Economics Essays – Aggregate Demand

Explain the meaning of aggregate supply (AS) and aggregate demand (AD) and explain what factors cause shifts in the curves.

Aggregate demand is the sum of all expenditure in the economy over a period of time.

AD = C+I+G+(X-M)

Where: C = consumption Spending

I = Investment Spending

G = Government Spending

(X-M) = net export or balance of payments (exports minus inputs)

The aggregate demand curve describes the aggregate demand (overall level of spending) at different price levels. Traditionally the y-axis displayed price but current thinking has replaced this with inflation. This is because an actual fall in prices is unlikely and that central banks prefer to target interests rates as opposed to money supply as a policy tool. On the x-axis is measured real GDP or Real National Income or Real Output. The AD curve is taken to slope down from left to right (fig 1) because a rise in the price level is assumed to be met by a rise in interest rates which will increase the cost of borrowing. Therefore consumption spending will fall, investment will fall and international competitiveness will decrease resulting in a fall in exports and a rise in imports (balance of payments decreases).

Shifts in AD occur when changes in C, I, G, X and M occur as the result for example a change in interest rates. Factors that increase C, I, G, X and M result in a shift of the curve outwards (AD2) and vice a versa. Factors affecting C, I, G, X and M are in fig 2

Fig 2:

Aggregate supply is the capacity of the economy, the amount it will produce (or can produce) at a given price. It is a function of the costs of production, level of technology, labour skills, incentives to production, taxation, capital, productivity and the labour market. However economists disagree on the resulting shape of the curve having an obvious impact on the conclusions of any analysis. There are three main approaches.

1)

Keysian economists suggest the curve shown in fig 3. At Yf the economy is at full production it cannot; labour force/skills and resources are exhausted. At Y1 the economy is at under-capacity and there will be widespread unemployment, since a lower level of production requires a reduced volume of labour. As the economy moves from Y1 to Yf resource and skill shortages occur.

Shifts in the curve result from changes in the production possibility frontier. For example new technology or an increase in the workforce as the result of immigration

2)     Classical economists divide AS into long and short term (fig 4). In the short-term wage rates and other input costs are fixed. However companies can only increase production by increasing costs. For example, although wage rate stays the same the payment of overtime results in a higher wage bill. Increases in input costs (e.g. an increase in the wage rate) result in a shift of the curve upwards and vice versa.

In the long term AS is said to be perfectly inelastic (vertical line), as wages and input costs are likely to adjust to price increases there will be no under use of resources and markets will clear resulting in firms supplying at the maximum capacity of the economy regardless of the inflation rate.

3) The middle approach used for general analysis fig 5. This assumes that as production increases so do costs but that this function although undefined falls somewhere between the Keysian and classical approaches.

b) Using AD/AS diagrams with discussion, illustrate the likely impact of a rise in interest rates on the growth of output and the level of prices in the UK.

Normally an interest rate rise would occur as a result of a rise in prices. However if we raise interest rates at a given price this rise will still increase the cost of borrowing. This will in turn lead to a fall in consumption spending and investment, international competitiveness will decrease resulting in a fall in exports and a rise in imports (balance of payments decreases). The AD curve will therefore shift inwards AD2 (fig 6). The equilibrium point between AD and AS will therefore move to E2. Since an actual fall in prices is unlikely this will result in a lower inflation level P2 but at the cost of a decrease in output (national income) and an increase in unemployment since the lower output requires fewer units of labour. Since we have moved along the AS curve to the left output growth is also likely to be diminished

Q2.

a)    Explain why unemployment and inflation are a problem for business.

A rise in inflation will result in a rise in interest rates, which will reduce aggregate demand, see Qu a. Reduction in demand will decrease sales and therefore profits, if businesses do not adjust this may also lead to oversupply.

In addition as interest rates increase the cost of borrowing, investment will therefore be reduced limited the business’ capacity for growth. Interest rate raises also harm competitiveness abroad and therefore will be damaging to export driven industries. If inflation rates rise this is likely to force companies to raise wages in the long run, which will squeeze profit margins.

Unemployment has an affect on consumption, if fewer people are working then they have less money to spend, less consumption results in reduced profits. Unemployment also indicates an economy at under capacity and therefore not maximising production which in turn means an under exploitation of potential (assuming demand would keep pace) sales/profits. Unemployed people also devalue in terms of experience and skills the longer they are unemployed which is damaging in the long term to business human resources

b)    Assess how the UK government policy has tried to control unemployment and inflation rates in the past 10 years.

Since the 1992 UK exit of the ERM UK government policy has concentrated on the creation of a stable environment for business the major target of which has been to keep inflation low. The government set a target of 2.5% inflation (retail price index measure) responsibility for meeting this target has fallen to the bank of England’s monetary policy committee (MPC) who has used the interest rate base rate to manipulate inflation. In 2004 the chancellor change the inflation target to within 1% point of 2% consumer price index. Inflation has remained low throughout this period. By focusing in inflation we would expect a negative effect on unemployment (Philip’s curve). The government used policy to promote job creation and improve education and skills in order to counteract this (new deal). Till the end of 2004 the UK saw 50 consecutive quarters of growth, in addition the UK’s growth and comparative economic strength have meant good international competitiveness all of which have meant that although unemployment has varied it has remained below EU average.

Q3.

a) Distinguish between a free trade area and a customs union in relation to the process of further economic integration.

Free trade area is a group of countries or states between which there are no tariff (direct tax or duties paid on goods entering) or non tariff (restrictions on quantity or entrance method, must all come through one port, or excessive bureaucracy) barriers. The difference between this and a custom union is that for it’s members a customs union offers a free trade area but to non members it offers a uniform customs policy (equal tariff and non-tariff barriers) regardless of which country of the union the external goods will be entering. Both mechanisms further economic interdependence by promoting trade, the more dependent a country is on another for its supply of goods or services the greater it’s dependence on that country and the reciprocation of this is therefore interdependence. However a customs union requires further economic integration because of the necessity to agree and implement the universe external tariff system. In addition the internal free trade area of a customs union positively biases trade between member states thus forming closer economic ties between the small numbers of member states.

A customs union is also normally formed as a method of increasing economic political and social ties between member states (e.g. EU) whereas general free trade agreements are normally directed at simply increasing trade and growth (e.g. GATT, WTO).

b) To what extent do the disadvantages of a customs union outweigh the benefits enjoyed by many firms in the member states?

The level of benefits or disadvantage to firms entering a customs union is greatly dependent on their situation prior to joining. If the states none union tariff level was high and firms were inefficient then joining the union would have a larger negative effect due to increased competition both from within the union and from outside (given a comparatively lower external tariff) and will be at a competitive disadvantage. If however the state has a low tariff structure and the firms are efficient they will benefit from better access to internal markets and if external tariffs are comparatively higher may enjoy more protection. The focus of a firms trading is important. If a firm imports resources form within the customs union these will become cheaper, if it imports from external states and the union tariffs are comparatively higher then its imports will become more expensive. If a firm operates domestically it will face increased competition form member states but may be better protected if tariffs are comparatively higher from external firms. Exporting firms will benefit form greater access to internal markets but may suffer from reciprocating tariffs of none member states if the CU tariff is comparatively higher. If a firm is prior to joining a CU highly protected and inefficient or if most of its business is done external to the union it is likely to have a net disadvantage in joining especially if the common external tariff differs negatively (dependent on firm) from the pre-CU level.