Topic

6
1. 2. 3. 4. 5. 6. 7.

Aggregate Demand and Supply

LEARNING OUTCOMES
By the end of this topic, you should be able to: Explain the meaning of the terms aggregate demand; Describe the factors that cause the aggregate demand curve to move downwards; Point out the aggregate demand determinant; Compose the meaning of the terms aggregate supply and the aggregate supply curve in the short-run; Summarise how level of production and price equilibrium are determined; Compare budget policy and financial policy using aggregate demand and aggregate supply; and Summarise the formation of long-term aggregate supply curve.

INTRODUCTION

Earlier, you were introduced to supply and demand. Knowledge about factors that affect or influence money demand and supply is important so that you can understand their effects on interest rate, investment and national income. This topic will explain the concept of aggregate demand and supply and their related matters. So let us start the topic!

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6.1

AGGREGATE DEMAND

What do you understand about aggregate demand? Aggregate demand is the total demand for goods and services in the economy during a specific time period. Usually, aggregate demand is shown using a curve or table that shows the various types of goods and services (real production) that are collectively purchased by consumers at a certain price level. An aggregate demand curve (AD) that slopes downwards shows a negative relationship between price and production level, assuming that all other factors remain the same (unchanged). When prices are low, demand for production is high. Vice versa, when prices are high, demand for production is low. Although both the aggregate demand curve (AD) and aggregate market curve look the same, the factors that cause the curves to slope downwards are different. The market demand curve slopes negatively because of the substitution effect and income effect. The factors that cause the aggregate demand curve to slope negatively are shown in Figure 6.1.

Figure 6.1: Three factors underlying the negative slope of the AD curve

Now, let us look at an important explanation on the factors that make the aggregate demand curve slope negatively.

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(a)

Real-balance Effect Consumer expenditure or consumption depend on how much money they have. This is a positive relationship. The more money you have, the more you spend. Having money also refers to wealth and the amount of bonds, shares, houses or physical assets one possesses. The amount of wealth owned depends on the price level.

However, there is a negative relationship between price levels and consumer wealth. If price levels increase, the real purchasing power reduces and money cannot buy as many goods and services. On the contrary, if prices drop, then purchasing power increases. Let us look at this example: Example 6.1: If Ahmad has RM5,000 and the price level has increased by 10%, then the value of Ahmads money has decreased by 10% because the price of the goods he wishes to buy has gone up by 10%. Therefore, an increase in price causes the purchasing power to drop. This will indirectly reduce consumption and production. Thus, the real-balance effect brings about a negative relationship between price and production. However, if the increase in general pricing is the same as the increase in share prices or properties prices, that means the real value of the shares and properties have not changed. (b) Interest Rate Effect Changes in interest rates can have a big impact on consumption and investment expenditure. The interest rate tends to increase and decrease as the price level increases and decreases. This means that a higher price level induces a higher interest rate, which raises the cost of borrowing and discourages investment and consumption or spending. A lower price level has the opposite result. Assuming that money supply remains the same, when the price level increases, money demand also increases and when that happens, interest rates also go up. For example, if prices go up, money d s demand will move up from M d 0 to M 1 . Assuming money supply M is fixed, the interest rate will increase from r0 to r1. This phenomenon is shown in Figure 6.2.

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Figure 6.2: Changes in interest rates

The change in interest rate will affect consumption by households and firms. For example, say the interest rate is 15% per annum. At the same time, the rate of returns firms obtain from capital purchase is 20%. This definitely allows firms to reap some profits because the investment returns exceed the interest rates. This will encourage firms to increase investment. If the reverse were to happen, with the interest rate at 15% and the rate of returns only at 10%, then firms will reduce their investments. This decision will make them reduce their production too. When the interest rate is high, households will delay consumption or purchases. Households accept an increase in interest rates as an indication of an increase in expenses and costs. For instance, consumers may delay purchasing a house because of the high interest rate and vice versa. In conclusion, increases in price will push money demand upward and eventually cause a hike in interest rates (assuming money supply remains the same). (c) Net-export Effect The total export and import in an economy depends on domestic and foreign prices. If Malaysian goods are expensive, Malaysia will import more from overseas. This will reduce the value of net exports. Generally, the relative increase of domestic price levels will reduce exports and the aggregate demand on production. On the other hand, the relative decrease of domestic price levels will increase exports and aggregate demand for production.

