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Aggregate economic activity is examined by using the concepts of aggregate demand and aggregate supply and an examination of equilibrium economic activity requires both.

5.5.1THE PRICE LEVEL

Aggregate supply (AS) is the amount of output firms are willing to supply at different price levels.

The price level of interest for aggregate economic activity is, not surprisingly, aggregate prices. National statistics providers collect information about prices on a regular basis using survey techniques and estimate the average price level, which is a weighted average of the prices of all goods and services. Taking a simple example, if citizens’ main expenditure is 30% on food, 25% on clothing and 45% on entertainment and if in 2002 and 2003 average prices of food, clothing and entertainment are as shown in Table 5.2, the change in price level can be estimated.

If the average price level rises, inflation is observed while if average prices fall, deflation occurs. (Inflation is discussed further in Chapter 8.)

T A B L E 5 . 2 A V E R A G E P R I C E L E V E L S A N D

I N F L A T I O N – A N E X A M P L E

	Food	Clothing	Entertainment	Total
Value of expendi-	5150	2850	3250	11 250
ture 2002 (2002
prices)
Value of expendi-	5325	2915	3450	11 690
ture 2003 (2003
prices)
A: Weights ×	1545	712.5	1462.5	3720
2002 prices
B: Weights ×	1597.5	728.75	1552.5	3878.75
2003 prices
Inflation rate	3.40%	2.28%	6.15%	4.27%
((B − A)/A) 100

Note: Weights used are those given in the text: 30% on food, 25% on clothing and 45% and are assumed to be the same for 2002 and 2003.

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While we know there is no such aggregate good as ‘food’, we can consider that it is made up of rice, pasta, cheese, fruit, etc. – a representative basket of goods bought by the ‘average’ person. We can further assume that an ‘average’ price for all the various components of ‘food’ can be computed with information on expenditure shares. Similarly for an aggregate good such as ‘clothing’ or ‘entertainment’.

In Table 5.2 the prices of the same amounts of the same goods are measured in both years so a like-with-like comparison can be made. In practice, this is almost impossible to implement since many goods are not exactly the same from month to month or year to year. The quality of food goods might increase or decline or different materials might be used in clothing, for example. In trying to measure price levels over time, however, we assume that quality is reasonably similar to allow reasonable comparisons to be made.

The level of average prices is shown for each year in rows 4 and 5 of Table 5.2. The same quantities of goods that cost £3720 in 2002 cost £3878.75 in 2003. This indicates that the average level of prices went up. The extent of the increase is found by measuring the increase in the average price levels between 2002 and 2003 and expressing it as a percentage of the average price level in 2002.

Thus, the annual inflation rate for the economy is computed as 4.27%, with components for each of food, clothing and entertainment as shown. Inflation was highest in entertainment and lowest in clothing. Inflation is often measured using the consumer price index, which is essentially a weighted average of a comprehensive list of the prices of goods and services taking into account their shares in expenditure. It is a more complex but essentially similar process to the example in Table 5.2.

5.5.2AGGREGATE DEMAND

Aggregate demand is the demand for output (of all goods and services) at different price levels.

Demand for output can be thought of in terms of the demand for consumption, investment, government and traded goods (remember C, I , G, X − M ). As a result the aggregate demand curve is a far more complex concept than the demand curves considered so far. This becomes evident when considering its shape and how it is derived. Before examining aggregate demand, it is necessary first to understand the link between aggregate expenditure and aggregate demand, shown in Figure 5.4.

Figure 5.4 panel A shows two aggregate expenditure functions which graph planned expenditure against national income (Y ): planned expenditure consists of C, I , G,

X − M .

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A		B
Planned		Aggregate
expenditure		price level
	AE1	PH	b
	a
b	AE2	PL		a
	c			AD
45°	Y			Y
Y2	Y1		Y2	Y1

F I G U R E 5 . 4 A G G R E G A T E E X P E N D I T U R E A N D A G G R E G A T E D E M A N D

An aggregate expenditure function indicates total planned expenditure in an economy for different levels of income or output (denoted Y ).

The aggregate expenditure functions slope upwards indicating that the higher national income (Y ), the higher planned expenditure. This makes sense since plans to spend depend on income and the higher (lower) income is, the higher (lower) planned spending will be.

Each aggregate expenditure function is drawn for a specific price level so we can see citizens’, firms’ and government’s expenditure plans at different levels of income for one specific price level. If the price level changes, people’s planned expenditures change too. In the case of an increase in the price level, planned aggregate expenditure falls.

We see this in a comparison of AE1 with AE2 where AE2 is the aggregate expenditure curve after an increase in the price level. Beginning at point a on

AE1 when income is Y1, this corresponds to the lower price level. If the price level rises, then with the same amount of income, Y1, people will cut back on planned expenditure to point c on AE2 because they cannot buy the same amount of goods with the same amount of income.

At the higher price level, planned aggregate expenditure falls (from AE1 to AE2).

The dashed line in Figure 5.4 panel A needs some explanation. At all points on this line, planned expenditure coincides with national income (output):

AE = Y .

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An economy in equilibrium generates sufficient income (output) to match planned expenditure; hence this occurs at only one point on each AE function, such as a on

AE1 and b on AE2.

In Figure 5.4 panel B the aggregate demand function is shown. Each point on an aggregate demand function is taken from the point on a corresponding expenditure function where the economy is in equilibrium where planned expenditures = national income. When the price level is relatively low at PL, the corresponding level of income shown in Figure 5.4 panel B is at a (and this corresponds to the point of equilibrium at a on AE1). When the price level rises to a higher level at PH, this corresponds to a lower amount of national income at point b (which corresponds to the equilibrium point b from AE2). Each point on an aggregate demand curve corresponds to an equilibrium point on an AE function.

There are three reasons why the aggregate demand curve slopes down:

•the real wealth effect;

•the interest rate effect;

•the international trade effect.

The real wealth effect: When there is a change in the price level, this has an impact on consumers’ utility because with the same amount of income they can buy more consumption goods if the price level falls (or less if the price level increases). In ‘real terms’ a change in the price level affects consumers because of the effect on their purchasing power. A 10% increase in the price level means for a given amount of income, 10% less goods can be bought. Because consumption is such a significant portion of aggregate expenditure, the change in planned consumption brought about by a change in the price level is clearly reflected in a negative relationship between the price level and income observed in the aggregate demand function.

The interest rate effect: If the price level increases, people need and demand more money for their purchases (some purchases can be put off until the future but others cannot). In the short run the amount of money in an economy is fixed (by the relevant central bank, to be explained later in Chapter 7). Any increase in the demand for money puts upward pressure on the price of money, the interest rate. Higher interest rates have implications for many components of aggregate expenditure. If the interest rate rises, this has implications for business investment, since much of it is financed by bank loans. Buying consumption goods on credit is also adversely affected by increased interest rates and some government expenditure may also be reduced due to a higher interest rate. An increase in the price level