4.

Aggregate Demand & Supply

Aggregate Demand
Thus far we have studied the macroeconomic concepts of consumption and
investment and their role in the Keynesian model. These concepts are part of
what Keynes called aggregate demand. Aggregate demand is defined as the
call on or demand for the use of societys resources. The aggregate demand
schedule shows the total quantity of goods and services that will be
demanded or purchased by society at different price levels.
We have already covered some of the components of aggregate demand and
their determinants: namely consumption and investment. Aggregate demand
also includes government spending and net exports which is the difference
between exports and imports!.
Government Expenditure
We now need to introduce government expenditure by the government
sector. We "now from our study of the circular flow of income that there are
three levels of government in Australia all of which have various
responsibilities that require the expenditure of money. #ach of these
governments has a budget which is a plan of income taxation! and
expenditure for the year ahead.
Keynes assumed that government expenditure $! was autonomous and
independent on the level of income. $overnment expenditure is set by
government policy and not determined by the level of income. Keynes also
assumed that governments could change the level of government
expenditure to influence the level of economic activity. %n addition
government expenditure is &ust li"e investment spending by firms in that it
can set off a multiplier process.
%n the four sector Keynesian model aggregate demand A'! is equal to the
level of consumption plus investment plus government expenditure.
AD = C + I + G
As a result of the assumption that government expenditure is autonomous it
can be added to the ( ) % line to form the ( ) % ) $ line which is used to
calculate four sector equilibrium. This new line will be parallel to the
*
consumption function and will rise above the ( ) % line by the amount of
government expenditure.
Keynes also added a +, degree line which shows all the points where output
or national income is equal to expenditure. This reference line can be used to
determine if aggregate demand or spending is above or below -ational
%ncome. This is an important point which we will refer to later.
Net Exports
.p until this point in our Keynesian model we have assumed that we have a
closed economy. A closed economy is one that does not trade with the rest of
the world. This is an unrealistic assumption as clearly all countries have
some international trade with the overseas sector. When an economy trades
with an overseas sector it is called an open economy.
Trade with the overseas sector involves selling exports /! and buying
imports 0!. #xports are locally made goods that sold to the overseas sector.
#xports generate incomes for the economy and stimulate economic activity.
Keynes regarded exports as being dependent on foreign incomes. This meant
that they were autonomous of domestic incomes. %mports are goods made
overseas which are sold in Australia. 1pending on imports subtracts from
economic activity in Australia.
The net difference between exports and imports is the net effect of the
overseas sector or international trade on the economy. Keynes called this net
exports.
Net Exports = ! "
2inally we can calculate the equation for aggregate demand in the domestic
economy. Aggregate demand is the sum total of all spending on the above
components.
AD = C + I + G + # ! "$
The aggregate demand equation and line is used in the diagrams that follow.
3
Aggregate Supply
Aggregate supply is a schedule or curve that shows the total quantity of
goods and services that will be supplied produced! at different price levels.
This is an indication of the real domestic output that will be produced at
each possible price level.
The aggregate supply schedule has three distinct phases:
%. &eynesian 'ori(ontal: Keynes assumed that at low levels of output there
would be large amounts of idle machinery and unemployed wor"ers. These
idle resources could easily be put bac" to wor" with little or no upward
pressure on the price level. Thus as output increases there is no upward
movement in prices at this stage.
). Intermediate *ange: %n this stage the expansion of real output is
accompanied by a rising price level. The economy is composed of a number
of product and resource mar"ets that dont reach full employment
simultaneously. As real output some industries reach full capacity and
resources become scarce. 4ess efficient and higher cost resources have to be
used to increase supply. This can only be done with higher prices. 5ther
industries continue to have idle resources and no price increase. 5verall
prices start to increase gradually in the economy.
+. Classi,al -erti,al: All economies have a maximum output possible
depending upon the availability of resources. This output level is called the
full employment level of income. 5utput cant be extended beyond this
point. Any further increase in the price level will fail to bring forth any
further increase in supply.
