1. The Market System & Circular Flow of Income: how do markets interact and generate economic flows?.
2. Macroeconomics of the CFoI:  The implications for government management of the economy - fiscal policy
   
3. Money Market: Why money matters & monetary policy
4. Interaction between Fiscal and Monetary Policy (IS/LM)
5. Aggregate Supply/Aggregate Demand (a cautionary note)
   
6. The Phillips Curve.
   

1.    The Market System and the Circular Flow of Income.

The general picture of interacting markets - the circular flow of income:

• Households own the factors of production (land - including raw materials, labour, management and physical capital).
• Note - capital here means physical capital - plant, equipment, buildings and machinery etc. (c.f. financial and money markets below)
• Households rent these factors to firms, in return for income:  land rents; capital interest and dividend payments, and equity appreciation (capital gains); wages and salaries.
• Factor ownership provides income which fuels consumption and demand in the goods and services markets
• Firms rent the factors of production from households according to their demands for these factors, which is derived from the demands for the final goods and services
• Factor markets operate so as to encourage the owners of land, labour, manaement and capital to rent out the services of the factors to the highest bidder
• Firms add value to their own purchases of inputs and raw materials. They earn gross margins (total revenues minus cash input costs [fuel, power, packaging etc.] which is the value added to these inputs.  The Gross margin, or added value, or gross product (each term means essentially the same thing for our purposes) is the income available to the fixed factors - land, labour, management and capital.
• In equilibrium, these returns will be normal profits - each firm earning sufficient to cover the opportunity costs of the factors of production which they employ. If some firms or sectors are earning more than normal profits (those necessary to persuade the participants to stay doing what they are already doing, rather than doing something else), then more people and resources are likely to come into this business, expanding supply, reducing prices and profits.
  

[Note:  profits in the everyday sense are, typically, just the returns to capital - the earnings of the firms which are left after all other legitimate costs (including labour and management costs) have been deducted.  For self-employed family businesses, taxable profits will include the returns to the owners own labour and management, as well as returns to the owners' land and capital, less allowable expenses in servicing mortgages, loans and debts. Economic profit is what is left after further deducting the opportunity costs of the owners' own capital, land, labour and management]

The UK food chain illustrates the outcome of this circular flow of income.
Agricultural and Food Chain, UK, 2016 (Defra, British Food and Farming at a Glance, April 2016).
(Reconcilliation of these data with data for farming alone is slightly problematic)
From Defra's Agriculture in the UK, 2015, Table 4.1, (in real terms) p 20/21, UK farms produced:
£25.3bn total (gross) output (average over 2011-2015), 
spent £16.1bn on purchased inputs (seeds, fertlisers, fuel, feed etc.)
leaving a gross margin ( Gross Product or Gross Value Added) of £9.2bn. (at market prices) on average.  In comparison with the figure, this implies that the fishing industry produced a Gross Margin (GVA) of £1.5bn approx). In addition, the farm sector received £3.3bn as Direct Payments, environmental payments etc. on average over 2011-2015. Making a total of £12.5bn. as the GVA at factor cost.

This GVA (GM, Gross Product) represents the returns to the factors of production (land, labour, management and capital). Ag in the UK, Table 4.1 (ibid) identifies:

• Depreciation (Consumption of Fixed Capital) cost:  £4.1bn.
• Interest (paid on loans): £0.36bn.
• Rent (as actually paid by tenants): £0.36bn.
• Labour payments: £2.5bn.
• Total £7.25bn.
• Leaving a 'surplus' of £5.2bn as the "Total Income from Farming" (TIFF).  This total income is the reward (return) to farmers for their own labour, management, capital investment and land ownership. 
  
