14.

0 AGGREGATE DEMAND AND AGGREGATE SUPPLY

Aggregate means total and in this case use the term to measure how much is being spent
by all consumers, businesses, the government and people and firms overseas. Aggregate demand
is an economic measurement of the sum of all final goods and services produced in an economy,
expressed as the total amount of money exchanged for those goods and services. Since aggregate
demand is measured through market values, it only represents total output at a given price level, and
does not necessarily represent quality or standard of living. The Keynesian equation for aggregate
demand is: AD = C+I+G+(Nx). Aggregate supply, also known as total output, is the total supply
of goods and services produced within an economy at a given overall price level in a given time
period. It is represented by the aggregate supply curve, which describes the relationship between
price levels and the quantity of output that firms are willing to provide. Normally, there is a
positive relationship between aggregate supply and the price level.

14.1 AGGREGATE DEMAND

Aggregate supply, also known as total output, is the total supply of goods and services
produced within an economy at a given overall price level in a given time period. It is represented by
the aggregate supply curve, which describes the relationship between price levels and the quantity of
output that firms are willing to provide. Normally, there is a positive relationship between aggregate
supply and the price level. Aggregate demand consists of the amount households plan to spend on
goods (C), plus planned spending on capital investment, (I) + government spending, (G)
+ exports (X) minus imports (M) from abroad. The standard equation is:

AD = C + I + G + (X M)
 Aggregate demand is generated as income is transferred to spending as a result of the
circular flow of income. Income is spent on consumer goods and services (C) plus spending on
capital goods by firms (I). Spending is also generated by government when it allocates resources
to public goods, merit goods and income transfers, such as pension benefits. Finally, there is 'net
overseas spending', which is overseas spending on an economy's exports of goods and services,
less what the economy spends on importing goods and services.

Prices and output

The AD - AS model shows how changes in the level of AD and AS affect an economys national
output (income) and its price level.
Example of aggregate demand

AD can be found by adding-up the value of all the individual components at various average
price levels.

PRICE C I G X M AD

LEVEL
200 30 50 10 50 450

0 0
180 32 60 10 10 425

0 5 0
160 34 70 11 15 400

0 0 0
140 36 80 11 20 375

0 5 0
120 38 90 12 25 350

0 0 0
100 40 10 12 30 325

0 0 5 0
80 42 11 13 35 300

0 0 0 0
60 44 12 13 40 275

0 0 5 0
Exercise calculate AD.

Answer

AD and the price level:

Apart from imports, the components of AD are inversely related to prices. Each component
responds differently to changes in prices, in other words they have different elasticities with
respect to the price level. For example, we can assume that overseas demand is elastic with
respect to price, because overseas consumers can choose from many global suppliers. This makes
them highly sensitive to changes in the prices of imported products.
14.1.1 AGGREGATE DEMAND CURVE

The AD curve shows the relationship between AD and the price level. It is assumed that
the AD curve will slope down from left to right. This is because all the components of AD,
except imports, are inversely related to the price level.

For convenience, the AD curve is normally drawn as a straight line, though it can be argued that
it is more likely to be non-linear, many suggesting it has a rectangular hyperbola shape. It is also
claimed that the downward slope of the AD curve reflects 'normal' macro-economic conditions,
and that in a deep recession, the AD curve could become vertical.
14.1.2 THE REASON WHY DEMAND AGGREGATE SLOPES DOWNDWARD

The AD curve slopes down because the components of AD are inversely related to the
price level. Price changes have a number of important effects on aggregate behavior of
households and firms. There are three main effects to consider.

The price level and international trade the trade effect

The first effect, on overseas trade, is perhaps the most obvious one. A rise in domestic
prices makes exports less competitive and imports more competitive; hence exports (X) are
likely to fall and imports (M) are likely to rise. Both of these reactions combine to create a trade
effect, with lower aggregate demand at the higher price level.

