Chapter 17 — Aggregate Demand and Aggregate Supply Analysis

Cambridge International AS & A Level Economics (9708) · Unit 4.3 · 4th edition coursebook

17.1Aggregate demand

The word 'aggregate' means total. Aggregate demand (AD) is the total spending on an economy's goods and services at a given price level over a given period of time. It captures spending by households, by firms, by the government, and by foreigners on the country's exports, less the amount spent on imports.

Aggregate demand has four components, summed by the identity AD = C + I + G + (X − M):

• Consumer expenditure (C) — spending by households on goods and services, also known as consumption.
• Investment (I) — spending by private sector firms on capital goods.
• Government spending (G) — total local and national government expenditure on goods and services.
• Net exports (X − M) — the value of exports minus the value of imports.

Each component responds to different influences, and a change in any of them will shift the AD curve.

17.2Determinants of the components of aggregate demand

Consumer expenditure

Consumer expenditure is spending by households on goods and services to satisfy current wants — food, clothing, travel, entertainment and so on. The single most important influence on consumer expenditure is the level of disposable income. When income rises, total spending usually rises with it, although richer households tend to save a larger proportion of any extra income than poorer ones.

When a person or a country is poor, most or all of disposable income has to be spent simply to meet current needs. Consumer expenditure may even exceed income, with households drawing on past savings or borrowing — a situation called dissaving. When income rises some of it can be saved, and saving is defined as disposable income minus consumer expenditure.

Other influences on consumer expenditure include:

• Distribution of income — if income becomes more equally distributed, total consumer expenditure tends to rise, because lower-income households spend a larger share of any additional income than higher-income households.
• The rate of interest — lower interest rates reduce the return from saving, make credit purchases cheaper, and leave existing borrowers with more money to spend.
• Availability of credit — easier access to loans tends to raise spending.
• Expectations — optimism about future jobs and incomes encourages spending; pessimism encourages caution.
• Wealth — a rise in the value of houses or shares tends to raise consumer expenditure.

Investment

Investment here means private sector spending by firms on capital goods such as factories, offices, machinery and delivery vehicles. Its determinants include:

• Changes in consumer demand — if firms expect to sell more, they expand capacity by buying more capital.
• The rate of interest — a lower interest rate reduces the cost of borrowing and the opportunity cost of using retained profits, and tends to raise expected demand, all of which encourage investment.
• Technology — advances in technology raise the productivity of capital goods and so make investment more attractive.
• The cost of capital goods — a fall in the price of capital equipment or in the cost of installing it tends to raise investment.
• Expectations — when firms are optimistic about the economic outlook, they invest more.
• Government policy — cuts in corporation tax or investment subsidies can encourage private sector investment.

Government investment is normally included in the government spending component, so the contribution of the public sector to AD can be seen clearly.

Government spending

Government spending includes expenditure on merit goods such as education and healthcare and on public goods such as defence — for example medicines for state hospitals, school equipment, military aircraft and government investment in infrastructure. It is shaped by:

• Government policy — if a government wants to raise economic activity, it may raise its spending.
• Tax revenue — higher tax revenue allows more spending without extra borrowing.
• Demographic change — more children raise pressure on education spending; more elderly people raise pressure on healthcare spending.

Net exports

Net exports are exports minus imports. They depend on:

• Domestic GDP — when a country's GDP rises, demand for imports usually rises and some products may be diverted from exports to the domestic market.
• GDPs of other countries — when incomes rise abroad, demand for the country's exports tends to increase.
• Relative price and quality competitiveness — improvements in productivity, quality or marketing of domestically produced goods raise exports.
• The exchange rate — a fall in the exchange rate makes exports cheaper abroad and imports dearer at home. If demand for exports and imports is elastic, export revenue rises and import expenditure falls, so net exports rise.

