1, a shift to the right of the AD curve will cause the equilibrium output as well as the price level to increase. And if the AD curve were to shift to the left, as in Graph 2, the opposite would be true: output and price level will decrease.
A shift to the left in SAS, as shown in Graph 3, will cause the price level to rise while equilibrium output will decrease. And a shift to the right, as shown in Graph 4, will decrease price level and increase output.
Long-Run Equilibrium
The equilibrium in the long-run is shown by the intersection of the AD curve, the SAS curve, and the Long-Run Aggregate Supply (LAS) curve. Since LAS represents potential output, a shift in the AD curve will only result in a change in price level: a shift to the right increasing price level and a shift to the left decreasing price level. If an economy is said to be in long-run equilibrium, then Real GDP is at its potential output, the actual unemployment rate will equal the natural rate of unemployment (about 6%), and the actual price level will equal the anticipated price level.
No comments:
Post a Comment