• Is it enough?  Ag in the UK (ibid) reports the total labour employed in the industry in Table 2.5 (p8).  Depending on assumptions made about the proportions of part-time, seasonal and casual labour which are equivalent to 1 full time person, the implied annual wage for farm labour is somewhere between £15k and £34k (divide the labour cost of £2.5bn. by the numbers of regular labour, excluding farmers etc.) This same table also records the number of farmers etc. trying to make a living from farming. Their own labour is 'worth' between £4.3 & £6.8bn at the implicit agricultural wage rate, leaving very little or nothing as a return to land and capital.  Similarly, Table 4.4 (p.27) reports on the capital assets and liabilities of the industry.  Total (average) liabilities are £26.6bn. (in real terms) associated with an interest cost of £0.36bn., an average interst rate of 2.47% (likely low because of the predominance of long term liabilities).  Applying this rate of return to the reported total assets (capital investment) of £242.6bn. generates a required return on own capital of £6.bn. [It used to be possible to apply the same logic to land - applying the average retns paid on rented land to the owned land area. However, Defra no longer produce data on rented and owned land areas).
• TIFF varies quite substantially over time, and is 'currently' (2015) depressed by historical standards.  The key variable detemining TIFF in the short term is the £/€ exchange rate, as pointed out graphically by Graham Redman of the Andersons Centre at the 2016 Agriculture in the UK Conference.

• In an exactly similar fashion, the input supply industries also process their own inputs, using their own factors of production, producing their outputs (purchased by the farm sector) and generating their own values added, as the incomes to their own land (including natural resources), labour, management and capital.
• Further processing by the Processing, Distribution and Retailing (PDR) sectors generates both values added (incomes to their own factors) and also the final output purchased by the final consumers.
• Thus, the final consumption figure (£198.3 bn.) represents the cumulative total of all values added throughout the food chain, and hence represents the total cumulative income earned by all those engaged in this food chain. (note - the sum of the GVAs identified in the food chain figure above is well short of the consumers' final spending, because the values added by the input suppliers to each of the main sectors of the food chain are not identified here.)
  
• Note that imports generate incomes in other countries rather than the UK, while exports generate incomes in the UK.

Measurement Issues:

• Each of these flows (measured in £ bn.) represents a large collection of individual trades (prices times quantities): P x Q
• Flows change through time because both prices and quantities change: P1 x Q1 different from P2 x Q2
• Comparison between different years (periods) compares both price and quantity changes
• Prices represent that rates at which quantities of one good or service are exchanged for other goods and services - including the services of factors of production (land, labour, management and capital), whose prices are rents, wages and salaries, and rates of return to capital.
• With prices set at some given, fixed level:  quantities then represent real income and real output of goods and services - the actual quantities of factor services which can be traded for the purchase of actual quantities of goods and services - the purchasing power of each good or service in terms of all other goods and services.
• To measure these real quantities,  prices (wages, rents etc. as well as prices of goods and services) have to be fixed at some given level. - Pf. -> constant prices (volume) measures
  
• Comparison of Pf x Q1 with Pf x Q2 then shows the changes in 'quantities' between Q1 and Q2.
• Also, comparison between Pf x Q1 and P1 x Q1 shows the difference in prices between the fixed, constant, prices and those ruling in period 1.
• Notice - simply fixing the price of ONE good (say for fertiliser), allows the actual physical quantities of fertiliser used by farms between years to be measured, but does NOT allow the measurement of the purchasing power of this fertiliser - to measure the purchasing power, we need to fix all prices at some constant level (typically using some general price deflator - a price index measuring changes in all prices - the Consumer Price Index, or the Retail Price Index, or the GDP deflator. -> output and input flows in real terms. (See UK ONS Consumer price indices) & here for how the Consumer Price Index is calclulated.
  