The price level and liquidity the liquidity/interest rate effect

When the price level increases, households and firms need to spend more money to
continue to consume the scarce resources they need. This makes them relatively short of cash
than they were at the lower price level. The liquidity of an asset refers to how easily it is
converted to cash, with cash itself being perfectly liquid. The loss of liquidity associated with a
rise in the price level forces some households and firms to borrow from banks, which reduces the
liquidity of banks. In response, banks are likely to raise interest rates as compensation for this
lost liquidity. The banks need to keep a certain amount of their reserves in a highly liquid form to
meet any unexpected increase in demand for cash. As a result of the lost liquidity, interest rates
are forced to rise, and both household and corporate spending may fall. Hence, aggregate
demand is lower at the higher price level.
The price level and the value of wealth the wealth effect

Given that interest rates will rise as financial markets readjust to the higher price level,
there are likely to be further knock on effects on household (and corporate) wealth. Higher rates
may lead to a fall in house prices, or at least slow-down house price inflation, and create a
negative wealth effect. The same may be true for those households and firms that rely on income
from shares. Rising interest rates tend to reduce corporate profits and reduce share values - again
creating a negative wealth effect. A lower price level will, of course, have the reverse effect, that
is to create a positive wealth effect on AD. The combined effect of these wealth effects is to alter
consumer and corporate spending, and hence alter the level of AD. When combined, the above
effects explain why aggregate demand responds inversely to changes in the price level. These
effects should not be confused with other exogenous affects, which will shift the whole position
of the AD curve.

14.1.3 Determinants of Aggregate Demand

An assortment of ceteris paribus factors other than the price level

that affect aggregate demand, but which are assumed constant when the
aggregate demand curve is constructed. Changes in any of the aggregate
demand determinants cause the aggregate demand curve to shift. The
specific ceteris paribus factors are commonly grouped by the four, broad
expenditure categories consumption expenditures, investment expenditures,
government purchases, and net exports. Aggregate demand determinants
are held constant when the aggregate demand curve is constructed. A
change in any of these determinants causes a shift of the aggregate demand
curve.
 The determinants work through the four aggregate expenditure
categories consumption expenditures, investment expenditures, government
purchases, and net exports. Should any specific aggregate demand
determinant change, it must affect the aggregate demand curve through one
of the four aggregate expenditures. A few of the more notable determinants
that tend to stand out in the study of macroeconomics and the analysis of
the aggregate market are:

Interest Rates: Interest rates affect the cost of borrowing and thus both
consumption and investment expenditures. Interest rates are a
component of investment-driven business cycles and play a key role in
monetary policy.

Federal Deficit: The federal deficit is comprised of government purchases,

which is one of the four basic expenditures, and taxes, which affects the
amount of disposable income available for consumption. Changes in the
federal deficit commonly result from the use of fiscal policy.

Expectations: Household and business expectations of future business-

cycle conditions, especially inflation and unemployment, affect
consumption and investment expenditures.

Money Supply: The quantity of money circulating in the economy directly

affects the buying capabilities of all four sectors and thus affects all four
expenditure categories--consumption, investment, government
purchases, and net exports. Control of the money supply is the key to
monetary policy.
 Consumer Confidence: The degree of household sector optimism or
pessimism affects current consumption expenditures.

A host of other specific aggregate demand determinants also surface

from time to time, including exchange rates between domestic currency and
foreign currency, the accumulation of physical wealth especially business
capital and household durable goods, and the accumulation of financial
wealth especially changes in the value of the stock market.

14.2 Aggregate Supply (AS)

Aggregate supply is defined as the total amount of goods and services

(real output) produced and supplied by an economys firms over a period of
time. It includes the supply of a number of types of goods and services
including private consumer goods, capital goods, public and merit goods and
goods for overseas markets. There are four component of aggregates supply
are:

Consumer goods: Private consumer goods and services, such as motor

vehicles, computers, clothes and entertainment, are supplied by the
private sector, and consumed by households. For a developed economy,
this is the single largest component of aggregate supply.

Capital goods: Capital goods, such as machinery, equipment, and plant,

are supplied to other firms. These investment goods are significant in
that their use adds to capacity, and increases the economys ability to
supply private consumer goods in the future.

Public and merit goods: Goods and services produced by private firms for
use by central or local government, such as education and healthcare,
are also a significant component of aggregate supply. Many private firms
 such as those in construction, IT and pharmaceuticals, rely on contracts
to supply to the public sector.
Traded goods: Goods and services for export, such as chemicals,
entertainment, and financial services are also a key component of
aggregate supply.

