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Economics Stage 3: Unit 3B Chapter 10: Aggregate Demand and Supply

Aggregate Demand (AD) Curve

The Aggregate Demand Curve shows the relationship between the general price level and the quantity of real GDP demanded by each of the different sectors: Households (C) Firms (I) The government (G) Overseas sector (X-M) The reason for the negative gradient of the AD curve is: i. The income effect ii. The interest rate effect iii. The open economy effect The Income Effect

If price levels rise (the inflation rate rises) the purchasing power of your income or wealth falls this means that as the price level increases, the real purchasing power of your income falls Hence why the first reason for the AD to slope downwards is because a rise in the general price level of the economy decreases consumption spending by the households

The Interest Rate Effect

A rise in the general price will mean that households and firms need to demand more funds to finance their transactions by withdrawing money from bank, borrowing or selling financial assets such as bonds The rising demand for money drives interest rates upwards increasing the cost of borrowing and acts as a disincentive to spend Hence why a rise in the price level increase interest rates which reduced investment and consumption

Open Economy Effect

If the domestic price level (inflation) rises relative to other countries, domestic goods and services will become less competitive in those countries resulting a fall in exports However a rise in the domestic price level will mean that consumers and business firms will purchase more goods and services from foreign producers and less from the domestic producers spending on imports will increase while net exports decrease

Summary

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Economics Stage 3: Unit 3B Chapter 10: Aggregate Demand and Supply

A rise in the general price level will decrease total spending in the economy and cause a movement along the Aggregate Demand Curve A change in price affects three of the components of aggregate expenditure: consumption, investment and net exports

Shifts in the Aggregate Demand Curve

The AD curve can shift to the left or right if any non-price factor affecting spending were to change. Any factor other than the price level that can change any of the components of aggregate expenditure will about a shift in the entire AD curve

Shifts to the Right Shifts to the right in the aggregate demand curve are referred to as an increase in aggregate demand. Events that lead to a rightward shift of the AD curve are:

A rise in consumer confidence will increase household consumption causing the AD to increase and the AD curve to shift to the right A depreciation in the Australian dollar will reduce the number of imports consumed, while cause the number of exports sold to increase (export prices are reduced, import prices are increased), resulting in an increase in net exports shifting the AD curve to shift to the right and increasing the level of real GDP A rise in share prices cause an increase the wealth of households causing the AD curve to shift to the right A fall in interest rates acts as an incentive to spend, increasing consumption and investment leading to a shift in the AD curve to the right A reduction in government taxes will lead to an increase in household consumption shifting the AD curve to the right

Shifts to the Left Shifts to the left in the aggregate demand curve are referred to as a decrease in aggregate demand. Events that will cause a leftward shift of the AD curve are:

A fall in business confidence or a rise in interest rates will decrease investment causing a decrease in the AD curve causing the curve to shift to the left as real GDP is decreasing

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Economics Stage 3: Unit 3B Chapter 10: Aggregate Demand and Supply

An increase in government taxes will cause the AD curve to shift to the left An appreciation in the Australian dollar will increase the number of imports consumed, while the number of exports sold are reduced (import prices are reduced, export prices rise), resulting in a decrease in the net exports, shifting the AD curve to shift to the left, reducing the level of real GDP A decrease in government spending will result in the AD curve to shift to the left

Aggregate Supply (AS) Curve

The aggregate supply curve is the relationship between the total output of goods and services that producers are willing to produce and the general price level The reason for the short run aggregate supply curve being upward sloping: i. Suppliers will be more willing to produce a greater level of output at a high price level than at a lower price level a rise in the general price level will induce a greater quantity of real GDP in the short run ii. Real GDP rises leads to increases in production costs because resources such as labour and capital will be in short supply

Shifts in the Aggregate Supply Curve

Shifts in the short run aggregate supply curve are cause by factors that can affect the costs of production across the entire economy. For example, unexpected changes in the prices of producers inputs

Shifts to the Right

If the real wage level fell, the whole short run aggregate supply curve would shift to the right as real GDP rises this is referred to as an increase in aggregate supply An improvement in the state of the technology would enable the economys output to be produced at a lower coast. This would shift the short run aggregate supply curve to the right as real GDP rises An increase in the size of labour force or an improvement in labour productivity would shift the short run aggregate supply curve to the right as real GDP rises

Shifts to the Left

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Economics Stage 3: Unit 3B Chapter 10: Aggregate Demand and Supply

An increase in the price of an important input in the economy such as oil would increase production costs as all sectors are affected. The short run supply curve shifts to the left as the level of real GDP falls this is called a decrease in the short run aggregate supply

Macroeconomic Equilibrium

By combining the economys aggregate demand curve with the aggregate supply curve we can shows the economys equilibrium level of real GDP and the equilibrium price level

The AD/AS Model and the Business Cycle


Advantage

The advantage of using the AD/AS model is that all phases of the business cycle can be explained expansions and contractions and the associated macroeconomic problems of unemployment and inflation

Recession

A recession occurs when the rate of economic growth decreases the level of real GDP falls and unemployment increases above the natural rate.

The AD/AS model shows that a recession can occur for two reasons: i. a recession could be caused from either a decrease in the AD curve or; ii. a decrease in the short run aggregate supply

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