Macroeconomics explained

Supply and Demand Macroeconomic Applications and the Minimum Wage Outline for a Raise Paper

Introduction

Aggregate Demand and Aggregate Supply Aggregate Demand Determinants

Consumption Patterns

Investment Spending Changes

Policy Changes in the Government

Adjustments in Aggregate Supply Net Export Determinants

Price Variations in Inputs

Changes in the Workforce

Changes in the Capital Stock of Technology

Variations in aggregate demand and aggregate supply

Aggregate Demand Variations

Market Equilibrium Changes in Aggregate Supply

The economic significance of pricing ceilings and price floors

Price Control in the Introduction of a Current Event

Macroeconomics, which is the study of how the economy aggregately performs, has become an important field in the contemporary economics. To determine the aggregate performance of an economy, various factors such as unemployment rates, investments, international trades, consumption, savings, national productivity, price indices, interest rates, as well as national income are considered; these factors are studied to understand how the whole economy functions. In this paper, we are going to analyse the application of macroeconomic principles of aggregate supply and aggregate demand; this will help understand how the whole economy functions.

Aggregate Demand and Aggregate Supply

The aggregate demand and aggregate supply (AD-AS Model) has become the standard model for explaining the application of macroeconomics principles in the economy. This model shows the real output against the price levels in an economy. The curve is downward sloping, which implies that in an economy, consumers demand more output when prices are low. This is caused by three factors namely (1) the real balance effect, (2) the interest rate effects, and (3) the net export effect (Brooman & Jacoby, 2008).

On the other hand, the aggregate supply curve is upward sloping and at low levels of output, the curve becomes more and more horizontal while at higher output levels it becomes more and more vertical. This is because this point corresponds to full employment because the economy cannot produce beyond its level of potential output. The graph below shows the aggregate demand and aggregate supply curve.

Figure 1: AD-AS Curve

Determinants of Aggregate Demand

Aggregate demand is the total spending on goods and services by all businesses, consumers, as well as the government in a given economy. The aggregate demand is given by the formula

Where AD, C, I, G, X, and M are aggregate demand, consumption, investment, government spending, exports, and imports respectively. This implies that in an economy, aggregate demand is determined by four major factors namely (1) changes in consumption, (2) changes in government policy, (3) changes in investment spending, and (4) changes in net exports (Jha, 2008).

Changes in Consumptions

The increase in the consumption level increases aggregate demand and vice versa. An overall decline in the household wealth in an economy will subsequently lead to decreased aggregate demand. If the wealth of households increases, the rate of consumption will increase and thereby increasing the aggregate demand.

Changes in Investment Spending

This includes changes in the spending on capital goods such as equipment, plants as well as new buildings, schools, public health facilities, and roads in order to enhance the production of more goods. In an economy, capital investment can come from both government and private investors. A decrease in investment may decrease the level of aggregate demand.

Changes in Government Policy

This includes changes in the amount of money the government spends on both public goods and merit goods. In overall, the aggregate demand falls when the government comes up with a policy to cut its total expenditure. However, an increase in government expenditure subsequently increases the total aggregate demand in an economy. Adoption of a government policy that leads to cuts in direct as well as indirect taxes eventually leads to an increase in aggregate demand. When the government creates a policy to expand the supply of credits as well as lower interest rates, the aggregate demand will increases.

Changes in Net Export

Net export is the value of total exports less total imports in an economy. An increase in net export increases the value of aggregate demand in an economy. When the net export is negative, the value of aggregate demand decreases. Over the last few years, United Kingdom has been running on large net export, which explains the continuous decrease in the value of aggregate demand in the economy.

Determinants of Aggregate Supply

Aggregate supply is simply the total amount of goods as well as services that are produced in an economy during a given specific period. In the short run, the aggregate supply in an economy may be affected by different factors such as changes in input prices, changes in labour force, changes in technology, as well as capital stock as discussed below (Taylor & Weerapana, 2009).

Changes in Input Prices

An increase in the cost of various items such as energy, wages, as well as raw material among others decreases the aggregate supply and vice versa. The cost of raw materials, energy, and other key resources may decrease due to high levels of competition in the economy. On the other hand, state minimum wage and union wage negotiations may lead to increase in wages paid to workforce a situation that may lead to a decrease in aggregate supply.

Changes in Labour Force

In an economy, a number of factors may cause the amount of workers to either increase or decreases. When the number of workers decreases, the supply will also decrease and vice versa. An increase in labour force actually shifts the aggregate supply curve to the right.

Changes in Technology

Changes in technology can have a huge impact on innovations, improvements, as well as workplace efficiency hence directly affecting the aggregate supply. Generally, technologically improvements cause the total aggregate supply in an economy to increase. For example, the automation of manufacturing processes with the use of machines, robots, and computers have helped increase the aggregate supply in United Kingdom over the past decade.

Capital Stock

Capital stock is the amount of money available in an economy that the business community can use to invest as well as purchase the necessary items needed for the production of goods and services. According to Terra (2015), increase in capital stock in an economy tends to increase the overall aggregate supply and vice versa. When more capital stock is available, businesses can buy the necessary machinery and hire more labour to improve their supply of products and services.

