<3.2: AD/AS>

• In MACROECONOMICS the level of aggregate demand = the amount of REAL GDP (goods and services) that all buyers in an economy are willing and able to buy at different possible INFLATION levels, in a year, ceteris paribus. 

• AD tells us how much households, firms, government, and foreigners would WANT to spend at different price levels

"Life is good, jobs everywhere, I am fine spending now!"

• CONFIDENCE:​ When households feel confident about the economic environment, future prospects, job security etc.., they tend to spend more money and vice versa.

"Money is cheap, I am going to borrow, borrow, borrow!"

• INTEREST RATES​: Interest rates are in effect the 'cost of borrowing' money, and therefore impact household spending in two ways, firstly the higher they are the less willing consumers are to take out loans to finance the purchase of goods and services, and secondly if they already have existing debt then changes in the interest rate will impact the size of their repayments, meaning their household disposable income will be directly impacted, which in turn impacts their ability to spend.

"My stocks are up, property price are up, I fell like spending...!"

• WEALTH: Not to be confused with income, this refers to the estimated value of assets that a household owns, for example, real estate and shares. If these were to ​increase in value then the household will feel more wealthy, and as a result more willing to spend money as 

"I've got more money in my pocket, I gotta spend it...!"

• INCOME TAX​: The amount of income a person has remaining to spend after-tax is referred to as 'Disposable income', therefore the income tax rate directly impacts the level of consumer spending.

"I've debt-free baby!, I feel free to spend...!"

• INDEBTEDNESS​: Clearly the level of debt impacts the amount of disposable income that a household have to spend.

"F.O.M.O., I gotta spend NOW...!"

• EXPECTATION: When future prices are expected to rise, people often rush to spend in the present, and vice versa.

"The streets, malls, restaurants are all full, I am expanding now!"

• CONFIDENCE:​ When businesses feel confident about the economic environment, future demand, price stability etc... they tend to spend more money on expanding their operations and vice versa.

"..the cost of borrowing is low, time to invest!"

• INTEREST RATES​: Interest rates are in effect the 'cost of borrowing' money, and therefore impact business spending in two ways, firstly the higher they are the less willing firms are to take out loans to finance the purchase of capital goods and services, and secondly if they already have existing debt then changes in the interest rate will impact the size of their repayments, meaning their profits will be directly impacted, which in turn impacts their ability to spend.

"We need an e-commerce site to compete, I am investing now!"

• TECHNOLOGY: When new-technology is introduced, firms cannot afford to be left behind by their rivals therefore need to update their operations.

"We can keep more profits yay, I am investing now!"

• CORPORATION TAX​: The amount of disposable profit a business has to spend on capital goods and services depends directly on the level of corporation tax.

"We are debt-free, so I am ready to invest!"

• INDEBTEDNESS​: Clearly the level of debt impacts the amount of disposable profit that a firm has to spend.

"The bank's are practically begging me to borrow, I am investing now!"

• ACCESS TO CREDIT: The correlation between access to credit and the ability of firms to engage in investment spending is obvious. During economic downturns, banks may be unwilling to lend money, and if they do, they may attach very high interest rates.

"I am 100% confident that any profits I make won;t be stolen!"

• PPR PROTECTION: Private Property Rights (PPR) are taken for granted in most developed nations, however in lesser developed countries in which the rule of law is not enforced, lack of protection of PPRs can mean entrepreneurs are reluctant to engage in investment activity, in fear that their gains will be taken from them. 

"Yikes, too much demand and not enough supply, prices are skyrocketing, let's reduce our public spending, shhhhhhhh!"

• BOOM: A boom is a period of rapid economic expansion resulting in higher GDP, lower unemployment, a higher inflation rate, and rising asset prices. Booms usually suggest the economy is overheating with demand greater than the potential creating a positive output gap and inflationary pressures, hence the government use policies such as contractionary fiscal policy (Less Gov’t spending) to reduce demand. (‘See Lawson Boom UK’)

"OMG, no-one's spending we need to kickstart some economic activity, fire up the printing press, let's spend some money!"

• TROUGH: A trough is the stage of the economy's business cycle that marks the end of a period of declining business activity and the transition to expansion. The government can help in the recovery bY stimulating demand via expansionary fiscal policy (More gov’t spending)

• "Our curency has dropped in value against other countries, no wonder we have so many tourists buying our stuff!"

• EXCHANGE RATE: The exchange rate refers to the Price of one currency in terms of another currency. Clearly, if the price of your currency rises in terms of another, your currency can buy more of the other currency, hence the price of their imports is cheaper in your currency, however, your exports are now more expensive in terms of their currency. 

• "Brazilians, Russians, Indians, and Chinese, are all generating higher incomes, and of course this means more demand for our stuff!"

• FOREIGN INCOME: Demand for exports is very much dependent on the income and economic situation within your trading partners. If they are in an expansionary phase then the demand for your exports should be growing.

• "We have signed a Free trade agreement with the US, so our stuff is much cheaper!"

• TRADE BARRIERS: A trade barrier is designed to reduce the demand for imports, in order to protect domestic producers from competition.

• AGGREGATE SUPPLY refers to the TOTAL QUANTITY of goods and services DOMESTICALLY PRODUCED in an economy at all given AVERAGE PRICE LEVELS in a given period of time, as measured by REAL GDP.

• However, the relationship between AVERAGE PRICE LEVEL and REAL GDP differs between the SHORT-RUN and the LONG-RUN, creating two distinct curves.

• If AD rises and the APL RISES in the SR the wage that a worker receives ('The NOMINAL WAGE') LOSES 'REAL' VALUE in terms of its purchasing power, in other words, THE REAL WAGE FALLS WHEN THE APL RISES.

• Workers are initially unaware of this fall in value, plus they tend to have contracts that have fixed wages and this inability to increase wages and restore their real values means 'REAL COSTS DECREASE' while the prices that firm's can charge rises so firms will have A PROFIT INCENTIVE TO PRODUCE MORE, in this time period.

• However, In the LR working contracts will eventually end and WORKERS having noticed that their real wage have fallen will SEEK HIGHER NOMINAL WAGES in order for their 'REAL WAGES' to regain their purchasing power, in other words, THE REAL WAGE IS RESTORED. This rise in costs for the firm makes the original profit motive disappear.

• When the APL FALLS in the SR the fixed wage that a worker receives ('THE NOMINAL WAGE') GAINS 'REAL' VALUE in terms of its purchasing power, in other words, THE REAL WAGE RISES WHEN THE APL FALLS.

• This inability to reduce wages and restore their real values means 'REAL COSTS INCREASE' and firms will have NO CHOICE but to REDUCE PRICE and OUTPUT, hence the SLOPE of the SRAS curve.

• In the LR working contracts will end and FIRMS will OFFER LOWER NOMINAL WAGES in order for their 'REAL WAGES/COSTS' to regain their real purchasing power, in other words, THE REAL WAGE IS RESTORED.

• Wages are usually CONTRACTUALLY FIXED, in addition, government regulations such as the MINIMUM WAGE will prevent wages from falling, whilst TRADE UNIONS will threaten to go on strike to prevent this from happening. Finally, firms will be reluctant to offer lower wages (even though the real value is the same) out of fear that it will DEMOTIVATE THEIR WORKERS.

• STICKY FACTOR PRICES (WAGES): As mentioned above, wages are very INFLEXIBLE, both downwards and upwards in the SHORT RUN, and it is this level of inflexibility that gives producers the PROFIT INCENTIVE to PRODUCE MORE when the PRICE LEVEL RISES and the LOSS REDUCTION INCENTIVE to PRODUCE LESS when the PRICE LEVEL FALLS:

  • • • • Think about it, If the UNIT PRICE that you can sell your product for RISES, whilst your FACTOR COSTS STAY THE SAME then it is PROFITABLE for you to supply more, hence the upward slope of the supply curve.