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2.   Macroeconomic Basics - the Circular Flow of Income (CFoI) & Fiscal Policy

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• Consumption (C) is spending on goods and services for final use (consumption) during this period.
• Investment  (I) - an injection into the CFoI - is the purchase of actual physical capital (equipment etc.), or the improvement of peoples skills and expertise - final spending on things which are intended to increase income levels in future periods rather than this one. [Please Note:  Firms are responsible for most of this investment, not governments, though some government spending is investment for future periods rather than spending on current (this year's) goods and services]
• Saving (S) is just and only income which is NOT spent on final goods and services. (= Yd - C) - a withdrawal from the CFoI. [Please Note:  Investment spending is matched with Savings through the financial and money markets (see below), which are separate from this Circular Flow of INCOME picture of the economy]
• Government Spending (G) is ONLY spending on final goods and services (wages and salaries, paper, power, building maintenance and improvement etc.) used up in this period or intended for use in future periods (includes any government investment) - an injection into the CFoI
  
• The other (major) part of total government expenditure is Transfer Payments:  social security, unemployment benefit, public (national) pension payments etc.  which simply add directly to the recipients incomes, and which are not paid in return for actual services.
• Taxes (T) are the government reciepts - actually also raised on the spending loop (VAT, excise duties), as well as on income streams (income and corporation taxes)  - a withdrawal from the CFoI
• Exports (X) of goods and services provide income for firms, and also measure this part of total output of the economy - an injection into the CFoI
• Imports (IM) of goods and services leak income out of the national (domestic) flow of income - a withdrawal from the CFoI
• Total Expenditure equals Output (C + I + G + X - IM) equals Income (called Gross Domestic Product) (Y) which equals Disposable Income (Yd) plus Taxes.

Distinguish between

• trend growth (improvement in technology and productivity (outputs per unit inputs)) typically about 2.5 - 3.5% per year
• cyclical growth (or decline) round the trend growth - booms (strongly positive growth rates) and recessions (slower growth rates) or depressions (negative growth rates).

• Increasing Injections (G, I, X) and/or reductions in Withdrawals (T, S, IM) will increase the CFoI (increasing income and output (expenditures) and vice versa. (hence the paradox of thrift - more savings meand lower incomes, unless these savings are invested in new plant, equipment etc.)
  
• Multiplier process - increasing an injection (for instance) increases income, which then leads to further increases in spending and resulting income
• until income levels have risen sufficiently that new levels of withdrawals equal the new level of injections (increasing incomes tend to lead to increased savings, taxes and imports).  Y (GDP) will not be in equilibrium until resulting Withdrawals balance Injections (see also, Economist, What is the Keynesian Multiplier (Sept. 2016)
  

• Government Fiscal Policy (the balance between G and T) can influence equilibrium Income levels
• Increase G (or reduce T) to counteract  a recession
• Reduce G (or increase T) to counteract an unsustainable boom (income growth exceeding full capacity of the economy, which leads to inflation - see below)

• Total Capacity of the economy to generate output and income depends on the quantities of land, labour, management and capital plant and equipment available
• When all of these factors of production are fully employed, the economy is operating at full capacity.  Otherwise, there is unemployment - the economy could produce more income and output.
• Capacity can be increased by:
• investment in capital plant and equipment - more capital for production and output;
• increase in the labour force participating in the economy - more employment -> more output & income;
• improvement in technology - more output & income from the same amounts of labour and capital through technological improvement - better quality and more productive capital;
• improved productivity of labour - better skilled and better organised labour increasing the amounts that can be produced and the income that can be earned;
• structural change- re-organisation of resources among different firms with lower costs, improving management.
• Fiscal Policy (G and T) can affect these capacity increasing processes - so should be used with care and caution.

• Nominal National Income (GDP) [or GDP Current terms] = P x Y  (a grand sum of millions of price times quantity trades, measured on the Expenditure loop). If all prices increase, then no-one is any better off, in spite of the fact that nominal (current) GDP has increased. Hence:
  
• Y is real income - in terms of purchasing power over all goods and services, and P is the general price level (an index of all prices in the economy) (and is reported in national statistics as the GDP deflator - ask if you want to know how this is calculated!)
  
• Money (M) is the medium through which these trades take place (notes, coins, and current accounts with banks).
  