Practice — after §17.2LO 4.3.5 · P1 | 2023 | s May/Jun | V3 | Q25

ABCD

17.3The aggregate demand curve

The aggregate demand curve (see Figure 17.3) shows the different quantities of total demand for an economy's products at different price levels. It slopes downwards from left to right: a rise in the price level causes a contraction in aggregate demand and a fall in the price level causes an extension. On the axes, the vertical axis measures the general price level (not the price of a single product) and the horizontal axis measures real GDP (not the quantity of a single product).

The downward slope of AD looks superficially like the demand curve for a single product, but the reasoning is different. A product's demand curve traces the effect of a change in its relative price while other prices are held constant; consumers switch towards or away from substitutes. Along the AD curve almost all prices are moving together, so the explanation must come from elsewhere. There are three reasons:

1. The wealth effect — a higher price level reduces the purchasing power of money held in bank accounts and other financial assets, so the real value of wealth falls and spending falls with it.
2. The international effect — a higher domestic price level makes exports less price-competitive and imports more attractive, reducing net exports.
3. The interest rate effect — a higher price level raises demand for money to pay for transactions; this pushes up the rate of interest, which discourages consumption and investment.

Shifts in the aggregate demand curve

A change in the price level moves the economy along the AD curve. A change in any non-price-level influence shifts the curve, as shown in Figure 17.4. A shift to the right indicates an increase in aggregate demand; a shift to the left indicates a decrease. Examples of changes that increase aggregate demand include:

• Consumer expenditure — a rise in consumer confidence, a cut in income tax, an increase in wealth, a rise in the money supply, or an increase in the population.
• Investment — a rise in business confidence, a cut in corporate tax, or advances in technology.
• Government spending — a desire to stimulate economic activity or to win political support.
• Net exports — a fall in the exchange rate, a rise in the quality of domestically produced products, or an increase in incomes abroad.

The opposite changes shift AD to the left.

Practice — after §17.3LO 4.3.4 · P1 | 2019 | s May/Jun | V2 | Q23

ABCD

17.4Aggregate supply

Aggregate supply (AS) is the total planned output of all the producers in the country. Economists usually distinguish between two time horizons. Short-run aggregate supply (SRAS) is the output supplied in a period in which the prices of factors of production have not had time to adjust to changes in aggregate demand and the price level. Long-run aggregate supply (LRAS) is the output supplied once the prices of factors of production have fully adjusted.

The short-run aggregate supply curve

The SRAS curve (see Figure 17.5) slopes upwards from left to right: as the price level rises, producers are willing and able to supply more goods and services. Three reasons explain this positive relationship:

1. The profit effect — as output prices rise but input prices such as wages remain unchanged in the short run, the gap between selling prices and factor costs widens, raising profits and encouraging more production.
2. The cost effect — even with input prices fixed along an SRAS curve, average cost tends to rise as output expands, because firms have to pay overtime, recruit additional workers, and so on. Higher prices are needed to cover these extra unit costs.
3. The misinterpretation effect — producers may confuse a general rise in the price level with a rise in their own product's relative price, and so raise output thinking that demand for their particular product has risen.

Shifts in the short-run aggregate supply curve

A change in the price level produces a movement along the SRAS curve. There are four main causes of a shift in SRAS:

1. A change in the price of factors of production — a rise in wage rates not matched by higher productivity, or a rise in raw material costs, shifts SRAS to the left.
2. A change in taxes on firms — a reduction in corporation tax or in indirect taxes shifts SRAS to the right.
3. A change in factor productivity or quality of resources — a rise in labour or capital productivity raises aggregate supply in both the short run and the long run.
4. A change in the quantity of resources — in the short run, supply of inputs can be hit by supply-side shocks such as natural disasters. Such shocks may not have a large impact on productive potential in the long run, but the factors that raise the quantity of resources in the long run will also raise SRAS.

The shape of the long-run aggregate supply curve

The LRAS curve shows the relationship between real GDP and the price level once input prices have had time to adjust. There are two views of its shape.