        • Similarly, If the UNIT PRICE that you can sell your product for FALLS, whilst your FACTOR COSTS STAY THE SAME then it is UNPROFITABLE for you to supply more, in fact, you will be losing money so you will likely reduce Qs, hence the upward slope of the supply curve.

• THE REASONS FOR A SHIFT IN THE SRAS ARE SIMILAR TO THE REASONS FOR A SHIFT IN THE SUPPLY CURVE FOR A SPECIFIC GOOD IN THE MICRO MODEL.

  • • • CHANGES IN WAGES: If wages INCREASE, with the price level constant, firms’ costs of production rise, resulting in a LEFTWARD shift in the SRAS curve and vice versa.

      • CHANGES IN OTHER RESOURCE PRICES: Changes in the price of non-labour resources, such as the price of oil, equipment, capital goods, land inputs, and so on affect the SRAS curve in the same way as changes in wages.

      • CHANGES IN BUSINESS TAXES: Business taxes are taxes on firms’ profits, and are treated by firms like costs of production. Therefore, HIGHER taxes on profits are like INCREASES in production costs, which shifts the SRAS to the LEFT.

      • CHANGES IN SUBSIDIES offered to businesses. Subsidies have the opposite effect to taxes, as they involve money transferred from the government to firms. If they DECREASE, the SRAS curve shifts to the LEFT; and vice versa.

      • SUPPLY SHOCKS: Supply shocks are events that have a sudden and strong impact on short-run aggregate supply. Some supply shocks directly affect aggregate supply. For example, a war or violent conflict can result in destruction of physical capital and disruption of the economy, leading to lower output produced and a LEFTWARD shift in the SRAS curve. Unfavourable weather conditions can cause a fall in agricultural output, also shifting the SRAS curve to the left. For example supply-chain issues following COVID, UKRAINE-RUSSIA conflict etc...

• So far we have assumed that in the short-run during an expansionary phase the economy produces beyond its NRU, and as a result, prices and output will rise at the same time, and that eventually IN THE LONG RUN FACTOR PRICES WILL ADJUST UPWARDS and real values will be restored, meaning only prices will rise and output will return to its full-employment level.

• Similarly, we have also assumed that in the short-run during a contractionary phase the economy produces below its NRU, and as a result, prices and output will fall at the same time, and that eventually IN THE LONG RUN FACTOR PRICES WILL ADJUST DOWNWARDS and real values will be restored, meaning only prices will fall and output will return to its full-employment level.

• This readjustment mechanism, due entirely to market forces outlines the school of thought held by the 'NEW CLASSICAL' economists who overwhelmingly trust in these forces to solve most misallocations.

• Whilst most economists agree, regarding the upward adjustment of prices during expansionary phases there exists some disagreement regarding the downward adjustment of factor prices (in particular the price of labour 'wages') during contractionary phases. 

• These economists come from the 'KEYNESIAN' school of thought, which cites real-world examples of wages not adjusting downwards during times of economic contraction, in particular during 'The Great Depression' in the US between 1929 – 1939.

• It was observed that factor prices (wages) as well as product prices did not adjust downwards and were in fact 'STICKY' in the downward direction, meaning the economy gets 'stuck in the short run' and cannot return to the Long run full employment level, meaning output levels will remain low, while unemployment will stay above the NRU. 

• WAGES do not fall easily, even over long periods of time, because of a variety of factors such as labour contracts, minimum wage legislation; worker and union resistance to wage cuts.

• PRICES do not fall easily either as the stickiness of wages means firms will avoid lowering their prices because that would reduce their profits. Furthermore, large oligopolistic firms may fear price wars; if one firm lowers its price, then others may lower theirs more aggressively in an effort to capture market shares, and then all the firms will be worse off. Such factors, it is argued, make prices unlikely to fall even in a recession.