FA1314 Essentials of Economics

Aggregate Demand & Aggregate Supply

Monetary Policy & Fiscal Policy

Lesson
11 & 12
 Aggregate Demand & Aggregate Supply
01
Economic fluctuations and growth
Aggregate Demand and Aggregate Supply
Curves
Effect of a change in Aggregate Demand and
Outline Aggregate Supply

The Influence of Monetary and Fiscal Policy

02
Introduction of Monetary Policy (MP) and
Fiscal Policy (FP)
How MP and FP influences AD
Using MP and FP to stabilise the economy
 Business Cycle

We learned in Lesson 10
 Aggregate Demand & Aggregate Supply
01

Recession
a period of declining real
incomes and rising
unemployment, which is
relatively mild

Depression
a severe recession
ECONOMIC GROWTH
the sustained expansion of production
possibilities measured as the increase
in real GDP over a given period (Parkin,
Economic Growth 2012)
The growth rate of real GDP

Increases in real GDP over time

Improvements in prosperity over time

Economic growth occurs when real GDP increases. But a one-
shot increase in real GDP or a recovery from recession is not
economic growth.

The economic growth rate is the annual

percentage change of real GDP.

The economic growth rate tells us

how rapidly the total economy is
expanding.
Measuring Economic Growth Rate
 AD & AS
Economic
Fluctuations Are
Irregular and
01 Unpredictable

Most Macroeconomic As Output Falls,

Quantities Fluctuate Unemployment
Together 02 03 Rises

3 Key Facts about

Economic Fluctuations
AD & AS Explaining Short-Run Economic Fluctuations
Economists use the model of aggregate demand and aggregate supply to
analyse economic fluctuations.

The model of aggregate demand and aggregate supply

 AD & AS Explaining Short-Run Economic Fluctuations

Aggregate-demand
curve
A curve that shows the
Aggregate-supply quantity of goods and
curve services that
A curve that shows households, firms and
the quantity of the government want
goods and services to buy at any inflation
that firms choose to rate
produce and sell at
any inflation rate
The model of aggregate demand and aggregate supply
 The Aggregate-Demand Curve
AD
 The Aggregate-Demand Curve
AD

• A fall in the inflation rate from π1 to π2 increases the quantity of

goods and services demanded from Y1 to Y2 .
• There are three reasons for this negative relationship.
• As the inflation rate falls, real wealth rises, the BNM reduces
interest rates and the exchange rate depreciates.
• These effects stimulate spending on consumption, investment
and net exports.
• Increased spending on these components of output means a
larger quantity of goods and services demanded.
 The Aggregate-Demand Curve
AD
Why the Aggregate-Demand Curve Is Downward-Sloping

Depend on economic conditions and, in

particular, on the inflation rate.

The Wealth Effect

The Interest-Rate Effect

The Exchange-Rate Effect

 The Wealth Effect

When inflation falls, these dollars are more valuable because they can now
be used to buy more goods and services.

Thus, a decrease in the inflation rate makes consumers feel more wealthy,
which in turn encourages them to spend more.

The increase in consumer spending means a larger quantity of goods and

services demanded.
 The Interest-Rate Effect

If the BNM lowers interest rates this, in turn, encourages borrowing by

firms that want to invest in new plant and equipment and by households
who want to invest in new housing.

Thus, a lower inflation rate induces the BNM to reduce the interest rate,
which encourages greater spending on investment goods, and thereby
increases the quantity of goods and services demanded.
 The Exchange-Rate Effect

When a fall in the Malaysian inflation rate causes Malaysian interest

rates to fall, the real exchange rate depreciates, and this
depreciation stimulates Malaysian net exports and thereby
increases the quantity of goods and services demanded.
 Why the Aggregate-Demand Curve Is Downward-Sloping

Summary

Three distinct but related reasons that a fall in the inflation rate increases the
quantity of goods and services demanded:

1.Consumers feel wealthier, which stimulates the demand for consumption

goods
2.The BNM reduces interest rates, which stimulates the demand for
investment goods
3.The exchange rate depreciates, which stimulates the demand for net
exports.

For all three reasons, the aggregate-demand curve slopes downwards.

 The Aggregate-Supply Curve
AS

• The aggregate-supply curve tells us the quantity of goods

and services that firms produce and sell at any given inflation
rate.

• The relationship between the inflation rate and the quantity

supplied depends on the time horizon.

• In the long run, the aggregate-supply curve is vertical,

whereas in the short run, the aggregate-supply curve is
upward-sloping.
 The Aggregate-Supply Curve
AS
• In the long run, the quantity of
output supplied depends on the
economy’s quantities of capital
and labour and on the
technology for turning these
inputs into output.
• The quantity supplied does not
depend on the overall inflation
rate.
• As a result, the long-run
aggregate-supply curve is vertical
at the natural rate of output.
 The Aggregate-Supply Curve
AS
Why the Aggregate-Supply Curve Is Upward-Sloping in the Short
Run
• An increase in the overall
level of prices in the
economy tends to raise
the quantity of goods
and services supplied

• A decrease in the level of

prices tends to reduce
the quantity of goods
and services supplied.
 AD & AS

• The long-run equilibrium

of the economy is found
where the aggregate-
demand curve crosses
the long-run aggregate-
supply curve (point A).