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From the explanation above, it can be concluded that the aggregate demand curve (AD) is not a combination of individual demand curves. The AD curve has a negative slope because of the real-balance effect, interest rate effect and netexport effect.

6.1.1

Constructing the Aggregate Demand Curve (AD)

How do we construct the aggregate demand curve? The AD curve can be constructed from the aggregate expenditure model. The aggregate expenditure components can be seen in Figure 6.3. Aggregate demand (AD) is the total demand for goods and services in the economy.

Figure 6.3: Aggregate expenditure components

At every point along the AD curve, the demanded quantity is the same as the aggregate expenditure. [C + l + G + (X M)]. In the analysis on how to draw the AD curve, we have to assume that the fiscal policy and monetary policy are fixed. In Figure 6.4, (a) shows the money market, (b) shows the investment curve that reflects the negative relationship between interest rates and investment levels, (c) is the aggregate expenditure model or market for goods and (d) is the aggregate demand curve that shows the inverse relationship between prices and quantity of production demanded.

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Figure 6.4: Constructing the aggregate demand curve (AD)

We assume the original equilibrium is at E0, which is at price P0, and production Y0, interest rate r0, quantity of money M0, investment level I0, and aggregate expenditure AE0. The change in price will influence the real value of wealth, the interest rate, and net exports. If the price level goes up, the real value of wealth and net exports will reduce, but the interest rate will increase and vice versa. If the price level moves up to P1, the quantity of money demand will increase as more money will be needed for expenditure. Therefore, the Md0 curve will shift to Md1, creating an increase in money demand, assuming that money supply is fixed. In order to achieve equilibrium in the money market, the interest rate increases to r1. The subsequent increase in interest rate will bring down investments to I1. The same goes for consumption and net exports. This situation is shown by the shift AE0 to AE1 (P1) and the decrease in production level to Y1 [Figure 6.4 (c)]. If the price level goes down to P2, the opposite will happen. The production level will go up to Y2 at the equilibrium point E2 [Figure 6.4 (c)]. In Figure 6.4 (d), if the points a, b and c are joined, a negatively sloped AD curve can be seen, which shows an inverse relationship between price and production level (Y). We can summarise that an increase in price level will cause the AE curve to shift downwards and a reduction in production Y. On the contrary, a decrease in price will cause AE to shift upwards and an increase in production Y.

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6.1.2

Aggregate Demand Determinants

The AD curve shows a negative relationship between price and income. Therefore, any changes in price will cause a change in aggregate demand, which is a change in the aggregate demand production quantity. This change happens all along the AD curve, assuming that all other factors are fixed (ceteris paribus). Actually, besides price, there are a few other factors that can influence aggregate demand (AD). These factors are shown in the next Table 6.1. The factors work through four aggregate expenditure categories consumption (C), investment (I), government purchases (G) and net exports (X M). Now, we let us look closely at these factors. (a) Consumption Expenditures (C) Consumption expenditures are usually connected to households. Among the factors that influence consumption and cause the AD curve to shift either to the left or right, are: (i) (ii) Consumer wealth; Consumer expectations;

(iii) Household debt; and (iv) Taxes. Let us now look at each of these factors in detail. (i) Consumers wealth This includes financial assets (stocks, bonds and shares) and physical assets (house and land). A decrease in the real value of assets will encourage more people to save and spend less in order to improve their economic situation. They will reduce their expenses and the AD curve will move to the left. If the reverse happens, the AD curve will shift to the right. Reminder: This concept differs from the concepts of wealth and real-balance because here, the AD curve changes when there is a change in price. The change in real wealth does not depend on a price change but on non-price factors that cause shifts in the AD curve. For example, reduction in price or in the real value of a house will decrease the consumers economic condition although the price level does not increase.

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(ii)

Consumer Expectations Consumer expectations focus on real income. Expectations of future economic conditions are an important determinant. If households expect real income to increase in the future, then they are inclined to buy more today, causing consumption expenditure and aggregate demand to increase, shifting the AD curve to the right. If real income is expected to fall, consumers will avoid spending. This will shift the AD curve to the left.

