H2 ECONOMICS NOTES FOR AGGREDATE DEMAND AND SUPPLY

Definitions Needed for This Topic

1. Aggregate Expenditure: is the total planned expenditure on goods
and services in an economy AE = Consumption + Investments
(I) + Government Expenditure (G) + Net Exports (X-M) in a 4-sector
economy.
2. Autonomous consumption: is the minimal consumption expenditure
by households when the income is zero i.e. independent of income.
3. Induced consumption: is the change in consumption when the
income changes. It is dependent on income.
4. Average propensity to consume (APC): is the proportion of total
income that is consumed
5. Marginal propensity to consume (MPC): is the change in
consumption as income changes.
6. Savings: is the residual in consumption.
7. Average propensity to save (APS) is the proportion of income that is
saved.
8. Marginal propensity to save (MPS): is the change in savings as
income changes.
9. Disposable income: is the income after deduction of personal
income tax and transfer payments.
10.
Investment: is the expenditure on the production of capital
goods and net additions to stock of goods over a given period of
time.
11.
Autonomous: is the investment influenced by the firms longrun profit outlook and is independent of national income (NI).
12.
Induced investment: is the investment that varies directly with
national income and is a result of firms responding to changes in the
flow of income.
13.
Marginal efficiency of investment (MEI): is the relationship
between interest rates and the level of investment.
14.
Government expenditure: is the current spending and capital
spending by the government on provision of goods and services.
This is assumed to be autonomous in the short run as it is
independent of national income.
15.
Net exports: is the difference between the value of exports
and the value of imports of goods and services. This is assumed to
be autonomous as it is independent of national income.
16.
The paradox of thrift: states that the other things being equal,
the more frugal and thrifty the economy is, the lower will be the
level of national income and total employment.
17.
Aggregate demand (AD): is the total level of demand in an
economy showing inverse relationship between price levels and real
equilibrium output level where planned spending (C+I+G+X-M) is
equal to actual output. This is illustrated by a downward sloping
curve.

H2 ECONOMICS NOTES FOR AGGREDATE DEMAND AND SUPPLY

18.
Aggregate supply (AS): is the amount of goods and services all
firms in the economy are willing to supply at different price levels
over a given time period, usually a year.

Consumption
Income Factors
1. Wealth
a. It refers to real assets (houses, cars) and financial assets
(cash, bank, insurance, stock)
b. More wealth spend more and save less of income C
increase + S decrease.
2. Distribution of income
a. The poor have higher MPC. With the increase in income, they
spend proportionately more so C increases. This is because
the poor has to fulfil their basic needs.
b. The rich have lower MPC. With the increase in income, they do
not spend proportionately more so C decreases.
3. Government policies
a. If the government raises the income tax, there is less
disposable income and less spending and savings. C and S will
decrease.
b. If the government reduces the income tax, there is more
disposable income and more spending and savings. C and S
will increase.
4. Expectation of future prices
a. Expect future prices of goods and services to rise, spend now
and current C increase.
b. Expect future prices of goods and services to fall delay
spending and current C decreases.
5. Expectation of future incomes
a. Expect future income to rise, the consumers feels richer will
spend now so current C increases.
b. Expect future income to fall or stagnate, spending will fall and
savings increase so current C decreases and S increases.
6. Thriftiness
a. Less thrifty materialistic spend more + save less C
increase + S decrease
b. More thrifty spend less + save more C decrease + S
increase.
7. Consumer credit
a. Easily available + low interest rate borrow more spend
more C increases.
b. Not easily available + high interest rate borrow less
spend less c decrease
Movement vs Shift

H2 ECONOMICS NOTES FOR AGGREDATE DEMAND AND SUPPLY

Movement: the change in consumption resulted from the change in

income i.e. income determinants
Shift: the change in consumption resulted from non-income factors.