• Money is a STOCK which is exchanged between different people and businesses as trades happen
• The FLOW of money round the CFoI is given by M x V, where V is the Velocity of Circulation - the number of times any one £ changes hands in the course of 1 year.
• MV = PY (the Quantity equation of exchange, or Fisher equation) always holds - it is the only way of defining and measuring V.
• If V is constant (which is it, approximately), then PY (nominal or current GDP, national income) can only increase if M increases.
• If Y is fixed by the Capacity Constraint - at Yf (full employment national income), then any increase in MV will lead to an increase in P - inflation.

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3.    Money Market

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The Market for Money (Money market)

• Demand for money (current account bank balances and credit limits) depends on:
• Income (especially for transactions or active balances)
• Price (the interest rate) especially for idle balances - the higher the interest rate, the greater the opportunity cost of holding wealth as money rather than as financial or physical assets.
• Money Supply is controlled by the Monetary Authority - the Bank of England (BoE).
• Monetary Policy is decided by the Monetary Policy Committee of the BoE, with the objectve of controlling inflation
• either through controlling the Supply of Money directly (which proves to be rather difficult)
• or by setting the base lending (interest) rate of the Bank of England to the commercial banking system - the current system of Monetary policy. (Setting the interest rate at a new level above r* will automatically result in a contraction of the supply of money to match the reduced demand - since the BoE, through its function as lender of last resort, implicitly sets the supply of money to match its ruling interest rate)

Interest Rates and the Circular flow of income - the I-S Curve

But other things can never be equal in a flow system - the circular flow of income. Because, when savings and investment change in the circular flow, then income also changes. And income determines savings and also influences investment - the more income an economy generates, the greater the incentives to invest in new plant and equipment to provide for new goods and services to satisfy the increased income.

So what? Suppose that Monetary Policy has set the interest rate "too high" for an equilibrium between savings and investment - the rate is such that there is a surplus of savings supply over investment demand. What will then happen? Think about the circular flow of income - with leakages or withdrawals from this flow (savings) greater than the injections (investment).

Income levels will fall in this case, and will go on falling until savings comes back into balance with investment. How does this happen?  As income falls, so savings will fall as well, there being less income to save. Eventually, income levels will adjust so as to bring the circular flow back into equilibrium - so that savings do equal investment at this "too high" interest rate. The consequence of the high interest rate is to reduce income (Y), thus shifting the Savings curve in the Capital Market, and probably shifting the Investment curve, too.
As Income changes, so the Savings supply and Investment demand curves shift in the capital market

The same argument works in reverse - a condition in which money market interest rates encourage more investment than saving. In this case, income levels in the circular flow will tend to increase, providing more savings to match the level of investment encouraged by the interest rate.

In other words, income adjusts in the circular flow of income to as to balance savings with the investment levels set by the interest rate (which is determined in the money market). This is the essence of the interaction between interest rates and the circular flow of income, and can be represented by the
Investment-Savings (I-S) curve relating interest rates to the level of national income (Y):

The IS curve shows the equilibrium relationships between the rate of interest (established in the money market) with the level of national income, assuming that the remaining injections and withdrawals (G, T, X and IM) stay as before. If these other (exogenous) injections and withdrawals change, then the IS curve itself will shift.
Thus, if government spending (G) is increased (and/or taxes (T) are reduced) - an expansionary Fiscal Policy - and the IS curve will shift to the right - because an expansionary fiscal policy will increase levels of national income for each and all levels of savings and investment, each and all levels of the interest rate.
The IS Curveslopes downwards because lowerinterest rates (r down) encourages investment and consumption and thus increasesnational income (Y). It thus represents the combinations of r and Y which are consistent with equilibrium in the goods and services markets (the circular flow of income).  Note this.  The CFoI is, in effect, a description of equilibrium in the markets for goods and services (and factors of production) -equilibrium in the 'real' (non money) part of the economy.
Note, too:  this curve is universally known as the IS curve - but it should really be called the JW curve - the equilibrium combinations of interest rates and incomes in the CFoI, recognising that interest rates might also affect G, T, X and IM, as well as S and I.  Interest rates can have effects on Government spending and Taxes, and on IMports and Xports, as well as on Savings and Investment in the domestic economy.
A significant part of Government spending is on servicing the national (Government) debt.  Interest payments on government debt will obviously change as the current interest rate changes.  This can trigger changes in tax to allow for the change in G.
UK interest rates versus interest rates elsewhere in the world can also affect the Imports and Exports of, especially, services such as insurance, commodity broking, financial and foreign exchange services and so forth.

