UNIT 4 AGGREGATE DEMAND & AGGREGATE SUPPLY IN THE MARKET ECONOMY

AGGREGATE DEMAND : Aggregate Demand is the total amount that all consumers, business, firms, government agencies and foreigners wish to spend on final goods and services. The actual numerical value of aggregate demand depends on the price level and a variety of other factors such as consumers income, government policies to some extent the events in foreign countries. COMPONENTS OF AGGREGATE DEMAND : AGGREGATE DEMAND = C + I + G + ( X IM) CONSUMER EXPENDITURE (C) is the total amount spent by consumers on newly produced goods and services (excluding purchases of new homes). INVESTMENT SPENDING (I) is the sum of the expenditures of business firms on new plant and equipment and households on new homes. Financial investment are not included. GOVERNMENT PRUCHASES (G) refer to the goods such as planes or paper clips) and services purchases by all levels of government . NET EXPORTS ( X IM) is the difference between exports (X) and imports (IM). It indicates the difference between what is exported and what is imported. AGGREGATE SUPPLY : Aggregate Supply is the total quantity of goods and services that all the nations businesses are willing to produce for each possible price level during a specified period of time, holding all other determinants of aggregate quantity supplied constant.

VARIABLES THAT SHIFT THE AGGREGATE DEMAND CURVE

P r i c e L e v e l

AD
1

AD
2

Real GDP

Figure 1 shows the decrease in the Aggregate Demand (Shift of AD curve to the left side/inwards 1. Interest Rates: Higher interest rate raise the cost to firms and households of borrowing, reducing consumption and investment spending (Figure 1) 2. Personal income taxes or business taxes: Consumption spending falls when personal taxes rise and investment falls when business taxes rise. 3. Growth rate of domestic GDP relative to the growth rate of foreign GDP: Exports will fall reducing net exports. 4. The exports rate (the value of the dollar) relative to foreign currencies: Imports will rise and exports will fall reducing net exports.

P r i c e\ L e v e l
Real GDP

AD AD
1 2

Figure 2 shows the decrease in the Aggregate Demand (Shift of AD curve to the right side/outwards 1. Government purchases (G) is a component of AD. 2. Households expectations of their future income: Consumption spending increases. 3. Firms expectations of the future profitability of investment spending: Investment spending increases. DETERMINENTS OF CONSUMER SPENDING: Wealth and income. Consumer spending. Government policy eg. interest rates, taxation. Consumer indebtness. Hire purchase and credit facilities.

Age distribution of population.

REASONS FOR DOWNWARD SLOPING DEMAND CURVE: Open economy effect. Real balance effect. Interest rates. DISTINCTION BETWEEN SHORT-RUN AND LONG-RUN Short-run is a time period when some inputs such as plant size cannot be changed. Long run is a time period in which all factors can be varied. AGGREGATE DEMAND AND AGGREGATE SUPPLY

INFLATIONARY AND RECESSIONARY GAPS USING AD AND AS CURVES Inflationary gap is the amount by which the equilibrium level real GDP exceeds the full employment level of GDP. In the figure 1, the real GDP is at $4,000 while the equilibrium level is at $5,000. The inflationary gap of $1,000 exists in this figure.

P r i c e L e v e l 10 0

Potential GDP AS

AD
Inflationa ry Gap

Fig.1

400 0

500 0 Real GDP

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Recessionary gap is the amount by which equilibrium level of real GDP falls short of potential GDP. In the figure 2, the full-employment of output is at $6,000 where as the equilibrium is at $5,000 indicating a recessionary gap of $1,000.

P r i c e L e v e l 10 0

Potential GDP AS

AD
Recession ary Gap

Fig. 2

500 600 0 0 Real GDP