Macro 2: Aggregate Demand and Supply, and Economic Growth

Macro 2: Aggregate Demand and Supply, and Economic Growth

At the end of this set of notes, you should be able to explain:

1. Aggregate Supply (AS) .................................................................................................2

2. Aggregate Demand (AD) ..............................................................................................3
3. Economic Growth – Definition and Measurement ................................................4
4. Potential Growth ............................................................................................................4
5. Actual Growth .................................................................................................................6
6. Benefits of Economic Growth ....................................................................................6
7. Costs of Economic Growth .........................................................................................7

Note: This set of notes is meant to concise with just enough information for “A” level
students. It is best used as a cheat sheet, complementary with official school notes.

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Macro 2: Aggregate Demand and Supply, and Economic Growth

1. Aggregate Supply (AS)

1.1 Aggregate Supply is the total output firms in an economy are willing
and able to supply at different price levels in a given period .

Figure 1

1.2 AS is the output which firms produce after the price level and factor
prices have been fully adjusted after any shift in Aggregate Demand.

1.3 Keynesians often illustrates the AS curve as perfectly elastic at low

levels of output, then upward sloping over a range of output and finally
perfectly inelastic.

1.4 Their view is that in the long run, the economy can operate at any level
of output and not necessarily at its full capacity (Q2 in Figure 1).

1.5 Figure 1 shows that if output expands from Q to Q1, output can be raised
without increasing the price level, as employment is low allowing firms
to attract resources without raising their prices.

1.6 As output rises from Q1 to Q2, firms begin to experience shortages of

resources, causing prices of factors of production to be bidded up.

1.7 At Q2, the economy reaches the maximum output it can produce with
existing resources.

1.8 A change in the price level causes a movement along the AS curve.

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Macro 2: Aggregate Demand and Supply, and Economic Growth

1.9 The AS curve will shift to the right if there is an increase in the:
a. quantity of resources
b. quality of resources
c. improvement in the level of technical expertise.

2. Aggregate Demand (AD)

2.1 Aggregate Demand is the total spending on an economy's products in

a given time period, but at different general price levels.

2.2 AD consists of 4 components:

a. Consumption (C)
b. Investment (I)
c. Government Spending (G)
d. Net Exports (X – M)

2.3 AD can be expressed as:

AD = C + I + G + ( X – M )

Figure 2

2.4 The AD curve is downward sloping from left to right (as shown in Figure
2) because a lower price will:
a. Stimulate consumption and investments.
b. Increase exports as they become more price competitive.
c. Reduce imports as domestic products become more price
competitive.

1.10 A change in the price level causes a movement along the AD curve.

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Macro 2: Aggregate Demand and Supply, and Economic Growth

1.11 A non-price change in any of the AD components will cause a shift of

the AD curve.

3. Economic Growth – Definition and Measurement

3.1 A country’s economic growth is measured by the annual percentage

increase in its real Gross Domestic Product (GDP).

3.2 GDP is the total money value of all final goods and services produced
within the geographical boundary of a country, regardless of whether the
resources are owned by its residents or foreigners.

3.3 The GDP growth rate for the current year can be expressed as:

𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝒚𝒆𝒂𝒓 𝒓𝒆𝒂𝒍 𝑮𝑫𝑷− 𝑷𝒓𝒆𝒗𝒊𝒐𝒖𝒔 𝒚𝒆𝒂𝒓 𝒓𝒆𝒂𝒍 𝑮𝑫𝑷

𝑹𝒂𝒕𝒆 𝒐𝒇 𝑬𝒄𝒐𝒏𝒐𝒎𝒊𝒄 𝑮𝒓𝒐𝒘𝒕𝒉 = x 100%
𝑷𝒓𝒆𝒗𝒊𝒐𝒖𝒔 𝒚𝒆𝒂𝒓 𝒓𝒆𝒂𝒍 𝑮𝑫𝑷

where,

𝑩𝒂𝒔𝒆 𝒚𝒆𝒂𝒓 𝒑𝒓𝒊𝒄𝒆 𝒊𝒏𝒅𝒆𝒙

𝑹𝒆𝒂𝒍 𝑮𝑫𝑷 = x Nominal GDP
𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝒀𝒆𝒂𝒓 𝒑𝒓𝒊𝒄𝒆 𝒊𝒏𝒅𝒆𝒙

4. Potential Growth

4.1 Potential growth refers to the increase in the productive capacity or

potential output of an economy.