(iii) Household Debt Consumers with hefty debt will reduce their expenses because their income or money will be used to settle their debts. Therefore, consumer expenditure will decrease. This drop is shown by the shifting of AD curve to the left. (iv) Taxes Income tax is a leakage in consumer income. The hike in the income tax rate will reduce peoples disposable income. This phenomenon will cause a drop in expenditure and the AD curve will move to the left. (b) Investment Expenditure Investment expenditure is usually incurred by firms. The changes in purchasing capital goods and other investments will cause the AD curve to move either to the left or to the right. The change in investment can be caused by: (i) (ii) Interest rate; Expected returns from investment projects;

(iii) Business tax; (iv) The level of excess capacity; and (v) Technology.

Let us look at each of these factors one by one in Table 6.1.

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Table 6.1: Factors that Cause Changes in Investment Factor Interest rate Explanation The increase in interest rates due to other reasons besides pricing, will cause the AD curve to shift. For instance, a hike in money supply will cause the interest rate to drop. This phenomenon will create an increase in investment. Therefore, the AD curve will move to the right and the reverse situation will cause it to move to the left. High returns from an investment project means profit to firms. If the expected returns are high, then firms will increase investment, namely, by buying capital goods. This will increase firms expenditure and the AD curve will shift to the right. The reverse situation will make the curve move to the left. Business tax is a leakage to the firm. The high rate of business tax will reduce profit after tax. This factor will eventually decrease the incentives for the firm to increase investment. Therefore, a firms expenditure reduces and the AD curve moves to the left and vice versa. This means there are excess production resources that are not used. Higher excess capacity will slow down the demand for new capital goods and reduce the aggregate demand as shown by the shift of the AD curve to the left. If the firm collectively finds that capacity level is low, then the firm will increase its purchase of capital goods and build new premises. This will increase the firms expenditure and the AD curve will move to the right. The discovery of new technology will increase investment expenditure and hike up the aggregate expenditure (AD curve will move to the right). For instance, with the discovery of new technology in the automobile industry, more money will be invested in this industry. This phenomenon will cause the AD curve to move to the right.

Expected returns from investment projects

Business tax

The level of excess capacity

Technology

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(c)

Government Purchases (G) In order to explain government purchases, let us take the example of providing infrastructure facilities. If the government increases its expenses in providing infrastructure through an expansionary fiscal policy, the AD curve will shift to the right. Instead, if the government practices a contractionary fiscal policy, then the AD curve will move to the left. Net Exports (X-M) The change in exports connected to the movements of the AD curve is influenced by factors other than price. Let us refer to Table 6.2.
Table 6.2: Factors Other than Price that Cause Changes in Exports Factors Explanation When the income of foreigners is high, their demand is relatively high too, whether it is for domestic or foreign goods. The increase in demand for foreign goods will increase the exports of the exporter country (assuming that exporter country imports less). The increase in net exports is shown in the shift of the AD curve to the right. If the income in foreign countries is low, then the net exports will decrease and the AD curve will move to the left. The change in foreign currency exchange rates also influences net exports and aggregate demand (AD). Let us use the exchange rate between Ringgit Malaysia and American Dollar (exchange rate E = RM/Dollar) as an example. If the value of the Ringgit deteriorates, then the rate of exchange has increased. Americans can get more Ringgit for each dollar. Whereas, Malaysians will get fewer Dollars. The deterioration in the value of the Ringgit will make Malaysian goods relatively cheaper compared to American goods. Therefore, Malaysias net exports will increase (assuming that our imports are less than the exports). This phenomenon will move the AD curve to the right. The reverse situation will make the curve move the other way.

(d)

Foreign income

Foreign currency exchange

Based on the explanation above, the movement of AD curve is shown in Figure 6.5. The original AD curve is at AD0. The shift to the right is from AD0 to AD1. The shift to the left is from AD0 to AD2.

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Figure 6.5: Movements of the AD curve

From this discussion, we can now conclude that the price factor will cause changes along the aggregate demand curve (AD), which means changes in the production quantity demanded. Subsequently, factors other than price, namely, aggregate expenditure components such as consumption (C), investment (I), government purchases/expenditure (G) and net exports (X-M) will cause the AD curve to shift either to the left or right.

