Aggregate Supply Curve In Malaysia

Since 1970, Malaysia has transformed itself from raw materials producer into rising multi-sector economy. Under present Prime Minister, Malaysia is trying to reach high-income status and to increase value-added production series by attracting investments in Islamic finance, technology manufacturing, biotechnology, and services.

The government is trying to enhance local demand and lessen economy’s reliance on exports since exports remain an economy major initiative. As oil and gas exporter, Malaysia has gained profit from higher world force prices, even though government subsidies is forced to cut down due to the growing domestic gasoline and diesel gas cost, mixed with overwrought government finances. The government is also aiming to lessen its reliance on state oil producer PETRONAS as oil and gas segment contributes above 40% of government income.

The central bank retains good foreign trade stores, and well-developed regulatory system has restricted Malaysia’s disclosure to threaten financial mechanism and global financial crisis. On the other hand, Malaysia could be at risk to fall in product prices or broad decelerate in worldwide economic activity because exports are Gross Domestic Product (GDP) main element. Prime Minister has lift up potential adjustments to the unusual economic and social favorites with the purpose of attract increased investment; however he has met major conflict, particularly from Malay nationalists and other vested interests.

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However, during global financial crisis in year 2008-2009, although Malaysian financial system was protected from the direct effects of financial contact due to disallowed of new derivatives into the country, the global financial crisis has transmit uncertainty on the Government’s plans to attain vision 2020 because of collapse in exports and slowdown in foreign direct investment (FDI).

Theoretical Background

Aggregate demand (AD) is aggregate quantity demanded for goods and services in economy at given general price level. It is symbolized by aggregate demand curve, which illustrates the negative relationship effect between price level and total output assuming no variation in government spending, net taxes or monetary policy variable. Aggregate demand curve is downward sloping because of wealth effect, interest effect and exchange rate effect.

At each point along aggregate demand curve, the total quantity demanded is exactly equal to planned aggregate expenditure, which is the combination of consumption, investment and government spending. Each point on aggregate demand curve stands for certain level of aggregate expenditure that is dependable with equilibrium in goods and money market at given price.

When the aggregate demand curve is moved along, the change of price level is presumed to cause equilibrium GDP change but other determinants of equilibrium GDP remain constant. When other determinants except price level lead the equilibrium GDP change, aggregate demand curve will shift itself. The other determinants of equilibrium GDP are consumption expenses, investment spending, government expenditure, taxes, net export and money supply.

Aggregate supply (AS) is total goods and services supplied that are produced in economy at particular overall price level. It is corresponded to aggregate supply curve or ‘price/output response” curve, which demonstrates positive relationship effect between total output amount supplied and overall price level. The curve also draws out the price and output choices of all markets and firms in economy under given set of circumstances.

In short run aggregate supply, the idea of fixed capacity plays role in macroeconomics. At low output point in economy, there is possible to be surplus capacity in economy. An increase in aggregate demand is possible to outcome in increase in amount produced with slightly or no raise in overall price. Thus, aggregate supply curve is likely to be flat at low aggregate output level. The economy maybe works below capability if there is cyclical unemployment even if firms are not holding surplus labor and capital. The short-run aggregate supply curve is upward sloping, because the price of a few inputs are supposed to be decided under auction-like situations, caused by markup pricing and/or presumed informational irregularities.

In long run aggregate supply, firms’ reaction to an increase in aggregate demand varies from primarily increasing output to principally increasing prices as unemployment rate falls, wages and cost of inputs will increase. When economy is producing at its maximum capacity, aggregate supply curve becomes vertical.

There must be time delay between change in input price and change in output price for aggregate supply curve to slope upward. If input prices altered instantly to output prices, the aggregate supply curve would be vertical. Wage rates may increase at similar rate as overall price if price level increases in fully foreseen.

The reasons of the shifts of short-run aggregate supply curve are cost of production, expectation on future price level, economic growth, public policy and weather condition. Meanwhile, the causes of shifts of long-run aggregate supply curve are change in labor, capital, natural resources and technology.

Equilibrium price level is the price level at which the aggregate demand and aggregate supply curves meet. Equilibrium price level matches up with equilibrium in the goods & money markets and lays down price/output decisions on part of all firms in economy AD/AS agenda is applied to assess the effects of monetary & fiscal policy on the economy. Potential GDP is aggregate output level that can be continued in the long run without inflation. Economists consider costs cover behind price level changes in the short run; eventually move with the overall price level in long run. If the price level increases at a fixed rate, inflation may be fully foreseen & built into labor contracts.