4.2 It means that the country's full employment level of income has
increased.

4.3 Potential growth can be illustrated graphically using either the PPC or
the AD-AS diagram:
a. An outward shift in the PPC shifts means the economy is now
capable of producing more of both consumer goods and capital
goods as shown in Figure 3.
b. A rightward shift in the AS curve from AS1 to AS2 means that
full employment level of real output increases from Yf1 to Yf2 , as
shown in Figure 4.

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Macro 2: Aggregate Demand and Supply, and Economic Growth

Figure 3

Figure 4

4.4 Causes for potential growth include increase in:

a. Quantity of resources (e.g. Land, labour, capital and enterprise).
b. Quality of resources (i.e. productivity of factor inputs, e.g.
education and training).
c. Technology (e.g. R&D into new products and production
techniques).
d. Deregulation (i.e. removal of regulations restricting competition
such as reducing barriers to entry).
e. Reformation of trade unions (i.e. reduce the bargaining power
of workers).

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Macro 2: Aggregate Demand and Supply, and Economic Growth

5. Actual Growth

5.1 A country's growth rate refers to the actual growth which is measured
by the percentage annual increase in real GDP.

5.2 If the economy is operating with considerable spare capacity and

unemployment, a rise in AD may increase output from Y1 to Y2 as
shown in Figure 5.

5.3 For output to continue rising, AS must rise in line with increases in AD.
If it does not, the economy will hit a supply constraint and will likely
experience inflation.

Figure 5

5.4 Causes for actual growth include an increase in:

a. Consumption (e.g. Decrease in income tax, increase in wealth,
optimism in economic prospects, fall in interest rate).
b. Investment (i.e. cut in corporation tax, fall in interest rate,
optimism in economic prospects).
c. Government Spending (e.g. ageing population, increase in
social spending, higher tax revenue, fiscal policy for recession).
d. Net Exports (e.g. rise in national income abroad, fall in export
prices, depreciation of domestic currency).

6. Benefits of Economic Growth

6.1 Higher economic growth should lead to an increase in material living

standards due greater satisfaction from higher purchasing power
allowing access to greater quantity of goods and services.

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Macro 2: Aggregate Demand and Supply, and Economic Growth

6.2 Economic growth should reduce unemployment due to an increase in

output generating an increase in labour demand.

6.3 Government’s fiscal health (i.e. budget position) will improve as tax
revenue increases when income, employment and output increases.

6.4 Economic growth can improve income distribution. For example, as

people's incomes rise, they automatically pay more taxes. These extra
revenues for government can be spent on programm es that improve
social welfare for the lower income.

6.5 An increase in AS (i.e. improved potential growth) will lower general

price levels, reducing inflation.

6.6 A high and sustained economic growth increases firms' and

consumers' confidence. This encourages investment as businesses
take advantage of consumers’ increased willingness to spend.

6.7 As society becomes more affluent, it may become less preoccupied with
private consumption and become more environmentally conscious.
Economic growth also enables more resources to explore safer and
cleaner production methods.

6.8 Sustained economic growth is cumulative by nature, which results in

high long-term growth. For example, a country, which maintains a
growth rate of 5% per annum, will double its real income in 15 years.

7. Costs of Economic Growth

7.1 In the short-run, at full employment level, to increase productive

capacity, resources will have to be moved from producing consumer
goods to capital goods, reducing current consumption.

7.2 Income distribution might worsen if the economic growth accrues to

high income earners rather than lower income earners due to greater
access to business opportunities.

7.3 Economic growth may also reduce non-material standard of living by

increasing working hours and stress as business needs increase.

7.4 As the economy booms, there may be greater stress on the

environment due to increased raw materials required.

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 Macro 2: Aggregate Demand and Supply, and Economic Growth

7.5 At or close to full employment, demand-pull inflation may occur,

causing general price levels to increase. Inflation may cause reduction
of export competitiveness and domestic purchasing power amongst
other effects.

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