Essay Plans

Explain carefully why the aggregate demand curve slopes DOWN and the aggregate supply curve slopes UP.

SYNOPSIS:

Very important to define your terms here. I taught the Lower Sixth at the John Mason School, Abingdon 1988/89 and only found AFTER I left that no-one knew what AGGREGATE DEMAND actually meant!! (No-one had asked, being content to sit quietly in mute respect ...)

POINTS:

  1. The aggregate demand curve equals the various commodities demanded at various price levels. The curve thus gives the relationship between the total amount of real national output that will be purchased at the price level.

  2. The reason for its downwards sloping is NOT a change in the price level as a change in the price level changes the average price of all goods and services on average.

  3. AMD slopes down for three reasons:

    Interest rates
    Wealth effects
    Substitution effects

    • Interest rate effects: inflation rises, interest rates rise so a decline in goods financed by borrowing (cars, private education) thus total production falls.

    • Wealth effects: where wealth is held in cash balances, these fall in real terms so less will be spent and planned purchases (real national income) will fall.

    • Inflation of domestically produced goods will cause imports to look more attractive. As withdrawals increase so demand for UK domestic real output (production) will fall. BUT inflation will cause exchange rate to fall making imports more expensive so the effect is therefore harder to measure.

  4. Further mention may be made of the following identity:

    AMD = C I G - T X - M. So if the price level rises, C and G will fall; if the interest rates rise, I falls; to overcome the price level rising then T will increase also, as discussed, X may fall and M may rise.

  5. The aggregate supply curve equals the relationship between output, or real income and the price level.

  6. If there is spare capacity in the economy (and unemployment defined as people able and willing to work) producers may employ more factors without paying higher prices thus aggregate supply will be horizontal. If there is no spare capacity, it will be vertical.

  7. If there is some spare capacity but not enough, output may be increased but prices of SOME goods and services will rise. The net effect of this depends on the mobility of factors of production ... in particular labour.

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