Money Markets and income changes - the L-M curve:  As incomes increase, so the demand for money will also increase - more income means more spending, which requires more money (or an increase in the velocity of circulation - the efficiency with which the money stock is used).

An increase in income will shift the demand curve for money to the right (see above). If the supply of money is kept constant, and assuming that the velocity of money also remains constant, then this shift to the right will increase the interest rate. The same argument works in reverse - a fall in income will reduce the demand for money, which will reduce interst rates, so long as the money supply is held constant.

This relationship between income and the interest rate through the money market is represented as the L-M curve - the Liquidity preference (demand for money) and Money supply relationship:

The LM curve shows all those combinations of Y and r which are consistent with an equilibrium in the Money Market (given a fixed money supply and a constant velocity of circulation)
The LM curve will shift to the right if the money supply is increased, or if interest rates are reduced, in the money market through monetary policy. An expansionary monetary policy shifts the LM curve to the right. A contractionary monetary policy shifts the LM curve to the left.
Notice, too, the effect of inflation (an increase in the price level (P)) on this relationship. If the price level increases in the economy, then the stock of money in the economy cannot finance the same level of real transactions as before. We will need more money for any given level of Y at higher price levels than at low price levels.  With a fixed supply of money, the greater demand for money at a higher price level means a higher rate of interest at a higher price level for any given Y.  So inflation shifts the LM curve to the left.  This is important - if you have not grasped the reasoning - try it again, slowly.

IS and LM interactions

For the two markets to be consistent with each other - the same rate of interest ruling in both the goods and services market and in the money market - there can only be one equilibrium level of national income (Y*), shown by the intersection of the IS curve with the LM curve.

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Links between Monetary and Fiscal Policy

• Fiscal Policy captured in the IS curve (where an expansionary fiscal policy shifts the IS curve to the right, and vice versa);
• Monetary Policy captured in the LM curve (where an expansionary Monetary policy shifts the LM curve to the right, and vice versa)

You should get the following results. (If you do not, then try again!):

• Expansionary Fiscal Policy - shifts IS right: will tend to increase Y and also increase the interest rate (r)
• Notice that, because monetary policy (the money supply) is held constant in this experiment, an expansionary fiscal policy forces the government to borrow the difference between G and T from the private sector, and this increased borrowing (or reduced lending to the private sector if T is greater than G) means that the interest rate must increase.
• Thus, given a constant monetary policy, the interaction between fiscal and monetary policy will reduce the effect of the multiplier through the effects of the interest rate on income levels - increased government spending crowds out private spending to some extent.
• Contractionary Fiscal Policy - shifts IS left: will tend to reduce both Y and r
• Notice that the contraction in fiscal policy frees up spending potential to the private sector through a reduction in the interest rate, which reduces the multiplier effect on income, so that income does not fall by as much as it would in the absence of the money market effect (if the LM curve were completely horizontal - no income effect on the rate of interest.)
• Expansionary Monetary Policy - shifts LM right - reduces r and increases Y
• Notice that the effectiveness of the monetary expansion depends on the slope of the IS curve. If the latter is steep, then the effect of monetary expansion is more concentrated on increasing interest rates than affecting the level of national income (Y) and vice versa.
• Contractionary Monetary Policy - shifts LM left - increases r and reduces Y

Which is more effective?