The Keynesian view. Keynesians draw LRAS as perfectly elastic at low rates of output, then upward sloping over a range of output, and finally perfectly inelastic (see Figure 17.7). They emphasise that, in the long run, an economy can operate at any level of output and need not be at full capacity. When output and employment are low, firms can attract extra resources without raising their prices — for example, when unemployment is high the offer of a job can be enough to attract workers without a higher wage. As output rises further, firms experience shortages and start bidding up wages, raw material prices and the price of capital equipment. At the maximum output the economy can produce with existing resources, the LRAS curve becomes vertical.

The new classical view. New classical economists draw LRAS as a vertical line (see Figure 17.8), on the view that in the long run the economy will always operate at full capacity. A rise in aggregate demand may raise output in the short run by encouraging firms to make more intensive use of existing resources — overtime, longer running of capital equipment between maintenance — but this intensive use raises costs of production over time. The SRAS curve shifts back, and output returns to its long-run level at a higher price level.

The distinction between these two views is a useful evaluative point in answering questions such as 'discuss whether a rise in aggregate demand will cause inflation'. On a Keynesian LRAS, the effect on the price level depends on where the economy is operating; on a new classical LRAS, the long-run effect is entirely on prices, not output.

Shifts in the LRAS curve

Keynesian and new classical economists agree about what shifts LRAS: changes in the quantity and/or quality of resources. Both raise the productive potential of the economy.

Causes of an increase in the quantity of resources in the long run include:

• Net immigration of people of working age, which increases the labour force.
• A rise in the retirement age, which increases the labour force as life expectancy rises.
• More women entering the labour force; the female participation rate varies widely between countries.
• Net investment — when gross investment exceeds depreciation, the capital stock grows.
• Discovery of new resources such as new oil fields or gold mines.
• Land reclamation, which can add to a country's usable land area.

The two main causes of an increase in the quality of resources are:

1. Improved education and training, which raise the skills of workers and so raise labour productivity.
2. Advances in technology, which both reduce costs of production and increase productive capacity.

Practice — after §17.4LO 4.3.5 · P1 | 2022 | w Oct/Nov | V3 | Q21

ABCD

17.5Macroequilibrium and disequilibrium

The equilibrium level of output and the price level are determined where aggregate demand equals aggregate supply. Macroeconomic equilibrium is shown by the intersection of the AD and AS curves (see Figure 17.11).

If the price level is below the equilibrium level, total demand exceeds total supply: shortages push prices up until equilibrium is reached. If the price level is above the equilibrium level, some goods and services go unsold and firms cut their prices until equilibrium is restored.

Changes in AD and AS move the economy to a new macroeconomic position. The size and direction of the change, and the economy's initial position, all matter. If an economy is operating below but close to its productive potential, an increase in aggregate demand may raise output, employment and the price level. If it is operating with a great deal of spare capacity, the same increase may raise output and employment with little effect on the price level. If it is operating at or near full capacity, most of the increase may show up as a higher price level rather than higher output. Some variables — including investment, net immigration and government spending on education — shift both the AD and the AS curves.

Practice — after §17.5LO 4.3.7 · P1 | 2023 | s May/Jun | V1 | Q21

ABCD

End-of-chapter practice

Past-paper questions from CIE 9708. Pick A, B, C or D. Answers are saved on this device — press Download report (PDF) at the top to save them.

End-of-chapter Q1LO 4.3.5 · P1 | 2021 | s May/Jun | V1 | Q25

ABCD

End-of-chapter Q2LO 4.3.5 · P1 | 2020 | w Oct/Nov | V2 | Q25

ABCD

End-of-chapter Q3LO 4.3.7 · P1 | 2020 | s May/Jun | V1 | Q26

ABCD

End-of-chapter Q4LO 4.3.5 · P1 | 2019 | w Oct/Nov | V2 | Q24

ABCD

End-of-chapter Q5LO 4.3.4 · P3 | 2018 | w Oct/Nov | V2 | Q28

ABCD

End-of-chapter Q6LO 4.3.5 · P1 | 2022 | s May/Jun | V2 | Q19

ABCD