AGGREGATE DEMAND AND SUPPLY

1
AGGREGATE DEMAND AND SUPPLY

• Just as the intersection of demand and supply for
  a product determines price in a single market,
  the intersection of aggregate demand and
  aggregate supply determines the overall price
  level in the economy
• The AD curve slopes down from left to right due
  to
• - international substitution effect if prices
  in economy fall people will be
• encouraged to buy more domestically
  produced goods (and less imports)
• - the inter-temporal substitution effect if
  prices fall people will need less
• money leading to lower interest rates and
  higher levels of expenditure
• - the real balance effect if prices fall
  peoples real savings will increase
• leading to further expenditure
• The AS curve slopes up from left to right due to
• - greater profits to be made at higher prices
  (while real wage rates remain the
• same however the curve tend to
  eventually become inelastic due to
• diminishing returns and growing shortages (as
  economy nears full production)

2
Aggregate demand and aggregate supply
AS
Price level
If the price level is initially P2, the excess
demand will cause price level to rise to Pe
AD
O
National output
3
ECONOMIC GROWTH AND THE BUSINESS CYCLE

• Distinction between actual and potential growth
• - Actual growth is the percentage increase in
  national output the rate of growth in actual
  output.
• - Potential growth is the rate at which an
  economy could grow if working at full capacity.
• An economy can easily under perform. Thus for
  example in a recession the actual rate of growth
  may be well below the potential level.
• Short-run concerns in economies often relate to
  the actual rate of growth (and the desire to
  maintain it at a high level).
• Long run concerns are more with factors of
  production in the economy that can potentially
  influence the rate of growth.

4
Growth and the production possibility curve
b
Good X
Growth in actual output
a
I
O
Good Y
5
ECONOMIC GROWTH AND THE BUSINESS CYCLE

• There are four phases that are identified in
  terms of the business cycle
• 1 The upturn
• 2. The expansion
• 3. the peaking out
• 4. The slowdown  
• - In practice this are not fully regular as
  diagrams would suggest. For example sometimes the
  expansion phase (boom)  might be very short. In
  other cases the slowdown (recession) might extend
  over a decade..
• - Also a recession could vary significantly from
  mild to extremely severe.
• - Fluctuations in output are usually caused in
  the short-term by variations in the overall level
  of aggregate demand (i.e. the total expenditure
  in the economy). - In the long-run changes in
  the potential of the economy to produce output
  are more important.

6
Real GDP in France and the UK
Source AMECO database (European Commission) and
OECD Economic Outlook (OECD) Note 2009 and 2010
figures based on forecasts
7
Economic growth in the UK
Source National Statistics times series data
8
The business cycle
Potential output
National output
Actual output
3
4
2
1
O
Time
9
POTENTIAL CONTRIBUTION TO GROWTH

• Increases in Quantity of Resources
• Capital
• - Output depends on stock of capital invested in
  economy e.g. roads, factories, machinery,
  buildings etc.
• - A major factor in the growth of the Celtic
  Tiger (1994 - 2001) was a huge increase in
  multinational investment in Ireland (especially
  by US firms). - By contrast very poor nations
  (as in Africa)  are unable to set aside
  sufficient resources for investment and therefore
  find it hard to achieve economic growth. -
  Investment needs to be financed out of savings
  (or borrowing) and understandably poor countries
  find it hard to save.

10
POTENTIAL CONTRIBUTION TO GROWTH (con)

• Labour
• - Clearly if the numbers working increases, the
  level of output should also increase.
• This was also a major factor in the boom in the
  Irish economies in the late 90's. the work force
  effectively doubled in 10 years enabling a very
  large increase in output.
• - However as well as the numbers working, the
  quality of labour employed (e.g. in terms of
  education and skills is very important).
• - Ireland can no longer compete with lower cost
  countries (such as in Eastern Europe) in terms of
  unskilled production. Thus it makes greater sense
  for us to concentrate on more skilled areas such
  as information technology.

