Aggregate supply measures the volume of goods and services produced each year. AS represents the ability of an economy to deliver goods and services to meet demand.
Short run aggregate supply shows total planned output when prices can change but the prices and productivity of factor inputs e.g. wage rates and the state of technology are held constant.
Long run aggregate supply shows total planned output when both prices and average wage rates can change – it is a measure of a country’s potential output and the concept is linked to the production possibility frontier
In the long run, the LRAS curve is assumed to be vertical (i.e. it does not change when the general price level changes)
In the short run, the SRAS curve is assumed to be upward sloping (i.e. it is responsive to a change in aggregate demand reflected in a change in the general price level)
Short Run Aggregate Supply Curve A change in the price level brought about by a shift in AD results in a movement along the short run AS curve. If AD rises, we see an expansion of SRAS; if AD falls we see a contraction of SRAS. Short run aggregate supply curve Shifts in Short Run Aggregate Supply (SRAS) Shifts in the position of the short run aggregate supply curve in the price level / output space are caused by changes in the conditions of supply for different sectors of the economy:
Employment costs e.g. wages, employment taxes. Unit labour costs are also affected by the level of labour productivity
Costs of other inputs e.g. commodity prices, raw materials. The exchange rate can affect the prices of key imported products
Impact of government e.g. environmental taxes such as carbon duties & business regulations which affect the costs of production
Shifts in the aggregate supply curve The main cause of a shift in the aggregate supply curve is a change in business costs – for example:
1.Changes in unit labour costs - i.e. labour costs per unit of output
2.Changes in other production costs: For example rental costs for retailers, the price of building materials for the construction industry, a change in the price of hops used in beer making or the cost of fertilisers used in farming.
3.Commodity prices Changes to raw material costs and other components e.g. the prices of oil, natural gas, electricity copper, rubber, iron ore, aluminium and other inputs will affect a firm’s costs
4.Exchange rates: Costs might be affected by a change in the exchange rate which causes fluctuations in the prices of imported products. A fall (depreciation) in the exchange rate increases the costs of importing raw materials and component supplies from overseas
5.Government taxation and subsidies:
An increase in taxes to meet environmental objectives (known as green taxes) will cause higher costs and an inward shift in the SRAS curve – for example a higher price for carbon emissions
Lower duty on petrol and diesel would lower costs and cause an outward shift in SRAS
6.The price of imports:
Cheaper imports from a lower-cost country has the effect of shifting out SRAS
A reduction in an import tariff on imports or an increase in the size of an import quota will also boost the supply available at each price level causing an outward shift of SRAS
Short run shocks to production: Temporary non-economic factors affect SRAS in different countries, for example a hurricane, a tsunami or the effects of drought, flooding or political crisis.
Key revision point: The main driver of SRAS for the economy is the level of production costs some of which are influenced by government policy, others by world prices. Remember that the exchange rate is important for the UK because a large percentage of our components / raw materials / energy are imported. Causes of a fall in aggregate supply
Aggregate means ‘total’ and in this case we use the term to measure how much is being spent by all consumers, businesses, the government and people and firms overseas. Aggregate demand (AD) = total spending on goods and services
AD = C + I + G + (X-M)
C: Consumers' expenditure on goods and services: Also known as consumption, this includes demand for durables e.g. audio-visual equipment and vehicles & non-durable goods such as food and drinks which are “consumed” and must be re-purchased.
I: Capital Investment – This is spending on capital goods such as plant and equipment and new buildings to produce more consumer goods in the future. Investment includes spending on working capital such as stocks of finished and semi-finished goods.
Capital investment spending in the UK accounts for between 15-20% of GDP in any given year. Of this investment, 75% comes from private sector businesses such as Tesco, British Airways and British Petroleum and the remainder is spent by the government – for example building new schools or in improving rail or road networks. Investment has important effects on the supply-side as well as being an important component of AD.
A small part of investment spending is the change in the value of stocks. Producers may find either than demand is running higher than output (i.e. stocks will fall) or that demand is weaker than expected and below current output (in which case the value of stocks will rise.)
G: Government Spending – This is spending on state-provided goods and services including public goods and merit goods. Decisions on how much the government will spend each year are affected by developments in the economy and the political priorities of the government. Government spending on goods and services is around 18-20% of GDP but this tends to understate the true size of the government sector in the economy. Firstly some spending is on investment and a sizeable amount goes on welfare state payments.
