Aggregate Demand and Aggregate Supply

Many of you will have spent quite a lot of time looking at '45 degree' diagrams, or 'Keynesian cross' diagrams. Until a few years ago, they were the main way in that the expenditure and income aggregates where analysed. Nowadays, aggregate demand and supply diagrams are preferred, although many teachers still like to explain the situation using the 'good old' 45-degree diagram. It should be noted, though, that examiners prefer students to use aggregate demand and supply analysis (see the next three Learn-Its).

On those grounds, I do not intend to spend too long on this. I do feel, though, that these diagrams are useful for explaining the concept of marginal propensity to consume (MPC). This, in turn, is important for the understanding of the multiplier.

Look at the diagram below.

You can see why this is called the 45-degree diagram. There is a line that comes diagonally out of the origin at an angle of 45 degrees. The reason why these diagrams have this 45-degree line is that for every point on the line, the value of whatever is being measured on the x-axis is equal to the value of whatever is being measured on the y-axis. In this case, that means that Y = C.

Actually, this fact it not so important when dealing with consumption functions, but it is very important if the y-axis is measuring planned expenditure. Equilibrium national income occurs where Y = E, and this would be every point on the 45 degree line.

Anyway, the other line in the diagram is the one that represents consumption in the economy at each level of income. For simplicity, we shall assume that we are dealing with a 2-sector model of the economy. Households either consume or save their income. The line starts at point 'a'. This means that even when income is zero, consumption is 'a'. This is called autonomous consumption. How can households consume if they have no income? We have to assume that 'saving' is negative, or that 'dissaving' is going on. In other words, households have to borrow money to consume, or dip into previously saved money, while they temporarily (one hopes!) have no income.

As income rises, consumption also rises. The gradient of the line represents something called the marginal propensity to consume. This is the amount of every extra pound earned that is spent. If you earned an extra £1, and spent 60p of it, then the value of the MPC would be 0.6. Notice that if you spend 60p of an extra £1, you must, by definition, be saving the other 40p. Hence, the marginal propensity to save (MPS) will be 0.4. It should also make sense that MPC + MPS = 1.

Here are the formulas:

Notice that the consumption line has been labelled C = a + BY. You may remember the equation of a line in GCSE maths (Y = MX + C). The consumption equation is exactly the same structure. 'a' is the intercept point on the y-axis (autonomous consumption) and 'b' is the gradient (the MPC).

This next diagram shows the relationship between the consumption function and the savings function.

Where the consumption line crosses the 45 degree line, Y = C. Hence savings must be zero. You can see that this is the case in the bottom diagram. To the left of this point (Y₁), C > Y, so saving must be negative. Dissaving is occurring. To the right of Y₁, C < Y, so saving is positive. Notice that since MPC + MPS =1, the gradient of the saving line is '1-b' where 'b' is the gradient of the consumption line.

The multiplier in the 2-sector economy

The multiplier is a very important concept in macroeconomics. The best way to explain the multiplier is to use a circular flow diagram.

Assume an initial £100 million of autonomous investment. This money will return to the households in terms of income earned from the factors of production (land, labour and capital) hired to the firms (the black line). It is assumed that the MPC = 0.8, and so the MPS = 0.2. Hence, households save 20% of this income. £20 million is saved and the rest is spent on the goods and services produced by the firms. This £80 million again returns to the households in terms of factor incomes. 20% of this is saved (£16 million) leaving £64 million to be spent on goods and services. This process keeps going. The initial £100 million will multiply to give a final increase in total national income of much more than £100 million. In fact, there is a formula that you can use to find the multiplier, and then another formula that can be used to find the final increase in national income.

So, using the formulae, the value of the multiplier in the example above is 5 (1 divided by 0.2). The final increase in national income is £500 million (£100 million times 5).

The multiplier in the more realistic 4-sector model

If we now bring in the government and the foreign sectors, the multiplier works in the same way, but there are more withdrawals from the economy.