If the IS curve is steep - then Monetary Policy will not be very effective in managing income, but will only be succesful in managing the interest rate.

On the other hand, if the IS curve is relatively flat, then Monetary Policy will be effective in managing the levels of national income. The effectiveness of Monetary Policy in governing levels of national income depends on how steep or flat the IS curve is.

If the LM curve is steep, then Fiscal Policy (shifting the IS curve) will mostly affect the interest rate and have little effect on national income - the crowding out effect will be nearly 100% - attempts to increase income with fiscal expansion will simply increase the interest rate and have little or no effect on income, as a result of the government spending crowding out private spending. Crowding out happens because the government spending must be borrowed from the private sector, raising interest rates and discouraging private spending, and, in the limit, means that the multiplier will be close to 0.

If the LM curve is flat, then Fiscal Policy will be powerful in determining national income, and will have little effect on the interest rate - there will be little crowding out.

Slopes of the IS and LM Curves:

The IS curve depends on the sensitivity (responsiveness) of aggregate demand to changes in the rate of interest. It will be flatter the more responsive aggregate demand (the expenditure loop of the CFoI) is to changes in the interest rate. On the other hand, if aggregate demand (consumption plus investment) mostly depend on the current state of the economy and feelings or expectations about future incomes and spending (growth), then interest rates may be relatively unimportant in determining aggregate demand, and the IS curve will be steep.

The LM curve depends on the sensitivity (responsiveness) of money demand to income - the more responsive the demand for money is to income changes, the steeper is the LM curve. It is also the case that the more responsive the demand for money is to interest rates, (the more elastic the demand for money w.r.t interest rates) the flatter is the LM curve.

Managing the Economy

• If investors are "shy" of investing in expanded capacity because they are unsure about the growth prospects for the economy rather than deterred by the level of interest rates, the IS curve will tend to be steep (Keynes referred to the "animal spirits" of business leaders being more important to investment decisions than the rate of interest).
• If, at the same time, the economy is stuck in a depressed state with consumers tending to save more in the face of uncertainty about the future, hence not increasing the demand for money much as incomes grow, then the LM curve will tend to be flat.
• If, in addition, the financial markets are following traditional patterns of "portfolio management", seeking security and reliability from financial and physical assets rather than "quick" profit or capital gain, then the demand for (speculative or idle) balances will be insensitive to interest rate changes and the LM curve will be flat

Scenario 2 - the more modern economy

• If interest rates are important to investment decisions, then the IS curve will tend to be flatter.
• If incomes are expected to grow and personal savings are largely pre-determined through current income levels (through mortgages, insurance premiums and pension contributions), then increases in incomes may well be associated with substantial increases in demand for money - as discretionary incomes increase. So the LM curve will be steeper since increased demands for money against a fixed supply will increase the interest rate.
• As financial markets become more sophisticated and communications make transactions faster and cheaper, and as the volumes of cash financial institutions have to deal with increase, so financial portfolio management by large companies may become more interest sensitive, making the LM curve steeper.

Effect of inflation: Notice, if there is inflation in the economy, then this will reduce the value of money in terms of its purchasing power, which will mean that more money is required to finance any given level of transactions or level of real national income. This means that the supply of money in real terms is reduced, shifting the LM curve to the left, increasing interest rates and reducing the level of national income.

Inflation will thus tend to reduce income and increase unemployment - so long as monetary policy is kept reasonably tight. Overheating (expanding) the economy will, in these conditions, generate stagflation (both inflation and increased unemployment) - the typical economic condition in the UK during the 1970s.

