3.2 Aggregate Demand (AD) Curve Flashcards
(24 cards)
aggregate demand (AD)
The total planned spending on domestic goods and services at various average price levels in a given time period. It is calculated as the sum of consumption (C), investment (I), government spending (G), and net exports (X − M): AD = C + I + G + (X − M).
AD curve
the AD curve illustrates the value of the total planned spending on final goods and services which households, firms, overseas buyers and the government are prepared (willing and able) to buy at different price levels over a given period of time, ceteris paribus.
The curve is downwards sloping as planned spending is assumed to fall when the overall price level of all goods and services increases.
business confidence
A measure of the degree of optimism (or pessimism) that firms have about the future state of the economy, which can influence their investment and employment decisions.
consumer confidence
A measure of the degree of optimism or pessimism that households have about their future income, employment prospects, and the overall economic outlook, which influences their consumption decisions.
wealth
The total market value of all assets (e.g. property, stocks, bonds) owned by an individual, household, firm, or country, minus liabilities (e.g. debts, loans).
direct taxes
Taxes levied directly on income, wealth, or profits, paid by households and firms directly to the government (e.g. income tax, corporate tax).
household indebtedness
The total amount of money owed by households to financial institutions, including mortgages, personal loans, and credit card debt.
price expectations
The beliefs or forecasts that consumers or firms hold about future price movements, which influence current consumption, saving, and investment decisions.
interest rate
The cost of borrowing or the reward for saving, expressed as a percentage of the principal, usually on an annual basis. It is influenced by central bank policy and affects aggregate demand.
business tax
A tax on the profits of businesses and corporations, reducing their after-tax income and potentially influencing investment decisions.
corporate indebtedness
The total outstanding debt that a corporation owes to creditors or financial institutions, including loans, bonds, and other liabilities.
exchange rate
The value of one currency expressed in terms of another currency. For example, if €1 = US$1.50, then the exchange rate is 1.5 USD per EUR. It affects international trade and capital flows.
APL
A weighted average of the prices of all final goods and services in an economy, used to measure the general price level at a given time.
Average price level (APL) is the main determinant of AD and so this relationship is plotted. As the average price level changes, so will the planned spending. This can be represented using an AD curve.
Note that an index number is used to calculate APL. This means that this value has no unit, thus you just write APL on the y-axis.
what happens when APL increases?
As APL increases and domestic goods and services on average become more expensive the different sectors in the economy will be less willing and able to spend, for example because:
* Domestic goods could become more expensive than foreign goods and so demand for imported goods increases while demand for domestic goods contracts, lowering spending within the economy
* Income is assumed to be fixed in the short term and so with the same income, households are able to buy fewer goods and services.
* Assuming the same level of national income, higher APL will reduce the purchasing power of the income and so lowers the real output which can be purchased.
how does the demand side of an economy differ from the demand side of a market?
The demand side of an economy is similar to the demand-side of a market, but the scale is different. Rather than studying the quantity demanded of one good at different prices, we are now taking into consideration all goods and services produced in a country and demanded, the real GDP.
what causes a movement along the AD curve?
Any change in the price level will cause a movement along the AD curve.
what causes a shift of the AD curve?
AD is made up of different parts or so-called components (the spending by the different sectors). The following formula summarises the different components of AD and is one of the most important macroeconomic formulae to remember: AD = C + I + G+(X-M).
A change in any of the above factors will result in a shift of the AD curve. In other words, a change in any of the components of AD, ceteris paribus, will result in more or less spending at the same price level.
The components of AD in more detail
consumption
Consumption or the spending by domestic households on final goods and services over a certain period of time, is the largest component of AD.
The ability to spend depends greatly
on the income earned. As income increases, households become more able to spend. This will result, ceteris paribus, in higher consumption and thus an increase in AD.
A change in income taxes can therefore impact the consumption in a country. The rate of interest will impact the willingness of households to save and take up loans which will also impact consumption.
In general, changes in consumption can be caused by changes in:
* consumer confidence
* interest rates
* wealth
* personal income taxes (and so disposable income)
* level of household indebtedness (the higher the level of debts households have the less able they will be to consume more and the more likely they will be to save to reduce debt)
The components of AD in more detail
gross investment
Gross investment is the total amount that the economy spends on new capital. includes the purchase of new buildings, new vehicles, new machinery and additions to inventory/stocks. Gross investment has two components:
1. replacement investment (to compensate for capital consumption / depreciation)
2. additions to existing capital (also called net investment spending)
The components of AD in more detail
investment spending
Investment spending (I) can be very volatile as investment decisions are based upon expectations of future business conditions like interest rates or future profits. Firms may decide to alter the amount for investment due to factors including:
● interest rates,
● business confidence,
● technology,
● business taxes and
● the level of corporate indebtedness
The components of AD in more detail
government spending
Government spending (G) is the total of national and local spending decisions by government agencies, examples include spending on defence, police, education, health and roads. Note that a few of these goods are public goods while others are merit goods.
Spending decisions are made politically, and are not directly dependent on the level of real national income. Political and economic priorities of governments will determine changes in government spending.
Governments base much of their spending on tax revenue, which depends on income, but they borrow as well. This is why certain models view government spending as given within a certain period of time.
The components of AD in more detail
sources of government revenue
● Indirect taxes
● Direct taxes
● Sale of goods and services
● Sale of state-owned enterprises
The components of AD in more detail
what can government spending be classified into?
● Current expenditures
● Capital expenditures
● Transfer payments
The components of AD in more detail
net exports
Exports (X) occur when domestic goods and services are sold to foreigners. This will represent an injection into the circular flow of income.
Imports (M) are the purchase of foreign goods and services by domestic residents and are a withdrawal from the circular
flow of income.
Net exports are the difference in export revenues and import expenditure.
Net exports can be a negative and positive number.
Exports are determined by decisions made by foreigners. These decisions are made outside the country. Export is therefore not determined by the income of the exporting country. Factors such as the income of trading partners, exchange rate changes and changes in trade barriers (level of protectionism) will impact export spending.