In this, more realistic, example, the MPC is still 0.8, giving a MPS of 0.2. We now assume that money is withdrawn from the economy via taxation and the purchase of imports. The marginal propensity to tax (MPT) is assumed to be 0.4 (the actual average tax paid by an individual is just under 40%). The marginal propensity to import (MPM) is assumed to be 0.2. You can see from the diagram that with so many withdrawals, the amount of money that subsequently flows around the economy after the initial injection is much smaller. The higher the withdrawals, the lower the value of the multiplier. In the 2-sector formula, we divided one by the MPS. In a sense, the MPS represented the marginal propensity to withdraw (MPW), because saving was the only withdrawal. The formula is the same for the 4-sector model, except we now have three withdrawals.

So, in the example above, adding the three marginal propensities to withdrawal gives 0.2 + 0.4 + 0.2 = 0.8. Hence the multiplier is one divided by 0.8, which equals 1.25. Finally, the total increase in national income is £125 million (£100 million times 1.25).

This example is much more realistic. The value of multipliers is rarely above 2 in the real world. Even though the savings ratio is quite low in the UK (less than 10%), the tax burden is about 38%, and around 30% of GDP is spent on imports. So you see, the MPW is likely to be well over 0.5, giving a value of the multiplier of less than two.

The concept of the multiplier is very powerful. For those who believe in the Keynesian 'demand management' way of running an economy, the idea that a given injection of money by the government can lead to a multiple increase in the final national income (and so the creation of more jobs) is very persuasive. The important final point to note is that the process is a dynamic one. In the last example, the £100 million does not turn into £125 million overnight. There will be a time lag between when the households receive their factor incomes and when it all gets spent. And then the money has to go round the circular flow again and again until the full £125 million is finally spent.

Remember that the multiplier process can work in reverse as well. When the German owned Rover decided to cut back its production in the UK, the resulting loss in jobs meant a reduction in consumer spending in the area, which will create further job losses in local shops that depended on the Rover employees' spending. Again this process can keep going.

Aggregate demand and supply analysis is very similar to the analysis in the 'Supply and demand' topic. The big difference is that aggregate demand and supply refer to the aggregates of the whole economy. The supply and demand analysis in the first topic is used in microeconomics to look at the behaviour of individual consumers, producers and industries. Inevitably, when dealing with aggregates it all gets a little bit more complicated. The good news, though, is that the diagrams look quite similar.

Aggregate demand is the sum of all planned expenditures in the economy. We said in the last Learn-It that this is C + I + G + X − M. The aggregate demand curve shows the amount of goods and services in the whole economy that are demanded at any given price level. The price level here is not the price of any one good, but the average price level for the whole economy.

Note that the x-axis is labelled real national income, but in brackets it is also called 'real output' and 'real expenditure'. Remember that these three things are equal because they are three different ways of measuring the same money flowing around the economy (see the Learn-It on the 'Circular flow of income')

As you can see, the aggregate demand (from now on, AD) curve has the familiar downward slope. At a higher price level (P₁) the demand for real national income will be relatively low (Y₁) and at a lower price level (P₂) the demand for real national income will be relatively high. This is a bit like the demand curve for any normal good, but the reasons behind the downward sloping AD curve are a little more complex.

We could explain this by going through each of the components of AD (C, I, G, and X − M) to see why the real expenditure in each category changes as the price level changes. This can get confusing, though. There are three main factors that explain the shape of the AD curve, some of which will affect more than one component of AD.

Remember that for each of these explanations, we are talking about a movement along the AD curve, not a shift in the curve (see the next section). The initial move is always a change in the price, which then causes the following three things to happen.

1. Interest rates:

   If the price level rises, the rate of interest rises in an effort to stop the price rise getting out of hand (see the topic 'Unemployment and inflation' for details of why this is bad). Consumers' mortgage payments will rise (in the UK, the majority of people have variable rate mortgages). This means that consumers will have less money left over to buy goods and services. Higher interest rates make it more expensive for consumers to buy 'big ticket' items, like new cars, for which money tends to be borrowed. In the same way, firms are less likely to borrow for investment. So, in response to a rise in the price level, the final effect is a fall in planned consumption and investment, and so a reduction in AD.

   In the old days, the government would rather not raise interest rates until they had to, because it made many people (voters!) feel less well off. They tended to raise rates in response to a rising price level. Nowadays the Monetary Policy Committee (MPC) of the Bank of England acts pre-emptively, raising rates in anticipation of a future price rise to stop it ever happening.