Modern Managment of the Economy

In the past, both monetary and fiscal policies have been used to try and manage the economy so as to avoid both depressions and overheating booms. However:

• The information on the current state of the economy is always out of date, so there is a tendency for economic managers to pull either policy lever (Fiscal or Monetary) in response to past conditions, rather than current conditions;
• the time lags between pulling on either the monetary or the fiscal levers and their effects on the economy are substantial and also variable.  It is this point which gives Monetary Policy an advantage - it can be changed more frequently and easily than Fiscal Policy, where changes in tax rates and schedules and changes in government spending take longer and more effort;
• the structure of the economy - crudely summarised as the slopes of the IS and LM curves - is always uncertain - so the balance between effective monetary and fiscal policy is also uncertain;
• Furthermore, the responses of the economy will depend very much on expections about the future, and also on its recent history (which conditions business and consumption/savings responses). If the experience has been one of booms and busts, then it is natural to expect people to expect the future to be the same and respond accordingly.

Thus, the prudent approach to managing the economy is now thought to be to keep a steady hand on both fiscal and monetary levers, and make as much use as possible of automatic stabilisers.

Automatic stabilisers are those elements of government spending and taxation which tend to operate counter-cyclically on their own, automatically - government spending which tends to increase as the economy moves into recession (like social security, unemployment benefit and employment policies) and vice versa ; and taxes which tend to increase as incomes and employment increase, and vice versa.

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5.   Aggregate Supply and Aggregate Demand (a cautionary note)

Aggregate Demand: We have already seen this concept in the Circular Flow of Income. The total (aggregate) demand facing an economy is composed of Consumption (C), Investment (I), Government spending (G), Exports (X) minus Imports (IM). These are the flows of spending facing the firms in the economy, which generate the national income, and the ability to pay taxes (T) and to save (S).

Aggregate Supply refers to the responsiveness of the economy in producing additional output and thus income to meet this demand. This responsiveness, however, is not well understood. In general, the greater the demands placed on the economy, the greater will be the supply, up to the point of full capacity of the economy - or 'full employment' (unemployment levels low, since there will always be some unemployment as people change jobs and switch careers etc.)

But, the capacity of the economy depends on:

• the size, skills and experience of the working population (Human capital)
  
• the amount and quality of the capital plant and equipment etc. these people have to work with (Physical Capital)
  
• the skills of management in organising the people with the capital (as well as the land) to produce output (Social Capital)
  
• the productivity of capital and labour in producing output (the quality of the various capitals)
  

If an economy does not typically run up against its capacity constraints, then the incentives to increase and improve capacity will be weaker. Thus, some inflationary pressure seems necessary to produce incentives for the economy to improve and extend its capacity.

However, increases in aggregate demand seldom occur across the whole spectrum of the components. Some sectors will experience faster growing demand than others, encouraging a re-structuring of the economy (a reallocation of resources from the declining sectors to the growing sectors), and thus altering the aggregate supply curve. This re-structuring necessarily involves price signals - those faster growing sectors exhibit tendencies for their prices, wages and returns to increase faster than eleswhere in the economy, and vice versa.

The resulting inflationary pressure of "excess demand" (aggregate demand greater than aggregate supply) will be uneven, and pure inflation (equal proportional changes in all prices and returns) will almosr never happen through real demand pressures on the economy. As a consequence, the actual responsiveness of aggregate supply to increases in aggregate demand will depend critically on where the demand pressure is exerted.

Aggregate Demand and Aggregate Supply with respect to the Price Level

Notwithstanding these observations, many textbooks and commentators use the notions of Aggregate Demand and Aggregate Supply with respect to (w.r.t.) the Price Level to illustrate and explain macroeconomic developments. Their diagrams are as follows:

The AS curve w.r.t the Price Level is generally assumed to become increasingly vertical as the economy approaches its capacity limit (otherwise known as full employment - Yf). The superficial logic is that the closer the economy is to full capacity, the more likely it is that additional demands will generate increase in prices (inflation) rather than increases in real output and income.

