Aggregate demand and supply

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Aggregate demand

  • the AD curve sloped downwards because: when prices fall consumers feel wealthier because their disposable incomes will buy more. This increases consumption.

factors affecting AD:

  • investment - the decision to invest is affected by a no. of difference factors:
    • the rate of interest: a fall here will shift the AD curve to the right, as borrowing is cheaper and firms will invest in new equipment to improve their competitive position.
    • Business expectations: if interest rates are low, businesses will expect more future sales as demand will increase. These positive expetations will increase I, shifting the AD curve to the right. 
    • the rate of technical progress: new equipment and tech development can increase I as it makes them more competitive and efficient.
    • the rate of change of income: affects firms' demand and at full capacity, an increase in demand will increase I as firms will produce more to meet demand. As the price of the required machinery is likely to be more than the value of the good produced, I will be a large injection and will shift AD to the right, producing a multiplier effect. Coupled with the accelerator effect can lead to sizeable fluctuations in demand.  
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Government expenditure and net exports

  • mainly spending on public and merit goods and local govt. services. 
  • over the last 50 years, govt. spending has reduced due to privatisation of companies e.g. royal mail AND austerity cuts
  • this reduction was so that tax rates could decrease and the govt. would borrow less.
  • govt investment into schools and hospitals will shift the AD curve to the right, while a cut in govt. spending will shift it to the left. 

net exports (X-M):

  • UK exports depend on AD in its major trading partners so if European economies are growing, demand for UK exports should increase, shifting the AD curve to the right. If the countries are in recession, we would expect  a shift to the left.
  • exports/ imports are affected by the value of the pound. SPICED and WPIDEC. cheaper exports will shift AD to the right.
  • if the UK economy is growing and incomes are rising, imports will increase and AD will shift to the left. This will also happen if the value of the sterling increases. 
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Aggregate supply - short run..

  • this curve slopes upwards from left to right.
  • shows the total output that an economy can produce using available factors of production at a particular price level. 
  • As the labour market tightens and required labour becomes scarce, wages increase, prices rise so the curve slopes upwards at a STEEPER rate. 
  • where the curve becomes VERTICAL, the economy is operating at full employment and is unable to produce any more g/s. 
  • This type of diagram could be a 'Keynesian' diagram as his view was that wages would remain fairly stable up to full employment and then rise as labour becomes scarce.
  • on the other hand, the classical view has LRAS and SRAS.
  • SRAS - the total quantity that will be supplied at different price levels when the prices of factors of production are assumed to be unchanged. 
  • factors affecting SRAS:
    • an increase in wage rates will increase firms' costs and shift the curve to the left.
    • an increase in the interest rate will make it more expensive to invest/borrow and will will reduce AS shifting the curve to the left.
    • a rise in the price of imported raw materials will shift it to the left.
    • an increase in corporation tax will increase firms' costs and shift it to the left.
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long run AS..

  • in the LRAS, factor prices can change. LRAS is the output that can be produced with the full employment of resources i.e. the productive capacity. 
  • Classical economists believe that the LRAS curve will become vertical BEFORE full employment is reached as there will be some workers who prefer not to work and to stay on benefits rather than work for low wages. i.e. actual output may not reach the economy's productive capacity. These people are referred to as 'voluntarily unemployed'. Here, the level of output where the curve becomes vertical is called the 'natural rate of unemployment'. 
  • factors affecting the LRAS: a rightward shift shows rising real output and econ growth.
    • an increase in the amount of capital equipment will increase output and shift the curve to the right. The increase in capital could have been caused by lower interest. Natural disasters can wipe out capital stock, reducing output and GDP of the economy (left shift)
    • better technology produces capital equip that is more productive, which increases labour thus increasing efficiency, shifting the curve to the right. Anything that increases labour output e.g. increased investment in education and training...
    • attitudes:lots of entrepreneurial individuals can increase AS. Also, a good institutional economy structure e.g. in the US economy where low interest rates provide an incentive for new individuals to set up their own businesses and not rely on the state so much. 
    • productivity: policies to persuade people to work reduce the natural rate of unemployment (right shift) e.g. reducing benefit rates
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