Document Sample

                               Shift in AD curve

A change in any of the components of AD(C,I,G,X or M) will change AD, i.e
shift the AD curve .

For eg., an increase in consumption increases aggregate demand from AD0
to AD1 and leads to increases real output (y1) and a higher price level. (P1)

The four main factors affecting AD are expectations, international
issues, fiscal and monetary policies.

EXPECTATIONS: Expectations are perhaps the most powerful overriding
force in changes in aggregate demand. The main expectations-based
variables are;

a)Inflationary expectations:

Inflationary expectations           C          AD      and vice versa.

b) Wealth & Income expectations:

Expected Income/wealth              C /S       AD       and vice-versa

c) Profit & Revenue expectations:

Profit & Revenue expectations              I      AD     and vice versa
d) Policy Expectations:

A favorable policy of government like an expectation of increase in interest
rates will affect expenditure pattern and thus can decrease AD & vice –versa


The three basic factors affecting an economy’s AD due to international
variables are exchange rate, trading partners’ income, relative prices
of trade partners

Exchange rate:

exchange rate            X   &M          AD   & vice-versa

Trading Partners Income:

Trade partners’ Y                X       AD

Relative Prices:

Trade partners’ price level          X   &M           AD

                          DEMAND SIDE POLICIES

The two remaining influences on AD have been put here, Under demand side
policies in order that their connection to political intentions and business
cycle may be made clearer. Fiscal and monetary policies conducted by
government and central bank respectively, have a major impact on AD and
business cycle.

                              MONETARY POLICY

Monetary policy is in the hands of central bank and involves adjusting
interest rates(r). Tight/contractionary monetary policy, here an
increase in interest rates(r) has a twofold effects;1) the opportunity cost of
consumption (which is the interest forgone) rises; and 2) the cost of
servicing loan (the interest payments) increases. The compound effect will
be that savings(S) increases and borrowing decreases. Both lead to a fall in
two major components of AD in the economy: Investment (I) and
Consumption (C). Conversely loose/expansionary monetary policy of
lowering interest rates will have a stimulatory effect on AD.
              I: business cycle &Demand management.

When real GDP increases beyond the long run trend of potential GDP (t0 in
the business cycle diagram) there are negative influences on several of the
main macro objectives, such as rising inflation and possibly a trade deficit.
The govt. can try to countermand this by deflationary policies; lowering
Govt. spending and increasing various taxes, while the central bank can
increase the interest rates.

An economy in recession will warrant opposite demand management;
expansionary policies. When the economy is operating below potential GDP
and moving into slump, around t1 in above fig, govt. can lower taxes and
/or increase Govt. Spending .The central bank can implement loose
monetary policy by lowering interest rates. Both policies help to induce firms
and households to increase investments and consumption, resulting in an
increase of AD.


The figure below shows the long run effect of expansionary demand
management- increasing govt. spending and/or lowering interest rates- with
the economy initially at full employment level of output, point A.

An increase in AD will increase output in the short run, but also make factors
scarce and decrease real wages for workers. As factor prices are bid up by
both firms and workers, in the long run the short run AS will shift to the left
back to the original LRAS curve but at higher price level.

                Interest rate as a tool of monetary policy

Real interest rate: = nominal interest rate - inflation rate

Interest rates are in fact the key tool in monetary policy and managed by
the central bank. Here are a number of functions of central bank, whereof
three are central to the monetary policy dealt with here

   1. To implement monetary policy through goals set by government,
      involving setting interest rates and the supply of money
   2. To be the lender of the last resort i.e. seeing to it that commercial
      banks’ need for cash is met. This is done at an interest rate known as
      discount rate which is a key in setting market interest rate.
   3. To regulate commercial bank lending, an example of which is setting
      minimum levels of cash which commercial banks must keep on hand,
      so called minimum reserve requirements.

   When interest rates are high, the tendency of people is to control their

  the government employs is to lower down the interest rates, to attract
  people to borrow money and spend them on projects or businesses.
  threatening a rise in inflation), the government increases interest rates to
  make access to excess money more expensive and arrest spending.

  Exchange rate policies: Monetary policy can intentionally affect a
  country’s exchange rate and thus the domestic economy. If the central
  bank raises interest rates, foreign firms, financial institutions,
  investors/speculators will see an increased rate of return if they buy their
  currency. This will increase the demand for the currency leading to
  appreciation and vice-versa.

                              FISCAL POLICY

Government can influence Ad in the economy by using taxes (T) and/or
government spending (G). An increase in income tax lowers households’
disposable income which in turn lowers consumption and AD. Increased
expenditure taxes, e.g. VAT, have the same effect. Since the govt. has the
power to adjust govt. spending- which is a component of AD – this will have
a direct impact on total expenditure in the economy. A boost in govt.
spending will lead to an increase in AD & vice versa.

Govt. budget

The govt. budget is a fiscal policy instrument and political intention
comprising govt. spending for a fiscal year. When receipts are higher than
spending then there is a budget surplus. When spending exceeds receipts
there is budget deficit. The sum of deficits minus surpluses over time
equals the national debt. The portion of national debt which is owed to
foreign banks/govt. is foreign debt.

Automatic stabilizers

Changes in government purchases, taxes and transfer payments can have
an impact on equilibrium aggregate demand. When a government
deliberately changes its spending or taxation policies in order to influence
aggregate demand, we call that "fiscal policy." But there is another, more
automatic way that spending and taxation can influence the economy.

