CHAPTER 8


AGGREGATE DEMAND AND AGGREGATE SUPPLY


















8.1 The Business (Trade) Cycle: Economic Fluctuations.


The economy tends to experience different trends. These can be categorised as the trade cycle and may feature boom, slump, recession and recovery


EXPANSION: A period of fast economic growth. Output is high due to increased demand, unemployment is low. Business confidence may be high leading to increased investment. Consumer confidence may lead to extra spending. This occurs when there is a positive growth of real GDP. Durin a Boom, the employment of resources increases and the general price levels of Economy begins to rise faster than before. An Increase in the general price level is known as INFLATION.

PEAK: Is the maximum level of real GDP, it marks the end of expansion. Here, unemployment of resources has fallen substantially and inflation may be rising rapidly. Economy is likely to be experiencing inflation.

CONTRACTION: A period when output slows down due to a reduction in demand. Confidence may begin to suffer. During a contraction, economy begins to experience falling real GDP (there is a negative growth) shown by the downward-sloping parts of the curve. If it lasts 6 or more months, it is termed as a RECESSION (the falling real GDP and growth unemployment of resources). Increases in inflation may slow down considerably, and it is possible that prices in some sectors may begin to fall. This is not always the case, sometimes it may be joined by increasing price levels or inflation.

RECESSION: A period where economic growth slows down and the level of output may actually decrease. Unemployment is likely to increase. Firms may lose confidence and reduce investment. Individuals may save rather than spend. A recession is the falling reall GDP and groeth unemployment of resources.

TROUGH: A period when the economy moves between recession and a expansion. Is the minimum level of GDP, the end of a contraction. It may be widespread of unemployment. Followed by a new period of expansion (also known as recovery).

NOTE: Expansions usually last longer than contractions.

WHAT HAPPENS IN AN EXPANSION?

- Businesses produce more goods
- Businesses invest in more machinery
- Consumers spend more money. There is a FEELGOOD FACTOR
- Less money is spent by the Government on unemployment benefits
- More money is collected by the Government in income tax and VAT
- Prices tend to increase due to extra demand (page)

WHAT HAPPENS IN A CONTRACTION?

- Businesses cut back on production
- Some businesses may go bankrupt
- Consumers spend less money. Fall in FEELGOOD FACTOR
- Individuals may lose their jobs
- More money is spent by the Govt on unemployment benefits
- Less money is collected by the Govt in income tax and VAT
- Prices start to fall


BUSINESS TRADE CYCLE:

Business_trade_cycle.png



OBJECTIVES OF MACROECONOMICS:

-Revolves around the business cycle, it looks for minimizing the slumps and recovery. If the recovery goes beyond potential output, it would result in inflation. In the other hand, if the slumps goes below potential output it results in recession (if it last more than 6 months).
- Increase the steepness of the business cycle line. This means that the more vertical the line gets a more rapid economic growth occurs.

8.2 The AD-AS Curves.


adgraph.gif



Aggregate Demand is defined as the total number of goods and services that consumers are willing to buy in an economy, ceteris paribvs. Unlike in microeconomy where consumers' demand where the only factor taken into account, in macroeconomy, aggregate demand includes consumers, firms, government and exports minus imports. The Aggregate Demand (AD) represents an inverse relationship when prices increases, quantity demanded (real GDP) decreases, and when prices decreases, quantity demanded increases. A movement along the AD curve is caused only by a change in price. Therefore, the only factor that affects demand is price.

A shift in the demand curve means that any determinant of demand has caused a leftward or rightward shift in the AD. The four components of spending that causes a shift in the AD are consumers, investment, government, and export minus import.


The following are some cases where a determinant of demand shifts the whole AD graph:

1. Consumers become optimistic about future conditions in the economy.


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The aggregate demand shifts to the right due to consumers´ high expectancy about the future of their economy.


2. The central bank decides to increase interest rates.


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In this case, both consumers and firms would be affected. Their AD will decrease because they will be paying more money in interest instead of expenditure.

3. A non-governmental organization (NGO) introduces a program that provides credit to small farmers.


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The AD increases because new, small firms are able to enter to the market, therefore they begin to invest, and increase the quantity demanded


Aggregate supply: is the total quantity of goods and services produced in an economy at different price levels, ceteris paribus.