Investments (I)
Income Factor:
Consumers incomes increase so the demand for goods and services
increases. Firms need to increase productive capacity as there is a need
for increase in investments such as factories or machineries so investment
increases.
Non-income Factors:
1. Interest rates
a. Low interest rates would mean a low cost of borrowing. Since
it is cheap to finance investments and there is a high
expected rate of returns, therew ill be an increase in the level
of investments, resulting in a rightward movement along MEI.
b. Higher interest rates would mean a high cost of borrowing.
Since it is expensive to finance investments and there is a low
expected rate of returns, there will be a decrease in the level
of investments, resulting in a leftward movement along MEI.
2. Business expectations
a. High business confidence due to a high expectation of
business profits will increase investment levels so I increases
and MEI shifts rightward.
b. Low business confidence due to a low expectation of business
profits will reduce investment levels so I decreases and MEI
shifts leftwards.
3. Cost and efficiency of new capital goods
a. Better technology would mean a low cost of capital goods and
high efficiency of new capital goods. This will yield higher
expected rate of returns on investment. This will increase
investment level so I increases and MEI shifts rightward.
b. However, if there is high cost of capital goods and low
efficiency of new capital goods, this will yield lower expected
rate of returns on investment. This will decrease investment
level so I decreases and MEI shifts leftward.
4. Government policies
a. Low corporate tax will mean higher post-tax profits. This will
yield higher expected rate of returns on investments .This will
increase investment levels so I increases and MEI shifts
rightward.
b. High corporate tax will mean lower post-tax profits. This will
yield lower expected rate of returns on investment. This will
decrease investment levels so I decreases and MEI shifts
leftwards.

H2 ECONOMICS NOTES FOR AGGREDATE DEMAND AND SUPPLY

Government Expenditure (G)

Examples:
1.
2.
3.
4.

Education
Healthcare
Military
Infrastructure

Net Exports (X-M)

Factors
1. Income
a. Foreign income increase will see an increase in spending and
imports so domestic X increases.
b. Foreign income decrease will see a decrease in spending and
imports so domestic X decreases.
c. Domestic income increase will see an increase in spending
and imports so domestic M increases.
d. Domestic income decrease will see a decrease in spending
and imports so domestic M decreases.
e. Increase in domestic M = increase in foreign X will see an
increase in foreign NY. Likewise, increase in domestic X will
see an increase in domestic NY and domestic M. This cycle
repeats itself, vice-versa.
2. Relative prices
a. Domestic general price level (GPL) decreases more than
foreign GPL as foreign M is more expensive than domestic
goods. Thus the consumption shifts from imported foreign
goods to domestic goods as M decreases and (X-M) increases.
b. Domestic general price level (GPL) increase more than foreign
GPL as foreign M is cheaper than domestic goods. Thus the
consumption shifts from domestic goods to imported foreign
goods as M increase and (X-M) decrease.
3. Relative quality
a. Domestic quality of goods and services is better than foreign
quality so consumption shifts from imported foreign goods o
domestic goods and M decrease as (X-M) increases.
b. Domestic quality of goods and services is worse than foreign
quality so consumption shifts from domestic goods to
imported goods and M increases as (X-M) decreases.
4. Exchange rate
a. Depreciation of domestic currency against foreign currency
buys less of foreign currency domestic goods cheaper than
imports M decrease (X-M) increase.
b. Appreciation of domestic currency against foreign currency
buys more of foreign currency foreign imports cheaper than
domestic goods M increase (X-M) decrease.

H2 ECONOMICS NOTES FOR AGGREDATE DEMAND AND SUPPLY

The Paradox of Thrift

How it works
1. Increase in savings withdrawals > injections C decrease AE
decrease Firms cut back production + reduce employment
National output decrease + unemployment increase Households
save even more Cycle repeats
2. In recession or periods of massive unemployment, there is increase
in thriftiness worsening economic recession leading to rising
unemployment rates.
3. In boom or periods of full employment there is decrease in
thriftiness, increasing inflationary pressures

