Aggregate Demand Flashcards
Aggregate demand
Total amount of goods and services demanded in the economy at a given time and price level.
Components that make up aggregate demand
Consumption (C)
Investment (I)
Government spending (G)
Exports minus imports (X - M)
Calculate aggregate demand
AD = C + I + G + X – M
What happens to Consumption expenditure when price rises?
- Increase in price - Consumers and firms need more money to buy the same number of goods and services
- Consumers and firms borrow more money -rate of interest increases
- Rise in interest rates leads to fall in consumption
What happens to Investment when price rises?
- Higher the rate of interest – the less profitable new investment projects become therefore fewer projects will be undertaken by firms
- Higher the rate of interest the lower the level of investment
What happens to Government spending when price rises?
Assumed to be determined by political decisions of the current government.
What happens to exports and imports when price rises?
- Higher price level in the UK – foreign firms can compete more successfully in UK economy
- Higher UK price level with price levels in other companies staying the same – lead to fall in UK exports
AD curve
Shows the relationship between the price level and equilibrium national income.
Why is the AD curve downwards sloping?
a rise in price level will lead to a fall in equilibrium level of national income and therefore of national output. Hence the AD curve is downwards sloping.
Wealth effect
Changes in the price level affect the real value of people’s wealth.
If the price level increases - the real value of wealth falls. People feel worse off and cut back on their spending on goods and services.
Therefore, as the price level increases, less output is demanded, leading to an upward movement along the AD curve.
If there is a fall in the price level, the real value of wealth increases, people feel better off and increase their spending, thus more output is demanded, causing a downward movement along the AD curve.
The international trade effect
If the domestic price level increases while price levels in other countries remain the same - exports become more expensive to foreign buyers who will now demand a smaller quantity of these.
At the same time, goods produced in other countries become relatively cheaper, so domestic buyers increase their purchases (imports) from foreign countries.
Therefore, a rising price level produces a fall in exports and a rise in imports so that net exports, X-M, fall.
Falling net exports represent a fall in quantity of output demanded or an upward movement along the AD curve.
A fall in the domestic price level relative to other countries - larger amount of exports demanded and lower amount of imports demanded, so that net exports, X-M, rise.
Therefore, there is a downward movement along the AD curve.
The interest rate effect
Changes in the price level affect rates of interest, which in turn affect aggregate demand.
Increase in price level - consumers and firms need more money to carry out their purchases and transactions.
This leads to an increase in the demand for money - increase in rates of interest.
As interest rates rise - cost of borrowing increases leading to a decrease in consumer purchases financed by borrowing, as well as investment spending by firms that must borrow to finance their expenditures.
Therefore, increases in the price level lead to a fall in quantity of output demanded, or an upward movement along the AD curve.
A fall in the price level leads to a rise in quantity of output demanded, or a downward movement along the AD curve.
Shift to the right in AD curve
A rightward shift from AD1 to AD2 means that aggregate demand increases: for any price level, a larger amount of real GDP is demanded.
Shift to left in AD curve
A leftward shift means that aggregate demand decreases: for any price level, a smaller amount of real GDP is demanded.
Domestic economy
The economy of a single country.
