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Study unit 8

Study unit 8. AD/AS FRAMEWORK. STUDY OBJECTIVES. Use aggregate demand and supply curves to analyse monetary and fiscal policies and supply shocks Monetary transmission mechanism Use AD-AS model to explain the policy dilemma in an open economy.

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Study unit 8

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  1. Study unit 8 AD/AS FRAMEWORK

  2. STUDY OBJECTIVES • Use aggregate demand and supply curves to analyse monetary and fiscal policies and supply shocks • Monetary transmission mechanism • Use AD-AS model to explain the policy dilemma in an open economy

  3. AGGREGATE DEMAND & AGGREGATE SUPPLY(MACROECONOMIC EQUILIBRIUM) AS AD P TOTAL PRODUCTION, INCOME

  4. SHIFT IN AD-CURVE – EXPANSIONARY MONETARY AND FISCAL POLICY AD1 AD AS P Y

  5. FACTORS WHICH LEADS TO AN INCREASE IN AD-CURVE

  6. AGGREGATE DEMAND • AD shifts if there is a change in total expenditure. • If A (TE) increase  AD  • If A(TE) decrease  AD  • Expansionary fiscal policy will shift AD to the right. • Government Expenditure increases • Taxes decreases • Expansionary monetary policy will shift AD curve to right. • Repo rate (interest rates decreases • Cash reserves decreases – Loans increase • Securities are bought back through open market transactions.

  7. SHIFT IN AS-CURVE AS1 AD AS P Y

  8. FACTORS WHICH LEADS TO A DECREASE IN AS-CURVE

  9. MONETARY TRANSMISSION MECHANISM • Changes in the monetary sector are transmitted to the real sector through transmission mechanism. • Real sector refers to the goods market, the factor market, production, income investment, imports, exports and consumption. • The demand for money shows an inverse relationship with interest rates

  10. KEYNESIAN TRANSMISSION MECHANISM • Supply for money is vertical or independent of the interest rate. • Investment is inverse related to interest rates. • What happens if there are changes in the money market? • SARB reduces interest rates.

  11. EQUILIBRIUM IN THE MONEY MARKET i MS1 Interest rate decreases Cash reserves decreases SARB buys back securities through open market transactions MS2 MD Quantity of money

  12. INVESTMENT FUNCTION i I Investment spending

  13. KEYNESIAN TRANSMISSION MECHANISM • Interest rates decrease  MS  i  I   AS  production  employment   Income   AD-curve  • The demand and supply for money determines the interest rate level, which is an important determinant of investment. Investment is an important determinant of aggregate spending, which determines production or income (Y). • Vital links in the transmission mechanism is: • interest rates is affected by the change in money supply • interest rates affects investment spending • Investment spending influences autonomous expenditure and AD-curve

  14. POLICY DILEMA IN AN OPEN ECONOMY • Exports is autonomous • Imports is positively related to income. • If exports exceeds imports - surplus on current account • If exports is smaller than imports - deficit on current account. • If open economy is experiencing unemployment, then the introduction of expansionary policy will solve unemployment problem, but increase the deficit on the current account. • In order to apply stimulative policies, the deficit on current account must be financed by an inflow of funds on the capital (financial) account of balance of payments.

  15. NET EXPORTS AT DIFFERENT LEVELS OF INCOME Z X & Z X Yb Y P surplus deficit X<Z X>Z Y YB

  16. A POLICY DILEMA AS P AD YB Ye YF

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