Discuss and argument

Aggregate Supply is the total supply of all goods and services in an economy.Normally , the aggregate supply curve is draw like vertical line, also name as classical range.But , in reality, this Aggregate supply are divided into 3 range , which is Keynesian range , intermediate range and also classical range.

Keynesian range occur in the short run and show a horizontal segment on of the aggreagate supply curve (blue line) , which represent the economy is under the recession condition.Base on table below ,the price level is fixed regardless how many the output had been produce by the country.When AD shift rightward from AD1 to AD2 ,the total output has increase but the price level remain the same.This is due to the substaintial idle production capacity such as unemployed worker competing for available jobs can put to work .

The intermediate range ,as show in the pink line,is the rising of aggragate supply curve when the economy is approaching full employment output.When the AD shift rightward from AD3 to AD4, the output and also price level increase .This show that they have the positive relationship between price level and real GDP .When the price level increase , this had cause the inflation occur.There are 3 factor cause this inflation occur, the first one is bottleneck occur because the firm no fully utilise the resources .Example,if the steel industry no fully supply to the steel firm .Bottleneck cause steel firm no enough raw material to produce their product and the cost of steel become higher, so they will also increase the price of thier product , so inflation occur.Moreover, when the company are earning higher profit, their worker will tend to ask for higher wages.The wage demand to increase is hardly to reject because company fear the worker will quit or strike .Beside , the company also can pass the cost on to consumer side easily because in this stage ,the unemployement rate is lower, all people got thier job and they are expect higher price of goods as they feel that will be more quality.Lastly is that sometime the firm still using the less produtivity worker or outdate machinery.This will cause the cost of production increase and become higher product price.

Lastly the classical range is occur only in Long run supply curve where the curve is vertical shape ,which show that the real GDP remain constant at full employment output at point Yn, regardless how many the price level had increase or decrease.When the AD shift rightward from AD4 to AD5, the output remain constant ,but it will cause the price increase, as a consequency economy suffer inflation.

The effect of increase in Aggregate demand

AD1

AD2

AD3

AD4

AD5

AD6

YN

Aggregate_supply_svg.png

Now we consider the aggregate demand curve is stationary and the factor that influence the aggregate supply curve to shift.This factor are call non-price-level determinants.

What happen aggreagte supply curve in Malaysia recently?

During the year 2008, the oil price in Malaysia suddenly increase sharpy to US$147.27 ,compare to the year 2002 which the oil price is merely US$20 (Hour, 2009). This issues was cause many household and also firm suffer a lot .As we know that the changes of aggregate demand is base on changes in total demand for all final goods and services.In the statistics of consumer price index (CPI) had found that every cunsumer use 68% from their income for consuming food, non-alcholic beverages, housing , utility, gas ,transportation and also fuel.After the fuel hike in june 2008, the CPI immediate rose to a 27-year high of 7.7% instead of 3.8% in may,2008, which had increase 3.9% within 1 month.Increase in input price had cause the price level of economy increase, the household purchase power will drop because their real income had decrease.For example, before increase in oil price, one plate of nasi lemak is cost RM2.00.but after increase the input price, the seller need to bear higher cost to transport the same quantity of nasi lemak, so they will transfer the cost to consumer by increase the selling price to RM4.00.Now ,with the same plate of nasi lemak , the buyer need to paid double price , therefore their purchase power decrease. Moreover, it also will affects the households monetary wealth drop .As a consequence, the total consumption decrease ,aggregate expenditure reduce, and finally affect aggregate demand drop .

Aggregate supply curve will shift based on changes in input price.As we know that most of the firms need the oil price for transport and deliver their product.When the oil price increase , the firms input cost will be increase as well, therefore , the firms will supply less outputs.then the short run aggregate supply curve will shift to left, then the price level increase ,total output decrease .When the output decrease, the manage will try to reduce the input cost such as layoff some existing labor.Therefore the unemployment rate will increase.

Why suppy shock will occur in Malaysia?

The first reason the affects the oil price shock occur in Malaysia is because 80% of the world’s oil reserves are own by state-owned oil firms so it tend to limited the international companies to access (Hour, 2009). Beside, the cause of shortage of oil supply is because of most of the big located field are found in the a few decade ago and one days this field will also be used up as the raw material are limited in this world.Furthermore, the size of the oil field found recently are very small and costly to operate .For example, if we found 10 small oil field in seperate location, that mean the firms need to set up 10 rigs compare to a big oil field they just need a big rig.

The suppy shock can solve antomatically?