      Some kinds of taxes rise more than proportionately when income
       increases. A progressive income tax is an example of this.
       "progressive" means that the tax rate is higher on higher incomes.
       Thus, when income in general increases, more people are in the higher
       tax brackets, and so the average tax rate is higher.
      Some kinds of transfer payments and government purchases rise
       when income drops. Unemployment compensation and income
       supplements for poor people are examples, as are purchases of
       services for the poor. When income in general drops, there are more
       poor people eligible for these transfers and services, so spending on
       them increases.

These taxes, transfers, and purchases are automatic stabilizers of the

Discretionary Fiscal policy

Discretionary Fiscal policy is the deliberate manipulation of government
purchases, taxation, and transfer payments to promote macroeconomic
goals, such as full employment, price stability and economic growth.

                        Shifts in AS/Supply Side Policy

   Shifting SRAS curve

   The SRAS curve in the AS-AD model will shift when production cost for
   firms change. Three specific short run influences are:

   1. Price of labour: An increase in wage rates will increase cost which
      mean shift of SRAS to left
   2. Price of inputs: If pr of input decreases then curve will shift right.

  3. Taxation & Legislation: If taxes decrease then supply will increase and
     legislation are favorable then supply increase.

  Increase & Decrease in AS

Shifting the LRAS Curve

  A number of other influences will affect SRAS, mainly improved
  technology, increases labour capital, improvements in production
  processes and general other efficiency gains. However, these are more
  long-run influences since the introduction of new technology, production
  methods and improvements in the labour force are incremental (bit by
  bit). LRAS represents long run potential output – will be affected by
  changes in the quality and /or quantity of factors of production.

   Supply side policies

Supply-side economic policies are mainly micro-economic policies designed
to improve the supply-side potential of an economy, make markets and
industries operate more efficiently and thereby contribute to a faster rate of
growth of real national output

Most governments now accept that an improved supply-side performance is
the key to achieving sustained economic growth without a rise in inflation.
But supply-side reform on its own is not enough to achieve this growth.
There must also be a high enough level of aggregate demand so that the
productive capacity of an economy is actually brought into play.

Supply-side policies in product markets are designed to increase competition
and efficiency. If the productivity of an industry improves, then it will be able
to produce more with a given amount of resources, shifting the LRAS curve
to the right. The following will lead to increase in LRAS.


Deregulation of Markets

Toughening up of Competition Policy

A commitment to free international trade

Measures to encourage small business start-ups / entrepreneurship

Capital investment and innovation:

Trade Union Reforms

Increased Spending on Education and Training

Income Tax Reforms and the Incentive to Work

         Advantages & Disadvantages of demand side policies

Advantages: By using demand side policies it is possible to influence the
level of economic activity and therefore output, unemployment, inflation and
the trade balance. It helps to achieve macro- economic goals. Automatic
stabilizers help even out economic cycles and create stability and

predictability in the economy. Discretionary fiscal policy allows govt. to steer
the economy in line with economic goals and economic welfare.


   1. Inflation

Inflation is the leading disadvantage of demand-side economics. The
demand-side perspective argues that the market economy, left to its own
devices, will not ensure sufficient adequate demand, which means that
society will not utilize its full production capacity.

   2. Budget Deficits

During a recession or other economic slowdown, output declines as a result
of reduced activity. Higher government spending to compensate for the
decline in aggregate demand is generally financed by borrowing, which
increases government deficits and raises the national debt.

   3. Policy Lags

The problem is the lag between recognition of the need for government
action and the actual implementation of appropriate policy measures. Often,
the policy-making process itself is responsible for the delay in the adoption
and implementation of policy measures. Further, there is an additional lag
between the policy itself and the effects resulting from it. Often, many
months may elapse between a change in government economic policy and
the policy's effect on the economy.

           Advantages & Disadvantages of supply- side policies

It is possible to influence the level of economic activity and therefore output,
unemployment, inflation and the trade balance.

The advantages
      1.     Supply-side policies can help reduce inflationary pressure in the
      long term because of efficiency and productivity gains in the product
      and labour markets.

     2.    They can also help create real jobs and sustainable growth
     through their positive effect on labour productivity and
     competitiveness. Increases in competitiveness will also help improve
     the balance of payments.

     3.    Finally, supply-side policy is less likely to create conflicts
     between the main objectives of stable prices, sustainable growth, full
     employment and a balance of payments.
The disadvantages
     1.    However, supply-side policy can take a long time to work its way
     through the economy. For example, improving the quality of human
     capital, through education and training, is unlikely to yield quick
     results. The benefits of deregulation can only be seen after new firms
     have entered the market, and this may also take a long time.

     2.    In addition, supply-side policy is very costly to implement. For
     example, the provision of education and training is highly labour
     intensive and extremely costly, certainly in comparison with changes
     in interest rates.

     3.    Furthermore, some specific types of supply-side policy may be
     strongly resisted as they may reduce the power of various interest
     groups. For example, in product markets, profits may suffer as a result
     of competition policy, and in labour markets the interests of trade
     unions may be threatened by labour market reforms.
     4.    Finally, there is the issue of equity. Many supply-side measures
     privatization have all contributed to a widening of the gap between rich
     and poor.


Shared By: