AGGREGATE DEMAND AND AGGREGATE SUPPLY

Aggregate Demand C = Consumer spending on goods and services

• a measurement of the total amount of demand I = Private investment and corporate spending on non-
for all finished goods and services produced in an final capital goods (factories, equipment, etc.)
economy. G = Government spending on public goods and social
• is commonly expressed as the total amount of services (infrastructure, medicare, etc.)
money exchanged for those goods and services at Nx = Net exports (exports minus imports)
a specific price level and point in time.
Aggregate demand curve - a curve that shows the
Four (4) Aggregate Demand Components: quantity of goods and services that households, firms, the
government, and customers abroad want to buy at each
1. Consumption Spending price level.
- represents the demand by individuals and • a decrease in the economy’s overall level of prices
households within the economy. (P0) raises the quantity of goods and services
- While there are several factors in determining demanded (Y0).
consumer demand, the most important are • Conversely, an increase in the price level reduces
consumer incomes and the level of taxation. the quantity of goods and services demanded.

2. Investment Spending What affects Aggregate Demand?

- represents businesses' investment to support
current output and increase production capability. a. Interest Rates
- It may include spending on new capital assets • affect decisions made by consumers and
such as equipment, facilities, and raw materials. businesses.
• Lower interest rates will lower the borrowing
3. Government Spending costs for big-ticket items such as appliances,
- represents the demand produced by government vehicles, and homes and companies will be able
programs, such as infrastructure spending and to borrow at lower rates, often leading to capital
public goods. spending increases.
- This does not include services such as Medicare • Higher interest rates increase the cost of
or Social Security, because these programs simply borrowing for consumers and companies and
transfer demand from one group to another. spending tends to decline or grow at a slower
pace.
4. Net Exports
- represent the demand for foreign goods, as well b. Income and Wealth
as the foreign demand for domestic goods. • as household wealth increases, aggregate
- It is calculated by subtracting the total value of a demand typically increases.
country's exports from the total value of all • Conversely, a decline in wealth usually leads to
imports. lower aggregate demand. When consumers are
feeling good about the economy, they tend to
Aggregate Demand Formula spend more and save less.
The equation for aggregate demand adds the amount of
consumer spending, investment spending, government c. Inflation Expectations
spending, and the net of exports and imports. The • consumers who anticipate that inflation will
formula is shown as follows: increase, or prices will rise tend to make
immediate purchases leading to rises in aggregate
Aggregate Demand = C+I+G+Nx demand.
d. Currency Exchange Rates 5. Changes in Producer Taxes and Subsidies: Changes in
• when the value of the U.S. dollar falls, foreign taxes on businesses or subsidies offered to certain
goods will become more expensive. Meanwhile, industries can affect production costs. Higher taxes or
goods manufactured in the U.S. will become reduced subsidies can reduce aggregate supply, while
cheaper for foreign markets. Aggregate demand lower taxes or increased subsidies can increase it.
will, therefore, increase.
• When the value of the dollar increases, foreign 6. Changes in Inflation: Inflation affects the real
goods are cheaper and U.S. goods become more purchasing power of money. High inflation can distort
expensive to foreign markets, and aggregate pricing and lead to uncertainty, which can affect
demand decreases. businesses' willingness to invest and produce, impacting
aggregate supply.
Aggregate Supply
• it represents the complete supply of goods and Two Categories of Aggregate Supply:
services within a national economy during a 1. Short-Run Aggregate Supply (SRAS):
specific period, typically associated with a specific • The SRAS curve represents the total quantity of
price level. goods and services that an economy can produce
• It includes the consumer products that individuals in the short run.
buy for personal consumption. • The SRAS curve can be influenced by factors like
• This is also known as total output. changes in input prices (e.g., wages and raw
materials), technological shocks, and expectations
SHIFTERS OF AGGREGATE SUPPLY of future prices.

1. Size and Quality of Labor: An increase in the size and 2. Long-Run Aggregate Supply (LRAS):
quality of the labor force, such as a larger skilled • The LRAS curve represents the maximum quantity
workforce or improved education and training, can of goods and services that an economy can
enhance an economy's production capacity, shifting the produce when all factors of production are
aggregate supply curve to the right. utilized efficiently.
• It is determined by factors such as the economy's
2. Technological Innovations: Technological potential output, its productive capacity, and the
advancements can boost productivity and efficiency, quantity and quality of labor and capital.
allowing businesses to produce more with the same
resources. This leads to an increase in aggregate supply.