11
POTENTIAL CONTRIBUTION TO GROWTH (con)

• Land and Raw Materials
• Ireland is well endowed with agricultural land
  (with agriculture and
• the food industry important sectors of the
  economy).
• Unfortunately we are not well endowed with
  important raw materials
• such as oil and gas.
• - However though helpful these are not vital
  for economic growth (as
• the success of Japan after the 2nd World
  War demonstrated).
• Enterprise
• - This is the 4th factor of production. If an
  economy is to thrive, people
• must be willing to undertake the risks
  of setting up business.
• In the past there was a great lack of an
  enterprise culture in Ireland
• which inhibited growth. This is why
  we began to rely so much on importing enterprise
  from
• abroad by attracting multinational
  companies through tax breaks and
• grants.  

12
POTENTIAL CONTRIBUTION TO GROWTH (con)

• Increases in Productivity
• - Changes in technology are very important to
  prevent the law of diminishing returns setting in
  with respect to investment. So for example the
  rise of computer and internet technology has
  greatly increased the possibilities for new types
  of investment thus enhancing growth prospects.  
  
• Policies to achieve Growth
• - The policies of the Government can greatly
  affect the capacity of an economy to grow.
  During the 1980's there was very little growth
  in the Irish economy largely because of the past
  effects of reckless Government borrowing. In
  recent years the determination of the Government
  to reduce income tax initially contributed
  considerably to our growth prospects. However
  subsequent reliance on a massive property bubble
  has created much of our present problems  

13
Explanations of Long-term Growth

• Neoclassical or Solow growth model
• diminishing returns to capital
• need for replacement investment
• steady-state national income
• effect of an increase in the saving rate

• human capital and education
• technological progress

14
CAPITAL ACCUMULATION

• The rate of growth of capital accumulation
  depends on two factors
• 1. the marginal capital output ratio this
  is the amount of extra capital
• ?K divided by the extra amount of output
  that it produces divided ?Y
• So k ?K/?Y
• The lower the value of k the higher is the
  productivity of capital
• 2. the proportion of national income that is
  invested (i) which assuming that
• all savings are invested is the
  proportion that is saved (s)
• The formula for growth becomes
• g i/k (or g s/k)
• Thus if 20 of national income went into new
  investment with the marginal capital output ratio
  k 4, then the growth rate 20/4 5

15
Steady-state output
Output (Y), Investment (I), Depreciation (D)
Equilibrium at point g
O
K1
Capital stock (K)
16
Effect of an increase in the rate of saving and
investment
Output (Y), Investment (I), Depreciation (D)
Initial equilibrium
K1
K2
Capital stock (K)
17
Effect of a technological advance
Output (Y), Investment (I), Depreciation (D)
K1
K2
Capital stock (K)
18
Explanations of Long-term Growth (con)

• Endogenous growth theory
• when technological progress is not a given
• determinants of technological progress
• importance of institutional factors policies
• research and development
• training and education
• incentives
• impact on production function?
• move upwards over time
• become steeper

19
REASONS FOR IRELANDS BOOM

• Continued investment in education since 1960s
  with more emphasis in recent years on technical
  education
• Considerable foreign direct investment (FDI) -
  especially from US - in Ireland due to following
  reasons
• - generous grant support and tax concessions by
  Government
• - Ireland a member of EU since 1973
• - only English speaking country in Eurozone
• - availability of skilled labour
• - political stability
• Generous structural funding by EU during late
  80s and 90s providing funds for infrastructural
  development
• Availability of labour supply both in
  quantitative and qualitative terms through
• - unemployed, significant increase in female
  participation, open approach to
• immigration etc.