2. Changes in real wealth:

   If the price level rises, for a given level of nominal wealth, then peoples' real wealth will fall. This will be true for incomes too if nominal incomes remain constant. Basically, people will feel less well off, and so will probably consume fewer goods and services.

3. The foreign sector:

   For a given exchange rate, if the UK price level rises, then home produced goods will become relatively more expensive in other countries, and so the demand for exports will fall. Also, imports into the UK from other countries will appear relatively cheaper, because their price level has remained unchanged while the price of the home produced goods are rising. The demand for foreign imports will, therefore, rise. Both of these effects cause the level of real national income to fall as the price level rises. Note that sustained differences in the price levels of two different countries will eventually cause the given exchange rate to change. See the topic called 'Exchange rates' for details.

For all three of these explanations, one can reverse the analysis when considering a fall in the price level. Also, note that none of the factors affected government spending (G). In these models it is assumed that government spending is exogenous, which means 'determined outside the model'. In other words, increases in real government spending tend to be unrelated to changes in the price level. In the summer of 2000, Gordon Brown announced huge increases in real government spending and yet the price level had been fairly stable. Perhaps the fact that the next general election was looming had more to do with the change in government policy.

It is important to understand why curves shift, both in the world of microeconomics (why might the demand curve for chocolate bars shift to the left or to the right?) and in the world of macroeconomics (why might the AD curve for the whole economy shift?). It is certainly a bit more confusing when we look at AD. It should be noted, for instance, that interest rates are a cause of a movement along an AD curve (following a rise in the price level) and can also cause a shift in the AD curve (when the change in the rate of interest happens independently of a change in the price level).

In the diagram above, the AD curve has shifted to the left, from AD₁ to AD₂, so that real national income falls at any given price level. At P₁, for example, real national income has fallen from Y₁ to Y₂ as a result of the inward shift of the AD curve.

Why might this have happened? I mentioned interest rates above. What if interest rates are raised even though the price level remains constant (i.e. not as a result of a change in the price level, which would be a movement along the AD curve). It was explained above that in the relatively new world of the Monetary Policy Committee, interest rates are often raised in anticipation of future rises in the price level, and not as a result of a change in the price level itself. This will cause all the effects mentioned above: reduced consumption because of higher mortgage payments; a reduction in the demand for 'big ticket' items and a reduction in investment by firms.

We now need to think of other 'big' macro reasons.

1. Unemployment: When unemployment rose during the recession of the early 90s, many households' purchasing power was greatly diminished. The demand for goods and services, and therefore AD, fell whatever the price level was.
2. Taxation: Although income tax (a direct tax) rates fell during the 80s, indirect taxes increased (see the topic called 'Taxation and government spending' for much more detail). A similar thing is happening at the moment. The Labour government have raised the tax burden, even though taxes directly on income have fallen slightly. This will have the effect of reducing AD whatever the price level; households will have less disposable income to spend. Businesses pay taxes as well. Increased business taxes may cause a firm to reduce investment if it feels it can no longer afford it.
3. Government spending: Gordon Brown's big increase in real government spending was mentioned earlier. Obviously this will increase real national income for any given price level. But the Chancellor was very cautious with taxpayers' money until a year before the 2001 election. In real terms the increases in spending were very low indeed. If government spending actually fell in real terms, then the AD curve would shift from AD₁ to AD₂.
4. The stock market: For most of the 90s the stock market has performed relatively well. In October 1987, there was a big crash in world stock markets. For those who had much of their wealth tied up in stocks, both directly and indirectly (through their private pension plans) this was bad news. They felt less wealthy and this would directly affect the amount they spent. The AD curve shifted to the left, ceteris paribus.
5. Business confidence: This is fairly straightforward. Regardless of the price level or the level of interest rates, firms will invest if they are confident about the future (of their company and the economy generally) and will not invest if they are pessimistic. The famous economist, Keynes, was keen on this factor. Whereas monetarists feel that the rate of interest is the main determinant of firms' investment, Keynesians feel that confidence is far more important. It doesn't matter how low the rate of interest is for a firm if they believe that a downturn is around the corner. They simply will not invest.
6. The exchange rate: The £ was fairly strong for most of 2000 (or was it just the weakness of the Euro - see the topic on 'Exchange rates' for more detail). This makes UK exports relatively more expensive abroad, and imports into the UK seem relatively cheap. The decline in the demand for UK exports and the increase in demand for foreign imports caused the AD curve to shift to the left, ceteris paribus.

