AGGREGATE DEMAND AND SUPPLY

The Need for Aggregate Model/Statistics:
The aggregate demand model is needed in every economy to assist in macro economic analysis. Such national statistics would be ideal for: 1) Making International Comparisons: In doing this it is necessary to convert the figures to same currency using a rate of exchange. 2) Government Planning: A rising real national income with a fairly constant capital stock will generally be associated with a fall in unemployment. Similarly, there is likely to be direct relationship between the level of real national income and the rate of inflation. As the equilibrium level of national income reaches the full employment level of national income, so inflationary pressure is likely to build up in the economy. To devise appropriate government policies, to combat unemployment and inflation and to estimate the effects of such policies, accurate national income statistics are essential. 3) Formulating macroeconomic policy. 4) The aggregate model is needed to explain why prices in general rise or fall. 5) Explaining what determines changes in the level of aggregate output

Aggregate Demand * This is the total quantity of output demanded at alternative price levels in a given time period, “ceteris paribus”. * Our view here encompasses the collective demand for all goods and services rather than the demand for any single good. * It therefore consists of demand of local consumers, firms, the government and foreigners in the case of open economy. That is QD = C + I + G +DX, where DX is export demand, C is local consumers, I is investment and QD is aggregate demand. * For closed economy, QD = C + I + G. * Aggregate demand can called as planned expenditure since it the total amount that the people are willing and able to spend. * The aggregate demand curve indicates how much output people will buy at different price levels the graph below illustrates this.

Price

P1

P2

Price

P1

P2

The downward slope of the aggregate demand curve suggests that with a give (constant) level of income, people will buy more goods and services at lower prices.
The downward slope of the aggregate demand curve suggests that with a give (constant) level of income, people will buy more goods and services at lower prices.

AD
AD

Q1 Q2 Quantity Q1 Q2 Quantity

Reasons why Aggregate Demand (AD) curve slopes downwards from left to right. 1) The Money Supply Effect: With nominal money supply remaining unchanged, a rise in the price level will reduce the real value of money supply. The contractionary money changes of this kind will in most cases reduce total spending and therefore cause a fall in demand. Similarly, a fall in price level will increase the real value of money supply and lead to a rise in AD. 2) Real Balance Effect: If the general price level should rise during the course of a year, the real value (or purchasing power) of the account will fall. This will have the effect of curbing individuals spending during the year. The reverse also applies, “mutatis mutandis”. 3) Macroeconomic Effect: As the price level falls, the consumers may decide to buy goods now which they were planning to buy in the future. If the price level rises, they may decide to postpone the purchases which were originally planned for the present. This effect which depends strongly on expectations of future inflation rates is called inter-temporal substitution effect. 4) Foreign Purchases Effect: There may also be international substitution effect if domestic buyers decide to buy more home produced gods and fewer imports as the domestic price level falls, and more imports and fewer home-produced goods as the price level rises. 5) The Rate of Interest Effect: This assumes that as the price level rises so will the rate of interest, and rising interest rates will reduce certain kinds of spending such as consumption spending on durables goods and investment spending. Causes of Shifts of AD curve a. A change in government spending b. A change in taxation. c. A change in nominal money supply. A rise in nominal money supply implies an increase in spending and therefore, AD shifts to the right. The reverse also applies.

Aggregate Supply * This refers to the total goods of all final goods and services that all firms in the economy wish to supply over a given period of time at alternative price and wage levels, “ceteris paribus” * Aggregate supply reflects the various quantities of real output that the firms are willing and able to produce at alternative price and wage levels in a given time period. * The aggregate supply curve indicates that businesses will be willing to produce and sell more output at higher prices and less at lower prices. This seems perfectly reasonable because higher prices help determine the extent to which producers get compensated for their efforts NB: Output (Q) = f(PQ, Ci, K, Technology), where Ci = cost of inputs, K = stock of capital, PQ = price of output. AS
Price

0

Quantity
The upward slope of the AS curve indicates that higher output will be associated with higher prices.
AS
Price

0

Quantity
The upward slope of the AS curve indicates that higher output will be associated with higher prices.

Causes of Shifts in Aggregate Supply (AS) Curve: a. The level of money wages: An increase in money wage rates, ceteris paribus, will raise firms’ costs and so make the production of marginal units less profitable. Firms will react to this by reducing output and the AS will shift to the left. b. Other Input Prices: An increase in the price of an input, ceteris paribus, will cause AS curve to shift to the left. The reverse also applies. c. Available supply of inputs and the state of technology: Growth in the available supplies of inputs in the economy and/or an improvement in the state of technology (which raises productivity of one or more inputs) will shift the AS curve to the right.

Equilibrium: Real Output and the Price Level: * In macroeconomics, we can say that the equilibrium level has been reached when there are no economic forces operating to change the level of national income. * This occurs when the total demand for all goods and services (aggregate demand) is equal to the total supply of these goods and services (aggregate supply). * Therefore, at equilibrium, AD = AS * We can say that the total value of goods and services that households and other economic agents want to buy is equal to the total value that firms want to produce when this condition is satisfied. * The point at which AD curve and AS curve intersect is the equilibrium level of real national income OYE and the equilibrium price level OPE as illustrated below.

AS
AD
At any price level other than OPE the behaviour of sellers and buyers is not compatible.
Price Level

P1

PE

P2

0 D1 YE S1 Real National Income (Real Output)
AS
AD
At any price level other than OPE the behaviour of sellers and buyers is not compatible.
Price Level

P1

PE

P2

0 D1 YE S1 Real National Income (Real Output)

* At OP1, producers want sell the quantity 0S1, but people demand 0D1. the excess supply (surplus) at 0P1 will tend to push the prices down until equilibrium is reached (at point E). What responses will the price level 0P2 elicit?