Chapter 4 summary AS

- Aggregate demand: The Total demand for a country’s goods and services at a given price level and in a given time period.
- Price level: The average of each of the prices of all the products produced in an economy.
- Consumer expenditure: Spending by households on consumer products.
- Investment: spending capital on goods.
- Government spending: spending by the central government and local government on goods and services.
- Exports: products sold abroad.
- Imports: products bought from abroad.
- Net exports: (X-M)

So: AD=C+I+G+(X-M); standard Keynesian formula.

- Transfer payments: money transferred from one person or group to another not in return for any good or service.
- Job seeker’s allowance: a benefit paid by the government to those unemployed and trying to find a job. (Is not included as Government spending)
- Trade surplus: (X-M) = positive
- Trade deficit: (X-M) = negative
- APC: Consumption quote
- Consumer confidence: how optimistic consumers are about the future economic prospects.
- Rate of interest: the charge for borrowing money and the amount paid for lending money.
- Net savers: People who save more than they borrow ( clever people )
- Wealth: a stock of assets, e.g. property, shares and money held in a savings account.
- Inflation: a sustained rise in the price level
- Distribution of income: how income is shared out between households in a country.

- Saving: Real disposable income minus spending

There are mostly seven things that influence savings:

1) Real disposable income. Rise in real disposable income will make the APS and the nominal savings rise.
2) The rate of interest. A rise of interest rates makes the reward for saving higher and people will start saving more.
3) Confidence and expectations. Households and firms tend to save more when they get more uncertain about the future.
4) Saving schemes. Some saving is contractual, like pension schemes.
5) Range of financial institutions. When people feel confident on placing their money into a bank they will feel it’s more usual to save money.
6) Government policies. (E.G. things like tax-free saving schemes)
7) The age structure of the population. Young people save very few, middle-aged people save most and old people mostly dissave ( spending more than disposable income) drawing on savings to maintain their living standards when they retire.
- Average propensity to save(APS): savings quote= savings ratio- Target savers: people who save with a target figure in mind.( E.G. someone wants to have total savings of 100,000)

- Investments is mostly influenced by the following eight things:

1) Changes in real disposable income. Real disposable income makes consumption rise and firms will react on the increase in demand by increasing supplies. New machinery is needed, making investments rise.
2) Expectations. Firms are much more likely to invest if they feel optimistic in the future.
3) Capacity utilization. Firms are also more likely to invest if they are operating close to full capacity. ( So now in the current rece(/depre?)ssion the investments probably won’t go up that much because the demand still is lower than before this all started)
4) Current profit levels. High profit levels can encourage investments in two ways. They provide, at first, the finance to invest. And also they are likely to make the firm more optimistic about the future.
5) Corporation tax. (corporate tax) Cuts in tax increases the profit and might increase investments. (more money left to spend)
6) The rate of interest. A higher interest rate makes borrowing more expensive and borrowing is mostly used to finance investments. Also, the higher interest rates will increase the opportunity cost of the investment because the return at the bank is getting higher. Finally, a higher interest rate tends to reduce the demand for shares. This might lead to lower share prices, so the firm is able to raise less funds for future investments.
7) Advances in technology. When there is new – revolutionary – machinery on the market, firms might feel forced to replace the machinery. This will always be to try to reduce the unit cost ( average cost per unit of output) and therefore increasing the profit.
8) Price of capital equipment. A reduction in the price of capital equipment may also increase investment. It will become affordable for more firms to buy new machinery.

- Retained profits: profit kept by the firms to finance investment.


- Government spending is mostly influenced by the following four things:

1) The government’s view on the extent of market failure and its ability to correct it. In countries where governments rely on the free market system the percentage of AD is lower because of fewer investments. (E.G. 27% for Sweden in 2007 and 12% for Chile in the same year)
2) The level of economic activity in the economy. High unemployment would increase government spending(more AD so more Employment, because employment – within the Keynesian theory - is calculated by: AD/productivity per unit of labour) and high inflation would reduce government spending.( less consumption-based inflation)
3) A desire to please the electorate. Politicians would like to get some votes in the next term, mostly this is on the things that hit people’s perceptions and feelings. (E.G. Education, health care, infrastructure)
4) War, terrorist attacks and rising crime.