Of course, all of these arguments can be reversed to give reasons why the AD curve might shift to the right.

Aggregate supply is the aggregate of all the supply in the economy. Hence, the aggregate supply (from now on, AS) curve is the sum of all the industry supply curves. It shows the relationship between the price level and real output (or real national income).

When we looked at firm and industry cost curves (see the 'Costs and revenues' topic and the relevant 'Market structure' topic) it was important to distinguish between the short and long run. We have to do this again here, in particular, the prices of all factor inputs (including wage rates) are assumed to be constant in the short run.

It makes sense, therefore, that in the short run the AS curve will be upward sloping, just like the industry supply curves. The obvious reason is that all the industry supply curves that are added together are upward sloping too. There is a more technical explanation, though.

If real output is to increase in the short run, firms cannot attract new labour by increasing the wage rate. The only way to make more output is to get the current workforce to work harder (overtime, perhaps). In the real world, overtime pays double the wage rate, or maybe time and a half. So the costs to the firms and industries are likely to rise as real output rises. These increased costs will tend to be passed onto the consumer through higher prices. In a roundabout way, the increase in real output has resulted in a rise in the price level.

The short run AS curve shifts for similar reasons as a firm's, or an industry's supply curve might shift. Anything that causes the costs of the industries within the economy to change (regardless of changes in the price level) will shift the AS curve. The factors must have nothing to do with changes in the general price level, remember. Otherwise, we would be dealing with a movement along the AS curve and not a shift in the curve.

In the diagram you can see that the short run AS curve (or SRAS curve) has shifted upwards (or to the left) from SRAS₁ to SRAS₂. There are two different ways that this can be interpreted.

You could argue that, for a given level of real output, Y₁, the price level has risen due to a rise in the costs of various industries (like an increase in wage rates, other input prices or even the tax imposed by the government) from P₁ to P₂.

Another way of looking at it is that real output falls for a given price level due to the increases in industries' costs. The firms may be unable to push the cost increases onto the consumer (for whatever reason) so real output cannot remain at Y₁, and so it falls to Y₂. The economy cannot make as much real output at the given price level if their costs rise.

Just like with AD curves, the SRAS curves can also shift to the right. Obviously, this would happen if there were an increase in costs for firms in the economy as a whole.

Given that we are assuming that factor input price should remain constant in the short run, the reasons given for the shifts in the SRAS curve do not make much sense. In the real world, industries and economies are often on the receiving end of supply side shocks. There is nothing they can do about them and they affect the costs of the industries or economies. The quadrupling of the price of oil in the 70s is a good example. The industries of the UK could do nothing about it, but it increased the costs of nearly all firms in all industries at the time, causing the SRAS curve to shift to the left.

Different economists have different views about the long run AS curve (LRAS curve). You have probably come across the differences between Monetarist (or classical) economists and Keynesian economists in your studies. The two sets of economists have different views about the shape of the LRAS curve.

The classical (or monetarist) view

Classical economists believe strongly in the concepts of supply and demand in all markets. Whilst they are prepared to believe that markets might not be in equilibrium in the short run, they believe that all markets clear (i.e. supply equals demand) in the long run. They also believe that if all markets are working efficiently and all resources are being used, then the economy must be at a point on their production possibility frontier (PPF). In other words, the economy is making as much as it can, given its resources.

Classical economists think that the LRAS curve is vertical. There is absolutely no spare capacity in the economy. The maximum real output is already being produced. In these circumstances, if there is an increase in AD (a shift from AD₁ to AD₂) for whatever reasons then all that will happen is the price level will rise (from P₁ to P₂). Demand increases, but there is no more output to buy, so the price of the various goods and services is bid up.

Note that the economy is in equilibrium where the AD curve cuts the AS curve (in this case, the LRAS curve). This occurs at point A initially, and then at point B after the shift in the AD curve from AD₁ to AD₂.