Changes in Aggregate Demand and Changes in Aggregate Supply

Changes in Aggregate Demand

In an economy, a number of factors might cause a shift in the aggregate demand curve; these factors include changes in exchange rates, distribution of income, foreign income, exportation, as well as monetary and fiscal policy. A shift to the left causes a fall in the quantity of goods and services demanded while a shift to the right causes an increase. A shift to the left represents contraction in an economy. As mentioned earlier, the components of aggregate demand are investment spending on investment, consumption, government, as well as net export. An increase in any of these factors will cause the aggregate demand curve to shift to the right and vice versa.

Figure 2: Shifts in aggregate demand curve

(a) An increase in the above factors causes the aggregate demand to shift from AD0 to AD1. This causes the equilibrium to shift from E0 to E1. (b) The reverse shift occurs when the factors decrease.

Changes in Aggregate Supply

In an economy, the aggregate supply curve may shift to the right or to the left; both the long-run aggregate supply curve (LRAS) and short-run aggregate supply curve may shift (SRAS). When either the productivity of economy increases or prices of inputs fall, the aggregate supply curve will generally shift to the right. This may make the condition of low unemployment, higher output, and low inflation possible in the economy. However, a rise in prices of key inputs shifts the aggregate supply curve to the left, which eventually creates a condition of lower inflation, lower unemployment, and higher output (Wray, 2015).

Figure 3: Shift in aggregate supply curve

(a) Increased productivity in an economy causes the short-run supply curve to shift from SRAS0 to SRAS1 and to SRAS2. The equilibrium also shifts from E0 to E1 and to E2. (b) Higher input prices shift the short-run aggregate supply curve from SRAS0 to SRAS1. This also causes the equilibrium to shift from E0 to E1.

Market Equilibrium

In an economy, a state of equilibrium is reached when forces of demand and supply are balanced. As a result, prices and quantities will remain at the same equilibrium value without any external influence. As shown in the previous sections, the slope of the aggregate demand is downward while the slope of the short-run supply curve is upward. Market equilibrium is reached at the point where these two curves intersect; it represents the short-run equilibrium price and real gross domestic product (GDP). In the long-run, the aggregate supply curve will be vertical and the market equilibrium will be reached at the point of intersection with the aggregate demand curve.

Figure 4: Market equilibrium

The government may set minimum prices for particular commodities and services in the market; this is called price floor. The government creates price floor to prevent unfair too low prices. Prices floors are usually set below the market equilibrium prices. Price floor may cause excess surplus (supply) if set above equilibrium prices.

On the other hand, the price ceiling is the maximum amount of price on particular goods and services set by the government. They are set to prevent sellers from charging too high prices. Price ceilings are usually set above the market equilibrium prices. Price ceiling may cause supply shortage if they are set below the market equilibrium prices.

Figure 5: Price floor and price ceiling

Economic relevance of price ceiling and price floor

Sometimes, a number of controversies arise in the prices and quantities that are established by the forces of demand and supply in the market. This sometimes causes series problems to products and services that are classified as necessities. Over the past years, a number of political and public pressures have emerged out of discontent over prices. At such a point, legislations for price controls through price floors or price ceiling becomes necessary. Often, this is done either to prevent prices from climbing too high or falling too low.

The appeal for price controls is understandable from the point that, even though they may hurt others and fail to protect many consumers, they hold out the promise of protecting a group that is hard-pressed in meeting certain prices. Secondly, price ceiling prevents prices from dropping too low and thereby creates shortage in the market. On the other hand, price floor prevents prices from skyrocketing and thereby creating surplus in the market.

A price ceiling, for instance, helps prevent suppliers from charging outrageously high prices or engaging in price gouging. It also helps keep the cost of living at affordable level especially during periods of high inflation rates in the economy. However, if not controlled effectively, price ceiling can have a negative impact on the market especially when suppliers are discouraged from producing more products. Price control may also lead to the emergence of the black market as well as waiting lists.

Application of Price Control to Current Event

Recently, the Ontario government introduced laws to control rent charged by the city’s property owners. This is an example of a recent price control. The suite of measures unveiled on April 20th by the Ontario government is aimed at making housing in the city more affordable.

To protect tenants from massive rent increases, the government introduced rent controls that limit increases on all residential and commercial properties in Ontario; the increase is limited to the rate of inflation in the country. Furthermore, the increment should not be more than 2.5%.

This law has limited the amount by which the property owners can raise rent charges in Ontario. It has protected tenants from property owners who may want to outrageous increase rent charges. However, the price floor has reduced a number of profits that property owners receive for their investments. Despite this, it has been effective in eliminating speculative property owners in Ontario thereby stability the market prices at new equilibrium values.

References

Brooman, F. S., & Jacoby, H. D. (2008). Foundations of macroeconomics: Its theory and policy. Piscataway, N.J: AldineTransaction.

Jha, R. (2008). Contemporary macroeconomic theory and policy. New Delhi: Wiley Eastern Ltd.

Taylor, J. B., & Weerapana, A. (2009). Principles of macroeconomics. Mason, OH: South-Western, Cengage Learning.

Terra, C. (2015). Principles of international finance and open economy macroeconomics: Theories, applications, and policies. London: Academic Press.

Wray, L. R. (2015). Modern money theory: A primer on macroeconomics for sovereign monetary systems. New York, NY : Palgrave Macmillan.