In long run, the oil price shock can be solve automatically if the government or central bank does not implement any policy.When the oil price increase,the input price for the supplier will be increase, then the short run aggregate suppy will shift to the left,price level will increase from Po to P1,aggregate output will decrease from Yo yo Y1.In the long term, the drop in the total output will cause the firms want to layoff the employees to reduce their cost,so the unemployement rate in market will rise .The price expectation of employees for higher wage will drop and cause the firms have more money to increase more outputs to supply. So the short run aggregate suppy curve will shift back to right from SRAS1 to SRASo.Therefore , the price level and also total output are back to equilibrium level and the stagflation is solve.

P

YN

Y1

P1

P0

LRAS

SRASO

ADo

Y

SRAS1

The supply shock can solve by government?

Although the oil price shock can be solve in long term , but in the short term the citizen are suffer a lot especially for the low income family and also the unemployement rate increase rapidly.The umemployed citizen are depend on the money in their saving account for survive.If the price level increase more higher ,they is stuck with high cost of living without any compensation from the government.So, government must implement the expansionary fiscal policy to solve the unemployement .When inplement this policy, the Aggregate demand curve will shift rightward from ADo to AD1.Then the price level will increase from P1 to P2,total output will increase back to equilibrium level of output from Y 1 to Y2, and now Y2=Y1.The price level had increase higher than before , and the output back to equilibrium level, and the higher inflation occur.

SRASO

SRAS1

ADo

AD1

LRAS

P

Y

YN= Y2

Y1

P1

P0

P2

Factor to shift the aggregate demand curve

Aggregate demand(AD) is the total number of demand of goods and services in economy. The AD is almost equal with aggregate expenditure(AE). The factor will affect the AD curve are based on equation of aggregate expenditure, AE=C+I+G+NX. In the AD curve, each point is representing certain level of AE that same with the equilibrium in money market at given price. When AD curve is moving along, price level change as due to the change of equilibrium GDP but other determinants are remain constant. When opposite direction, change of other determinants change the equilibrium of GDP, AD curve shift itself. Therefore, the other determinants are consumption spending, investment spending, government spending, taxes, net export and money supply.

The quantity of money supplied at a given price level will affect the AD curve. When money supply is increase, the curve shift to the right from Ms0 to Ms1. The interest rate will drop from r0 to r1. The interest drop due to the increase of investment spending and the AE increase cause the real GDP increase. AE curve shift upward show that the output will decrease. At the end, the AD curve will shift right from AD0 to AD1 to remain the price at the constant.

P

AE=Y

AE1

AE

Y

Y0

Y1

I

r0

I0

I1

Md

r1

r

r

Ms0

Ms1

Md

M

r0

r1

P

Y

AD0

AD1

P0

Y0

Y1

In the others hand, if there are spending shock, means the government spending is increase, this will affect the AD curve shift to the right. Shown from the graph below, when the increase in government spending at any given price level, the AE curve will shift upward and rise the real GDP. when the real GDP higher the given price level, it cause the AD curve shift to the right from AD0 to AD1.

P

Y

AD0

AD1

P0

Y0

Y1

P

AE=Y

AE1

AE

Y

Y0

Y1

G

Why oil price shock will affect aggregate demand curve?

Aggregate demand is based on changes in total demand for all final goods and services. During the oil price shock, the oil price increase in Malaysia. This increase of oil price cause the price level of economy increase. The price level affect the real income decrease and reduce the purchase power of household. Household purchase power drop mean that the consumption decrease. Consumption spending is one of the factor to shift the AD curve. When consumption decrease, it shift the AD curve to the left from AD0 to AD1. Therefore, the price will decrease from P0 to P1 and the output also decrease from Y0 to Y1

AD1

P0

AS

AD0

P1

LRAS

P

Y

Y0

Y1

How to solve the aggregate demand automatically?

If the government or central bank do not implement any policy during the shock of the oil price, this has to solve the aggregate demand automatically. After the aggregate demand shift to the left from AD0 to AD1, the price and the output were reduced. When the output drop, the employment decrease and unemployment increase. This affect the expected price drop and the wage rate decrease. At the same time, the short run supply curve shift to the right from AS0 to AS1. At the end, in the long run, output will return back from Y1 to the natural output Y0, but the price will keep on decrease from P0 to P1 and P2. This cause the deflation occur in the economy.

Y0=Yn

AD1

AS1

P0

AS0

AD

P1

LRAS

P

Y

Y1

P2

How the government or central bank solve the supple shock?