The Keynesian view

John Maynard Keynes (1883 - 1946) is probably the most famous economist of the twentieth century. Until the depression of the 1930s, all economists were effectively classical. Unemployment rose to astronomical levels during the depression (a very bad recession!). The classical economists, with their belief in supply and demand up their sleeves, said that the labour market would 'clear'. Unemployment was caused by excess supply of labour due to the wage rate (the price) being too high. Before long, the wage rate would fall as workers realised that the only way to get work was to take a lower wage. Of course, when this didn't happen after a number of years, they could not explain why.

Keynes was an economist who was always looking for answers to problems. He didn't care that every other economist in the world said that wages would fall and, with them, unemployment. As far as he was concerned, it wasn't happening, so the theory was wrong. He argued that an economy could find itself in a situation where unemployment was high and stuck at the high rate. In other words, the economy could find itself in an equilibrium (i.e. a state of rest) that was not the full employment equilibrium.

In the diagram above, the levels of real output between 0 and Y₁ are ones where there is a lot of excess capacity. There are many unused resources (unemployed labour, for example) and the economy is at a point well within its PPF (see the topic called 'Market failure' for details of the PPF). This was the situation in the depression of the 30s. Keynes' solution was simple. If there is excess supply, the solution is not to hope the wage (and other prices) fall, causing the supply of labour to be offered onto the market to fall. Why not close the gap by increasing demand? Consumers were too poor at the time to create this increase in AD, so, Keynes argued, it was up to the government to create this demand, through investment in roads, railways, hospitals, etc. Not only would this create jobs for the unemployed, but it would also improve the infrastructure of the economy.

Anyway, diagrammatically, you can see that, up to point A, the AD curve can shift to the right without the price level rising. A large increase in real output with no rise in the price level. Also note that at every point where an AD curve cuts the LRAS curve is an equilibrium point. Importantly (as Keynes said), these equilibrium levels of real output can occur at levels below the full employment level of real output (like the equilibrium at point C, price P₁ and real output Y₁).

The section of the LRAS curve between points A and B shows the levels of output where the economy is coming out of recession. If AD continues to rise (a shift to AD₂, say), real output will still rise, but the price level will also rise. In this situation, some industries will still be experiencing excess capacity, but others will be finding that they are getting close to full capacity. So some prices will not be rising, but others will be. The price level, remember, is a measure of the average price level across the whole economy. So, in this situation, the price level will rise.

The final section of the LRAS curve, above point B, is vertical. Keynes agreed with the classical economists that, once the economy had reached the full employment level of real output, any rise in AD will be inflationary. A shift in AD from AD₃ to AD₄ will result in no increase in real output, but the price level will rise from P₃ to P₄. This last bit of the Keynesian LRAS curve is the same as the whole of the classical LRAS curve.

Comparisons with the 45 degree diagram analysis

For those of you who prefer the 45 degree diagram analysis, look at the diagram below and see how it compares with the AS/AD diagram above.

The Y = AD line at 45 degrees to the horizontal gives all the points where the economy is in equilibrium, just like all the points where the various AD curves cut the LRAS curve are equilibrium points in the previous diagram. Notice that each AD line in this diagram denotes planned expenditure, which is C + I + G + X − M.

Note that AD₃ gives the full employment level of real national income (Y_FE), just as the AD curve, AD₃, does as is crosses the LRAS curve at point B in the previous diagram.

The AD₄ lines are showing the same thing as well. In the first diagram you see the price rise to P₄, and in the second diagram this rise in the price level is illustrated by the inflationary gap in green.

The AD₁ lines are also showing the same thing. In the first diagram, this gives a level of real output of Y₁, which is below the full employment level, and in the second diagram it does the same. The deflationary gap in blue illustrates the downward pressure on prices of being in this recessionary position.

You can probably see why examiners prefer the AS/AD approach. It shows both the Keynesian position and the classical position (when the LRAS curve is vertical), whereas the 45-degree diagram is just a Keynesian diagram. Also, when AD shifts to a position past AD₃, real output remains at the full employment level Y_FE. This doesn't really happen on the 45-degree diagram. The AS/AD diagram also shows the price levels. The 45-degree diagram hints at what is going on with prices with its deflationary and inflationary gap, but it is not specific.

