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| Graphing Exercise: Aggregate Demand - Aggregate Supply The aggregate demand - aggregate supply (AD-AS) model is useful for analyzing changes in both real GDP and the price level. Changes in either aggregate demand, aggregate supply, or both can help to explain recession and unemployment, inflation, and economic growth. Now click here to view an interactive exercise. This will open a new browser window. Then answer the questions below. This exercise is from the website for Begg and Ward Economics for Business. If you have clicked on the link above and cannot see the interactive exercise, you may need to install a free Java plugin for you internet browser. Click here for the plugin. The graph shows the aggregate demand and aggregate supply curves for a hypothetical economy. The AD curve shows an inverse relationship between the aggregate price level and real GDP. This is because an increase in the price level: 1) reduces the real value of dollar-denominated assets, which reduces consumption expenditures; 2) increases the demand for money, which increases interest rates and thereby reduces investment expenditures; and 3) makes domestic goods less attractive to foreigners, which reduces net exports. The aggregate supply curve, on the other hand, reflects the costs of producing a given level of GDP. At very low levels of GDP, resources are unemployed and output may increase with no upward pressure on the price level. However, as real GDP approaches full employment, bottlenecks for some resources appear and costs begin to rise. The price level must rise sufficiently to cover these higher production costs. At some point, however, even higher prices will not attract additional output. The economy has reached its production capacity. The economy is initially at the full employment level of real GDP, labeled Q, and the price level is stable at price level P. To use the graph, click and drag either the AD or AS labels to shift the aggregate demand or aggregate supply curve, respectively, to a new location. The button labeled Reference Lines will toggle on or off the previous locations of the AD and AS curves and the corresponding price and GDP levels. Hitting Reset will restore the economy to full employment GDP and a stable price level. 1. Starting from full employment, what will be the impact of an increase in desired consumption expenditures? AnswerClick Reset to begin from full-employment GDP. An increase in consumption will increase aggregate demand. Click on the AD label and drag it to the right. The shortage of goods and services will start to pull up the price level and provides an incentive for firms to increase their production. The price level and real GDP both rise. 2. Suppose the economy is operating in the vertical range of AS and the government lowers taxes. What effect will this policy have on real GDP and the price level? AnswerDrag the AD curve to the right until it intersects the AS curve in its vertical range. Click on the Reference Lines toggle to establish this as the initial equilibrium. Next, drag the AD curve to the right to illustrate the effect of lower taxes. The price level rises, but no further increase in real GDP is forthcoming because the economy is already operating at its capacity. 3. Suppose the economy is in a deep recession. The government increases the money supply, thereby reducing interest rates. Will this policy increase real GDP? Will it affect the price level? AnswerDrag the AD curve to the left until it intersects the AS curve well into its horizontal range. Release the mouse button to establish this as a starting point. Then, click and drag the AD curve to the right. Initially, real GDP may increase without affecting the price level. However, continued increases in the money supply (further increases in AD) will cause the price level to rise. 4. Suppose the economy is operating at full employment and prices are stable. All else equal, will an increase in wages and salaries increase the aggregate price level? AnswerClick Reset to establish an initial full-employment, stable-price equilibrium. An increase in wages and salaries will decrease aggregate supply. Click and drag the AS label to the left. The price level rises and real GDP falls, a condition known as "stagflation." 5. The late 1990s were a period of dramatically rising stock values and rising labour productivity. Real GDP increased, yet prices remained relatively stable. How might this be explained by the AD-AS model? AnswerClick Reset and note the initial values of real GDP and the price level. Rising stock values increased consumer wealth and expenditures, which increased AD. Click and drag AD to the right. By itself, this would raise both real GDP and the price level. Rising productivity, however, caused a reduction in unit costs and caused AS to increase. Click and drag the AS curve to the right. The price level falls as real GDP increases. Compared to the initial equilibrium, the price level has remained relatively constant while real GDP increased. Graphing Exercise: Aggregate Expenditures An economy will tend towards that level of GDP at which total desired spending is equal to the amount produced. In other words, GDP equals aggregate expenditures of consumption, gross investment, government spending, and net exports. GDP will then fluctuate whenever there are changes in any of these spending components. By implication, GDP need not reach equilibrium at a level consistent with full employment of its resources. For example, if there is too little spending by consumers or by businesses, GDP will fall short of the full employment level, creating a recessionary gap. Exploration: How do changes in aggregate expenditures affect GDP?Now click