6.1.3

Movement of Aggregate Demand Curve and Aggregate Expenditure Model

Try to recall the aggregate expenditure components that we discussed earlier. Aggregate expenditure includes consumption (C), investment (I), government purchases (G) and net exports (X-M). If a change happens in one of those components, the AD curve will shift, assuming that the price level is fixed. From Figure 6.6, we assume the original equilibrium is at AE0, whicht produces real production (Y) at Y0 and the AD curve is AD0. If investors are optimistic and expect profits to increase in the future, then the investment level will increase as well. This is shown by the movement of the curve AE0 to AE1, with the price fixed at P0 and the new production level is achieved at Y1. In line with this, the AD curve also moves to the right to AD1 (look at Figure 6.6).

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Figure 6.6: The movement of AD curve and AE model

The actual increase in investment is shown by the AD curve shifting from AD0 to the dotted line. However, the multiplier process has caused AD to move to AD1 and production to increase from Y0 to Y1. Therefore, the rise in investment will shift the AD curve to the right. The distance between AD0 and AD1 is the increase in investment (I) times the multiplier value k (l u k). Therefore, the movement of AE and AD are towards the same direction, or simply, The distance of AD0 to AD1 = l u k. whereby k is the multiplier. Besides the mentioned factors, any changes in the supply of money (Ms) also cause the aggregate demand (AD) to shift either to the right or to the left from AD0 to AD1 or AD2 as in the previous Figure 6.6. For example, if there is an increase in the money supply and the price level is constant, the interest rate falls and this causes the planned investment, and therefore planned aggregate expenditure, to increase. The AD curve then shifts from AD0 to AD1.

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6.2

AGGREGATE SUPPLY (AS)

Prior to this, you have been exposed to the concept of demand. Now, let us look at the definition of aggregate supply. Firstly, what does it mean by aggregate supply? Aggregate supply means the total of real production of final goods and services available in the economy.

This definition is an analogy to the definition of an individual supply of goods and services. The AS curve slopes positively, showing the positive relationship between price and production quantity supplied, assuming ceteris paribus. The AS curve is reflected in a table or curve that shows the real production level (Y) that is produced and supplied by the firms at various price levels, while other factors remain fixed (ceteris paribus). However, the AS curve is not a combination of individual supply curves in the economy.

6.2.1

Constructing the Aggregate Supply (AS) Curve

How do we construct the aggregate supply curve? The aggregate supply curve can be constructed by looking at the labour market and the production function curve. Let us look at Figure 6.7.

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Figure 6.7: Constructing the aggregate supply curve (AS)

Figure 6.7(a) shows the nominal wage curve with the price level on the vertical axis. Figure 6.7(b) shows the labour market with labour demand and labour supply curves. Figure 6.7(c) shows the production function curve and Figure 6.7(d) shows the aggregate supply curve. We assume the original equilibrium is at E0,, which is at P0 and Y0, the employment level is L0 and real wage is W0/P0. The change in price will influence the real wage rate, level of employment, and therefore, the output level, Y. Now let us say that the price level decreases to P1 and the real wage rate is at (W0/P1), meaning that the real wage is now higher than before. Supply of labour will be greater than demand for labour. We assume that nominal wage is rigid downward; therefore, unemployment occurrs when SL > DL. Total unemployment will be L1L2. At L1, the total output that will be produced is Y1. Therefore at P1, the total number of workers that will be employed is L1. When the price level is at P2, the real wage rate is at (W0/P2), which is lower than before. Therefore, demand for labour will be higher. With the assumption that nominal wage is rigid downward but not upward, nominal wage will increase until (W0/P2) = (W0/P0). The number of workers that will be employed is L0 and output that will be produced is Y0. So at P = P1, Y is at Y1 and when P = P2, Y is at Y0. When we join all the points, we will get the aggregate supply curve.

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However, the aggregate supply curve will have a different shape depending on the assumptions made, for example, the Classical case and Keynesian case as described in the next following subtopics.

6.2.2
(a) (b) (c)

Short-run Aggregate Supply

Aggregate supply curve (AS) can be divided into three parts, namely: Horizontal (Keynesian); Upward sloping; and Vertical (classical).

Figure 6.8 shows these three parts of the AS curve. How can this situation exist?

Figure 6.8: Short-run aggregate supply curve

(a)

Horizontal Section (Keynesian) This part shows that the economy is suffering from a recession. Faced with falling economic activity, resource employment and real production tend to fall. When there is an increase in production, there is no increase in price. This situation relates to the Keynes analysis during the recession that took place in the 1930s. In line with that, this section is named the Keynesian section. Increase in production will not cause the price level to rise because unused resources (labour and raw material) will be used to increase production. Consequently, the overall average cost is constant. Therefore, there is no reason for the price to go up as there is no increase in the average cost of production.

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This level also shows the position when the production quantity is reduced. However, the production price level and input does not decline. This means that production and employment may reduce but the price of input and production may be difficult to change. (b) Upward Sloping Section At this level, the production increases from Y0 to Y1 and the production factor decreases by a reciprocal amount. Firms will compete against each other for resources that are scarce. This will cause the input price to rise, meaning the cost of production will increase. Firms will increase the production price as an incentive to increase production. Therefore, at this level, there will be a direct connection between real production (Y) and price level. The increase in production from Y0 to Y1 will cause a hike in price from P0 to P1. Vertical Section (Classical) At this level, the economy has achieved full employment (Y1). Here, it is difficult to increase production unless there is a price increase. Therefore, the AS curve is vertical. This part is also known as the classical section because it is in relation to the theories by classical economists who opined that the economy always operates at full employment. Firms will compete to get resources and increase production. However, this will cause losses to some firms as the competition will increase the production costs and price levels. The actual production will not change, however, which means the price increases to P2 but the production remains at Y1. This situation accelerates the inflation process.

(c)

6.2.3

Determinants of Aggregate Supply Curve

ACTIVITY 6.1

Price can affect the aggregate supply curve (AS). Can you try to identify factors other than the price that affect the AS curve?

From the positive slope of the AS curve, we can see that price is one of the determinants of the AS curve. However, a change in prices will only cause changes along the aggregate supply curve, that is, changes in the production quantity supplied. For instance, when price goes up from P0 to P1, the production quantity supplied will increase from Y0 to Y1 (refer to the previous Figure 6.8).

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Besides the price factor, other factors that can cause the AS curve to shift either to the left or right are: x x x x Input price; Productivity; Government policy; and Environment.

Now let us learn these four factors further. (a) Input Price Did you know that input price can be divided into domestic resource and imported resource? What are they? (i) Domestic Resource This resource includes land, labour, capital and entrepreneurs. Innovation in resource can reduce the price of the resource. For example, there is an increase of womens participation in the labour market. This phenomenon will increase the labour supply and eventually cause the production cost per unit to drop. The drop in production costs will become an incentive for firms to increase production, as shown by the AS curve moving to the right. The reverse position will cause the curve to shift to the left. Imported Resource In the production process that uses imported resources, the rise in input price, or a cost shock, will cause the AS curve to shift to the left. When the reverse happens, the AS curve will move to the right.

(ii)

(b)

Productivity Productivity measures the average real production (total production divided by total input). An increase in productivity means the economy enjoys a large amount of real production based on limited resources. For example, in order to produce 10 units of production, if you need total input of five units at RM2 per unit, then the productivity and average costs are calculated as:

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Productivity

= =

Total production Total input

10 5

Average cost

= = =

Total cost Total production RM2 u 5 10

RM1

If firms intend to increase production to 20 units at the same price and unit input, the productivity value is four, which is 20/5 and the cost per unit is RM0.50. Therefore, productivity increases from two to four and production cost reduces from RM1 to RM0.50. This means productivity doubles and production cost per unit drops by half. This situation will cause the AS curve to shift to the right. On the other hand, if productivity drops, the reverse will happen. (c) Government Policy There are two components in the government policy. They are: (i) Business Subsidies and Taxes Increases in business tax such as excise sales tax will increase production cost. This will cause the AS curve to move to the left. If the government provides subsidies, it will reduce the production costs, and this is shown by the AS curve shifting to the right. Regulation Usually, the government will control the production of certain products. In order to comply with government regulations, firms are forced to allocate some money to carry out control activities. For instance, each firm is required to form a quality control unit. This will increase the firms cost of operations and the AS curve will shift to the left.

