question
Aggregate demand
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Total planned spending on domestic goods and services at different average price levels over a period of time.
Spending can originate from households, firms, gov, and foreigners. Includes consumption expenditures (C), investment expenditures (I), gov expenditures (G), and exports (X), and subtracted imports.
AD=C + I + G + (X-M)
Spending can originate from households, firms, gov, and foreigners. Includes consumption expenditures (C), investment expenditures (I), gov expenditures (G), and exports (X), and subtracted imports.
AD=C + I + G + (X-M)
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Difference between GDP expenditure approach and aggregate demand
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GDP is actual output and aggregate demand shows planned level of spending at diff price levels in a country. So GDP is a number and aggregate demand is a function.
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The aggregate demand curve is downward sloping because of
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-The wealth effect (if average price level increases real value of money people have in their banks and financial assets decreases, consumer expenditures fall. Thus, if average price levels rise then spending on domestic goods and services falls, leading to a downward sloping AD)
-The trade effect (if average price level increases exports become less competitive abroad and imports attractive domestically, so net exports a component of AD, decreases. Thus, if average price level rises, NX falls, leading to downward sloping AD)
-The Interest effect (If average price level increases, people need to hold more money to buy the same goods, demand for holding money eg. cash and cheque accounts increases. If supply by central bank is constant, price of money so interest rises. Higher interest rates decrease consumption (C) and investment expenditures (I) as people and firms borrow less from banks. So if average price level rises consumption and investment decrease, leading to downward sloping AD)
-The trade effect (if average price level increases exports become less competitive abroad and imports attractive domestically, so net exports a component of AD, decreases. Thus, if average price level rises, NX falls, leading to downward sloping AD)
-The Interest effect (If average price level increases, people need to hold more money to buy the same goods, demand for holding money eg. cash and cheque accounts increases. If supply by central bank is constant, price of money so interest rises. Higher interest rates decrease consumption (C) and investment expenditures (I) as people and firms borrow less from banks. So if average price level rises consumption and investment decrease, leading to downward sloping AD)
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There is a movement along the AD curve when
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There is a change in the average price level
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Shifts in aggregate demand are caused by determinants of AD
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-Changes in consumption expenditures resulting from determinants
-Changes in investment expenditures resulting from determinants
-Changes in gov expenditures resulting from determinants
-Changes in net exports resulting from change in determinants
-Changes in investment expenditures resulting from determinants
-Changes in gov expenditures resulting from determinants
-Changes in net exports resulting from change in determinants
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Consumption expenditures as a determinant of AD(spending by households on durables and non-durables and services)
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-Interest rates (Cost of borrowing or reward of saving money over a period of time expressed as a %. Households borrow to finance durables eg. cars. Increase in interest, less borrowing and spending, leftward shift of AD curve. Decrease in interest rates, more spending, rightward shift of AD curve)
-Consumer confidence (measure of how optimistic households are and how secure they feel about the future. Higher confidence, higher spending, rightward shift of AD. Lower confidence, less spending, leftward shift)
-Household wealth (refers to value of what households own stocks, bonds, deposits, real estate minus debts. Increase in wealth, due to increase in property prices, more spending, rightward shift of AD. If stock price falls, less spending, decrease AD, leftward shift)
-Personal income taxes (determine level of disposable income, income left after taxes. If gov raises personal income tax, disposable income falls, spending falls, AD decreases and leftward shift. Vice versa.)
-Household indebtedness (how much money households owe from loans or credit cards. If owe a lot, less spending, decrease AD, leftward shift. Vice versa)
-Expectations of future price levels (If households expect average price to decrease/deflationary expectations they may delay purchases so spending falls shift left. If inflationary expectations AD increases now.)
-Consumer confidence (measure of how optimistic households are and how secure they feel about the future. Higher confidence, higher spending, rightward shift of AD. Lower confidence, less spending, leftward shift)
-Household wealth (refers to value of what households own stocks, bonds, deposits, real estate minus debts. Increase in wealth, due to increase in property prices, more spending, rightward shift of AD. If stock price falls, less spending, decrease AD, leftward shift)
-Personal income taxes (determine level of disposable income, income left after taxes. If gov raises personal income tax, disposable income falls, spending falls, AD decreases and leftward shift. Vice versa.)