3. Increase in Wages: An increase in wages can either

encourage or discourage work. If higher wages lead to
more people entering the workforce, it can increase
aggregate supply. However, if wages rise significantly and
businesses face increased labor costs, it can reduce
aggregate supply.

4. Increase in Production Costs: A rise in production

costs, such as higher raw material prices or energy costs,
can reduce the profitability of production and lead to a
leftward shift in the aggregate supply curve.
 INFLUENCE OF MONETARY AND FISCAL POLICY ON AGGREGATE DEMAND

Monetary Policy
• is an economic policy that manages the size and ➢ Interest on reserves - refers to the amount of
growth rate of the money supply in an economy. money banks earn by keeping reserves at the Fed.
• It is a powerful tool to regulate macroeconomic If they earn a higher interest rate on those
variables such as inflation and unemployment. reserves, they are less likely to use the reserves to
• Central banks use monetary policy to manage make loans to customers.
economic fluctuations and achieve price stability, ➢ Open market operations - involve buying or
which means that inflation is low and stable. selling bonds in an effort to manage the ratio of
• Central banks in many advanced economies set money to bonds held by banks.
explicit inflation targets.
Fiscal Policy
Monetary Policies can be Expansionary or • is the use of public expenditure and taxation to
Contractionary influence the economic conditions, particularly
macroeconomic conditions.
➢ Expansionary Monetary Policy • Economic conditions refer to the present state of
- This is a monetary policy that aims to the economy in a country or region.
increase the money supply in the • Governments employ fiscal policy tools to have an
economy by decreasing interest rates, impact on the economy. These mostly consist of
purchasing government securities by adjustments to the tax and spending rates. Taxes
central banks, and lowering the reserve are decreased and spending is increased to
requirements for banks. promote growth. This frequently entails
- An expansionary policy lowers borrowing through the issuance of public debt.
unemployment and stimulates business Taxes could be increased, and spending cut down
activities and consumer spending. on to cool a sweltering economy.
• The government may reduce tax rates or boost
➢ Contractionary Monetary Policy spending during a recession to boost demand and
- The goal of this policy is to decrease the the economy. On the other hand, it can increase
money supply in the economy. It can be rates or reduce spending to slow down the
achieved by raising interest rates, selling economy in order to battle inflation.
government bonds, and increasing the • He (Keynes) contended that the absence of the
reserve requirements for banks. aggregate demand components of corporate
- The contractionary policy is utilized when investment and consumer spending is what
the government wants to control inflation causes economic recessions.
levels. • Keynes thought that by changing spending and
tax policies to account for the shortcomings of the
The Main Monetary Policy private sector, governments could control
➢ Reserve requirements - restrict the amount of economic production and stabilize the business
deposits banks can use to make loans. When cycle.
banks must keep more cash in reserve, they are • Fiscal policy is said to be tight or contractionary
able to lend less. when revenue is higher than spending (i.e., the
➢ The discount rate - is the interest rate, or cost, for government budget is in surplus) and loose or
a bank to borrow reserves from the Fed. If the expansionary when spending is higher than
Fed charges a lot for these loans, banks are less revenue (i.e., the budget is in deficit).
likely to borrow and therefore less likely to lend to
customers.
Expansionary Fiscal Policy Influence of Fiscal Policy on Aggregate Demand
• lowers tax rates or increases spending to increase
aggregate demand and fuel economic growth. Two primary components in Fiscal Policy
• A fiscal expansion's primary effect is to increase ➢ Taxation
consumer demand for goods and services. As a ➢ Government spending.
result of the increased demand, both output and
prices rise. 1. The change in taxes made by the government has an
• Higher demand affects output and pricing to indirect effect on aggregate demand because it is still
varying degrees, depending on the business based on the decisions of firms and households whether
cycle's stage. to spend or not.
• This strategy is justified by the idea that when • When the government cuts personal income
people pay less in taxes, they have more money taxes, the households’ disposable income
for spending or investing, which increases increases. The household will have this additional
demand. Due to the increased demand, income. The tendency is that they will spend it on