(ii)

(d)

Environment Lastly, let us learn the final determinants which is environment. Environment includes weather, natural disasters and wars. For example, during the monsoon season, fishermen cannot go out to sea. This will cause a reduction in seafood supply, as shown in the movement of the AS curve

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to the left. Instead, when there is no monsoon season, supply will increase and the AS curve will shift to the right. The movement of the AS curve to left and right can be seen in Figure 6.9. The shift to the right is from AS0 to AS1, whereas the shift to the left is from AS0 to AS2.

Figure 6.9: Movement of the aggregate supply curve (AS)

6.3

PRODUCTION LEVEL AND EQUILIBRIUM PRICE

How do we determine the production level and equilibrium price? What are the factors involved in determining these? Equilibrium happens at the point where the AD curve and AS curve meet. (Figure 6.10).

Figure 6.10: Equilibrium price and production

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Equilibrium price and production is achieved at Pe and Ye. If the price level exceeds Pe, for example if it is at P1, then there will be excess aggregate supply amounting to Y0Y1. At this price level, consumers only demand Y0 but firms supply Y1. This situation will force the price level to fall again to equilibrium price Pe. If the price level is lower than Pe, for instance, if it is at P2, then there will be an excess demand totaling Y0Y1. At a price lower than the equilibrium price, the quantity demanded is higher than the quantity supplied. This phenomenon will force the price level to rise towards the equilibrium price, Pe. The equilibrium for both price and production is achieved at the point where the AD curve and the AS curve meet, which is at price Pe and production Ye.

6.3.1

Changes in Equilibrium

Changes in equilibrium can happen due to changes in the AD and AS curves. (a) Changes in Aggregate Demand We assume the AS curve does not change. Change in the AD curve happens if there is a change in one of the aggregate expenditure components or in AD determinant factors other than the price level. The effect of a change in the AD curve depends on the part of the AS curve which crosses the AD curve. The analysis is based on Figure 6.11.

Figure 6.11: Movement of the aggregate demand curve (AD)

At the horizontal section (Keynesian), we assume the original equilibrium is at AD0 and AS0 (P0 and Y0). The changes in AD will affect the price. For example, if the government increases its expenditure (G), the AD curve will move from AD0 to AD1. This affects production, which will increase to Y1,

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but the price level will remain at P0. This is because the unused resources will be used to increase production while maintaining the production cost per unit. Therefore, the price level does not rise because there is no increase in the average production cost per unit. If equilibrium happens in the upward sloping section, at the original equilibrium AD2 and AS0 (P2 and Y2), the increase in government expenditure will shift the AD curve from AD2 to AD3. This will cause a hike in the price and production levels to P3 and Y3. The increase in price happens because there is a shortage in resources. Assume that the original equilibrium at the vertical section as AD4 and AS0 (P4 and Y4). The increase in government expenditure will cause the AD curve to shift to AD5 and the price level will increase to P5 but the production level remains at Y4 (production at full employment). If the reverse happens, the AD curve will move to the left. In conclusion, it can be seen that a shift of the AD curve will bring about changes in price and quantity. However, the final effect depends on the section of the AS curve which overlaps the AD curve. (b) Changes in Aggregate Supply (AS) Equilibrium price and output quantity for goods and services change when the aggregate supply curve shifts. The movement in the AS curve is due to several determinant factors other than price level. This analysis is based on equilibrium at the upward sloping section of the AS curve, assuming that the AD curve is fixed (refer to Figure 6.12).

Figure 6.12: Shift of AS curve

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We assume that the original equilibrium is at AS0 and AD0 (P0 and Y0). If there is an increase in technology or productivity, the AS curve will shift to AS1. This phenomenon will cause an increase in production level to Y1 and a decrease in price to P1. If the reverse happens, for example, the rise in production costs will shift the AS curve to the left to AS2. The effect of this is the increase in price to P2 and decrease in production to Y2. In the horizontal and vertical sections, the effect is the same. A shift of AS to the right brings a hike in production and a price drop. Whereas when AS shifts to the left, the price will go up and production will drop.

ACTIVITY 6.2
Give your analysis of other aggregate demand determinant factors.

6.4

AGGREGATE DEMAND AND AGGREGATE SUPPLY: FISCAL POLICY AND MONETARY POLICY

The AD and AS model or approach can be used to analyse the effects of budget policy and financial policy (refer to Figure 6.13).