-Household indebtedness (how much money households owe from loans or credit cards. If owe a lot, less spending, decrease AD, leftward shift. Vice versa)
-Expectations of future price levels (If households expect average price to decrease/deflationary expectations they may delay purchases so spending falls shift left. If inflationary expectations AD increases now.)
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Investment expenditures as a determinant of AD(spending by firms on capital goods per period of time. Investment increases stock capital of an economy and influences aggregate demand and supply and so rate of long-term economic growth)
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-Interest rates (if increases borrowing to finance capital goods becomes more expensive and firms will find fewer possible investment projects profitable. Even if firm uses own funds to finance investment project opportunity cost of keeping them in banks as bonds increase. Investment decreases, AD shifts to left. If interest decreases borrowing falls, increase investment spending, AD increases and shifts to right)
-Business confidence (how businesses feel about future sales and economy. Needs economic and political stability. If optimistic, increases investment and AD, shift right. Vice versa. Keynes considered entrepreneur investment decisions to be herd imitation, can swing due to unpredictable factors.
-Technology (Industries where tech improves fast will witness more investments, thus increase in AD and rightward shift)
-Business taxes (affect firms' profits. Taxes decreases investment profitability increases, i sending increases, AD increases, shifts right. Vice versa)
-Corporate indebtedness (If high debt from past borrowing, hesitant to take out more loans and make investments as they will first try to decrease debt. So AD decreases and curve shifts left)
-Business confidence (how businesses feel about future sales and economy. Needs economic and political stability. If optimistic, increases investment and AD, shift right. Vice versa. Keynes considered entrepreneur investment decisions to be herd imitation, can swing due to unpredictable factors.
-Technology (Industries where tech improves fast will witness more investments, thus increase in AD and rightward shift)
-Business taxes (affect firms' profits. Taxes decreases investment profitability increases, i sending increases, AD increases, shifts right. Vice versa)
-Corporate indebtedness (If high debt from past borrowing, hesitant to take out more loans and make investments as they will first try to decrease debt. So AD decreases and curve shifts left)
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Government expenditures as a determinant of AD (In many economies large proportion of total expenditures on goods and services)
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-Categorized as: current spending on goods and services, capital (public investments) spending which refers to infrastructure, and transfer payments which refers to pensions and unemployment benefits (not included in national income as since they do not represent rewards to current productive effort)
-Spends to ensure adequate amount of public and merit goods and services available and to regulate markets in an attempt to guarantee product safety/environmental standards/competitive conditions etc. May also redistribute income so a socially acceptable minimum is guaranteed for all. Lastly, gov spends to affect aggregate demand. This is part of fiscal policy. Therefore, economic and political priorities affect the level of gov spending.
-Spends to ensure adequate amount of public and merit goods and services available and to regulate markets in an attempt to guarantee product safety/environmental standards/competitive conditions etc. May also redistribute income so a socially acceptable minimum is guaranteed for all. Lastly, gov spends to affect aggregate demand. This is part of fiscal policy. Therefore, economic and political priorities affect the level of gov spending.
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Net exports as a determinant of AD(difference between spending by foreigners on domestic output minus domestic spending on foreign output per period of time)
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-Income of trading partners (if increases, level of spending will increase. Part of this will be on imports, so our exports. Thus exports of an economy will tend to increase if income of trading partner increases, increasing AD and shifting curve to right. Vice versa)
-Exchange rates (price of a country's currency expressed in terms of another's. If it depreciates, so EU is closer to USD, EU exports become more competitive abroad in US while imports become less attractive domestically in the EU. So net exports increase, increasing AD and shifting right. If appreciates, decreases.)
-Trade policies (Restrictions to international trade such as tariffs or quotas imposed by govs. If one country imposes restrictions on imports of another, imports fall and NX rises, increasing AD and shifting curve rightward. relaxing trade restriction can have the reverse effect.)