Net exports are mainly influenced by the following five things:

1) Real disposable income abroad. A rise in income in countries abroad. (Consumers in those countries will have more money to pay for imports, increasing the Net exports for the country we’re looking at.
2) Real disposable income at home. A rise in income at home may result in a fall in exports. This is because firms may divert some products from the export market to the home market to meet the rising domestic demand.
3) The domestic price level. If the domestic price level rises relative to the price levels in the country’s trading partners the value of exports fall and the value of imports rise. So if domestically produced products become more expensive, firms and households at home and abroad will switch from them to products made in other countries.
4) The exchange rate.(price of one currency in terms of another currency) A fall in a country’s exchange rate will reduce the price of exports and raise the price of imports. Due to this the value of exports will rise and imports will decrease. Net exports increase.
5) Government restrictions on free trade. A country’s net exports may rise if other countries’ governments remove trade restrictions. (EG, if the USA would remove the tarrifs( a tax on imports) on Chinese steel there would have been way more import from China.

The relationship between AD and price level.


Note: We are talking about the level of inflation so the price level of all goods, not just the price level of one single good.

There are three main reasons for the downward sloping AD curve.
1) The wealth effect .
When the price level is low you can buy more with our money.
2) The rate of interest effect.
A rise in the price level means that some people will sell financial assets, such as government bonds(a financial asset issued by the central or local government as a means of borrowing money), to obtain more money to pay the higher prices. Making the price of government bonds decrease. Due to the fact that the interest on a bond will nominally stay the same the amount of interest rises. (5 on 100 makes 5% but if the price falls 50% to50, the interest rate will increase from 5% to 10%.) A higher interest rate is likely to reduce consumption and investments making the AD value lower.
3) The international trade effect.
A rise in price level in a country will make your country more expensive for foreign countries so exports will fall. Decreasing AD.

Shifts in the AD line:

A change in any of the components will cause a shift of the AD curve, while a change in the price level causes a movement along the AD curve.
Examples of things that influence the AD curve to shift: Changes in expectations, changes in government policy, changes in the exchange rate and a change in population size.
A fall in share prices worldwide would lead to a fall in the AD because people will become less wealthy(so consume less) and firms will have more problems raising funds for investments. (so invest less)



If the AD shifts to the right (AD increases) there are three main possibilities:
1) When there is spare capacity left within an economy, the AD is likely to raise the output of the economy, reduce unemployment and leave the price level unchanged.


2) When there is not that much spare capacity left within an economy or there are shortages of resources, the increase in AD will increase the price level and the real GDP.
- If the economy is already operating at full employment level, with no spare capacity, an increase in AD will be purely inflationary.



- Aggregate supply: the total amount that producers in an economy are willing and able to supply at a given time period.
The shape of the AS curve is influenced by the level of the capacity in the economy.


When output and unemployment is high, as shown over the range 0 to Y in figure 4.3, AS is perfectly elastic. This means that more can be supplied without raising the price level. Any increase in output can be achieved by offering unemployed workers jobs at the going wage rate and paying the going price for raw materials and capital equipment. Between Y and Y1, AS is at first elastic and then it becomes increasingly less responsive to changes in the price level. Ass resources become scarcer, producers have to employ les efficient workers and machinery. This pushes up unit costs of production and the price level. At Y1 all resources are employed and AS becomes perfectly inelastic. At full capacity it is not possible to produce more, irrespective of how high the price level rises.

Shifts in the AS curve.

In the short run the main reason for a shift in the supply curve is due to the change in the costs of production. (EG due to wages, price of raw materials)
In the long run, the two main causes of shifts in the AS curve, which alter productive capacity, are changes in the quantity and quality of resources. (EG by education increasing the quality of labour and therefore increasing productivity)



When the AS curve is changing there are mainly two possibilities:
1) When the economy is at, or close to, full capacity the output of the economy will raise and lower the price level.



2) When the economy is initially operating at a low level of ouput with a high level of unemployed resources. In this case, the increase in AS will increase potential output but not actual output and will leave the price level unchanged. The increase in AS will have NO impact on the economy.


There may also be a combination of both, a change in AD as well as a change in AS. There are again a few possibilities:
1) An increase in AD and AS in the same rate will increase Y and does not have inflationary pressures:



2) An increase in AD and AS, but AD increases more than AS. This is also known as overheating, causing inflationary pressures:



- Output gap . The difference between an economy’s actual and potential real GDP.
The output gap is ab in the next graph:



- Macroeconomic equilibrium: A situation where aggregate demand equals aggregate supply and real GDP is not changing.
- The circular flow of income: The movement of spending and income throughout the economy.
- Factor services: the service provided by the factors of production.
- Leakages: Things that reduce AD; things like imports, savings and taxes.
- Injections: additions of extra spending into the circular flow of income.( consisting of: Investments, Government spending and Exports)
If injections equals leakages there will be a macroeconomic equilibrium.
- Multiplier effect: The process by which any change in a component of aggregate demand results in a greater final change in real GDP