LESSON 7
equipment, facilities, and raw materials.
LESSON:
 AGGREGATE DEMAND AND
AGGREGATE SUPPLY
 INFLUENCE OF MONETARY AND
FISCAL POLICY ON AGGREGATE
DEMAND
Aggregate Demand
 a measurement of the total amount
of demand for all finished goods and
services produced in an economy.
 is commonly expressed as the total
amount of money exchanged for
those goods and services at a specific
price level and point in time.
Four (4) Aggregate Demand Components:
1.Consumption Spending - consumer
spending represents the demand by
individuals and households within the
economy. While there are several factors in
determining consumer demand, the most
important are consumer incomes and the
level of taxation.
2.Investment Spending -investment
spending represents businesses' investment
to support current output and increase
production capability. It may include
spending on new capital assets such as G = Government spending on public
goods and social services
(infrastructure, medicare, etc.)
3.Government Spending -government Nx = Net exports (exports minus
spending represents the demand produced imports)
by government programs, such as
infrastructure spending and public goods. Aggregate Demand Curve
This does not include services such as
Medicare or Social Security, because these
programs simply transfer demand from one
group to another.
4.Net Exports - net exports represent the
demand for foreign goods, as well as the
foreign demand for domestic goods. It is
calculated by subtracting the total value of a
country's exports from the total value of all
imports.
Blue – AD Curve
Light Blue – AS Curve
Aggregate Demand Formula
Like most typical demand curves, it slopes
The equation for aggregate demand adds
downward from left to right with goods and
the amount of consumer spending,
services on the horizontal X-axis and the
investment spending, government spending,
overall price level of the basket of goods and
and the net of exports and imports. The
services on the vertical Y-axis. Demand
formula is shown as follows:
increases or decreases along the curve as
prices for goods and services either increase
Aggregate Demand = C+I+G+Nx or decrease.
where: The aggregate demand curve is a curve that
C = Consumer spending on goods and shows the quantity of goods and services
services that households, firms, the government, and
I = Private investment and corporate customers abroad want to buy at each price
spending on non-final capital goods level.
(factories, equipment, etc.)
This means that, other things being equal, a
decrease in the economy’s overall level of
prices (P0) raises the quantity of goods and
services demanded (Y0). Conversely, an
increase in the price level reduces the
quantity of goods and services demanded.
What affects Aggregate Demand?
a. Interest Rates - interest rates affect
decisions made by consumers and
businesses. Lower interest rates will lower
the borrowing costs for big-ticket items such
as appliances, vehicles, and homes and
companies will be able to borrow at lower
rates, often leading to capital spending
increases. Higher interest rates increase the
cost of borrowing for consumers and
companies and spending tends to decline or
grow at a slower pace.
b. Income and Wealth - as household
wealth increases, aggregate demand
typically increases. Conversely, a decline in
wealth usually leads to lower aggregate
demand. When consumers are feeling good
about the economy, they tend to spend Aggregate Supply Curve
more and save less.
c. Inflation Expectations - consumers
who anticipate that inflation will increase, or
prices will rise tend to make immediate
purchases leading to rises in aggregate
demand. However, if consumers believe
prices will fall in the future, aggregate
demand typically falls.
d. Currency Exchange Rates - when the
value of the U.S. dollar falls, foreign goods
will become more expensive. Meanwhile,
goods manufactured in the U.S. will become
cheaper for foreign markets. Aggregate Blue – AD Curve
demand will, therefore, increase. When the Light Blue – AS Curve
value of the dollar increases, foreign goods
are cheaper and U.S. goods become more On the chart, the Y-axis represents the "Price
expensive to foreign markets, and aggregate Level" or "Inflation Rate," measuring the
demand decreases. overall price level of a basket of goods and
services. The X-axis, on the other hand,
signifies the "Real Gross Domestic Product
Aggregate Supply (GDP)" or the "Quantity of Goods and
Services." It displays the actual quantity of
 it represents the complete supply of goods and services an economy can
goods and services within a national produce. The upward-sloping curve on the
economy during a specific period, chart reveals the relationship between these
typically associated with a specific axes. It illustrates that as the price level
price level. It includes the consumer increases (along the Y-axis), businesses
products that individuals buy for become more willing to supply more goods
personal consumption. This is also and services (along the X-axis). In simpler
known as total output. terms, it shows how businesses respond to
changes in prices within the economy.

SHIFTERS OF AGGREGATE SUPPLY
1. Size and Quality of Labor: An increase in
the size and quality of the labor force, such
as a larger skilled workforce or improved
education and training, can enhance an
economy's production capacity, shifting the
aggregate supply curve to the right.