-Exchange rates (price of a country's currency expressed in terms of another's. If it depreciates, so EU is closer to USD, EU exports become more competitive abroad in US while imports become less attractive domestically in the EU. So net exports increase, increasing AD and shifting right. If appreciates, decreases.)
-Trade policies (Restrictions to international trade such as tariffs or quotas imposed by govs. If one country imposes restrictions on imports of another, imports fall and NX rises, increasing AD and shifting curve rightward. relaxing trade restriction can have the reverse effect.)
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Aggregate supply
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Planned level of output domestic firms are willing to offer at different average price levels per period time. Not real GDP, shows how much they are planning to offer. Shape of AS curve controversial as reflects different assumptions by diff schools of thought.
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AS under Monetarist/New Classical
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Distinction between short run and long run, so SRAS and LRAS
question
Short run AS
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Period during which money wages are fixed and unable to adjust to changes in average price level. Money wage is what's on the pay slip, real wage is what you can buy with it. So,
Wr=Wm/APL (average price level)
Wr=Wm/APL (average price level)
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Money wages and SRAS
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Usually determined by labour contracts, so price level in an economy changes as long as contracts are in effect money wages will not adjust to match APL. Additionally, 2nd explanation that workers are slow to adjust expectation of inflation and only realize they've affected purchasing power later. Wm is closely related to AS because they account for ht largest part of firms' production costs. As long as Wm remains fixed, when APL changes only Wr will be affected so workers become cheaper or pricier inducing an output response. If APL increases then Wr decreases and firms will be willing to offer more output. If APL decreases Wr increases and firms will be willing to offer less. Thus, SRAS curve is upward sloping
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The SRAS curve will shift when
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Shifts mainly caused by production costs, there will be changes in costs of production that will effect most firms in an economy not one specific market.
-Money wages change: e.g. min wage. If min increases, higher costs, decreases SRAS and leftward shift. Vice versa if gov weakens labour union power.
-Energy prices change: changes in price of oil affect SRAS in the same way as wages, increase in price decreases SRAS so leftward shift. Vice versa
-Indirect taxes or subsidies change: indirect taxes like sales tax, affect costs of production. So higher taxes decrease and shift SRAS to the left and vice versa. Increase in gov subsidies reduce costs of production and increase SRAS to the right. Vice versa
-Money wages change: e.g. min wage. If min increases, higher costs, decreases SRAS and leftward shift. Vice versa if gov weakens labour union power.
-Energy prices change: changes in price of oil affect SRAS in the same way as wages, increase in price decreases SRAS so leftward shift. Vice versa
-Indirect taxes or subsidies change: indirect taxes like sales tax, affect costs of production. So higher taxes decrease and shift SRAS to the left and vice versa. Increase in gov subsidies reduce costs of production and increase SRAS to the right. Vice versa
question
LRAS
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Money wages assumed flexible and fully adjusting to APL. Wr constant, so firms no longer respond to changes in APL by changing real output as firms' profitability does not change to induce response. Drawn as vertical curve at economy's potential level of real output to show this since LR economy produces whatever its resources and tech allow it. Output at potential level, considered full employment level, however still some unemployment referred to as natural unemployment that exists when the labour market is in equilibrium. If LRAS increases and shifts rightward, implies potential level of output has increased, so economy's production capacity has increased.
