Revise Econs: AD-AS
AD: Relationship between general price level and real equilibrium output, where planned spending = actual output; shows volume of real output demanded at each possible price
- Why downward sloping? 2 possible reasons:
- As GPL decreases, purchasing power of money increases, firms and households encouraged to spend, increase expenditure
- As GPL decreases, exports gain competitiveness while imports lose competitiveness and locals turn to relatively cheaper domestic substitutes, increase expenditure via net exports
- Factors affecting AD:
- [C, I] Economic outlook; if economic outlook is bad...
- Households: expect higher incomes in future, will increase consumption now, AD ↑
- Firms: revise r/r of investments upwards because higher profitability from higher sales foreseen, increase I, AD ↑
- [C] Expected rate of inflation: higher expected rate of inflation will increase consumption now to avoid higher prices, AD ↑
- [G] Government policy: expansionary/contractionary
- [C, I] Money supply and i/r (credit)
- Money supply i.e. quantity of credit: the more credit available, the more people will borrow for consumption/investment in businesses, AD ↑
- i/r i.e. cost of borrowing: the lower the i/r, the more people will borrow for consumption/investment, AD ↑
- But depends on economic outlook also (whether people will even spend so much or not)
- [X-M] Exchange rate: when local currency depreciates against foreign currencies, X gain competitiveness and M lose competitiveness causing people to switch to local substitutes, net exports ↑, AD ↑
- [X-M] Economic situation of trading partners: if economies of partners are strong, people receive high incomes, X ↑, AD ↑
- Magnitude of shift depends on income elasticity of imported products
- [C, I] Economic outlook; if economic outlook is bad...
- Different parts of the AS curve:
- Keynesian range
- Almost flat
- Plentiful excess capacity
- Increase in AD brings about increase in real NI but not price
- Hence full k effect felt
- For an economy in recession due to weak demand in Keynesian range, government should increase AD via spending since impact after k effect is maximised
- Intermediate range
- Upward sloping
- Small excess capacity, supply bottlenecks start to surface
- Increase in AD brings about increase in real NI and GPL as shortages of labour and raw materials start to occur as we approach FE
- Classical range
- Vertical; perfectly price inelastic supply
- No excess capacity i.e. full employment
- Increase in AD only brings about increase in price, results in DD-pull inflation, whereby GPL increases because AS is unable to expand to meet increasing AD
- Only way to increase real NI is to increase LRAS
- Keynesian range
- Factors affecting SRAS:
- Input prices/COP: when COP increases without corresponding increase in productivity, LRAS does not shift; only SRAS shifts leftwards
- Supply shocks: temporary, hence no effect on LRAS/long-run productive capacity; only SRAS shifts e.g. bumper harvests, natural disasters
- Factors affecting SRAS and LRAS:
- Taxation on FOPs: gives/removes incentive to work while enhancing/lowering productivity (e.g. higher income taxes: you get taxed more if you work more)
- Government regulation on doing business: the stricter the rules, the more money has to spent i.e. less productive and COP may increase too e.g. when time has to be spent doing admit audit stuff for submission to authorities
- Capital stock and human capital i.e. quality of labour: not only reduce costs but also increase potential output
- Technology and innovation: entrepreneurs who invent new cost-saving technologies that also improve productivity and efficiency
- Quantity of labour: the greater the quantity, the lower wages tend to be and the greater the amount of potential output