Using the Aggregate Supply and Aggregate Demand Framework - Essay Example

How equilibrium occurs using the aggregate supply (AS) and aggregate demand (AD) framework Introduction In macroeconomics and microeconomics, aggregate supply curve expresses the overall price level in a nation. The aggregate supply curve slopes upward in the short run and nearly vertical in the long run. On the other hand, the aggregate demand curve reflects price levels for goods and services produced domestically and which consumers, government, foreigners and businesses are willing to purchase. It slopes downwards to the right with the decrease in price levels with the increase in demand. This paper describes the occurrence of the equilibrium using aggregate supply and aggregate demand curves, and the fluctuation of real GDP around the potential GDP with reference to the economy in UK. Aggregate Demand Aggregate demand curve represents the desired spending, consumer behaviour and the buying of equipment by governments and foreigners. The aggregate demand rises with the increase in expenditure caused by increased optimism by the households on lifetime incomes and increased need for the product. The combined monetary assets and the decrease in interest rates stimulate the desire to spend by the firms and households. Low interest rates reduce the saving reward and borrowing costs for households, but for businesses, this reduces the borrowing costs for investing in equipment and plant (James, Walte and James 2006, p. 777-790). The aggregate demand curve slopes downwards due to the fixed nominal value for some assets, particularly the money itself. The increase in prices for the goods with no changes in money leads to the real value of money balances declining and this result to decreased liquidity. The rise in prices increases the demand for dollars in financing the transactions. Short liquidity to the monetary assets results when nominal dollars’ supply does not change. Graph 1: Aggregate Demand Curve Source: http://www.cliffsnotes.com/study_guide/Aggregate-Demand-AD Curve.topicArticleId-9789, articleId-9737.html Horizontal axis in the aggregate demand curve represents total economic output, and the vertical axis represents price measures. Aggregate demand curve indicate relationship between price level and the output. Prices and output are inversely related. Shifts in aggregate demand curve Aggregate demand curve changes due to wealth effects like the money supply, interest rate effects, and the net exports effects. The changes are represented by shifts in aggregate demand curves either to the right, or to the left. A right shift in aggregate demand curve (AD1 to AD2) indicates an increase in GDP at the same price level for the quantity demanded. A left shift (AD1 to AD3) indicates a decreased GDP for the quantity demanded at the same price levels (Justiniano & Claudio 2011, p. 89). Shifts in aggregate demand curve Source:http://www.cliffsnotes.com/study_guide/Aggregate-Demand-AD-Curve.topicArticleId-9789,articleId-9737.html Aggregate Supply Aggregate Supply (AS) model measures volume of the goods and services produced by an economy at given overall price level. The AS curve summarizes the production behaviour for the side markets, and it slopes upwards. The Aggregate Supply curve may be horizontal or vertical depending on the conditions (James, Walte and James 2006, p. 777-790). The curve is inelastic in the long run and elastic in the short run. Therefore, when the long-run curve is vertical, the return is to natural output level as the equilibrating forces pull back to vertical long-run curve. The upward facing slope is caused by changes in firm prices due to the increased demand. In the presence of menu costs, firms raise the prices or increase the production, resulting to aggregate increase in both output and prices (Berrah and Cliville 2007, p.709-719). Graph 2: Aggregate Supply Curve Source: http://www.cliffsnotes.com/study_guide/Aggregate-Supply-AS-Curve.topicArticleId-9789,articleId-9738.html The vertical axis in aggregate supply curve represents the price level while the horizontal axis represents the output. However, the difference between aggregate demand and aggregate supply curves is that aggregate supply curve represents total output from the producers in an economy. The curve contains a relatively flat region which rapidly becomes vertical. Shifts in aggregate supply curve In aggregate supply, a right shift, SAS1 to SAS2 for SAS curve or from LAS1 to LAS2 for the LAS curve indicates an increased GDP for the quantity supply at the same price levels. A left shift, SAS1 to SAS3 for SAS and LAS1 to LAS3 for LAS curve indicates a decreased GDP for the quantity supplied at the same price levels (Justiniano & Claudio 2011, p. 89). Shifts in aggregate supply Source: http://www.cliffsnotes.com/study_guide/Aggregate-Supply-AS-Curve.topicArticleId-9789,articleId-9738.html Equilibrium in AS/AD Models The short-run equilibrium occurs when aggregate demand and the aggregate supply curve at short run intersect. On the other hand, the long-run equilibrium occurs when aggregate demand curve and long-run aggregate curve intersect. The ongoing changes like the steady growth in the natural output and the sustained inflation cause the Aggregate Demand and Aggregate Supply curves to shift Graph 3: Effects of Increase in the Aggregate Demand Source: www.aeaweb.org/aea/2012conference/program/retrieve The expansionary monetary fiscal policy action affects the increase in the desired expenditure from other sources. Since