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Increase in LRAS caused by
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-Quantity of factors of production increases eg. increase in labour due to immigration
-Quality of factors of production improves eg. greater skills/education
-Improvements in tech
-Efficiency increases, if economy makes better use of resources it can produce greater quantity of output
-Institutional changes, improvements in institutional framework increases economy's productive capacity. Eg. reducing amount of bureaucracy that facilitates economic activity
-Quality of factors of production improves eg. greater skills/education
-Improvements in tech
-Efficiency increases, if economy makes better use of resources it can produce greater quantity of output
-Institutional changes, improvements in institutional framework increases economy's productive capacity. Eg. reducing amount of bureaucracy that facilitates economic activity
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AS under Keynesian school
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No distinction between short and long run, so only one AS curve with three sections. Section 1 is horizontal implying higher levels of output can and will be produced without rising APL because real output levels corresponding to this region are significantly below full employment denoted with Yf. Economy at this section operates presumably in deep recession, unemployment is high and spare capacity. Section 3 is vertical at full employment level of output Yf, this employment considered within extreme Keynesian analysis of the "wall" implying no unemployment. Real output cannot increase beyond Yf. Section 2 illustrates upward sloping curve due to economy consisting of many diff sectors employing diff resources, which do not reach full employment conditions together. Referred to as bottlenecks in production: spare capacity in some industries may coexist with full employment in others. Real output may rise but due to capacity constraints in some industries, wages, and more generally production costs may also be rising and so will prices.
Keynes not interested in long run.
Keynes not interested in long run.
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Macroeconomic equilibrium under monetarist/new classical
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SR equilibrium and LR equilibrium
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Short-run equilibrium monetarist/new classical
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Exists at the level of real output at which AD is equal to short-run aggregate supply.
Any shift in aggregate demand will induce a change in the equilibrium average price and output levels in the same direction as the shift. E.g. if AD increases due to lower interest rates, will lead in the SR to higher real output and APL.
Shifts in SRAS will induce changes in the APL and equilibrium output that are in the opposite direction. If oil prices increase then since production costs rise SRAS will decrease shifting curve left. Higher APL accompanied by lower equilibrium output.
Any shift in aggregate demand will induce a change in the equilibrium average price and output levels in the same direction as the shift. E.g. if AD increases due to lower interest rates, will lead in the SR to higher real output and APL.
Shifts in SRAS will induce changes in the APL and equilibrium output that are in the opposite direction. If oil prices increase then since production costs rise SRAS will decrease shifting curve left. Higher APL accompanied by lower equilibrium output.
question
Long-run equilibrium monetarist/new classical
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Equilibrium will necessarily be at the economy's potential or full employment level of output, as a any deviation from the potential level will of output can only exist in the short run because money wages are assumed fixed. Deviations of SR equilibrium from potential level of output will be temporary and the economy will always return in long-run to potential or full employment level of output as money wages fully adjust to change in APL.
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If AD decreases on SRAS equilibrium diagram in monetarist model
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On diagram LRAS is vertical with x axis labelled natural/normal rate (NRU) and APL is at APL1.
E.g. if AD decreases average price level decreases and since in SR wages are fixed the real wage increases and profitability decreases so real output decreases. Net movement on SRAS from A1 to A2 (no shift). Real output is below it's potential (full employment) level so unemployment rises above NRU. Economy is characterized by deflationary/recessionary gap equal to difference between potential level of output and lower equilibrium level of output.
E.g. if AD decreases average price level decreases and since in SR wages are fixed the real wage increases and profitability decreases so real output decreases. Net movement on SRAS from A1 to A2 (no shift). Real output is below it's potential (full employment) level so unemployment rises above NRU. Economy is characterized by deflationary/recessionary gap equal to difference between potential level of output and lower equilibrium level of output.
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Deflationary/recessionary gap
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Exists when equilibrium real output is below potential (full employment) level of output
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If AD decreases on LRAS equilibrium diagram in monetarist model
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Since money wages are flexible they will decrease to match decrease in price level. (Money wages are a shift factor for SRAS so SRAS increases and curve shifts right to SRAS'). Since adjustment of money wages is assumed full real wage returns to og level. Since real wage is unchanged unemployment must return to natural state and so real output back to potential level. The economy has therefore moved automatically to point A3 (equilibrium of SRAS' with APL')
question
Monetarists on deflationary gap from decrease in AD
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Believe an economy will bounce back so gap will close only through an adjustment of money wages. Thus, there is no need for a government to intervene. However, the question is how fast the economy will return to full employment. Not specified so long run may prove too long especially for unemployed.
question
Increase in AD on SRAS equilibrium in monetarist model
answer
Increase in AD shifts AD curve rightward. Price level rises from APL1 to 2. In short run real wage decreases and profitability for firms increases so real output rises. Net movement in short run along SRAS curve from A1 to A2. SR equilibrium is at A2, intersection of of AD2 with SRAS. Real output is above its potential (full employment level) so unemployment falls below natural rate. Economy characterized by inflationary gap equal to difference between between potential level of output and the greater equilibrium level of output.