14.2.1 Short Run AS Curve

The total (or aggregate) real production of final goods and services
available in the domestic economy at a range of price levels, during a period
of time in which some prices, especially wages, are rigid, inflexible, or
otherwise in the process of adjusting. Short-run aggregate supply (SRAS) is
one of two aggregate supply alternatives, distinguished by the degree of
price flexibility; the other is long-run aggregate supply. Short-run aggregate
supply is combined with aggregate demand in the short-run aggregate
market analysis used to analyze business-cycle instability, unemployment,
inflation, government stabilization policies, and related macroeconomic
topics.

At higher price levels across the economy firms expect that they can
sell their final products at higher prices, and there will be a positive
relationship between the price level and aggregate supply. Any increase in
input prices (costs) which may follow is assumed to lag behind increases in
the general price level. Because of this firms expect that they will benefit - at
least in the short run - from a rise in the price level. Based on this we can
derive a simple AS supply schedule, as shown below:

Price Label
Quantity Supply
P8 650
P7 600
P6 550
P5 500
P4 450
P3 400
P2 350
P1 300
p 250

The short run aggregatesupply curve is upward-sloping specifying a

direct
 relationship between the price level and the quantity supplied of real
GDP.

14.2.2 Shift In The Short Run AS Curve

Higher prices for inputs that are widely used across the entire economyfor example,
wages and energy productscan have a macroeconomic impact on aggregate supply. Increases
in the price of such inputs cause the SRAS curve to shift to the left, which means that at each
given price level for outputs, a higher price for inputs will discourage production because it will
reduce the possibilities for earning profits. Diagram B, on the right above, shows the aggregate
supply curve shifting to the left, , which causes the equilibrium to move. This movement from
the original equilibrium of the new equilibrium of .1 brings a nasty set of effects: reduced GDP
or recession, higher unemployment because the economy is now further away from potential
GDP, and an inflationary higher price level as well. Take, for example, the US economic
recessions in 19741975, 19801982, 199091, 2001, and 20072009each was preceded or
accompanied by a rise in the key input of oil prices. In the 1970s, this pattern of a shift to the left
in SRAS leading to a stagnant economy with high unemployment and inflation was
nicknamed stagflation.

On the other hand, a decline in the price of a key input like oil will shift the SRAS curve
to the right, providing an incentive for more to be produced at every given price level for
outputs. From 1985 to 1986, for example, the average price of crude oil fell by almost half, from
$24 a barrel to $12 a barrel. Similarly, from 1997 to 1998, the price of a barrel of crude oil
dropped from $17 per barrel to $11 per barrel. In both cases, the plummeting price of oil led to a
situation like that presented in Diagram A, on the left above, where the shift of the SRAS
curve to the right allowed the economy to expand, unemployment to fall, and inflation to
decline.

Along with energy prices, two other key inputs that may shift the SRAS curve are the
cost of labor, or wages, and the cost of imported goods that are used as inputs for other products.
In these cases as well, the lesson is that lower prices for inputs cause SRAS to shift to the right,
while higher prices cause it to shift back to the left.

1.4.2.3 Compare the AS Curve Under Classical and Keynesian

In classical economic theory, a long term perspective is taken where inflation, unemployment,
regulation, tax and other possible effects are considered when creating economic policies.
Keynesian economics, on the other hand, takes a short term perspective in bringing instant
results during times of economic hardship. One of the reasons as to why government spending is
so important in Keynesian economics is that, it is treated as a quick fix to a situation that cannot
be immediately corrected by consumer spending or investment by businesses.

Classical economics and Keynesian economics take very different approaches to varying
economic scenarios. Taking an example, if a country is going through an economic recession,
classical economics states that wages would fall, consumer spending would decrease, and
business investment would reduce. However, in Keynesian economics, government intervention
should kick in and stimulate the economy by increasing purchases, creating demand for goods
and improving prices.