here to view an interactive exercise. This will open a new browser window. Then answer the questions below. This exercise is from the website for Begg and Ward Economics for Business. If you have clicked on the link above and cannot see the interactive exercise, you may need to install a free Java plugin for you internet browser. Click here for the plugin. The left side of the window shows the current level of taxes as well as the levels of each of the components of aggregate expenditures - C, Ig, G, and Xn - as they are related to the level of GDP. The right side of the window illustrates how these expenditures are combined to form the aggregate expenditures relationship. The consumption graph is drawn such that the marginal propensity to consume is 0.6 while investment, government spending and net exports are assumed to be independent of the level of GDP. To use the graph, click on and adjust any of the sliders adjacent to Investment (I), Government expenditure (G), Consumption expenditure (C), or Lump-sum taxes (T) graphs. These actions will be reflected as autonomous changes in Aggregate Expenditures. Click on the Adjust Income button to restore the economy to equilibrium GDP; click the Reset button to restore all spending components to their original values. 1. Total production is currently £5000 billion. What are the current levels of Consumption, Investment, Government expenditure, taxes, and net exports? What is the current equilibrium level of GDP? AnswerAt the current output level of £5000 billion, consumption expenditure is £3520 billion, investment, government expenditures and taxes are all £800 billion and net exports are £-120 billion. Adding the components of aggregate expenditure, C + I + G + Xn equals current output of £5000 billion. Accordingly, this is the equilibrium level of GDP. 2. By how much does equilibrium GDP change if desired investment spending increases by £400 billion? What is the value of the multiplier? What is the value of the MPC? AnswerUse the mouse to adjust the Investment slider to bring desired investment to a total of £1200 billion. At the £5000 billion level of income, desired expenditures exceed total production; desired inventories will begin to be depleted and production will start to rise. Click on the Adjust Income button to restore equilibrium. The new equilibrium level of income is £6000 billion, £1000 billion greater than before. Since the change in spending which brought this about is only £400 billion, the multiplier is 2.5: £400 times 2.5 = £1000. On the consumption graph, you can see that with the increase in production of £1000, consumption expenditures rose from £3520 billion to £4120 billion, an increase of £600 billion. Therefore the MPC is 600/1000, or 0.6. 3. Suppose the government decides to increase spending by £200 billion. What impact will this have on equilibrium GDP? How does this compare with a £200 billion decrease in taxes? AnswerClick Reset. Both an increase in government spending and a reduction in taxes lead to an increase in desired expenditure. First, drag the Government Spending slider to raise government spending by £200 billion. Note that AE also rises by £200 billion, so that aggregate expenditures exceeds the amount produced at this level of GDP. Click on the Adjust Income button to observe the economy’s readjustment to its new equilibrium income of £5500 billion. (The change in income is the multiplier of 2.5 times the change in government spending.) Click the Reset button to restore the previous income and spending levels. To observe the impact of taxes, click on the Tax slider to reduce taxes by £200 billion. This raises disposable income by £200 billion, of which £80 billion saved and £120 is spent: note the increase in the consumption line by £120 billion. Again, there is an excess of desired spending over production and equilibrium GDP will rise. However, because the amount of increased spending caused by lower taxes is less than the amount of the tax decrease itself, the increase in income is smaller for a tax decrease than it is for an increase in government expenditures. Click on the Adjust Income button; equilibrium income rises to £5300 billion. Comparing these two outcomes, we see that the increase associated with a tax cut is only 0.6 times as large as that from an equal increase in government spending: £300 = 0.6 x £500. That this value is the same as the MPC is no coincidence. 4. In late 2000 and early 2001, the stock market declined substantially and many people’s wealth, in the form of retirement accounts, employee stock ownership plans, and other stock accounts, was substantially reduced. How might this have affected equilibrium GDP? AnswerThe reduction in wealth reduced consumers’ confidence and willingness to spend. To see the impact this had on the economy, drag the consumption slider down to reflect diminished consumption. Aggregate expenditures decreased, resulting in not enough expenditures to support the amount produced. Click the Adjust Income button to observe that equilibrium GDP decreased. 5. Suppose the economy is at equilibrium at the full employment level of GDP of £5000, labeled as Y* in the graph. Further suppose that a fall in consumer confidence dropped consumption spending by £400 billion. How large a recessionary gap would be created? What policies might restore the economy to full employment? AnswerClick the Reset button to restore all spending to initial levels. Equilibrium GDP is £5000. Then, drag the Consumption slider all the way down from 3520 to 3120. Click Adjust Income to observe the corresponding drop in GDP. A recessionary gap of £400 is created. This gap can be eliminated by any combination of policies which would increase spending by £400 - any increase in government spending, investment or net exports, or a reduction in taxes which combine for a net increase of £400 in spending will eliminate the gap and restore full employment. 