AD changes are unexpected, expected price level will remain at Pe. The natural level of the output (Yn) is independent of aggregate demand, thus no shift in aggregate supply curves. The point e’ in graph 3 above indicates the effect of short-run when the aggregate demand increases (Kremer, Schneeweiss and Zimmermann 2006, p. 656-666). The increased output in short-run goes to point Y1 and the rise in the price level to P1. Assuming permanent changes in aggregate demand, the price expectations adjust upwards in long-run with the increase in the actual prices. Short-run aggregate supply curve should shift upwards since SRAS passes through the Y=Yn. Expected price and SRAS shift upwards continuously until e’’ is reached, and the price level rise to P2 while the output returns to unchanged natural level. Change in aggregate demand affects the prices and output in the short run, but affects prices only in the long run. The increase in money supply changes the aggregate demand; hence, monetary expansion does not affect long run output (Kremer, Schneeweiss and Zimmermann 2006, p. 656-666). Dynamic Equilibrium in AS/AD Model The increase in natural output and determinants of the aggregate demand depict the dynamism in the economy. The movement of AD curve in the long run results from the increase in monetary supply. Graph 4: Inflationary Growth in AS/AD Model Source: www.aeaweb.org/aea/2012conference/program/retrieve Graph 4 shows the changes in aggregate supply, which increases natural level of the output from Yn to Yn′. The assumption of expected price level not changing shifts the SRAS and LRAS to the right, and SRAS curve pass through the coordinates (Yn′, Pe). If there are no changes in aggregate demand, short-run equilibrium is at e′, and the output increases to Y1 while price falls to P1. The expected price level in long-run adjusts downward with the decline in the prices. The eventual equilibrium thus occurs at e″ with the price decreasing further to P2 and the real output increase to new natural level (Kremer, Schneeweiss and Zimmermann 2006, p. 656-666). The AS curve shifts over time since the natural output level increase over time. When capital resources and labour are employed fully, their increases result to increased natural output. This pushes the aggregate supply curve to the right. At a steady state, annual percentage growth rate is constant, and the aggregate supply curve in the long-run shift to the right by a constant proportion (Kremer, Schneeweiss and Zimmermann 2006, p. 656-666). The fluctuation of real GDP around the potential GDP Aggregate Supply - Aggregate Demand (AS/AD) model represents the quantity of output in a single industry for the entire economy. Graph 6: An AS/AD Model Source: www2.hmc.edu/~evans/chap2.pdf Graph 6 represents quantity variable on the horizontal axis; real GDP that measures true value of the annual national production. The vertical axis represents the price level, with economic, statistic value of inflation. Equilibrium level for real national output, GDP, is represented by interaction of AS and AD curves. This determines the rate of national inflation.  Aggregate demand depicts total spending level in the income accounts of a nation, government purchases, net exports, investment and consumption. The changes in equilibrium in AS/AD model are due to changes in variables affecting demand and supply. Changes in variables cause the left or right shifts for the curves (Reeves 2012, p. 32-56). For aggregate demand, factors causing a shift to the right are income, wealth, and availability of credit, population, the government demand and the foreign demand. A shift to the left is caused by interest rates and taxation. For aggregate supply, a shift to the right is caused by investment, productivity, availability of credit and the profits. The shift to the left is caused by the costs, the interest rates, the foreign supply and taxation (Reeves 2012, p. 32-56). The Applications of AS/AD Model in Business Cycle Analysis Fig 1: Business Cycle in AS/AD Model: Equilibrium points Source: www2.hmc.edu/~evans/chap2.pdf The representation of business cycle in AS/AD model is reflected by movement of equilibrium with the shift in AD and AS curve. From fig 1, the aggregate demand has high volatility than the aggregate supply, and most shifts in equilibrium depend on movements of AD curve. The economic expansion is reflected by the shift of equilibrium from left to right. Such movement represents the growth in the real GNP. Recession is indicated by movement in the opposite direction from right to left representing contraction of the real GNP. Falling GNP reflects a negative growth rate. The upward equilibrium movement represents an increase in the inflation rate while a downward movement represents the decline in the inflation rate. From point ‘a’ marks beginning of recovery close to the recession trough. The movement from point ‘a’ to ‘b’ reflects normal and healthy recovery and expansion phase, with a substantial increase in GNP and a moderate increase in inflation price. This movement is caused by the right shift in AD curve increased growth reflected in the increased capacity utilization rate (Urriolagoitia 2007, p.157-166). The AS curve shifts to the right due to investment and productivity depicting increase in the production capacity of an economy. The late expansion phase movement to strongly inflation phase is reflected by equilibrium shifting form ‘b’ to ‘c’ with decreased real growth and inflation rate being high. The AD curve moves to inflationary