Explaining the components of Aggregate Demand (C, I, G, X, M)
Explaining the curve of Aggregate Supply
short-run slopes and output
Long-run (Keynesian vs. neo-classical approach)
Describing when and where the full employment level of national income occurs.
Showing the equilibrium level of national income on a AD/AS model
Illustrating the Inflationary or Deflationary gap using an AS/AD model
Explaining a diagram illustrating the trade/business cycle
Changes in these components can change the overall level of aggregate demand Eg. increase in investment increases stock of capital goods, these help produce other goods which leads to increased economic activity in the long term. The components of Aggregate Demand are shown in the expenditure approach. C + I + G + ( X – M) = GDP = AD Consumer Spending – C Investment – I Government Spending – G Export Receipts – X Import Payments – M
You can create a mind map or table to show your understanding of these changes
Revision Matchup Game
Component of AD? AD decreases? AD increases? Increased consumer confidence in the future Increases in the price of imports due to exchange rates Government increases the Minimum Wage Central bank increases interest rates Government reduces core spending to avoid a deficit. Indirect taxation on consumer goods is increased from 7-10% Business survey predicts lack of confidence in the future of the economy.
Output can increase without any additional costs (elastic)
Level of output is approaching potential capacity of the economy. Costs begin to increase due to scarcity, any increase in output results in higher price levels.
All factors of production are fully utilized. Potential capacity reached. Perfectly inelastic curve.
All factors of production are fully utilized Average Price Level (P L ) LR AS P 2 1 Y Full P 1 2 3
Price Level (P L ) Y 1 SRAS 1 SRAS 2 AD 1 AD 2 What happens….. AD increases – leads to increased prices, purchasing power of worker wages falls Workers demand higher wages to maintain purchasing power. Cost of production for the firm increase therefore SR AS shifts to left – Price level rises, no change in output.
Price Level (P L ) LRAS SRAS 0 Y Full SRAS 1 SRAS 2 A B C D E As output increases and prices rise in SR this causes movement along the curve (A – B) Workers realise that prices are increasing so demand higher wages to maintain purchasing power. So SRAS 1 shifts upwards. Again firms attempt to increase output and increase prices in the SR. In the LR the prices will rise as output returns back to Y 0 Potential output of the economy depends on productivity (the quality and quantity of factors of production)
Price Level (P L ) LRAS Y Full Neo classical economists argue that in the long run the economy will automatically shift to its long run equilibrium. In the Long Run an increase in AD will lead to an increase in the price level but no change to the equilibrium level of output. AD 1 AD 2
Price Level (P L ) LRAS Y F SRAS 1 SRAS 2 If there is a change in AD 1 to AD 2 due to changes in the components of AD then in the short run there will be an increase in output from Y F to Y 1 According to neo classicists this is only possible in the SR by paying workers overtime wages to attain Y 1 In the long run there is no unemployed resources, so the prices of all resources will increase due to scarcity. Remember in the short run this leads to an increase in the costs of production which shifts the SRAS curve to the left. LR equilibrium is back to Y F but higher Price level. Potential output of the economy depends on productivity (the quality and quantity of factors of production) AD 1 AD 2 Y 1
Consumer Goods Capital Goods These all show the same concept increases in the production capacity in the Long Run Increases in production capacity are created by supply side policies Price Level (P L ) LRAS 1 Real Output LRAS 2 Price Level (P L ) LRAS 1 LRAS 2 Real Output
The dotted line represents the economic capacity to sustainably supply goods and services. Overtime as it rises the economy becomes larger. When the actual line is above the potential line the economy is said to have a positive output gap as at point B. Demand exceeds the sustainable capacity thus shortages occur and prices rise (inflation) also called an inflationary gap When the actual line is below the potential line the economy has a negative output gap as at point C. At this point there is spare capacity, higher then average unemployment leading to less inflationary pressures. Also called a recessionary gap . B C
Unemployment Output (Y) Inflation (P L ) Boom decreasing increasing Inflationary pressure increasing Peak Very low Highest level but not increasing High inflationary pressure Recession increasing Decreasing Disinflation Depression Very high Lowest level but not decreasing further Potential deflation Recovery Starting to decrease Increasing Small increases in inflation rate.
Draw a Keynesian view of AS/AD model to show an example of expansionary fiscal policy.
Draw the Neo Classical view of SRAS and AD. Suppose the Central Bank reduces the Base Interest Rate (loosening of monetary policy). Show the effect of this change in the economy and any recessionary or inflationary gaps.
Draw a Neo Classical AS/AD graph operating beyond its potential capacity with an inflationary gap. Show the impact of an introduction of the Carbon Emissions Trading scheme, where firms pay for permits to pollute.
Draw a Neo Classical view od AS/AD model to show an economy operating below but near its full LR capacity. Show the impact of an increase in the minimum wage to $12.00 per hour.
For each AS/AD graph state the effect on inflation/unemployment/growth