Aggregate Demand (AD) and Aggregate Supply (AS) Analysis

Changes in price level are represented by movements along the AD and AS curves.

The AD curve is shifted by factors such as exchange rate, distribution of income, interest rates, expectations, foreign income, monetary and fiscal policies.

The AS curve is shifted by factors which affect costs of production, for example price of raw materials and wage rates.

The LRAS curve is shifted by the factors which affect potential output: for example entrepreneurship, technological developments, size of workforce, size of capital stock, levels of education, investment and labour productivity. In other words, any long term change in quality and/or quantity of the factors of production.

An increase in price level will shift the AS curve leftwards, as costs of production will be higher.

An increase in cyclical unemployment will shift the AD curve leftwards.

Economic growth is represented by a rightward shift of the LRAS curve.

The Circular Flow of Income

The Circular Flow of Income is a simple economic model that describes the reciprocal circulation of income between producers and consumers.

National Output = National Income = National Expenditure

Injections: Additions to investment, government spending or exports (i.e. money that originates outside the circular flow of income) leading to a multiplied expansion of national income/output/expenditure.

Withdrawals: Increases in saving, taxes or imports (i.e. money not passed on in the circular flow of income) leading to a multiplied contraction of national income/output/expenditure.

An economy is said to be in a state of macroeconomic equilibrium when planned withdrawals equal planned injections.

The Economic Cycle

The economic cycle describes the cycle/fluctuation of economic growth around the trend rate of economic growth which for the UK is 2.25-2.50%.

When actual GDP is below the productive potential of the economy there exists a potentially deflationary negative output gap:

↓AD → ↑stock levels for firms → ↓requirement for production → ↓firms’ output → ↓derived demand for F.O.Ps (including labour) → labour supply surplus → ↓wage rates → ↓household income → ↓household expenditures → ↓AD

This deflationary spiral may continue, leading to a slump, characterised by rapidly rising unemployment, falling output and falling prices.

When the economy is underperforming, the government may seek to intervene to boost AD.

When actual GDP is above the productive potential, there exists a potentially inflationary positive output gap:

↑rate of growth → AD>AS → employed F.O.P.s → ↑firms’ output ↑derived demand for labour → ↑wage rates → ↑production costs → ↑prices (firms seek to maintain profit margins)

The economy is ‘overheating’ during a boom, characterised by high levels of output, low unemployment, rising wage levels and rising prices, and the government may seek to intervene to reduce aggregate demand.

Macroeconomic Indicators

Data commonly used to measure the performance of an economy:

Gross Domestic Product – the total value of all goods and services produced in the economy.

GDP per capita – GDP divided by the population. A measure of living standards.

Consumer Price Index (CPI) – a measure of the price level used widely in the Eurozone and as the target measure for inflation by the government and MPC since 2004. Similar to RPI but excludes mortgage interest costs and uses a geometric mean rather than an arithmetic mean.

Retail Price Index (RPI) – one of the two main measures of inflation used in the UK to measure the changes in the cost of living of a typical household. RPI tracks changes in the cost of a fixed basket of goods over time combining 180,000 price quotes across 650 representative items.

Unemployment level – the number of individuals without a job but who are actively seeking work at current wage rates.

The Balance of Payments on the Current Account.

Index numbers:

Index numbers allow us to compare relative values quickly. A base is identified and given a value of 100. All other values can then be compared to this base. Index numbers express nothing about absolute values.