Aggregate Demand (AD) Flashcards
(27 cards)
What is Aggregate Demand
AD is defined as the total output and/or expenditure of the domestic economy on all goods and services produced over a given period of time at a given general price level (GPL)
How is AD calculated?
It is computed via summing up consumer spending by households (C), investment expenditure by firms (I), government spending (G) and net export expenditure (X-M)
AD = C + G + I + (X-M)
Why is the AD downward slopping?
There is an inverse relationship between the GPL and the level of real national output/income. This is affected by 3 different factors:
- Wealth Effect
- Interest rate effect
- International trade substitution
These effects explain the shape and slope of the AD curve, determining movement along the curve overtime.
How does the wealth effect affect the nature of the AD curve?
As the GPL falls, purchasing power of consumers increase. Hence, there is an increase in consumption for goods and services with it taking up a smaller proportion of their incomes. Therefore, consumers are wealthier and encouraged to spend more, implying a larger quantity of goods and services demand, ie real national output increases at each and every unit GPL falls.
How does the interest rate effect affect the nature of the AD curve?
When GPL falls, the demand for money falls. This causes interest rates, the price/cost of borrowing/loaning, to fall. Subsequently, lower interest rates encourage borrowing by households/firms for consumption/investment (respectively) which increase. Thus, quantity of goods and services demanded increases due to the fall in the GPL.
How does the international trade substitution affect the nature of the AD curve?
When domestic GPL falls, purchasing power of consumers increase, allowing them to increase consumption of goods and services more. At the same time, prices of foreign goods remaining the same/increasing will result in domestic residents demanding lesser foreign goods and foreigners demanding more domestic goods due to cheaper/lower prices ceteris paribus. Hence, a fall in GPL leads to increase in quantity demanded for domestic goods and services, increase real national output levels.
What are the non-price determinants of aggregate demand from Consumer Expenditure?
Consumer expenditure is incurred by households when they use thier income to purchase final goods and services to satisfy current needs and wants. This is spent on perishables, consumer durables, or services.
- Economic outlooks & Consumer confidence
- Interest rates & Access to credit
- Expectation of future prices
- Distribution of income
- Wealth
- Personal Income taxes
What are the non-price determinants of aggregate demand from Investment Expenditure?
Investment is the act of acquiring new fixed capital assets (building, plants, equipments and machineries by firms). Investment also includes the accumulation of stocks and inventories such as raw-materials, semi and finished goods.
- Interest rates & Access to credit
- Business confidence & expectations
- Corporate tax rates
- Technological changes
What are the non-price determinants of aggregate demand from Government Expenditure?
Spending by governments on goods and services within a country. Payment of salaries of gvt. workers and spending on public works and investments on infrastructure. This allocation of expenditure/budget increases of decreases depending on gvt. plans to achieve macroeconomic goals, known as fiscal policy.
- Government Revenue
- National Reserves
- Access to credit
What are the non-price determinants of aggregate demand from Net Exports
Export expenditure are on goods and services produced within the country and sold to foreigners. Import expenditure refers to domestic spending on goods and services that have been produced in foreign countries.
- National income of trading partners/domestic households
- Changes in other countries’ GPL
- Exchange rates
- Trade Policies - Protectionism
How does economic outlook impact AD
Economic outlook & Consumer confidence:
Measures how optimistic consumers are about their future income and the future of the economy.
Consumers that expect their income to rise will likely be more willing to spend more on goods and services, increasing their consumption.
How does Interest rate & access to credit for consumers impact AD
Consumer spending is sometimes financed by borrowing from banks etc. Interest rates reflect the cost of borrowing. Falling rates will result in consumers encouraged to borrow more as the cost of borrowing is lower. Hence, the opportunity cost of consumption falls and consumers would buy more goods and services, ie consumption increases.
How does expectation of future prices impact AD
When consumers expect prices to increase in the future, they will increase their demand for more goods and services in the short term/now as they are cheaper than in the future, hence consumption increases, cet. par.
How does distribution of income impact AD
Redistribution of income from the rich to the poor in the form of higher income taxes on the rich and more benefits to the poor can increase the level of consumption expenditure in a country.
How does wealth impact AD
Defined as the value of assets people own (house, stocks/bonds, jewelry, material items) Wealth is not the same as income. An increase in consumer wealth will cause consumers to be more willing to increase their expenditure on goods and services at the prevailing income level. Hence, consumption will increase.
How does personal income taxes impact AD
When personal income taxes are lowered, there is a higher level of disposable income (total personal income - personal income taxes) and thus consumer possess greater purchasing power, increasing their consumption of goods and services to meet their unfulfilled wants and needs.
How does Interest rate & access to credit for firms impact AD
Interest rate (IR) is defined as the cost of borrowing for firms to finance their investments. The MEI is defined as the expected rate of returns for every additional unit of investment a firm uptakes at the given IR level.
Firms will only invest in an additional quantity of investments if its marginal efficiency of investment (MEI) is greater than than the interest rate levels and will stop when its MEI = IR cet. par.
A fall in IR levels will be met with an increase in investment projects. This is due to the fact that there is a greater number of projects that will yield an MEI which is greater than or equal to the new lowered IR.
Thus, a fall in IR will lead to an increase in the quantity of investments, reflected by a downward movement along the MEI curve.
Access to credit is defined as the ability of firms to attain loans and financial services from lenders.
Firms with an ease of access and availability to credit will result in high levels of lending by financial institutes to firms, and in turn, higher investment.
How does business confidence & expectations impact AD
Business confidence is defined as how optimistic firms are about their future sales and the level of economic activity they would have.
Firms which are more optimistic about their future sales and economic activity will expect their rate of returns on investments to increase cet. par.
This results in a rightward shift of their MEI curve resulting in an increase in the level of investment at the given IR level
How does corporate tax rates impact AD
Corporate tax rates are defined as compulsory payments made by firms to the government which is taxed on firms’ profits.
A fall in corporate tax rates will increase a firms’ after-tax profit. This increases a firms’ willingness to invest resulting in an increase in the MEI cet. par.
This results in a rightward shift of the MEI curve, and in turn, increasing the level of investment at the given IR level.
How does technological changes for firms impact AD
Technological changes are defined as improvements to techniques of production.
Such improvements will increase investment spending as new technologies will create new capital which are more efficient. This will increase the return on investments causing the MEI curve to shift rightwards, increasing investment at the given IR, cet. par.
Technologies can also make new capital cheaper which also increases the return on investment, causing the MEI to shift rightwards, increasing investment at the given IR, cet. par.
How does government expenditure impact AD
Government expenditure is defined as spending by the government on g/s within the country such as salaries of gvt workers, public works and investment on infrastructure and system.
This level of spending differs based on gvts desire to achieve micro & macro goals as well as their revenue, national reserves, and access to credit
How does National Reserves impact AD
Next Book
How does access to credit for governments impact AD
Next Book
How does national income of partner countries & domestic households impact net exports and AD
Net exports are defined as the value of all exports minus imports. Exports expenditure is defined as the total value of all g/s produced within the country and is sold to foreigners. Import expenditure is defined as the total value of all g/s produced by other countries and purchased by the domestic country.
A rise in national income for trade partners of the domestic country will increase PP and result in an increase in foreign demand for the domestic country’s g/s assuming these exports are normal goods ie YEDx > 0. Cet. par. net exports increase.
A rise in the domestic country’s national income will increase the domestic PP and increase demand for domestic g/s. Despite a rise in import expenditure, part of this spending will go overseas and will not enter the domestic AD, still causing AD to increase