Figure 6.13: Policy components

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Fiscal policy is divided into two, namely expansionary policy and contractionary policy. Expansionary policy will shift the AD curve to the right, whereas contractionary policy will move the AD curve to the left. This phenomenon will eventually change the equilibrium price level and production quantity. The effects of a fiscal or monetary policy can be analysed based on Figure 6.14. Assume the economy is short-term and the original equilibrium is at AD0 and AS0 (P0 and Y0) at the upward sloping section, or the economy has not achieved full employment.

Figure 6.14: Effects of fiscal and monetary policy and movements in the curve

If expansionary monetary or fiscal policy is carried out, the AD curve will shift to the right, from AD0 to AD1. Price and production will increase to P1 and Y1. On the contrary, contractionary fiscal policy will shift the AD curve to the left from AD0 to AD2. Price level and production will drop to P2 and Y2. If the economy operates at full employment, at the vertical section of the AS curve, the effects of the fiscal policy will differ. Assume the original equilibrium is at AS0 and AD4 (P4 and Y4). Expansionary fiscal policy (assuming that the monetary policy is fixed) will move the AD curve to the right to AD5. This expansion will not cause an increase in output because all resources have been used for production. Therefore, expansionary budget policy, which is the shift of AD4 curve to AD5, with a fixed monetary policy will cause a hike in interest rates.

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Increase in interest rates will reduce investment, and eventually there will be a drop in production level (Y). When there is an increase in government expenditure (G), and at the same time there is a same amount of decrease in investment (I), there will be no change in production level. The final effect is the increase in price from P4 to P5 but production is fixed at Y4. When there is a recession (horizontal section), expansionary or contractionary; fiscal or monetary policy will only change the production level (fixed price level). Based on the previous Figure 6.14, we assume the original equilibrium is AS0 and AD6. If an expansionary fiscal or monetary policy is practiced, the AD curve will move to the right from AD6 to AD7. The price level will remain at P6 but the production level will increase to Y7. If a contractionary policy is implemented, the production level will drop to Y8.

6.5

CONSTRUCTING THE LONG-RUN AGGREGATE SUPPLY CURVE

In the short-run, the changes in cost and price do not occur simultaneously. At the upward sloping section of the aggregate supply curve (AS), the increase in cost is higher than the increase in production. Therefore, the increase in price is higher than the increase in production level. In the long-run, adjustments can be made to suit the changes that occur based on knowledge of real price level. The adjustment is made so that there are no surprises regarding the price in the longrun. The construction of long-run aggregate supply curve can be analysed based on Figure 6.15.

Figure 6.15: Long-run AS curve

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Assume that the original short-term AS curve is AS0. Equilibrium is achieved at point a with price and productions levels at P0 and Y0. Y0 is the potential production level and P0 is the expected price. If the aggregate demand rises, as shown by movement of the curve from AD0 to AD1, the new short-run equilibrium is achieved at point b (P1 and Y1). The short-term real price level exceeds the expected price and the production level is more than the potential production. This excess total is known as the expansionary gap, which amounts to Y0Y1. When real production exceeds potential production, the actual unemployment rate will be lesser than the natural unemployment rate. Therefore, there will be overtime for labour and capital. Since the price in the short-run is more than the expected price, the nominal fee at expected price P0 drops. Besides this, when real production exceeds potential production, the pressure of inflation begins to set in. The more the short-run production exceeds the potential production, the expansionary gap becomes bigger and the pressure for price increase also rises. What does it mean by long-run? Long-run is the period when firms and resource suppliers (production factors) know the market situation, specifically the aggregate demand and real price level. Firms and resource suppliers have the time to bargain based on the actual price. The price hike to P1 has dragged down the value of real nominal fee. Employees will now bargain with the firms to obtain a higher fee. If this process succeeds, it will increase the firms production costs. The increase in costs will shift the AS curve to AS1 ,to the left, (assuming that the increase in price is adjusted by the cost hike at the same rate). The new equilibrium is achieved at AD1 and AS1 (P2 and Y0). At this new equilibrium (point c), only the price is found to have increased but the production remains the same at Y0 and the real price is the same as the expected price. Therefore, this equilibrium is for both the short-run and long-run. If the reverse happens, which means a drop in demand as shown by movement of the AD curve to the left (AD2), the new price and production levels are achieved at point d (P3 and Y2). P3 is the real price level, which is less than the expected price (P0), and Y2 is the real production level, which is lower than the potential production (Y0). This total is known as a contractionary gap amounting to Y2Y0 and the unemployment rate exceeds the natural unemployment rate. When unemployment rate exceeds the natural unemployment rate, it encourages an increase in the real fee during the short-run. In the long-run, producers are unwilling to pay a high nominal fee due to the actual price level. The actual price is lower than the expected price and the unemployment rate, but higher than the