2. Technological Innovations: Technological
advancements can boost productivity and
efficiency, allowing businesses to produce
more with the same resources. This leads to
an increase in aggregate supply.
3. Increase in Wages: An increase in wages
can either encourage or discourage work. If
higher wages lead to more people entering
the workforce, it can increase aggregate
supply. However, if wages rise significantly
and businesses face increased labor costs, it
can reduce aggregate supply.
4. Increase in Production Costs: A rise in
production costs, such as higher raw
material prices or energy costs, can reduce
the profitability of production and lead to a
leftward shift in the aggregate supply curve.
5. Changes in Producer Taxes and Subsidies:
Changes in taxes on businesses or subsidies
offered to certain industries can affect
production costs. Higher taxes or reduced
subsidies can reduce aggregate supply, while
lower taxes or increased subsidies can
increase it.
6. Changes in Inflation: Inflation affects the
real purchasing power of money. High
inflation can distort pricing and lead to
uncertainty, which can affect businesses'
willingness to invest and produce, impacting
aggregate supply.
Two Categories of Aggregate
Supply:
1. Short-Run Aggregate Supply (SRAS):
The SRAS curve represents the total quantity
of goods and services that an economy can
produce in the short run. It typically slopes
upward and to the right, indicating that as
the overall price level in the economy
increases, the quantity of goods and services
supplied by firms also increases. The SRAS
curve can be influenced by factors like
changes in input prices (e.g., wages and raw
materials), technological shocks, and
expectations of future prices.
2. Long-Run Aggregate Supply (LRAS):
The LRAS curve represents the maximum
quantity of goods and services that an
economy can produce when all factors of
production are utilized efficiently. In the long
run, the LRAS curve is typically vertical
because it is not influenced by changes in the
overall price level. It is determined by factors
such as the economy's potential output, its
productive capacity, and the quantity and
quality of labor and capital.
What is Monetary Policy?
 is an economic policy that manages
the size and growth rate of the
money supply in an economy. It is a
powerful tool to regulate
macroeconomic variables such as
inflation and unemployment.
Central banks use monetary policy to
manage economic fluctuations and achieve
price stability, which means that inflation is
low and stable. Central banks in many
advanced economies set explicit inflation
targets.
Monetary Policies can be Expansionary or
Contractionary
 Expansionary Monetary Policy
This is a monetary policy that aims to
increase the money supply in the economy
by decreasing interest rates, purchasing
government securities by central banks, and
lowering the reserve requirements for
banks. An expansionary policy lowers
unemployment and stimulates business
activities and consumer spending.
 Contractionary Monetary Policy
The goal of a contractionary monetary policy
is to decrease the money supply in the
economy. It can be achieved by raising
interest rates, selling government bonds,
and increasing the reserve requirements for
banks. The contractionary policy is utilized
when the government wants to control
inflation levels.
The Main Monetary Policy
 Reserve requirements
restrict the amount of deposits banks can
use to make loans. When banks must keep
more cash in reserve, they are able to lend
less.
 The discount rate
is the interest rate, or cost, for a bank to
borrow reserves from the Fed. If the Fed
charges a lot for these loans, banks are less
likely to borrow and therefore less likely to
lend to customers.
 Interest on reserves
refers to the amount of money banks earn
by keeping reserves at the Fed. If they earn a
higher interest rate on those reserves, they
are less likely to use the reserves to make
loans to customers.
 Open market operations
involve buying or selling bonds in an effort
to manage the ratio of money to bonds held
by banks.
What is Fiscal Policy?
 is the use of public expenditure and
taxation to influence the economic
conditions, particularly
macroeconomic conditions. These
include employment, inflation,
economic expansion, and the total
demand for goods and services.
Economic conditions refer to the
present state of the economy in a
country or region.
 Governments employ fiscal policy
tools to have an impact on the
Expansionary Fiscal Policy
economy. These mostly consist of
adjustments to the tax and spending
rates. Taxes are decreased and
spending is increased to promote
growth. This frequently entails
borrowing through the issuance of
public debt. Taxes could be
increased, and spending cut down on
to cool a sweltering economy.
 The government may reduce tax
rates or boost spending during a
recession to boost demand and the
economy. On the other hand, it can
increase rates or reduce spending to
slow down the economy in order to
battle inflation.
 He (Keynes) contended that the
absence of the aggregate demand
components of corporate
investment and consumer spending
is what causes economic recessions.