Supply side policies are those that improve the supply side of the economy. In other words, they are government policies that increase the amount of 'supply' that is capable of being produced over the long term. They improve the productive potential of the economy. Diagrammatically, it can be illustrated by an outward shift in the production possibility frontier (PPF), or a shift to the right of the long run aggregate supply curve (LRAS curve). In the next two sub-sections you will see that Keynesian and Monetarist (and classical) economists disagree about the need for these policies. First we shall look at some examples of these policies. They can be split into those to do with the product market and those linked to the labour market.

Product market supply side policies

All of the policies in the product market are designed to increase competition, and so efficiency. If the productivity of an industry improves, then it will be able to produce more with a given amount of resources, shifting the LRAS curve to the right. All of the following policies are, in some way or another, trying to increase the level of competition in product markets.

1. Privatisation. This was the major supply side policy on the product market side of the 1980s. The privatisation of various large industries (telecommunications, electricity, gas, etc.) was designed to break up the state monopolies to create more competition. Of course, many of these privatisations simply turned public sector monopolies into private sector monopolies, but there have been efforts to introduce competition into these industries. You may have seen the numerous TV adverts by lots of companies selling gas and electricity. Some large companies were also privatised, so that they would be exposed to the rigours of the market. British Airways is an example. For more details on the topic of privatisation, see the topic with the same name.
2. Deregulation. This is another form of privatisation. The best example is the deregulation of the bus industry. Competition was certainly increased, but many questioned whether the quality of services remained the same. Some economists would include the deregulation of the capital markets (1979) and the stock exchange (1986) in this section.
3. Membership of the WTO. This may not seem like a 'policy' as such, but it does symbolise a country's commitment to 'free trade'. If you look at the topic called 'Why trade', you will see that trade between countries, whose different resources mean that they are good at making different goods, is beneficial to all concerned. World real output is higher than it would otherwise be when tariffs are removed and trade is free.
4. Help for businesses. In particular, small businesses. The governments of the 80s encouraged enterprise with various grants, reductions in small business tax rates and tax breaks for investment. The new Labour government has also helped with training for those thinking of starting a business and guarantees on bank loans for those that would have had no chance of getting a bank loan otherwise.

Labour market supply side policies

The following policies are all designed to improve the quality and quantity of labour. Increased numbers will obviously increase the productive potential of an economy. Increased quality will improve the productivity of labour. If a given amount of labour increases its productivity, then they will produce more with a given set of resources, and so the productive potential of the economy will again improve. As with the product market policies, successful labour market supply side policies will shift the LRAS curve to the right.

1. Legislation against trade unions. Trade unions are a barrier to the free working of a labour market. They stop employers from negotiating the wage individually with employees and arriving at the equilibrium wage. Unions tend to push the wage above the market equilibrium, and, in the 70s especially, can be quite disruptive in terms of going on strike. The governments of the 80s passed many laws in Parliament to reduce the power of the trade unions. This made labour markets more flexible and efficient. See the topic called 'Labour markets' for details.
2. Education and training. Some would say that this is the most important of all supply side policies (Blair - "education, education, education"). Government spending on education and training improves workers' human capital. They become better quality workers. Their productivity improves and so the LRAS curve shifts to the right. Economies that have invested heavily in education are those that are well set for the future. Most economists agree, with the move away from industries that required manual skills to those that need mental skills, that investment in education, and the retraining of previously manual workers, is absolutely vital. It should also be noted that improved training, especially for those who lose their job in an old industry, will improve the occupational mobility of workers in the economy.
3. Income tax rates. Whilst income tax is a requirement, so that the government can pay for important public services, there is always someone who thinks that it is too high! In the late 70s, very few would have disagreed. The highest marginal income tax rate was over 80%! Even the basic rate, paid by relatively low earners, was 33%. This meant that is you were a relatively high earner, you would pay more than 80p in every extra £1 that you earned. Unsurprisingly, many felt that this was a disincentive to work in the labour market. Why work harder if the government will keep most of your earnings? The governments of the 80s reduced these high marginal income tax rates to encourage more people to work hard. The final big drop was in the Budget of 1988, when the top marginal rate fell from 60% to 40% where it remains today. Of course, indirect taxes were raised to make up for it (e.g VAT), but the point was to get more people to be economically active, and those already in work might work harder.
4. Unemployment benefits. In some countries where government spending is relatively high (like Sweden and France), unemployment benefits are so high that the difference between disposable income in work and benefits received out of work is small. There is little incentive to take a job. If the unemployment benefits are very low, so low that it is difficult to live on benefit alone, then even low paid jobs will seem attractive. Some very extreme supply side economists believe that unemployment benefit should not exist! The other option is to offer in-work benefits. The new Working Families Tax Credit is a benefit that is paid through the pay packet. Whether out of work benefits are reduced or in work benefits are increased, the idea is to create incentives for people to work and so increase the supply of labour and the productive potential of the economy.

