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Aggregate Demand and Aggregate Supply (Aggregate Demand (Why does the AD…

- - - - Consumers are faced with a basket of goods that is increasing in price. As a result, consumers tend to spend less. This is due to the same rational decisions as consumers show when buying a single product or service.
    - - Interest rates are a vital factor in encouraging investment, or deciding it is not worth it.
      - As the rate of interest falls, some projects that were deemed unprofitable become profitable and so firms invest (and vice versa)
      - So as price levels rise, so do rates of interest which leads to lower investment and output.
    - - When it comes to international trade (exports and imports), the levels of X and M are influenced by relative price levels in the trading economies
    - - is exogenous (outside of the model) as government decisions are not influenced by price levels - decisions are autonomous.
- - - - This increases costs
      - This cannot be sustained into the long run.
  - - - Monetarists believe that in the Long Run the economy settles in an equilibrium point of full employment. In other words supply is totally inelastic, because all the factors of production are being used to their full capacity.
      - The real GDP (output) can only be increased by increasing the productive capacity of the economy, by making the factors of production more efficient - in other words economic growth
      - Monetarist tend to use a combination of money supply and supply-side policies to support and/or encourage economic growth.
      - Using the bath analogy, the economy will be in equilibrium in the long run with the bath full as all factor of production are being used.
        
        any increase in aggregate demand that is greater than the increase in LRAS, must cause an increase in the overall price level (inflation) - the bath will overflow
    - - Keynesians believe that an economy can be in equilibrium at a point below full employment and that this can last into the long term
      - The only way that this position can be rectified is to stimulate aggregate demand through the use of fiscal policies
      - They believe in the concept of demand deficient unemployment.
      - Keynesians believe that it is possible for AD to increase without significant increases in the price level when the economy is working within its PPF and at less than full employment.
      - There will come a time when all factors of production are working to their full capacity and the LRAS becomes vertical, just like the Monetarist LRAS
      - Problems:
        
        Keynesian and/or AD stimulus approaches exist in terms of time lags and the multiplier/accelerator.
        
        The government cannot totally predict the final outcome of any additional stimulus in terms of increasing AD into the medium, or even long run
        
        In the intervening period, other factors can change.
        
        Any change in fiscal policy will lead to a change in borrowing requirements. Setting a budget deficit, means that the government must find additional income form somewhere - usually through additional borrowing that increase the national debt.