SHORT RUN IN MACROECONOMICS:
  • Period of time in which nominal prices of resources, mainly wages do not change in response to changes in the price level.
  • Resource prices can therefore be stated as constant.
LONG RUN IN MACROECONOMICS:
  • Period of time in which nominal prices of resources including wages change in response to changes in price level.
DIFFERENCES BETWEEN THE SHORT RUN AND THE LONG RUN IN MACROECONOMICS:
  • In the short run wages are constant
  • In the long run wages changes in response to changes in the price level.

FACTORS THAT CAUSES WAGES TO BE INFLEXIBLE:
  • Ideas of fairness may dictate the level of wages.
  • Workers and labour (trade) unions resist wage cuts.
  • Labour contracts fix wage rates for certain periods of time (a year, or two or more).
  • Wage cuts have negative impacts on worker morale, causing firms to avoid them.
  • Minimum wage legislation fixes the lowest legally permission wage.
  • In the graph we can see there is a positive (direct) relationship between price level and real GDP supplied
  • A higher price level is associated with a greater quantity of real GDP.
  • A lower price level with a lower quantity of real GDP.

The relationship is based on firm profitability ( when there is an increase in price level output prices have increased); but with nominal resource prices (mainly wages) firms’ profits increase.
the_upward-sloping_SRAS_curve.png

A falling price level means a falling output prices. Constant nominal wages = firm profitability falls and output decreases.
  • A rightward shift means that a short-run AS increases for any price level. The firm produces more real GDP.
  • A leftward shift means that AS decreases for any price level. The firm produces less real GDP.

8.3 Macroeconomic controversies: Neoclassical Economy

Shifts_in_the_SRAS_curve.png

FACTORS THAT CAN CAUSE SRAS CURVE SHIFTS:
  • Changes in non- labour resource prices.
  • Changes in business taxes.
  • Changes in subsidies offered to businesses.
  • Supply shocks (sudden events impacting on short-run AS.

During short periods of time the SRAS curve tends to shift as a result of factors that influence firms’ costs of production, as well as supply shocks.

8.4 Macroeconomic controversies: the Keynesian perspective


The Keynesian perspective is based on the basis of John Maynard Keynes’ work. He argued that economy cannot always automatically self-correct as classical economy stated.
The Keynesian believed there is a “symmetry between wage movement in the upward and downward direction”. This is why neoclassical perspective differ with Keynesian because neoclassical argue that all resources and product prices are flexible. During inflation, Keynesian argues that wages began to increase rapidly. Nonetheless during a recession, wages and product prices do not decrease because there are other factors that affect the AD. On the other hand, neoclassical believed that price level will fall.
Based on Keynesian perspective, they argue that the economy can be “stuck” in the short run. This happens when Aggregate Demand decreases, but the prices level instead of decreasing states the same. This would create that the economy will not be able to get out of recession because price level cannot fall. This situation gives the shape to the “Keynesian Curve”. The shape means that the economy may get “stuck” if the government does not intervene.

keynesian.pngfig.8.13 b

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The graph shows AD shifting along with the AS curve, so the economy in this case continues to be in a position of full employment equilibrium as it grows (though it is not necessary that the AD curve will always increase along with the AS curve).


As we may remember, in the short run, as AD shifts to the right, there will result some increase in real GDP as well as an increase in price level.
In long run, increases in aggregate demand give rise only to increases in the price level, while leaving real GDP unaffected.
In the Keynesian perspective, when the economy is in the horizontal range of the AS curve, increases in aggregate demand lead to increases in real GDP without affecting the price level.

8.5 Some Final Observations:


In the Neoclassical persepective, if the governement pursues policies to influence aggregate demand, in the short run these may intensify the business cycle (making inflatory and recessionary gaps larger); in the long run they will only result in changes in the price leve.
What governments should do is:
  • Encourage competition: Resource and output prices will respond to the forces of supply and demand: this allows the economy to automatically correct short-run inflationary and recessionary gaps.
  • Adopt policies that influence the supply side of the economy: This policy shifts the LRAS curve to the right, achieving long-run economic growth.


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In the Keynesian perspective, government policies are imperative in order to deal with the short-run term fluctuations of the business cycle to influence aggregate demand.

Particularly when economi is in a less than full employment equilibrium (inflatory or recessionary gap), government must intervene with policies that will increase aggregate demand, as otherwise the economy will remain stuck at low levels of real GDP and high unemployment over long periods of time.

Efforts should be made to shift the AD curve to the right, until it intersects the Keynesian AS curve at full employment real GDP. It is only in the upward- sloping and vertical portions of the Keynesian AS curve that further increases in aggregate demand become inflationary. (See fig 8.13 b).