Supply side policies are very popular with classical, or monetarist, economists. The following diagrams should explain why.

Look at the diagram below.

You can see a 'normal' looking AD curve and the initial LRAS curve, LRAS₁. This gives an equilibrium level of real national income of Y₁ at a price level of P₁. It is clear to see that, given the assumption of the classical economists that the LRAS curve is vertical at all price levels, and shift to the right of this curve due to supply side policies will be beneficial both in terms of a higher level of real national income (Y₂) and a lower price level (P₂).

The monetarist governments of the 80s were very keen on supply side policies. Many of these policies were long term in nature. Some economists think that the Labour government should thank the Conservative governments of the 80s for creating the right economic fundamentals for healthy, but sustainable, growth to occur in the late 90s and beyond.

As we shall see in the next section, these policies did not work in the depression of the 30s when there was a severe lack of demand.

Keynesian economists agree that the productive potential of the economy can be improved with supply side policies, but stress that this is of no use if there is a depression, or a severe recession, where a chronic lack of demand is the key problem.

As a result of supply side policies, the LRAS curve has shifted to the right, but only the vertical part has shifted. This is still a good thing because the productive potential of the economy has improved. A higher real national income can be achieved before the cost of a rising price level kicks in.

But these policies are no good in times of severe recession, or depression. If an economy is currently at a level of demand represented by AD₁ (price P₁, real output Y₁), the increase in the possible full employment level of real output from Y_FE1 to Y_FE2 is of no significance. The price level and real income level both stay the same. This is also true for the level of demand represented by AD₂. If the economy has a level of demand represented by AD₃, or even AD₄, then the supply side polices will be useful (similar to the classical diagram above), and Keynesians would admit this fact, but in times of depression, they argue, supply side policies are of no use. In fact, they could make things worse. Reducing unemployment benefit at a time when unemployed workers simply cannot get a job due to the lack of demand in the economy will make their plight even worse. Also, they themselves will have less money to spend, thus accentuating the problem of lack of demand.

This topic is called 'Aggregate demand and supply. But before we look at these concepts, it is important that you understand the 'big picture'. The circular flow of income is a good place to start. It shows all of the money coming into an economy (injections) and all of the money that goes out of an economy (leakages or withdrawals). It allows you to see the 'general' reasons why an economy might grow or shrink in size. Once you can see the 'big picture' we can then look at the specifics of aggregate demand and aggregate supply.

Let's start with the simplest model. The economy is assumed to consist of only two sectors: households and firms.

In this very simple model of the whole economy, it is assumed that the households own all the factors of production. They sell these factors to the firms, earning rent on their land, wages for the use of their labour, and profit and interest for the use of their capital. This is shown on the left hand side of the diagram. The green line shows the factors of production going from the households to the firms and the red line shows the money payments by the firms for these factors going back to the households.

The firms then use these factors to produce goods and services. And who buys these goods and services? The households, of course, using the income they earned from the sale of their factors. This is shown on the right hand side of the diagram. Again, the green line represents movements of the physical and the red line shows the movement of the money.

Although this model is very simple, it does emphasise one very important point. When measuring the size of an economy, or the level of economic activity, there are three ways of doing it. In the diagram above you can see that three of the four moving lines have also been labelled in black. The 'rent, wages, profit and income' branch represents total income of the economy. The 'goods and services' branch represents the total output of the economy and the 'expenditure on goods and services' branch represents the total expenditure of the economy.