14.3 MACROECONOMICS EQUILIBRIUM AND POLICIES CHANGES

The purpose of the aggregate supply-aggregate demand model is to understand and

predict changes in real GDP and the price level. To achieve this purpose, we combine aggregate
supply and aggregate demand and determine macroeconomic equilibrium. There is a
macroeconomic equilibrium for each of the time frames for aggregate supply: a long run
equilibrium and a short-run equilibrium. Long-run equilibrium is the state toward which the
economy is heading. Short run equilibrium describes the state of the economy at each point in
time on its path toward long-run macro~ economic equilibrium. The set of government rules and
regulations to control or stimulate the aggregate indicators of an economy frames the
macroeconomic policy. Aggregate indicators involve national income, money supply, inflation,
unemployment rate, growth rate, interest rate and many more. In short, policies framed to meet
the macro goals.
Two main regulatory macroeconomic policies are fiscal policy and monetary policy. Fiscal
policy is the macroeconomic policy where the government makes changes in government
spending or tax to stimulate growth. Monetary policy deals with changes in money supply or
changes with the parameters that affects the supply of money in the economy.

14.3.1 Fiscal Policy

Fiscal policy is the government spending and taxation that influences the economy.
Elected officials should coordinate with monetary policy to create healthy economic growth.
They usually don't. Why? Fiscal policy reflects the priorities of individual lawmakers. They
focus on the needs of their constituencies. These local needs overrule national economic
priorities. As a result, fiscal policy is hotly debated, whether at the federal, state, county or
municipal level.

There are two types of fiscal policy. The first, and most widely-used, is expansionary. It
stimulates economic growth. It's most critical at the contraction phase of the business cycle.
That's when voters are clamoring for relief from a recession. How does it work? The government
either spends more, cuts taxes, or does both if it can. The idea is to put more money into
consumers' hands, so they spend more. That jump starts demand, which keeps businesses running
and adds jobs. Politicians debate about which works better. Advocates of economics prefer tax
cuts. They say it frees up businesses to hire more workers to pursue business ventures.

14.3.2 Monetary Policy

Monetary policy is how central banks manage liquidity to create economic growth.
Liquidity is how much there is in the money supply. That includes credit, cash, checks and
money market mutual funds. The most important of these is credit. It includes loans, bonds and
mortgages.
 The primary objective of central banks is to manage inflation. The second is to
reduce unemployment, but only after they have controlled inflation. The U.S. Federal
Reserve, like many other central banks, has specific targets for these objectives. It seeks
an unemployment rate below 6.5 percent. The Fed says the natural rate of unemployment is
between is between 4.7 percent and 5.8 percent. It wants the core inflation rate to be between 2.0
percent and 2.5 percent. It seeks healthy economic growth. That's a 2-3 percent annual increase
in the nation's gross domestic product.

All central banks have three tools of monetary policy in common. Most have many more.
They all work together in an economy, by managing banks' reserves. The Fed has six major
tools. First, it sets a reserve requirement, which tells banks how much of their money they must
have on reserve each night. If it weren't for the reserve requirement, banks would lend 100
percent of the money you've deposited. Not everyone needs all their money each day, so it is safe
for the banks to lend most of it out.

The Fed requires that banks keep 10 percent of deposits on reserve. That way, they have
enough cash on hand to meet most demands for redemption. When the Fed wants to restrict
liquidity, it raises the reserve requirement. The Fed only does this as a last resort because it
requires a lot of paperwork. It's much easier to manage banks' reserves using the Fed funds rate.
This is the interest rate that banks charge each other to store their excess cash overnight. The
target for this rate is set at the eight annual Federal Open Market Committee meetings. The Fed
funds rate impacts all other interest rates, including bank loan rates and mortgage rates.

The Fed's third tool is its discount rate. That's how it charges banks to borrow funds from
the Fed's fourth tool, the discount window. The FOMC usually sets the discount rate a half-point
higher than the Fed funds rate. That's because the Fed prefer banks to borrow from each other.

Fifth, the Fed uses open market operations to buy and sell Treasuries and other securities
from its member banks. This changes the reserve amount that banks have on hand without
changing the reserve requirement.
 Sixth, many central banks including the Fed use inflation targeting. It clearly sets
expectations that they want some inflation. That's because people are more likely to buy if they
know prices are rising. In addition, the Fed created many new tools to deal with the Great
Recession. To find out more, see Federal Reserve Tools.