 Keynes thought that by changing
spending and tax policies to account
for the shortcomings of the private
sector, governments could control
economic production and stabilize
the business cycle.
 Fiscal policy is said to be tight or
contractionary when revenue is
higher than spending (i.e., the
government budget is in surplus) and
loose or expansionary when
spending is higher than revenue (i.e.,
the budget is in deficit).
 lowers tax rates or increases
spending to increase aggregate
demand and fuel economic growth.
 A fiscal expansion's primary effect is
to increase consumer demand for
goods and services. As a result of the
 increased demand, both output and
prices rise.
 Higher demand affects output and
pricing to varying degrees,
depending on the business cycle's
stage.
 This strategy is justified by the idea
that when people pay less in taxes,
they have more money for spending
or investing, which increases
demand. Due to the increased
demand, businesses increase hiring,
which reduces unemployment and
intensifies the labor market
competitiveness. In turn, this helps
to increase salaries and give
customers more money to spend and
put away. It's a constructive
feedback loop or virtuous cycle.
 Another option is for the government
to increase spending (without
equivalent tax increases) in order to
stimulate the economy rather than
cut taxes. For instance, expanding
the transportation system may boost
jobs, driving up demand and growth.
 Spending deficits are typically a
characteristic of an expansionary
fiscal strategy. When spending
exceeds revenue from taxes and
other sources, there is a deficit. In
reality, tax cuts and increased
spending frequently result in deficit
spending.
Contractionary Fiscal Policy
 raises rates or cuts spending to
prevent or reduce inflation.
 A government can implement
contractionary fiscal policy in
response to rising inflation and other
expansionary indicators, possibly
even to the point of triggering a brief
recession in order to bring the
economic cycle back into balance.
 The government does this by
increasing taxes, reducing public
spending, and cutting public sector
pay or jobs.
 Where expansionary fiscal policy
involves spending deficits,
contractionary fiscal policy is
characterized by budget surpluses.
This policy is rarely used, however, as
it is hugely unpopular politically.
Influence of Fiscal Policy on Aggregate
Demand
There are two primary components in Fiscal
Policy, and these are Taxation and
Government spending.
The change in taxes made by the
government has an indirect effect on
aggregate demand because it is still based on
the decisions of firms and households
whether to spend or not. When the
government cuts personal income taxes, the
households’ disposable income increases.
The household will have this additional
income. The tendency is that they will spend
it on consumer goods, thus, resulting in the
rise of aggregate demand. But, when there is
an increase in taxes, the aggregate demand
will go down.
The change in government spending can
have a direct effect on aggregate demand.
An increase in government spending
stimulates aggregate demand, and causes
growth in the real GDP. That growth
generates jobs and more people can earn
income which sparks greater consumer
spending that increases the aggregate
demand. A decrease in government
spending decreases aggregate demand on
the other hand. Moreover, there are two
macroeconomic effects stated under
government purchases. These are the
Multiplier Effect and the Crowding-out
Effect. The multiplier effect refers to the
additional shifts in aggregate demand that
result when expansionary fiscal policy
increases income and thereby increases
consumer spending. This is where the
amount of money spent by the government
increases aggregate demand more than
what was spent. The formula for this is
Multiplier = 1/(1 - MPC). MPC is the marginal
propensity to consume, it is the fraction of
extra income that a household consumes
rather than saves. Thus, a larger MPC means
a larger multiplier in an economy.
Personal Income Tax - The individual income
tax (or personal income tax) is a tax levied on
the wages, salaries, dividends, interest, and
other income a person earns throughout the
year.
Disposable Income - Disposable income is
the money that is available from an
individual’s salary after he/she pays local,
state, and federal taxes.
Meanwhile, the crowding-out effect is an
economic theory that argues that rising
public sector spending drives down or even
eliminates private sector spending (Kenton,
2023). Government spending causes higher
interest rate, thus, reduces investment
spending. According to Kenton (2023), it
reduces aggregate demand because it
discourages spending and the demand for
borrowing due to higher interest rates and
reduced income.
Influence of Monetary Policy on Aggregate
Demand
Monetary Policy is enacted by central banks
by manipulating the money supply.
Influences aggregate demand in two ways,
either it can be Contractionary or
Expansionary.
-Money supply is the total of all of the
currency and other liquid assets in a
country's economy on the date measured.
In Contractionary or Tight monetary policy,
higher interest rates and a smaller pool of
loanable funds. It limits the money supply to
slow growth and decrease inflation that
would affect two components of aggregate
demand. Business investment will decline
because it is less attractive for firms to
borrow money, and even firms that have
money will notice the high-interest rates. It
would be much more beneficial to put those
funds in a financial investment than to invest
in physical capital investment. Another
aspect would be, it may discourage
consumers spending due to the rise in
interest rates that would indirectly affect
them and it would lead them to save more
of their income.
In loose or expansionary monetary policy, it
hints to lower interest rates and a higher
quality of loanable funds will tend to surge
business investment and consumer
borrowing for big-ticket items. During a
recession and high unemployment,
expansionary policy grows economic
activity, by lowering interest rates, saving
becomes less attractive, and consumer
spending as well as borrowing increases. In
some cases Net exports are affected by
expansionary monetary policy, it can
influence exchange rates. Government
Spending is not directly affected when
expansionary monetary policy occurs,
because mainly the only ones affected by it
are the private institutions.
Monetary Policy in the Philippines
The central bank or in the Philippines the
Bangko Sentral ng Pilipinas (BSP) has a
number of monetary policy instruments at
its disposal to promote price stability. To
increase or reduce liquidity in the financial
system and uses open market operations,
accepts fixed-term deposits, offers standing
facilities, and requires banking institutions to
hold reserves on deposits and deposit
substitutes.
Open Market Operations
Open market operations are a key
component of monetary policy
implementation. These consist of
repurchase and reverse repurchase
transactions, outright transactions, and
foreign exchange swaps.
Repurchase - the BSP buys government
securities from a bank with a commitment to
sell it back at a specified future date at a
predetermined rate. The BSP’s payment to
the bank increases the latter’s reserve
balances and has an expansionary effect on
liquidity.
Reverse repurchase transactions - the BSP
acts as the seller of government securities
and the bank’s payment has a contractionary
effect on liquidity
Liquidity - the ease with which an asset, or
security, can be converted into ready cash
without affecting its market price.
Acceptance of fixed-term deposits
The BSP accepts deposits from banks
through the form of a Special Deposit
Accounts (SDA) facility that consists of fixed-
term deposits by banks and by trust entities
of banks and non-bank financial institutions
with the BSP to expand its toolkit in liquidity
management.
Standing Facilities
The BSP extends discounts, loans, and
advances to banking institutions to influence
the volume of credit in the financial system.
Rediscounting is a standing credit facility
provided by the BSP to help banks meet
temporary liquidity needs by refinancing the
loans they extend to their clients. The
rediscounting facility allows a financial
institution to borrow money from the BSP
using promissory notes and other loan
papers of its borrowers as collateral.
There are two types of rediscounting
facilities available to qualified banks:
- the peso rediscounting facility
- the Exporters’ Dollar and Yen Rediscount
Facility (EDYRF)
Reserve Requirements
Reserve requirements refer to the
percentage of bank deposits and deposit
substitute liabilities that banks must keep on
hand or in deposits with the BSP and
therefore may not lend. Changes in reserve
requirements have a significant effect on
money supply in the banking system, making
them a powerful means of liquidity incomedistribution has shifted. Hence, one
management. of the goals of government policy is
tomaintain price level stability, which
implies avoiding inflation and deflation.
LESSON 8
Issue # 3. The Trade Cycle:
6 Major Macro-Economic Issues
It refers to the tendency for output (GNP)
Macroeconomics is a branch of economics
and employment to fluctuate over time in a
that studies how an entire economy—
recurring sequence of ups and downs. Good
markets, businesses, consumers, and
trade periods alternatewith bad trade
governments—behaves.
periods, or boom periods of high output and
high employmentalternate with slump
Macroeconomics studies economic
periods of low output and low employment.
phenomena such as inflation, price levels,
During boom times, employment is low, but
economic growth rate, national income,
inflation is high. During adepression (or
gross domestic product (GDP), and changes
recession), unemployment is high and
in unemployment.
inflation is moderate. Inmacroeconomics,
we investigate the causes of business cycles
Issue # 1.Employment and Unemployment:
and propose
solutions.
Unemployment is defined as the involuntary
idleness of resources, including labor. If this
Issue # 4. Stagflation:
problem exists, the actual output (or GNP) of
society will be less than its potential output.
Most modern mixed economies suffer from
As a result, one of the goals of government
stagflation, which ischaracterized by the
policy is to ensure full employment, which
coexistence of inflation and unemployment
means no involuntary unemployment of any
in a stagnanteconomy. The trade-off
kind.
between inflation and unemployment is
possibly today's most complex
Issue # 2. Inflation:
macroeconomic issue. Every country on the
planet is now working hard to combat the
It refers to a situation in which commodity
disease of stagflation.
and production factor prices areconstantly
rising. Deflation is the inverse of inflation.
Issue # 5. Economic Growth:
Some people benefit frominflation while the
majority suffer. As a result, the pattern of
Economic growth refers to the long-term
trend in the nation's total output.It also
refers to an increase in a society's
production capacity, such ascultivating new
land or establishing new factories. Growth is
represented by arightward shift in the
production possibility curve, which is
measured by theannual rate of increase in
per capita income.
There are three major sources of growth:
(1) The growth of the labour force,
(2) Capital formation and
(3) Technological progress.
A country seeks economic growth primarily
to raise the living standards of itscitizens. If
the rate of economic growth exceeds the
rate of population growth,the average
person's standard of living is likely to
improve.
Issue # 6. The Exchange Rate and the
Balance of Payments:
The balance of payments is a systematic
record of all economic transactions in an
accounting year between members of the
home country and the rest of the world. The
exchange rate has a significant, if not
complete, impact on these transactions. It is
the exchange rate at which a country's
economy is converted into another currency
(or gold).
Short Run Trade-Off between Inflation
and Unemployment: The
Phillips Curve
The short-run trade-off between inflation
and unemployment is an economic concept
that suggests a temporary balance between
the two economic variables. In the short run,
when unemployment is low, inflation is likely
to be high. In contrast, when inflation is low,
unemployment is high. This trade-off
exists because inflation and unemployment
are both directly and inversely
related. People have more money to spend
when unemployment is low, which drives up
prices and leads to inflation. When inflation
is high, people have less money to spend,
which causes prices to fall and leads to
unemployment.
In a 1958 study work, A. W. Phillips found a
statistically significant negative link between
the rate of change of money pay and the
unemployment rate. It was also
demonstrated that a similar negative
association exists between the rate of
change in prices (i.e., inflation) and the
degree of unemployment. The Phillips Curve
can explain this relationship.
Therefore, the Phillips curve depicts the
inverse relationship between the two
variables, can be used to illustrate the short-
run trade-off between inflation and
unemployment.
Zero rate of inflation can only be achieved
with a high positive rate of unemployment
of, say, 5 p.c., or near-full employment
situation can be attained only at the cost of
high rate of inflation.
Phillips Curve drawn in Fig. 11.8 shows that
as the unemployment level rises the rate of
inflation falls.
This Phillips Curve relation poses a dilemma
to the policy makers. If the objective of price
stability is to be attained, the country must
accept a high unemployment rate or if the
country designs to reduce unemployment, it
will have to sacrifice the objective of price
stability. The presence of a short-run trade-
off between inflation and unemployment is
critical to understanding how expectations
are generated
However, by the end of the 1960s, the stable
relationship between the two appeared to
be in jeopardy as unemployment, wages,
and prices all began to rise. In the late 1960s,
the empirical Phillips link between inflation
and
unemployment broke broken, coinciding
with new theoretical work, most notably by
M. Friedman (1968) and E.Phelps (1967)
argued that the simple Philips curve of the
1960s did not have a persistent trade-off
between inflation and unemployment.
In the mid-1960s, Milton Friedman and
Edmund Phelps disputed the idea of a
permanent inflation-unemployment trade-
off, arguing that the behavior of inflation
expectations, which are endogenous to the
structure of the economy, would render any
such trade-off ephemeral.
According to Friedman, such a trade-off—a
negative sloping Phillips Curve—can exist in
the short run but not in the long run.
Because the relationship between these two
macroeconomic variables is not stable, the
Phillips Curve may shift either upward or
downward in the short run. In the long run,
however, Friedman claims that there is no
trade-off between inflation and
unemployment.
unemployment required to achieve a certain
actual inflation rate. Phelps developed the
expectations-augmented Phillips curve.
Thus, the impact of expectations, whether
adaptive or rational, has a significant impact
on the relationship between inflation and
unemployment. Friedman contends that
there is no long-run trade-off between
inflation and
unemployment because of expectations.

People make incorrect price change

expectations in the short run due to
insufficient information. As a result, a trade-
off relationship emerges between the two
variables. However, in the long run, actual
and expected price changes become equal
as price change expectations become
rational. According to this rational
expectations viewpoint, people correctly
predict future economic events.

Phelps pointed out that present inflation is

influenced by both unemployment and
inflation expectations. This reliance stems
from the reality that salaries and prices are
only modified seldom. As a result, when
changes are made, they are based on
inflation estimates. The higher the expected
rate of inflation, the higher the