However, as noted above, this is likely to depend critically on the way in which demand pressure is exerted, and also on the general expectations of those involved (the business community) on the likely persistance of these pressures. For example, if these commerical concerns expect the emergence of inflationary pressures to result in a contraction of the economy (as macroeconomic policy tightens), then there will be less incentive to invest for future growth, and the AS curve will be steeper (more likely to result in price increases). On the other hand, if businesses expect that inflation will be controlled, and the economy managed to generate more or less steady growth, then demand pressure resulting in inflationary pressure might well be interpreted as a sign of continued further growth - triggering increases in productive capacity and supply.  In other words, the notion of a reliable AS curve is a figment of imagination - in practice, any such simplification will depend critically on the context and circumstance of the economy, and on expectations about the future.  This does not seem a very sensible simplification to me - it all depends!

In the limit, some extremists argue that the AS curve is always vertical at the full employment level.  There is NO supply response at the aggregate level to increased demand pressure (expressed as pressure to increase the price level).  This argument is based on the microeconomic theory that supply only responds to relative prices, not to the absolute level of any price.  In a pure inflation (uniform changes in all prices equal to the change in the overall price level) the relative prices (each price relative to others, do not change - so there will be no supply response to a change in the price level.  In this case, demand expansion will only result in inflation and never in an increase in real income and employment.  Trying to boost the economy with fiscal expansion, in this case, will simply generate inflation.  This is all true for PURE inflation - and the AS curve would be vertical under these conditions - BUT these condtions NEVER happen - they are a figment of the theorist's imagination.  In practice, inflationary pressures happen in some bits of the economy more than others, some prices keep pace with or exceed the general inflation rate and other do not.

The AD curve, on the other hand, ONLY shows the general macroeconomic relationship between real income (Y) and the price level (P). This is NOT THE SAME THING as the microeconomic relationship between quantities demanded and specific (relative) prices. An increase in P means that ALL PRICES AND RETURNS increase at once. This means that RELATIVE PRICES DO NOT CHANGE. The microeconomic demand curve shows the response to a change in the price of one good or service (or factor of production) relative to all others. If relative prices do not change, then microeconomic demand quantities DO NOT CHANGE EITHER.

So, the AD curve DOES NOT SHOW THIS MICROECONOMIC RELATIONSHIP. All it shows is the various possible combinations of P and Y which could go to make up the total nominal demand in the economy:- P*Y, given a fixed money supply and fixed velocity of circulation. Thus, increases in AD are shown by shifts of the AD curve to the right and vice versa. These shifts could arise because of:

• increases in the money supply (monetary expansion - equivalent to reductions in the interest rate);
• expansionary fiscal policy;
• increases in autonomous (not government controlled) aggregate demand (increases in investment (I) or net trade (X - IM) or reductions in savings and associated increases in consumption).

Any of these increases in AD could result in either an increase in the price level (P) or an increase in real income and output (Y), or both, as shown in the AS/AD diagram. So what do we learn from this? Not very much at all, since the answer to what will actually happen is that it all depends on what sort of demand increase we are talking about, and hence what sort of shape the relevant AS curve looks like.  IN SHORT, I DO NOT FIND THIS ANALYSIS EITHER VERY CONVINCING OR VERY HELPFUL in understanding how the economy works.  Do you? Comments and questions to DRH.

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6.   The Phillips Curve

The ideas underying the Aggregate supply curve lead to a notion of the Phillips Curve - a trade-off between Inflation (as the general (average) rate of change of prices in the economy) and Unemployment. So called after A W Phillips, who identified an apparent statistical relationship between inflation and unemployment.  Economics online has a good account of this relationship, and its place in current macroeconomic thinking.

Sources:  Unemployment statistics from 1881 to the present day (1881-1994): http://www.ons.gov.uk/ons/rel/lms/labour-market-trends--discontinued-/january-1996/index.html & ILO: http://laborsta.ilo.org/STP/guest
Inflation Consumer Price Inflation since 1750:  www.ons.gov.uk/.../consumer-price-inflation-since-1750.pdf
[A useful page for historical UK Inflation rates - back to 1751]