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natural rate of unemployment. With high unemployment rate, those who are unemployed will compete with one another to obtain a job and they are willing to receive a low fees (assuming the price and fee levels are flexible). A low nominal fee rate will reduce the firms production costs. This is shown by the movement of the AS curve to the right to AS2. The new equilibrium is achieved at point e (AS2 and AD2). The price level drops to P4 and production falls back to potential production (drop in price equals drop in fee level). Since the expected price is the same as the real price, the short-run and long-run equilibrium are both at point e. Generally, what has happened at points a, c and e are: (a) (b) The real price level equals the expected price level; and Production quantity demanded and supplied in the short-run is the same as that in the long-run.

In summary, actual production can be more or less than potential production in the short-run, but not in the long-run. Equilibrium in the long-run is achieved when the AD curve crosses the potential output vertical line. If the points a, c and e are joined, the vertical long-run AS curve (LRAS) can be seen.

6.5.1 Long-run Aggregate Supply Curve

The long-run aggregate supply curve is vertical because in the long-run, adjustments will take place. We know that fiscal and monetary policies will shift the AD curve. Let us look at Figure 6.16.

Figure 6.16: Long-run aggregate supply curve and policy effects

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Based on Figure 6.16, assume the original equilibrium e (P0 and Y0). If an expansionary budget or financial policy is implemented, the policy will make the AD curve shift to AD1. The new equilibrium price and production will be P1 and Y0, which means the production level remains the same, and only the price increases. Therefore, the multiplier effect of a change in government spending (G) on aggregate output (Y) in the long run is zero. Similarly the tax multiplier is also zero. On the other hand, if contractionary fiscal or monetary policy is implemented, the AD curve will shift to the left (AD2). The new price and production level will be P2 and Y0. Conclusively, in the long-run, whether an expansionary or contractionary policy is implemented, only the price level changes.

EXERCISE 6.1
1. What is shown by an aggregate demand curve that is sloping negatively from left to right? Explain FOUR factors that influence changes in the aggregate supply curve either to the left or right. What is meant by macroeconomic equilibrium in the short-run? If the government of Malaysia increases its expenses by buying more goods and services, is this change a fiscal policy or monetary policy? Why? Why is the long-run aggregate supply curve vertical?

2.

3. 4.

5.

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x x

Aggregate demand is the total demand for goods and services by consumers in an economy. An aggregate demand curve (AD) is negatively sloped, showing the negative relationship between price and production level, assuming that all other factors are fixed (not changed). Factors that cause the aggregate demand curve to slope negatively are the real-balance effect, the interest rate effect and the net-export effect. Aggregate expenditure is the total expenses of households, firms, government and foreign sector. Aggregate supply means the total supply of goods and services in an economy. Aggregate supply curve can be divided into three sections, namely, horizontal (Keynesian), upward sloping and vertical (Classic). Aggregate supply is determined by input price, productivity, government policy and environment. Changes in equilibrium can take place due to changes in aggregate demand and aggregate supply curves. Fiscal policy involves government expenditure and taxes, whereas monetary policy involves money supply. There are two types of policy namely, expansionary and contractionary. Expansionary policy will shift the AD curve to the right, whereas contractionary policy will move the AD curve to the left. The long-run aggregate supply curve is vertical because in the long-run adjustments will be made. Let us look at the summary of this topic in Figure 6.17.

x x

x x

x x x

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Figure 6.17: Summary of Topic 6

Aggregate demand Aggregate supply Classical Consumer wealth Consumption Contractionary policy

Equilibrium Expansionary policy Government expenditure Investment Keynesian Net export