When the supply shock solve by automatically, it will stay back the output value but the price decrease continuously. This affect the whole market economy and become deflation. The deflation will make the economy down and this will make suffer to the whole country. Therefore, government should implement the policy to solve this problem. To shift back the aggregate demand curve, government need to implement the expansionary fiscal policy. This policy can shift the aggregate demand curve to the right from AD1 back to AD0. In the long run, the price back to the natural price P0 and the output also change from Y1 to the natural output of Y0.

AS

LRAS

Y

AD1

AD0

Pn=P0

P1

P

Y0=Yn

Y1

Conclusion

The oil price shock in 2008 had brought a large impact for Malaysia’s economy. After rising in oil price, producers need to pay higher input price for the production purpose. Thus, firms sold their goods for higher price which causing consumers’ purchasing power dropped and the aggregate demand decrease. The increasing input prices also causing firms to produce less output which might cause the unemployment rate increase.

In short run, government can implement the expansionary fiscal policy to solve the unemployment problem. However, the price will increase even higher than before which might cause hyperinflation. If the government or central bank does not implement any policy during the oil price shock, the problem will be solved automatically in the long run but it might cause consumer to suffer a lot in the short run.

We recommend Malaysia government to develop reasonable oil price setting instrument, obtain cheap oil from foreign country, searching alternative resources, give subsidies to firms and increase wage rate of workers in order to minimize the consequences of increasing oil price.

Throughout this assignment, we have a better understanding about the aggregate demand and aggregate supply and able to apply it in real economy situation. We had also learned how to work in a team efficiently and effectively in terms of collaboration and time management in order to accomplish the task given.

Recommendation

Increasing in oil prices is a serious issue that may affect aggregate supply and aggregate demand which bring large impact to Malaysia’s economy. Appropriate ways need to be taken in order to minimize the consequences of increasing oil price in Malaysia. Our suggestions are as follow:

Reasonable Oil Price Setting Instrument

First, government needs to develop reasonable oil price setting instrument which may ensure the oil prices are setting within a range which is reasonable and affordable for citizens, and allow realistic profit for oil industries. There are three aspects that should be taken into consideration while determine the oil price range, which are the consumers’ purchasing power, an estimation of profit for oil industries in reasonable level, and the international oil prices. With the help of this mechanism, Malaysia’s oil prices will be more realistic and reasonable which may prevent uncontrollable increasing of oil prices in Malaysia. When the oil prices are set in a reasonable level, there will be no large impact on the aggregate demand and aggregate supply curve.

Obtain Cheap Oil from Foreign Country

In order to minimize the impact of high oil price, government is suggested to search for the new sources of low-cost oil from other country. Malaysia’s government can import cheap and low quality oil from foreign country and refine it to become better quality oil which is qualified to issue to the market with lower cost. The reservation of the cheap oil in a certain amount is also necessary in order to avoid Malaysia from being the victim of increasing prices in the cheap oil. With the available of cheaper oil (input), firms will increase the aggregate supply of the outputs which might prevent shortage of goods in the market. When there is an increasing output in the market, the price of the goods will be reduced and the aggregate demand will increase to a certain level.

Searching Alternative Resources

High oil price problem only can be solved by associate effort of both government and individual. In order to minimize the impact of high oil price, the organization should attempt to do some investigation or discover the substitute of the oil like bio gas and electronic bike and should try to innovation so that the product of the organization can be produce on other alternatives. In this situation, the company can reduce the quantity of the oil which used to produce the output. Then, the supplier or provider would not reduce the quantity of supply which affects the aggregate supply shift to the left. On the other side, aggregate demand also relatively would not be affected which the curve shift to the left because the consumer can continue to consume the product in the normal price.

Give Subsidies

Once the oil prices increase, it will directly or indirectly affect the whole production cost, including the fee of the transportation or other else. In order to solve it, the government should provide subsidies to the supplier or provider in order to control the market price. After the suppliers receive the subsidies from government, they will not increase the retail price of their products since they want to maintain their organization’s profit. By implementing this strategy, the inflation problem can be avoided because the supplier would not increase the price of product due to the higher input price. Hence, the aggregate demand and aggregate supply would not be affected.

Increase Wage Rate

In the market, increasing oil prices may lead to inflation problem in Malaysia. This problem will caused our citizens suffer from financial burden and their purchasing power will decrease. In this case, government can raise the amount of minimum wage in order to make sure the organization provides the cost of living to the employee. This can help the employee are able to maintain their basic needs in their daily life although the high oil price situation happened in Malaysia. Individual who using the vehicle during the daily life, the oil price increase will directly increase their daily expense. Purchasing power of the individual will be decreased and finally it will affect the aggregate demand shift to the left because consumer consume less than before. After increasing wages rate, this problem can be solved and the curve of the aggregate demand will back to original.