20
REASONS FOR IRELANDS BOOM (con)

• Government Policy
• - promotion of a more enterprise oriented
  approach
• - responsible management of fiscal policy
• - emphasis on continuing tax reductions as a way
  of stimulating
• incentives
• Pay Constraints
• - in view of the high productivity levels
  attained, growth in incomes
• were very moderate during the 90s
• - significant improvement in industrial
  relationships
• International Conditions
• - as Ireland is a very open economy, favourable
  conditions in major
• markets are very important (with rapid
  increase in exports up till
• 2001)

21
REASONS FOR IRELANDS BOOM (con)

• After temporary downturn in01 and 02 return to
  substantial economic growth (03 -07) though at a
  lower rate than in first phase
• However a significant change in the reasons for
  growth was at work
• - continued foreign investment in Ireland under
  threat from cheaper
• countries in Eastern Europe and elsewhere
• - exports which had grown very rapidly until
  2001 had been stagnant since
• 2001
• - later boom very much driven by massive growth
  in construction
• - demand for property largely dependent on the
  extension of increased credit
• So in a sense we were borrowing from
  future to pay for todays activities
• - wage rates and other expenses had risen
  considerably making Ireland an
• increasingly expensive country within
  which to do business

22
PRESENT SITUATION

• A sharp downturn in Irish economy has taken place
  due to a number of reasons
• - substantial drop in activity in construction
  sector (which had been
• the recent engine of growth)
• - continuing fall in stock markets around the
  world (and especially in
• Ireland) further damaging business
  confidence
• - severe worldwide financial crisis directly
  impacting on construction
• activity and on economy in general
• - reckless lending by Irish banking sector has
  damaged our credit
• worthiness abroad
• - recession in US and other markets (of great
  importance to Irish
• economy)
• - despite recent fall in inflation, cost basis
  still very high in Ireland making us vulnerable
  to competition and movement of multinational
  firms elsewhere

23
GROWTH IN CHINA

• Capital
• - high savings rate is then efficiently
  channelled by government into
• key infrastructure projects
• - clever concentration on showcase investment in
  key areas which
• helps to attract foreign investment
• - creation of specific investment zones, free
  trade and tax incentives
• - quick approval of investment projects
• - strong industrial tradition with China now
  seen as the worlds
• leading manufacturing base
• Labour
• - China benefits from a vast pool of potential
  cheap labour with many
• of the 40 of the population still working
  for very low returns in
• agriculture eager to move to other sectors
• - benefit from a vast diaspora abroad who
  increasingly are being
• encouraged home to aid the economic
  effort
• - increasing emphasis on educational and
  technical skills with many
• going abroad to achieve their objectives

24
GROWTH IN CHINA (con)

• Land and Raw Materials
• - China has an abundance of natural resources
  e.g. coal, iron ore,
• oil, natural gas and minerals (such as
  lead aluminium and zinc)
• - because of the demands of domestic growth,
  China has invested
• heavily in Africa and other countries
  with a view to exploiting its rich
• natural resources such as oil and copper
• Enterprise
• - liberalisation measures by ruling party has
  greatly increased
• opportunities for domestic enterprise
• - multinational investment - which is at present
  welcomed increases
• access to enterprise in the higher tech
  industries
• Other
• - huge domestic market
• - strong business attitude
• - authoritarian government (preserving political
  and social cohesion) with a
• desire to promote growth

25
COSTS OF ECONOMIC GROWTH

• The benefits of economic growth are obvious. The
  standard of living increases with people in
  general having more money to spend on consumer
  goods and services. Also it enables the
  Government to improve services such as health and
  education and spend more on improving the
  infrastructure e.g. roads.
• However there are costs
• Higher growth in the short run could require more
  investment thus lessening resources for
  consumption. This happened in a dramatic fashion
  in the Soviet Union under Stalin!
• Growth can generate extra demands and social
  pressures to keep up so that people still feel
  that they have too little.
• There may be adverse social effects as people
  become more materialistic and less caring in
  society.
• There can also be environmental consequences e.g.
  terrible traffic congestion in major cities.
• Non-renewable resources e.g. oil and gas can be
  run down and finally the benefits may not be
  distributed equally.  