Aggregate Demand
Factors
1. Changes in economic outlook
a. Changes in business confidence can affect the rate of
investment affecting AD
i. A confident outlook, expecting future income to
increase, will encourage firms to increase investments.
It will see an increase in C and I as well as AD increase.
Thus, the AD curve shifts rightward.
ii. A pessimistic outlook will result in AD decreasing, so the
AD curve shifts leftward.
2. Changes in expected inflation rate
a. Changes in expected inflation rate will result in changes in
expenditure (C+I), thus affecting AD.
i. Expecting a rise in the inflation rate encourages
spending now so as to avoid paying more in future. This
will see an increase in C and AD. Thus, AD curve shifts
rightward.
ii. Expecting a fall in the inflation rate consumers delay
expenditure, leading to AD decreasing. Thus, AD curve
shifts leftward.
3. Change in interest rate
a. Changes in interest rate or money supply will see a change in
cost of borrowing so there are changes in C + I affecting AD.
i. When the interest rate falls, the cost of borrowing will
fall, seeing an increase in C + I, leading to an increase in
AD. Thus, AD curve shifts rightward.
ii. When the interest rate rises, the cost of borrowing will
rise, seeing a decrease in C + I, leading to a decrease in
AD. Thus, AD curve shifts leftward.
4. Changes in exchange rate

H2 ECONOMICS NOTES FOR AGGREDATE DEMAND AND SUPPLY

a. Changes in exchange rate will affect prices of exported and

imported goods and services so affecting AD.
i. Depreciation lowers prices of exports in domestic
currency and raises prices of imports in foreign currency.
This will increase the quantity demanded for domestic
exports and decrease the quantity demanded for foreign
imports i.e. increase (X-M) increase AD so the AD
curve shifts rightward.
ii. Appreciation raises prices of exports in domestic
currency lowers prices of imports in foreign currency.
This will decrease the quantity demanded for domestic
exports and increase the quantity demanded for foreign
imports i.e. decrease (X-M) decrease AD so the AD
curve shifts leftward.
5. Changes in national income of trading partners
a. Changes in the national income of trading partners will change
the demand for domestic exports
i. An increase in the national income increases the
demand for domestic exports leading to an increase in X
and AD so the AD curve shifts rightward.
ii. A decrease in national income decreases the demand for
domestic exports leading to a decrease in X and AD so
the AD curve shifts leftward.

Aggregate Supply
Illustrations
1. Short run
a. Horizontal segment (Keynesian range) : During recession there
is a large amount of unused resources and unemployment.
Due to this excess capacity, production does not rise per unit
cost.
b. Positive-sloped segment (intermediate range): Due to excess
capacity in some sectors but not others, production rises per
unit cost for some sectors so GPL rises.
2. Long run
a. Vertical or nearly vertical (classical range): No excess capacity
due to the full employment of all resources. Production cannot
increase but GPL increases as the supply is perfectly price
inelastic.
Factors shifting SRAS
Changes in cost of factor of production
1. Changes in cost of factors of production will lead to changes in cost
of production affecting GPL as shown where there is a shift in SRAS.

H2 ECONOMICS NOTES FOR AGGREDATE DEMAND AND SUPPLY

a. The increase in the cost of factors of production will lead to an

increase in the cost of production. It will increase the GPL of
goods and services thus decreasing SRAS and the SRAS curve
shifts leftward.
b. The decrease in the cost of production will lead to a decrease
in the cost of production. It will decrease the GPL of goods and
services thus increasing SRAS and the SRAS curve shifts
rightward.
2. Supply Shock: It causes unanticipated but temporal shift in SRAS.
a. Natural disasters e.g. droughts decrease in SRAS the
SRAS curve shifts leftward.
b. Bumper harvest increase in SRAS the SRAS curve shifts
rightwards.
Factors shifting SRAS and LRAS
1. Changes in the size of the labour force: There are changes in the
size of the labour force so SRAS and LRAS shifts.
a. Increase legal working age or increase in working population
size will increase labour force and potential output so the
LRAS curve shifts rightward.
b. Increase in labour force depresses wages but increase SRAS.
2. Change in productivity of factors of production
a. Increase investments in training of labour force and
advancement in technology results in low costs and increases
SRAS and LRAS, so the SRAS and LRAS curve shift rightward.
3. Changes in capital and human stocks: Changes in capital stock
changes potential output which affects SRAS and LRAS.
a. Investment in capital stock improves the quantity and the
quality of capital stock. It lowers the cost of production in SR,
increases SRAS and output in the long run as well as LRAS, so
the SRAS and LRAS curves shift rightward.
b. Investment in human capital improves productivity and
increases productive capacity and LRAS increase. This reduces
the cost of production and SRAS increases so the SRAS and
LRAS curves shift rightward.