businesses increase hiring, which reduces consumer goods, thus, resulting in the rise of
unemployment and intensifies the labor market aggregate demand. But, when there is an increase
competitiveness. In turn, this helps to increase in taxes, the aggregate demand will go down.
salaries and give customers more money to
spend and put away. It's a constructive feedback 2. The change in government spending can have a direct
loop or virtuous cycle. effect on aggregate demand.
• Spending deficits are typically a characteristic of • An increase in government spending stimulates
an expansionary fiscal strategy. When spending aggregate demand, and causes growth in the real
exceeds revenue from taxes and other sources, GDP.
there is a deficit. In reality, tax cuts and increased • Two macroeconomic effects stated under
spending frequently result in deficit spending. government purchases: the Multiplier Effect and
the Crowding-out Effect.
Contractionary Fiscal Policy • The multiplier effect - refers to the additional
• raises rates or cuts spending to prevent or reduce shifts in aggregate demand that result when
inflation. expansionary fiscal policy increases income and
• A government can implement contractionary thereby increases consumer spending. This is
fiscal policy in response to rising inflation and where the amount of money spent by the
other expansionary indicators, possibly even to government increases aggregate demand more
the point of triggering a brief recession in order to than what was spent.
bring the economic cycle back into balance. • The formula for this is Multiplier = 1/(1 - MPC).
• The government does this by increasing taxes, • MPC is the marginal propensity to consume - it is
reducing public spending, and cutting public the fraction of extra income that a household
sector pay or jobs. consumes rather than saves. Thus, a larger MPC
• Where expansionary fiscal policy involves means a larger multiplier in an economy.
spending deficits, contractionary fiscal policy is • Personal Income Tax - The individual income tax
characterized by budget surpluses. This policy is (or personal income tax) is a tax levied on the
rarely used, however, as it is hugely unpopular wages, salaries, dividends, interest, and other
politically. income a person earns throughout the year.
• Disposable Income - Disposable income is the
money that is available from an individual’s salary
after he/she pays local, state, and federal taxes.
 • Meanwhile, the crowding-out effect - is an • In some cases Net exports are affected by
economic theory that argues that rising public expansionary monetary policy, it can influence
sector spending drives down or even eliminates exchange rates.
private sector spending (Kenton, 2023). • Government Spending is not directly affected
Government spending causes higher interest rate, when expansionary monetary policy occurs,
thus, reduces investment spending. According to because mainly the only ones affected by it are
Kenton (2023), it reduces aggregate demand the private institutions.
because it discourages spending and the demand
for borrowing due to higher interest rates and Monetary Policy in the Philippines
reduced income. • The central bank or in the Philippines the Bangko
Sentral ng Pilipinas (BSP) has a number of
monetary policy instruments at its disposal to
Influence of Monetary Policy on Aggregate Demand
promote price stability. To increase or reduce
• Monetary Policy is enacted by central banks by
liquidity in the financial system and uses open
manipulating the money supply. Influences
market operations, accepts fixed-term deposits,
aggregate demand in two ways, either it can be
offers standing facilities, and requires banking
Contractionary or Expansionary.
institutions to hold reserves on deposits and
• Money supply is the total of all of the currency
deposit substitutes.
and other liquid assets in a country's economy
on the date measured.
Open Market Operations
• are a key component of monetary policy
In Contractionary or Tight monetary policy
implementation.
• higher interest rates and a smaller pool of
• These consist of repurchase and reverse
loanable funds.
repurchase transactions, outright transactions,
• It limits the money supply to slow growth and
and foreign exchange swaps.
decrease inflation that would affect two
components of aggregate demand.
Repurchase - the BSP buys government securities from a
• It would be much more beneficial to put those
bank with a commitment to sell it back at a specified
funds in a financial investment than to invest in
future date at a predetermined rate.
physical capital investment.
• Another aspect would be, it may discourage
Reverse repurchase transactions - the BSP acts as the
consumers spending due to the rise in interest
seller of government securities and the bank’s payment
rates that would indirectly affect them and it
has a contractionary effect on liquidity
would lead them to save more of their income.