6. Experiment on your own. What conclusions can you draw about the relationship between levels of the components of aggregate expenditure and equilibrium GDP? AnswerAdjust any of the sliders to show a net increase in aggregate expenditure and click the Adjust Income button. Equilibrium GDP will increase. Likewise, any change in any or all components of aggregate expenditure which cause net expenditures to fall will cause equilibrium GDP to fall. Graphing Exercise: Equilibrium GDP In a closed private economy, where there is neither a government nor foreign sector, aggregate expenditures is equal to consumption expenditures plus planned gross investment expenditures. The equilibrium output of such an economy is that level of output at which the total amount of spending is just equal to the amount produced, or GDP. That is, equilibrium GDP = C + Ig. Consumption expenditures rise with GDP while planned gross investment is independent of the level of GDP. The aggregate expenditures schedule shows the amount of desired spending at each possible output level and can be used to determine the equilibrium level of output. Exploration: What level of GDP is sustainable as an equilibrium? Click here to view an interactive exercise. This will open a new browser window. Then answer the questions below. This exercise is from the website for Begg and Ward Economics for Business. If you have clicked on the link above and cannot see the interactive exercise, you may need to install a free Java plugin for you internet browser. Click here for the plugin. The graph illustrates the relationship between real aggregate expenditures - consumption plus planned gross investment - and the level of real GDP, labeled "Y" on the graph. The graph also illustrates a 45° line. All points on this line share the feature that spending, as measured on the vertical axis, is equal to GDP, as measured on the horizontal axis. As such, points on this line are a graphical statement of the equilibrium condition that planned expenditures equal GDP. To use the graph, click and drag on the green triangle to select a level of GDP. As you drag the triangle, note the "Y" labels on both axes. These move together along the 45° line to indicate the same level of GDP, representing potential equilibria. Click on the Income Adjustment button to observe the economy’s readjustment to equilibrium. 1. Currently the level of GDP is £470 billion. What is the level of desired consumption spending at this level of GDP? What is the level of investment spending? AnswerReading vertically up to the consumption line, we see that consumption spending is £450 billion. Investment spending adds another £20 billion. 2. At what level of GDP is saving equal to zero? At what level of GDP is saving equal to £40 billion? AnswerIn a closed, private economy, saving is the difference between GDP and consumption. On the graph, this is measured by the vertical distance between the 45° line and the consumption line. Drag the green triangle to a GDP of £430 billion. Observe that consumption equals £430 at this level of GDP. If consumers are spending all of their income, saving must equal zero: saving is zero when GDP = £430 billion. To find saving of £40 billion, we need to find the GDP at which consumption is £40 billion less. Drag the triangle to a GDP of £510 billion. Consumption is £470 at this level, or £40 billion less than GDP: saving is £40 billion when GDP = £510 billion 3. If GDP is £510, what is the level of aggregate expenditures, C + Ig? AnswerDrag the green triangle to the right, increasing GDP by £40 to £510 billion. Aggregate expenditures (AE on the vertical axis) is £490. 4. What are the MPC and the MPS in this simple closed, private economy? AnswerClick Reset. Drag the green triangle to the right, increasing GDP by £40 billion to £510 billion. On the vertical axis, observe that expenditures increase by £20 billion, from £470 billion to £490 billion. Investment is constant, so any change in aggregate expenditure must be because of changes in consumption spending. The MPC is the change in consumption expenditure divided by the change in GDP which brought it about. Accordingly, the MPC = £20/£40, or ½. The MPS and the MPC must add to one, so the MPS is also ½. 5. What happens to GDP if desired aggregate spending exceeds the amount produced? AnswerClick Reset. Drag the green triangle to the left, then back to the right, observing the level of aggregate expenditures relative to GDP (labeled "Y" on the vertical axis). Aggregate expenditures will exceed production if GDP is less than £470 billion. Drag the green triangle to a GDP less than £470 billion and click the Income Adjustment button to restore equilibrium. GDP rises until equilibrium is restored at C + Ig = GDP = £470 billion. 6. Explore on your own. How is the difference between saving and investment related to equilibrium GDP? AnswerClick Reset. Saving is measured by the vertical distance between the 45° line and the consumption line. At the current level of GDP, £470 billion, both saving and investment are £20 billion. Drag the green triangle to the left. Saving begins to fall while investment remains at £20 billion. Click the Income Adjustment button and observe that GDP will begin to rise. Drag the green triangle to the right of £470 billion. Saving rises above £20 billion while investment remains a constant £20 billion. Click the Income Adjustment button and observe that GDP begins to fall to restore equilibrium. In summary, if saving exceeds investment, GDP will begin to fall. If saving falls short of investment, GDP will rise. |