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AD & AS Analysis

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23 views7 pages

AD & AS Analysis

Uploaded by

Aarij Kashif
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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AGGREGATE DEMAND & SUPPLY

Aggregate means total whereas aggregate demand is the total spending on an


economy’s goods and services at a given price level in a given time period.
According to John Keynes, aggregate demand is an economic measurement of
the sum of all final goods and services produced in an economy, expressed as
the total amount of money exchanged for those goods and services.

AD = C + I + G + (X – M)
Where C : consumption
I : Investment
G : Govt. spending
X-M : net exports
Consumption is the responsibility of the households, investment is done by the
firms. Govt. spending is done by the govt. on public or merit goods whereas
the foreign sector is responsible for net exports.

The aggregate demand curve shows the different quantities of total demand
for the economy’s products at different price levels.

The AD curve is downward sloping and there are three major reasons for this.

1. Increased spending power

At a lower price level, consumers are likely to have a higher real income and
therefore they are able to spend more.

2. Increase in demand for exports

If there is a lower price level in a country, for example UK, UK goods will
become relatively more competitive, leading to higher exports. As exports are
a component of AD, therefore AD will be higher.
3. Lower interest rates

At a lower price level, interest rates usually fall and this causes the cost of
borrowing to decrease which will lead to an increase in consumption and
investment and hence there will be an increase in aggregate demand.

The shift in the AD curve will be due to changes in consumption, investment,


government spending and net exports, Examples of what could cause an
increase in AD include:

1. Factors affecting on consumption


• Wealth , consumption
• Income tax , consumption
• Age structure (young) , consumption
• Population , consumption
• Interest rate , consumption
• Range of goods and services on offer , consumption
• Availability of credit , consumption
• Expectation of future income , consumption

2. Factors affecting investment


• Technology improves, investment
• Cost of capital , investment
• Corporation tax , investment
• Subsidies , investment
• Expectation of future profit , investment
• Infrastructure improves, investment
• Interest rate , investment
• Foreign relations improve, investment
• Political stability improves, investment
• Demand for consumer goods, investment

3. Factors affecting govt. expenditure


• Economic objectives

If the govt. wants to achieve full employment, government spending will


increase. If the govt wants to achieve price stability government
spending will decrease.

• Economic activity

If the economy is going through a boom, govt spending will decrease


and vice versa.

• Social objectives

If the govt. wants to eradicate poverty and achieve equal distribution of


income, it will have to increase spending.

• Need for merit and demerit goods.

If there is a greater need for merit goods like healthcare and education
in the society and also for public goods like street lights etc.,
government spending will increase in the economy.

4. Factors affecting Net export (X-M)


• Foreign income , Net exports
• Domestic income , Net exports
• Relative quality of exports , Net exports
• Tariffs (protectionism) , Net exports
• Exchange rate , Net exports
Aggregate supply is the total supply of goods and services available to a
particular market from producers. It measures the volume of goods and
services produced each year. It represents the ability of an economy to deliver
goods and services to meet demand.

Short term aggregate supply curve shows the total output of an economy that
will be supplied in the short run. It slopes up from left to right as shown in the
figure.

Due to changes in the price level, there is a movement along the same curve in
the short run aggregate supply curve.

The shifts in the short run aggregate supply curve are due to:

1. A change in the price of factor of production or cost of production.


2. A change in taxes on firms
3. A change in the factor productivity or the quality of resources.
4. A change in the quantity of resources.
5. Interest rates
6. Government subsidies
Long run supply curve shows the relationship b/w real GDP and the price level.
When there has been time for input prices to adjust to changes in aggregate
demand.

Keynesians, the followers of John Keynes, are of the view that govt.
intervention is needed to achieve full employment. According to them LRAS
curve is initially perfectly elastic at lower output, then upward sloping over a
range of output and finally perfectly inelastic.

According to neo classical economists, LRAS curve is vertical and there is no


need for govt. to intervene and the economy will move towards full
employment w/o govt. intervention.

Overall, the equilibrium level of output or NY and the equilibrium price level
are determined when aggregate demand is equal to aggregate supply. The
macroeconomic equilibrium is shown by the point where AD and AS curves
intersect.
According to the figure, 𝐸1 is the equilibrium point where both
the AD and AS curves are equal to each other. At this point, the
equilibrium price is 𝑃0 and equilibrium level is 𝑌0.

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