The Long-Run Equilibrium

AD & AS Causes of Recession:
(1) A Contraction in Aggregate Demand
AD & AS Causes of Recession:
(2) An Adverse Shift in Aggregate Supply
 Aggregate Demand & Aggregate Supply
01
Economic fluctuations and growth
Aggregate Demand and Aggregate Supply
Curves
Effect of a change in Aggregate Demand and
Outline Aggregate Supply

The Influence of Monetary and Fiscal Policy

02
Introduction of Monetary Policy (MP) and
Fiscal Policy (FP)
How MP and FP influences AD
Using MP and FP to stabilise the economy
 The Influence of Monetary and Fiscal Policy on
Aggregate Demand 02
Monetary policy
The management by the central bank of liquidity
conditions in the economy
Monetary Policy How Monetary Policy Influences Aggregate Demand

Why the Aggregate-Demand Curve Is Downward-Sloping

The Wealth Effect

The most
The Interest-Rate Effect important
reason!
The Exchange-Rate Effect
Monetary Policy How Monetary Policy Influences Aggregate Demand

Monetary Policy Diagram

• The BNM monitors several
economic variables to determine
whether or not to change interest
rates.
• But its primary objective is to keep
inflation in the range of 2–3 per
cent.
• The inflation target was developed
to facilitate a stable financial
system and to assist with stable
economic growth.
 Monetary Policy

• An increase in the inflation

rate from π1 to π2 leads to the The Slope of the Aggregate-demand Curve
BNM increasing the interest
rate.
• Because the interest rate is
the cost of borrowing, the
increase in the interest rate
reduces the quantity of goods
and services demanded
from Y1 to Y2 .
• This negative relationship
between the inflation rate
and quantity demanded is
represented with a
downward-sloping aggregate-
demand curve.
Monetary Policy

2 Steps

A negative
01 i 02 AD relationship
between the
inflation rate
A higher inflation A higher interest rate reduces and the
rate induces the the quantity of goods and quantity of
BNM to increase services demanded. goods and
interest rates. services
demanded.
Fiscal Policy How Fiscal Policy Influences Aggregate Demand

Fiscal policy refers to the government’s choices regarding the overall

level of government purchases or taxes.

Fiscal policy influences saving, investment and growth in

the long run.

In the short run, however, the main

effect of fiscal policy is on the
aggregate demand for goods and
services.
Fiscal Policy

When the government changes its own purchases

of goods and services, it shifts the aggregate-
demand curve directly.
Inflationary Gap vs Deflationary Gap

Inflationary Gap Situations of

• Occurs when national disequilibrium
income exceeds the
full employment level. • May be due to an increase in
aggregate expenditure.
• Is measured as the excess of
Full employment is aggregate expenditure over full
achieved when a country’s employment aggregate supply.
resources are fully used
with maximum efficiency
Inflationary Gap vs Deflationary Gap

Deflationary Gap
• Occurs when national income is below the full
employment level.
• National income is not at full employment.
• Resources are not fully utilized.
• Measured as the difference between aggregate
expenditure and full employment aggregate supply.
 Expansionary fiscal policy

Expansionary fiscal policy is adopted to overcome

unemployment or recession problems.

During recession, the economy suffers from rising unemployment,

falling income and shrinking economic activity.

Expansionary fiscal policy refers to increases in government

spending or decreases in taxes or both, so that the net effect on
aggregate demand is an increase in net government spending.
Expansionary fiscal policy
Policy aimed at increasing
AD through increases in
government expenditures
and/or decreases in taxes to
achieve macroeconomic
goals.
Used when the economy is in
___________________.
Contractionary fiscal policy
Policy aimed at decreasing
AD through decreases in
government expenditures
and/or increases in taxes to
achieve macroeconomic
goals.
Used when the economy is in
___________________.
How government can use fiscal policy to solve
macroeconomic problem Example

• If the economy is experiencing an inflationary

gap → the government would undertake a
contractionary fiscal policy to solve this
problem.
• There will be a decrease in government
purchases or increase in taxes, or both.
How government can use fiscal policy to solve
macroeconomic problem Example

G T
• This will lead to a leftward
shift in the aggregate
demand curve from AD1 to
AD2, restoring the economy
to the natural level of Real
GDP, QN.
Question?
Class Exercise

• Using the aggregate demand and short-run aggregate

supply (AD-SRAS) model, illustrate the effect of each
of the following on the equilibrium price level and real
output:
(1) A decrease in interest rate
(2) An increase in income taxes