So the size of an economy can be measured using either the income, output or expenditure method. Notice that the three methods should give exactly the same answer. It is fairly obvious that the amount of money spent must equal the value of the goods and services that this money is spent on. Although less obvious, it should make sense that the amount of money spent will equal the income of the spenders, assuming that none of this income is saved. This brings us to another key point. There are no injections into this circularflow and no leakages from the circular flow (like saving) at this stage. Hence, Income = Output = Expenditure.

Including leakages and injections

In this simple model, we have, so far, assumed that the system is completely closed. It would be fair to assume, though, that households will not spend all of their income, and that firms will, on occasion, invest in new capital.

The diagram above has taken the first circular flow diagram a step further.The two blue lines show savings leaking out of the economy and the injection of investment into the economy. Where does the saving leakage go, and where does the investment injection come from? Put very simply, savings are deposited in the banking sector or the capital markets, and the firms borrow to invest from the same sort of sources.

In the first diagram, E (Expenditure) = O (Output) = Y (Income). Now there are two types of expenditure: consumption (by households) and investment (by firms), So E = C + I. Also, the households? income is not all spent anymore. Some of it is saved, so Y = C + S. We know that in equilibrium, Y = E, so by substituting we have:

So we can see that in this 2-sector model, actual investment (the injection) must equal actual saving (the leakage). It makes sense that the injections should equal withdrawals in equilibrium. Think of the circular flow diagram as water flowing through pipes, and the 'households' and 'firms' squares as water tanks. If injections were greater than withdrawals, the amount of water in the system would become infinite, which doesn't make sense. If withdrawals were greater than injections, after a time there would be no water in the system, which also doesn't make sense.

Although the amount that households plan to save may not be the same as the amount that firms plan to invest, the actual amounts are always equal. If the plans are not the same, the firms' stock levels (which count as investment) will adjust until actual investment (planned investment plus unplanned changes in the stock level) equals actual saving. Of course, the economy is only in an equilibrium position if the plans are the same. Otherwise, firms will find their stocks build up (or disappear) and change their output levels accordingly to allow for the different saving plans (and, therefore, consumption plans) of the households.

It does make sense that savings equals investment. In most economies in the world, the amount that is invested over the long term is closely related tothe amount that the economy saves. The UK traditionally has quite a low savings ratio, especially when the economy is doing well, and this has been translated into a poor record on investment over the years. In Japan, the savings ration is very large. Investment is also high in Japan, as is their investment in projects abroad.

In the real world, we know that there are more 'players' in an economy than simply households and firms. The '3-sector' model includes the government sector. For the purposes of the circular flow diagram, governments do two things: they tax businesses and consumers, and they then spend this money on consumers (benefits and pensions) and businesses (subsidies). The diagram below includes the government sector.

We now have the following situation: E = C + I + G, Y = C + S + T and Y = E in equilibrium, so:

The situation is a little more complicated now. We have two leakages (saving and taxation) and two injections (investment and government spending). Now that we have a situation where actual saving does not necessarily have to equal actual investment. Now, saving and taxation together have to equal investment and government spending together. This means that investment can be greater than saving as long as taxation is higher than government spending (and vice versa).

We are still missing something. We have not yet included the foreign sector, or exports and imports. Notice that in the diagram below, X denotes exports and M denotes imports. Don't ask why, that's just the way it is!

The foreign sector box has been added on the right of the diagram. The black line for imports (M) comes out of the red consumption (C) line. This is because it is the consumers who buy these imports (like German and Japanese cars) which means that money leaks out of the economy. The injection into the economy is the exports (X). This black line rejoins the red consumption line because exports are consumption by foreigners of UK goods and services.

So, now our equilibrium formula will look like this:

S, T and M are the leakages from an economy and I, G and X are the injections into an economy. The economy will only be in equilibrium if injections equal leakages.

You may have seen in many textbooks the fact that National expenditure, or aggregate planned expenditure, is equal to C + I + G + X − M. The reason why M is included, but not S or T is that imports are a sub-group of consumption (or C). C includes all consumption by UK consumers, including the consumption of imports as well as home produced goods. This has to be taken away because it is a leakage. S and T are also leakages, but are not contained within C, I, G or X. They are separate and not part of expenditure, so they are not included.