range of AS curve. Point ‘c’ reflects the maximum real growth, and the cycle is at the peak. The subsequent steps are dependent on the continuity of inflation after the recession of the economy. Movement from ‘c’ to‘d’ indicates a recession and the real GNP falls. However, inflation rate continues to increase, and past point‘d’, inflation rate abates while recession continues. The final leftward resting point in mild recession equilibrium will be to the far right of the original point ‘a’ and possibly point ‘b’. The real GNP falls only in severe depression at the initial point of previous recovery. Recessions are mild compared to the expansions. In all business cycles, the movement of equilibrium is first from left to right in expansions, then from right to left during contractions. The mix of the inflation with cycle varies from one cycle to another, thus altering the shape of the one cycle to the next (Urriolagoitia 2007, p.157-166). Different countries have different business cycles that depict the fluctuations in income and production and the spending rates. Length and volatility of the cycle change with evolution of the economy. The previous observed relationship between inflation and unemployment in UK changed, making it hard to manage the economy. The chart below shows the annual percentage changes in the national output at constant price Fig 1: UK Business Cycle over Last Twenty-five years Source: Reuters EcoWin Between 1990 and 1992, recession in UK led to three million layoffs. Since 1993, UK experienced over 13 years of sustained economic growth. 1997 was the strongest year with 3.3% real GDP that expanded to 4% in 2000. For over 40 years, UK has enjoyed the longest period of a sustained economic growth. In 1989-1990, rate of economic growth slowed down after a strong consumer boom. In 1989, the consumer demand decreased, causing an increase in stocks for raw materials and goods held by the firms. The period between 1991 and 1993 was characterized by businesses seeking for the reduction of the stock levels. Businesses sought for reduction of the stock levels by selling remaining stocks at discounted prices. This resulted to inflation. The AD resumed at the start of recovery, and stock levels rose quite strongly (Zouache 2008, p. 105-27). Economic growth in UK based on AD-AS framework Fig 1: Outwards Shift in the AD Source: www.tutor2u.net/economics/.../a2-macro-fluctuations-economic-activity.html The equilibrium income raises increase from Y1 to Y2. This takes the national output closer to the potential output, Yfc. An AD beyond AD2 creates excess demand. This stage of business cycle in short-run aggregate is inelastic, and it may trigger an increase in wages and commodity prices, leading to increased inflation (Zouache 2008, p. 105-27). Fig 3: Shift in AD Source: www.tutor2u.net/economics/.../a2-macro-fluctuations-economic-activity.html The outward AD shift reflects the state of economy beyond the potential GDP. This leads to positive output gap represented by the distance AB. This results to increased wages and rise in the labour costs taking the economy to full capacity output (Roger 2007, p. 34). Conclusion Changes in aggregate demand are caused by changes in the price level while changes in aggregate supply are caused by changes in economic growth and input prices. In the measurement of equilibrium, shift to the right reflects an increased real GDP while shifts to the left reflect decreased GDP. In AS/AD model, the intersection of aggregate demand and the aggregate supply curve in the short run gives the short run equilibrium. The long run equilibrium is represented by the intersection of the aggregate supply curve in long-run and the other to curves in the short run equilibrium (Berrah and Cliville 2007, p.709-719). Also, the shifts in the equilibrium have been analyzed relative to changes in GDP for both expansions and contractions, based on the business cycle in UK. From the analysis, the cyclical fluctuations lie within the economy and the growth in income, output and spending vary regardless of the shocks to the economy causing the shifts in AS and AD models. References List Berrah, L., & Cliville, V. (2007). Towards an Aggregation Performance Measurement System Model in a Supply Chain Context, Computers in Industry 58(7). p.709-719. James, P., Walte, R. E., & James, H. (2006). Using the Aggregate Demand-Aggregate Supply Model to Identify Structural Demand-Side and Supply-Side Shocks: Results Using a Bivariate VAR, Journal of Money, Credit, and Banking 38(3). p. 777-790. Justiniano, A., & Claudio, M. (2011). The Cyclical Behavior of Equilibrium Unemployment and Vacancies in the US and Europe , Cambridge, MA, National Bureau of Economic Research. p. 89. Kremer, M., Schneeweiss, C., & Zimmermann, M. (2006). On the Validity of Aggregate Models in Designing Supply Chain Contracts, International Journal of Production Economics 103(2). p. 656-666. Reeves, S. (2012). Microeconomics and Macroeconomics, New Delhi, World Technologies. p.32-56. Roger, E. A. (2007). Aggregate Demand and Supply, Cambridge, MA:,National Bureau of Economic Research. p. 34. Urriolagoitia, L., & Planellas, M. (2007). Sponsorship Relationships as Strategic Alliances: A Life Cycle Model Approach, Business Horizons 50(2). p.157-166. Zouache, A. (2008). On the Microeconomic Foundations of Macroeconomics in the Hayek-Keynes Controversy, The European Journal of the History of Economic Thought 15(1). p. 105-27. a64e20c5-4fef-4b15-aa6f-3146882a1556 Y2:a64e20c5-4fef-4b15-aa6f-3146882a1556 Read More