This document describes key macroeconomic concepts related to aggregate demand and aggregate supply, including: 1) The components of aggregate demand (C, I, G, X-M) and factors that can change each component. 2) The short-run and long-run aggregate supply curves and how costs of production and productivity can cause shifts. 3) Using AD/AS models to illustrate inflationary and deflationary gaps and analyze the effects of fiscal and monetary policy changes.

2. 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

3. 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

4. Consumption spending increases Investment spending decreases Government Spending increases Expenditure on imports increases AD  AD  AD  AD 

5. Decrease (AD 1  AD 3 ) Fall in investment Drop in consumer spending Decrease in government spending Increase (AD 1  AD 2 ) Drop in interest rates Rise in consumer confidence Increase in government spending Average Price Level (P L ) Real output, National Income (Y) AD 1 AD 3 AD 2

6. Using textbook, read through notes in IB Companion - Pg 171 – 174 to understand What causes changes in Consumer Spending ? What causes changes in Investment ? What causes changes in Government Spending ? What causes changes in Net Exports ? You can create a mind map or table to show your understanding of these changes Revision Matchup Game

7. 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.

8. This describes the supply side of the economy – producers / firms / companies and the production of goods and services. Definition: The total amount of goods or services that all industries in the economy will produce at every given price level. Sum of all the individual supply curves. There are differences between the Short Run AS and Long Run AS curves.

9. Why does the curve slope upwards…? At low levels of output Y 1 the average price level will be low As output levels rise firms face higher average costs of production. Eg Labour costs more per hour, resources become scarce. Average Price Level (P L ) Real output (Y) Short Run AS P 2 Y 1 Y 2 P 1

10. What causes the curve to shift? Costs of production increasing (shift to the left) Costs of production decreasing (shift to the right) Changes in productivity (shift to the left of right) Average Price Level (P L ) Real output (Y) Short Run AS Cost of production decreasing Cost of production increasing

11. Costs of Production increasing (left) Costs of Production decreasing (right)

12. Remember in the Long Run all factors of production are variable, capital, labour and types of resources used. There are two important ways that economists view what happens to Aggregate Supply in the Long Run. Keynesian view – 3 phase LRAS curve Neo Classical view – vertical LRAS curve

13. 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

14. 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.

15. 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)

16. 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

17. 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

18. 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

19. Total demand = total supply for the whole economy No upwards or downwards pressure on prices. No pressure to change output Ceteris Paribus Price Level (P L ) SRAS Real GDP (Y) AD Y P L

20. Shift from AD 1 to AD 2 leads to no increase in the average price level. No inflationary pressure Plenty of spare capacity in the Economy Price Level (P L ) LRAS Y Full Y 1 Y 2 AD 1 AD 2

21. This is unemployment of the factors of production, or output gap. Labour Land Resources As AD shifts further to the right unemployment falls and price level begins to rise Price Level (P L ) LRAS Y Full Y 1 Y 2 AD 1 AD 2 P L1 P L2

22. Increase in AD Leads to decreased unemployment Increase in Real Output Price Level rises. Price Level (P L ) LRAS Y Full Y 1 Y 2 AD 1 AD 2

23. 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

25. Consumption decreases Inflation pressure rises Govt Spending decreases AS increases AD increases AS decreases Investment increases Price level increases Consumption Increases Inflation pressure eases Unemployment falls Real Output Increases Real Output decreases Price level decreases Unemployment increases Investment decreases Govt Spending increases Net Exports increases Net Exports decreases

26. The Central bank announces an increase to the market interest rates from 4 – 5.5% The economy is currently at a historically low level of economic activity and will enter a recession in the next 6 months. The government proposes decreasing the company tax rate. Consumer confidence falls after higher than expected unemployment figures are announced. To boost the level of economic activity the government issues food coupons to all families The exchange rate appreciates leading to an increase in the price of imported goods. An economy is operating near to full capacity. Show the effect of introducing carbon emission taxes on the economy in general.

27. Show the effect of an increase in direct taxes on an aggregate demand and supply graph.

28. Inflationary Gap SRAS greater than LRAS Recessionary Gap SRAS less than LRAS SR AS changes LR AS changes

29. AS AD

30. AS AD

31. 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.

32. Task One: Read the article. Describe, in as much detail as possible what will happen to each component of GDP using specific information from the article. Task Two: complete the following questions Write a paragraph in your book explaining the overall affect of the global events on Real GDP in New Zealand (use specific examples) Write a paragraph to explain the affects on aggregate supply. Consider the overall level of supply after describing the changes in productivity and costs of production. Task Three: check that you have finished homework from last week. Pg

33. What are the labels for the x and y axis of an Aggregate Demand and Supply model When a government is operating expansionary fiscal policy , what happens to the two flows G and T? What is the factor reward for labour? What are the three approaches used for measuring National Income? List three withdrawals from the circular flow of economic activity What is one limitation of GDP? What is the most common tool used to measure Economic Development? Name two less developed nations, one in Africa and one in Asia How do changes in wealth affect aggregate demand? List two factors that cause a shift in the SR Aggregate Supply curve

34. Inflationary pressure Recession Unemployment Full capacity Real Output Taxation Government Spending Expansionary Fiscal Policy Contractionary Fiscal Policy Interest Rates fall Average Price Level Interest rates increase Circular Flow model Transfer payments Investment Savings Consumer Confidence Business Confidence November Exchange Rates

35. 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

36. The effect of a decrease in aggregate demand on output and the price level depends on the shape of the aggregate supply curve.” Explain this statement. What does the shape of the AS curve look like? Draw a graph to show three distinct phases (Keynesian Macro Economic theory) What is the effect of a shift in AD to the left in each of these three phases? As the slope of the AS curve increases the price level changes more than proportionality compared to the real output. => scarcity

37. Identify the components of aggregate demand and briefly explain two factors, which might determine each of these components. What are the components of AD? C interest rates, confidence, wealth and income I interest rates and business confidence G fiscal policies and political change (X-M) – exchange rates Appreciation leads to X decreasing, M increasing Depreciation leads to X increasing, M decreasing

38. Evaluate the likely impact on an economy of a substantial rise in the level of interest rates. What are interest rates and which components of AD do they affect. I – short run and long run impacts of changes in investment, growth potential? Affects of net borrowers and net savers. Which part of the economy will benefit the most? Is there any affect on AS? In Short Run or Long Run.