6
%n the above diagram the Keynesian idle capacity stage extends to output 78
and the price level remains constant at ,8. 9etween output levels 78 : *88
the economy experiences the intermediate stage with the price level
increasing to ;8. The full employment level of income for this economy is
*88. At this point further price increases cause no increase in aggregate
supply. This is the classical stage.
Determinants o. Aggregate Supply
Domesti, *esour,e Availa/ility
An increase in the availability of domestic resources would lower input costs
which would result in lower production costs. This would motivate firms to
increase aggregate supply. 0ore land resources could become available with
the discovery of natural resources and minerals. 2ewer domestic resources
would have the opposite effect and reduce aggregate supply. The loss of
agricultural land due to drought or salinity would be an example of this.
The availability of labour resources could change with immigration policies.
An increase in the supply of s"illed labour would reduce input costs and
increase aggregate supply. 1hortages of s"illed wor"ers would have the
opposite effect. Wage costs are another important factor. <igher average
wages would increase input costs and reduce aggregate supply.
%f society is able to save more and direct funds into capital formation then
this would increase aggregates supply. 9etter quality capital goods will
improve efficiency and productivity and reduce input costs. This means that
aggregate supply can increase. %mprovements in technology that come from
spending on research and development are also important in improving the
quality of the capital stoc".
%mported resources can add to a countrys productive capacity. The
availability of cheap resources internationally= whether it be cheap labour in
developing countries or budget priced capital goods from newly
industriali>ing countries= the effect is lower input costs in increased
aggregate supply.
0rodu,tivity
?roductivity is determined by comparing real output with the level of inputs
into the production process. ?roductivity @ real output A input. An increase in
productivity means that more domestic output can be obtained in the same
+
time period and therefore aggregate supply can increase. ?roductivity also
increases efficiency and reduces cost.
*egulation & 1axation
$overnments often impose regulations on firms to achieve social ob&ectives
li"e equity or reduced pollution. %f such costs increase input costs for firms
then aggregate supply will decrease. %f governments introduce deregulation
and use industry codes of conduct= this may reduce input costs for firms and
increase aggregate supply.
All governments impose taxes to raise revenue. %ncreased taxes will increase
input costs for firms and reduce aggregate supply. Tax concessions for firms
will reduce costs and increase supply. $overnments provide firms with a
variety of assistance including subsidies and tax concessions for capital
expenditure. All such assistance will increase aggregate supply.
E2uili/rium *eal 3utput
The intersection of the aggregate demand and aggregate supply schedules
determines the equilibrium real domestic output and the equilibrium price
level. An equilibrium point is where aggregate demand and aggregate supply
are equal and there is no tendency to change. %t is a stable resting place for
the economy. (hanges in the determinants of aggregate demand and supply
will cause the curve to shift and the equilibrium real output and price level to
change. %f the intersection or equilibrium point occurs in the Keynesian
hori>ontal stage of the aggregate supply curve and it may be possible to
increase real output without increasing the price level.
,
%n this case there would be unemployed or idle resources in society and
aggregate demand would need to increase to increase production such that
the full employment level of income can be achieved. 1hortly we will refer
to this as a deflationary or recessionary gap. The solution requires
government to increase the level of aggregate demand.
%f aggregate demand cuts aggregate supply in the intermediate stage then a
modest increase in the price level would occur. As aggregate demand
increases from A'* to A'3 the price level increases from ,8 to B8 The main
reason for this is that some shortages of inputs would occur and competition
between firms would increase input costs which causes the price level to
increase.
%f aggregate demand were to cut aggregate supply in the vertical classical
stage all that would occur is an increase in the general price level which is
called inflation. The economy does not have sufficient resources to satisfy
this level of aggregate demand because the full employment level of income
is currently *88 billion. 1hortly we will refer to this as an inflationary gap.
The solution requires government to reduce the level of aggregate demand or
increase aggregate supply.
7
As a result of an increase in aggregate demand from A'* to A'3 the price
level has increased from B8 to *88. 2urther increases in aggregate demand
will simply can a higher price level and inflation. This is also called the
ratchet effect and the type of inflation is called demand pull.
De.lationary Gap
#ach and every economy has an optimal output which can be calculated
according to the resources that it possesses. Keynes called this output level
the full employment level of income. Keynes assumed that this output level
was fairly stable and changed gradually over time as the economy increased
its resources.