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inflationairy gap
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Exists when equilibrium real output is greater than potential (full employment) output
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Increase in AD on LRAS equilibrium in monetarist nmodel
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Money wages fully adjust matching increase in APL. SRAS decreases shift curve leftward to SRAS'. Real wage returns to original level and since real wage is unchanged employment returns to natural state and real output back to potential level. The economy has therefore moved automatically at point A3. inflationary gap will close only through market adjustments, namely increase in money wages so no need for gov intervention according to monetarists.
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Equilibrium in the Keynesian model
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Within Keynesian framework an economy may find itself stuck at an equilibrium level of real output with less than full employment, no endogenous forces exist that will restore full employment.
Money wages assumed "sticky downwards" (money wages may increase but do not easily adjust downwards. AD is the driving force behind the equilibrium level of economic activity in this model. Instead of believing in "supply creating its own demand" it is AD that determines the equilibrium level fo real output. If AD proves insufficient to to establish full employment then then a market economy will suffer a system-wide failure as it will be unable to independently restore full employment conditions.
Money wages assumed "sticky downwards" (money wages may increase but do not easily adjust downwards. AD is the driving force behind the equilibrium level of economic activity in this model. Instead of believing in "supply creating its own demand" it is AD that determines the equilibrium level fo real output. If AD proves insufficient to to establish full employment then then a market economy will suffer a system-wide failure as it will be unable to independently restore full employment conditions.
question
If AD decreases in equilibrium Keynesian model
answer
AD curve shifts leftward, equilibrium real output decreases to Y2, below full employment level of output Yf. Thus deflationary gap equal to Yf-Y2. Sticky downwards as as no automatic adjustment mechanism to push economy back to full employment level of output. So economy may remain stuck, Gov must therefore intervene to increase AD and restore full employment Can be achieved either through expansionary fiscal policy or loose monetary policy.
question
If AD increases in equilibrium Keynesian model
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Shift AD rightward, equilibrium real output will remain at Yf due to "wall". APL will rise from APL1 to APL2. Vertical distance can be referred to as the inflationary gap, in this model gap is now on vertical axis as full employment in this model refers to 0 unemployment.
question
Natural rate of employment in Keynesian model
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Define NRU as some level of output to the left of where the vertical section of the AS curve would intersect the horizontal axis. Increase in AD creates inflationary gap equal to YfeY1 on the horizontal axis.
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Case of deflationary gap in monetarist model
answer
-Decrease in AD in SR leads to decrease in APL. Since money wages are fixed real wage increases inducing firms to reduce output
-Deflationary gap will arise since equilibrium level of real output will fall below potential output level
-In LR, money wages are flexible and will adjust and decrease to match decrease in APL. Real wage will be stored and so will the potential level of output.
-No need for gov intervention
-Deflationary gap will arise since equilibrium level of real output will fall below potential output level
-In LR, money wages are flexible and will adjust and decrease to match decrease in APL. Real wage will be stored and so will the potential level of output.
-No need for gov intervention
question
Case of inflationary gap in monetarist model
answer
-Increase in AD in SR leads to increase in APL. Since money wages are fixed, real wage decreases inducing firms to increase output.
-Inflationary gap will arise since equilibrium level of real output will exceed potential output level
-In LR, money wages are flexible and will adjust and increase to match increase in APL. Real wage will be stored and so will the potential level of output.
-No need for gov intervention
-Inflationary gap will arise since equilibrium level of real output will exceed potential output level
-In LR, money wages are flexible and will adjust and increase to match increase in APL. Real wage will be stored and so will the potential level of output.
-No need for gov intervention
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