Liquidity - the ease with which an asset, or security, can

In loose or expansionary monetary policy
be converted into ready cash without affecting its market
• it hints to lower interest rates and a higher quality
price.
of loanable funds will tend to surge business
investment and consumer borrowing for big-ticket
Acceptance of fixed-term deposits
items.
• The BSP accepts deposits from banks through the
• During a recession and high unemployment,
form of a Special Deposit Accounts (SDA) facility
expansionary policy grows economic activity, by
that consists of fixed-term deposits by banks and
lowering interest rates, saving becomes less
by trust entities of banks and non-bank financial
attractive, and consumer spending as well as
institutions with the BSP to expand its toolkit in
borrowing increases.
liquidity management.
Standing Facilities Macroeconomic Issues and Short-Run Trade off between
• The BSP extends discounts, loans, and advances Inflation and Unemployment
to banking institutions to influence the volume of
credit in the financial system. Macroeconomics
• Rediscounting - is a standing credit facility • a branch of economics that studies how an entire
provided by the BSP to help banks meet economy—markets, businesses, consumers, and
temporary liquidity needs by refinancing the governments—behaves.
loans they extend to their clients. The • studies economic phenomena such as inflation,
rediscounting facility allows a financial institution price levels, economic growth rate, national
to borrow money from the BSP using promissory income, gross domestic product (GDP), and
notes and other loan papers of its borrowers as changes in unemployment.
collateral.
6 Major Macro-Economic Issues
Two types of rediscounting facilities available to
qualified banks: Issue # 1. Employment and Unemployment:
1. peso rediscounting facility Unemployment is defined as the involuntary idleness of
2. Exporters’ Dollar and Yen Rediscount Facility (EDYRF) resources, including labor. If this problem exists, the
actual output (or GNP) of society will be less than its
Reserve Requirements potential output.
• refer to the percentage of bank deposits and
deposit substitute liabilities that banks must keep Issue # 2. Inflation:
on hand or in deposits with the BSP and therefore It refers to a situation in which commodity and production
may not lend. factor prices are constantly rising. Deflation is the inverse
of inflation. Some people benefit from inflation while the
majority suffer. Hence, one of the goals of government
policy is to maintain price level stability, which implies
avoiding inflation and deflation.

Issue # 3. The Trade Cycle:

It refers to the tendency for output (GNP) and
employment to fluctuate over time in a recurring
sequence of ups and downs. During boom times,
employment is low, but inflation is high. During a
depression (or recession), unemployment is high and
inflation is moderate.

Issue # 4. Stagflation:
Most modern mixed economies suffer from stagflation,
which is characterized by the coexistence of inflation and
unemployment in a stagnant economy. The trade-off
between inflation and unemployment is possibly today's
most complex macroeconomic issue.
Issue # 5. Economic Growth: In the late 1960s, the empirical Phillips link between
Economic growth refers to the long-term trend in the inflation and unemployment broke broken, coinciding
nation's total output. It also refers to an increase in a with new theoretical work, most notably by M. Friedman
society's production capacity, such as cultivating new land (1968) and E.Phelps (1967) argued that the simple Philips
or establishing new factories. curve of the 1960s did not have a persistent trade-off
Growth is represented by a rightward shift in the between inflation and unemployment.
production possibility curve, which is measured by the
annual rate of increase in per capita income. In the mid-1960s, Milton Friedman and Edmund Phelps
disputed the idea of a permanent inflation-
Three major sources of growth: unemployment trade-off, arguing that the behavior of
(1) The growth of the labour force, inflation expectations, which are endogenous to the
(2) Capital formation and structure of the economy, would render any such trade-
(3) Technological progress. off ephemeral.

Issue # 6. The Exchange Rate and the Balance of According to Friedman, such a trade-off—a negative
Payments: sloping Phillips Curve—can exist in the short run but
The balance of payments is a systematic record of all not in the long run. In the long run, however, Friedman
economic transactions in an accounting year between claims that there is no trade-off between inflation and
members of the home country and the rest of the world. unemployment.

Short Run Trade-Off between Inflation and Phelps pointed out that present inflation is influenced
Unemployment: The Phillips Curve by both unemployment and inflation expectations. This
reliance stems from the reality that salaries and prices
The short-run trade-off between inflation and are only modified seldom. As a result, when changes
unemployment - is an economic concept that suggests a are made, they are based on inflation estimates. The
temporary balance between the two economic variables. higher the expected rate of inflation, the higher the
unemployment required to achieve a certain actual
In a 1958 study work, A. W. Phillips found a statistically inflation rate. Phelps developed the expectations-
significant negative link between the rate of change of augmented Phillips curve.
money pay and the unemployment rate. It was also
demonstrated that a similar negative association exists Thus, the impact of expectations, whether adaptive or
between the rate of change in prices (i.e., inflation) and rational, has a significant impact on the relationship
the degree of unemployment. between inflation and unemployment. Friedman
contends that there is no long-run trade-off between
Phillips curve - depicts the inverse relationship between inflation and unemployment because of expectations.
the two variables, can be used to illustrate the short-run
trade-off between inflation and unemployment

Zero rate of inflation can only be achieved with a high

positive rate of unemployment of, say, 5 p.c., or near-full
employment situation can be attained only at the cost of
high rate of inflation.

By the end of the 1960s, the stable relationship between

the two appeared to be in jeopardy as unemployment,
wages, and prices all began to rise.