%n contrast Keynes assumed that the level of aggregate demand fluctuates
according to the various determinants of consumption and investment as
well as the level of government expenditure and changes to net exports. %t is
aggregate demand that needs to change to suit the needs of the economy. %f
aggregate demand is deficient a deflationary gap was said to occur.
#conomists use the word deflation to describe economic conditions where
the level of aggregate demand is low and there are low levels of economic
activity. 1uch periods are also called recessions or depressions and are the
low points in the trade cycle. Keynes thought that such events were caused
by a deflationary gap.
B
A deflationary gap can be shown on the following diagram.
The aggregate demand line is upward sloping in this diagram because as
-ational %ncome increases then there is more expenditure. The +, degree
line shows the level of income at each output level. $aps between the
aggregate demand line and the +, degree line can be used to determine if
aggregate demand is excessive or insufficient.
The economy is always assumed to be trying to operate at the full
employment level of income. %n the above diagram lets assume that the full
employment level of income *388 Cbillion. Aggregate demand would need
to be *388 Cbillion to ensure that all resources were fully employed. %nstead
aggregate demand is only **88 Cbillion which is insufficient to ensure full
employment of all resources. The gap between the aggregate demand line
and the +, degree line at income *388 Cbillion is called a deflationary gap.
Keynes assumed that the economy would find a stable resting place at this
level of output and the government needed to stimulate aggregate demand to
close a deflationary gap.
In.lationary Gap
%f the determinants of consumption or investment change and the level of
aggregate demand increase= it may rise beyond the level necessary to
achieve equilibrium at the full employment level of income. %f this happens
an inflationary gap will be created. The economy is unable to meet this level
of demand if it is beyond the full employment capacity. 9oom periods and
;
the problems that they cause were thought to be the result of an inflationary
gap. An inflationary gap can be shown in the following diagram.
%f we assume that the full employment level of income is ;88 Cbillion= then
the economy would need ;88 Cbillion of aggregate demand to maintain full
employment. At the full employment level of income the level of aggregate
demand is *888 Cbillion which is excessive. This gap between the level of
aggregate demand required and the actual level is called an inflationary gap.
#xam Duestions
0ultiple (hoice Duestions
*. The maximum possible output that can be produced by an economy is
called:
a! The equilibrium level of income.
b! 5ptimal output.
c! The full employment level of income.
d! #quilibrium.
3. %f an inflationary gap exists then:
a! The full employment level of income is greater then the equilibrium level
of income.
b! The full employment level of income is equal to the equilibrium level of
income.
c! The full employment level of income is less than the equilibrium level of
income.
d! Any of the above.
E
6. %f a deflationary gap exists then:
a! The full employment level of income is greater then the equilibrium level
of income.
b! The full employment level of income is equal to the equilibrium level of
income.
c! The full employment level of income is less than the equilibrium level of
income.
d! Any of the above.
+. %f the government has successfully closed an inflationary gap then:
a! The full employment level of income is greater then the equilibrium level
of income.
b! The full employment level of income is equal to the equilibrium level of
income.
c! The full employment level of income is less than the equilibrium level of
income.
d! Any of the above.
1hort Answer
*. 'efine the following terms: aggregate supply= aggregate demand=
deflation= inflation.
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3. #xplain the meaning of the term Gfull employment level of incomeH.
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*8
6. <ow can a government eliminate deflationI
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#xtended Jesponse
'o4 ,an a government ,lose an in.lationary gap5 6se diagrams.
Jule *: 'efine the terms in the question: %nflationary gap
Jule 3: %dentify K define related concepts: #quilibrium level of income= full
employment level of income= and aggregate demand.
Jule 6: 4in" introduced terms to the question: At the full employment level
of income the level of aggregate demand is excessive.
Jule ,: 'raw relevant diagrams: %nflationary gap diagram.
Jule 7: Text reference to diagram in your answer: An inflationary gap exists
between points A K 9 in diagram *.
Jule +: 'raw logical conclusions: An inflationary gap can be closed if a
government reduces the level of aggregate demand.
**