Transfer payments in the form of benefits (e.g. state pensions and the job-seekers allowance) are not included in current government spending because they are a transfer from one group (i.e. people paying income taxes) to another (i.e. pensioners drawing their state pension having retired, or families on low incomes).
X: Exports of goods and services - Exports sold overseas are an inflow of demand (an injection) into our circular flow of income and spending adding to aggregate demand. M: Imports of goods and services. Imports are a withdrawal of demand (a leakage) from the circular flow of income and spending.
Net exports measure the value of exports minus the value of imports. When net exports are positive, there is a trade surplus (adding to AD); when net exports are negative, there is a trade deficit (reducing AD). The UK has been running a large trade deficit for several years now.
Components of Aggregate Demand - £bn, 2006 prices
Consumer Spending
Government Consumption
Fixed Investment
Exports
Imports
2003
859.3
297.9
221.9
362.1
409.6
2004
887.2
309.3
235.7
379.7
438.0
2005
912.6
316.3
244.4
414.1
468.4
2006
928.8
323.3
258.1
463.8
515.3
2007
954.7
325.7
277.3
454.3
507.3
2008
946.0
332.4
258.3
459.1
498.6
2009
912.2
334.9
215.1
419.3
445.1
2010
921.0
336.5
221.2
447.3
480.1
2011
916.4
336.4
215.9
467.2
481.5
2012
927.4
345.7
217.0
471.3
494.9
Components of Aggregate Demand Shocks to aggregate demand
Many unexpected events cause changes in the level of demand, output and employment
These events are called “shocks”. Some of the causes of AD shocks are as follows:
A large rise or fall in the exchange rate – affecting export demand and second-round effects on output, employment, incomes and profits of businesses linked to export industries.
A recession in main trading partners affecting demand for exports of goods and services.
A slump in the housing market or a big change in share prices
An event such as the credit crunch (global financial crisis) – involving a fall in the amount of credit available for borrowing by households and businesses.
An unexpected cut or an unexpected rise in interest rates or change in government taxation and spending – for example deep cuts in government spending as part of fiscal austerity
These shocks will bring about a shift in the aggregate demand curve
The Aggregate Demand Curve
The AD curve shows the relationship between the general price level and real GDP The AD curve Aggregate Demand and the Price Level There are several explanations for an inverse relationship between AD and the price level in an economy: 1.Falling real incomes: As the price level rises, the real value of people’s incomes fall and consumers are less able to buy the items they want or need. If over the course of a year all prices rose by 10 per cent whilst your money income remained the same, your real income would have fallen by 10% 2.The balance of trade: A persistent rise in the price of level of Country X could make foreign-produced goods and services cheaper in price terms, causing a fall in exports and a rise in imports. This will lead to a reduction in net trade and a contraction in AD 3.Interest rate effect: if the price level rises, this causes inflation and an increase in the demand for money and a possible rise in interest rates with a deflationary effect on the economy. This assumes that the central bank (in our case the Bank of England) is setting interest rates in order to meet a specified inflation target. Shifts in the AD Curve
A change in the factors affecting any one or more components of aggregate demand i.e. households (C), firms (I), the government (G) or overseas consumers and business (X) changes planned spending and results in a shift in the AD curve.
Shifts in the AD curve Factors causing a shift in aggregate demand
Changes in Expectations Current spending is affected by anticipated income and inflation
When confidence falls, we see an increase in saving and businesses postpone investment projects because of worries over weak demand and lower expected profits.
Changes in Monetary Policy – i.e. a change in interest rates
If interest rates fall – this lowers the cost of borrowing and the incentive to save, encouraging consumption & investment
There are time lags between changes in interest rates and AD
Changes in Fiscal PolicyFiscal Policy refers to changes in government spending, taxation and borrowing
Income tax affects disposable income e.g. lower income tax raises disposable income and should boost consumption.
A budget deficit is a net injection of aggregate demand
Economic events in the world economyInternational factors such as the exchange rate and foreign income
A depreciation in a currency makes imports dearer and exports cheaper - the net result should be that UK AD rises
An increase in overseas incomes raises demand for exports. In contrast a recession in a major export market will lead to a fall in exports and an inward shift of aggregate demand.
Changes in household wealth
Changing share and property prices affect the level of wealth
Declining asset prices can hit confidence / a fall in expectations
Changes in the supply of credit
The availability of credit is vital for the smooth functioning of most modern economies
Many banks and other lenders are now more reluctant to lend
Interest rates on different loans have become more expensive
Exports - an injection into the circular flow and a component of AD