26
UNEMPLOYMENT

• Meaning of Unemployment
• - measurement by live register
• - QNHS measurement by ILO and PES methods
• Standardised Unemployment
• - ILO measurement which requires that no payment
  for
• even I hrs work in previous week made, or
  that no search
• was made in previous four weeks or that
  person not
• available to take up employment in next two
  weeks
• Labour force made up of those in employment or
  seeking employment excludes many students still
  in full-time education and married women who opt
  to stay at home

27
Unemployment rates in selected industrial
economies
Notes 2011 and 2012 based on forecasts EU-15
the member countries of the European Union prior
to 1 May 2004 Source based on data in AMECO
Database, European Commission, DGECFIN
28
Average unemployment rates by decade ()
29
Standardised unemployment rates(December 2010)
Source Statistics Database, Eurostat, European
Commission
30
TYPES OF UNEMPLOYMENT

• Classical - arises from artificial restrictions
  on market forces e.g. by trade unions
• Involuntary (Keynesian) - due to business cycle
  e.g. a fall in aggregate demand
• leading to recession
• Structural - applies to special groups of workers
  or regions of the economy requires special
  measures
• Frictional (short-term) - can reflect a healthy
  jobs market leading to considerable job mobility
• Cyclical - due to variations in economic activity
• Technological e.g. application of IT systems
• Seasonal e.g. changing availability of work in
  tourist sector
• Wholetime, part-time and temporary
• Hidden

31
Classical unemployment
ASL
Average (real) wage rate
W2
We
ADL
O
No. of workers
32
Equilibrium and disequilibrium unemployment
ASL
N
Disequilibrium unemployment
Average (real) wage rate
b
a
c
W2
e
We
ADL
O
No. of workers
33
COSTS OF UNEMPLOYMENT

• Losses to unemployed themselves in terms of lower
  earnings than possible from social welfare
  payments
• Losses to economy and economic growth through
  waste of valuable productive resource
• Costs to government and tax payers (less tax
  raised and higher social spending required)
• Workers who stay unemployed for long periods may
  lose valuable skills
• Other costs - higher rates of crime and domestic
  problems
• Can be very demoralising for those affected and
  community as a whole

34
MEASURES TO DEAL WITH UNEMPLOYMENT

• Achieving and maintaining higher levels of
  economic growth in economy
• Adopting specific measures to deal with problem
  areas - e.g. retraining for workers made
  unemployed, special job schemes for young
  workers, infrastructural investment in
  disadvantaged regions etc.
• Improving job information services
• Matching educational programmes to future job
  needs in economy
• Job sharing schemes
• Incentives for those with enterprising ideas
• Lower tax rates on employed

35
INFLATION

• Inflation refers to the general rise in prices in
  economy
• Main measurement is Consumer Price Index (CPI)
  which is perhaps the best known of all indices.
  It is now measured on a monthly basis in Ireland
• Level of inflation in Ireland had been higher
  than other EU countries
• prior to the recession but fell from 4.1
  for 2008 to 4.5 for 2009
• The degree of inflation can vary as between
• - mild
• - creeping
• - rampant
• - hyper
• Fast rising inflation undermines the value of
  money

36
CAUSES OF INFLATION

• Demand pull
• - when overall demand exceeds supply (e.g. in a
  boom)
• Cost push
• - when costs push up demand e.g. wages through
  trade union pressure,
• - profits of monopoly firms and imported
  inflation
• Sectoral inflation
• - e.g. when excess demand in certain labour
  markets pushes up price
• Monetarism
• - where inflation is due to excess money supply

37
Demand-pull inflation
AS
Price level
P2
P1
AD2
AD1
O
Q1
National output
38
Cost-push inflation
AS2
AS1
Price level
P2
P1
AD
O
Q1
National output
39
Inflation rates for selected countries (average
per annum)
Source based on data in European Economy
Statistical Annex (European Commission)
40
Inflation in Zimbabwe
41
EFFECTS OF INFLATION

• Reduces the value of money creating a wage price
  spiral
• Can redistribute money away from those on fixed
  incomes
• Encourages speculation in the economy
• - property market in Ireland during Celtic Tiger
• - investments in stock market
• Penalises savers and rewards borrowers
• - higher inflation in Ireland than EU
  contributed to credit boom
• Causes uncertainty which is bad for planning
• Can have damaging effect on international
  confidence affecting exchange rates, interest
  rates, foreign investment etc.