An Introduction to Aggregate Demand
This is the total planned spending on domestic goods and services at various
possible average price levels per period of time.
The Aggregate Demand curve shows the relationship between the total amount of
real output demanded by the country’s components and the economy’s price level
(rate of inflation) over a period of time.
Why does the Aggregate Demand curve slope downwards?
a) Wealth effect: changes in the price level affect the real value of people’s wealth. If
the price level (F) increases, people feel worse off and cut back on their spending of
goods and services. As the price level increases less goods and services (output) are
demanded. People’s savings don’t go far.
On the other hand, if there is a fall in the price level the real value of wealth
increases, people feel better off and consequently spend more, thus more output is
demanded, causing a shift in the AD curve. The existing income does not buy as
much as it used to when prices rise.
b) The interest rate effect: When there is inflation or prices rise excessively the
government (or MPC) will increase the interest rate. If price levels increase then
consumers and firms need more money to pay for the higher prices and to continue
to buy goods and pay their bills, so the demand for loans will increase.
c) The International Trade effect: A fall in the domestic price level relative to that of
other price leads to a larger amount of exports being demanded and a lower amount
of imports. Mexico, Turkey and Nigeria are in this situation at the moment. It will
lead to a greater volume of imports.
If prices start to rise there will be a fall in demand for exports and there will be a rise
in demand for imports. Net exports will decrease.
Net exports rise. (NX)
Therefore, there is a downward movement along AD.
Aggregate value fall exports spend increases
wealth interest rate extension four Turkey
price country’s exports output worse
NX
Aggregate Demand: The sum of all demand for all goods in the economy
Shifts in Aggregate Demand
1
Any factor that produces a change in any one of the four components of Aggregate
Demand will cause the AD curve to shift outwards or inwards. Explain each of the
factors using page 238 of your textbook please.
Changes in consumer spending arise from:
Consumer confidence:
A high level of consumer confidence will encourage a higher marginal propensity to
consume. Therefore, causes an increase (rightward shift) of the aggregate
demand curve.
A fall in levels of consumer confidence is often an indicator of an economic
downturn. This will cause a decrease (leftward shift) of the aggregate demand curve.
Household indebtedness:
The higher the debt level of the household sector, the larger the amount of debt that
the sector must repay and the greater the reduction in consumption and,
thus, aggregate demand.
Expectations:
A change in the inflationary expectations, by changing consumption expenditures,
induces changes in aggregate demand. Expectations of higher inflation
increases aggregate demand and expectations of lower inflation decreases aggregate
demand.
Wealth:
An increase in wealth will induce people to increase their consumption. The
consumption component of aggregate demand will thus be greater at lower price
levels than at higher price levels.
Y (Income)
As household wealth increases, aggregate demand usually increases as well.
Conversely, a decline in wealth usually leads to lower aggregate demand.
Explain how AD can be shifted by changes in Investment
2
Business confidence:
If business confidence is high, then firms tend to spend more on investment,
believing that the future payoff from that investment will be substantial. (A shift to
the right). On the other hand, if consumer or business confidence drops, then
consumption and investment spending decline. (A shit to the left).
Interest rates:
When interest rates rise, it becomes more “expensive” to borrow money. That
borrowed money would typically go toward consumer expenditures and capital
investment, and so these two sectors diminish under higher interest rates.
Therefore, aggregate demand decreases.
Changes in technology:
An advance in technology makes it possible to produce more output with a given
quantity of resources or to produce the same quantity of output with fewer
resources, hence causing an increase in both long-run and short-run aggregate
supply. The cost of production goes down, and consumers will demand more of the
product at lower prices.
A less common decline in technology means producing less output with a given
quantity of resources or to produce the same quantity of output with more
resources, hence causing a decrease in both long-run and short-run aggregate
supply.
Changes in business taxes:
Tax cuts for individuals will tend to increase consumption demand, while tax
increases will tend to diminish it. Tax policy can also pump up investment demand by
offering lower tax rates for corporations or tax reductions that benefit specific kinds
of investment. Since both consumption and investment are components of
aggregate demand, changing either will shift the AD curve as a whole.
The level of corporate indebtedness:
Legal and institutional changes:
Causes of changes in government spending
3
Changes in political priorities:
Changes in economic priorities:
Causes of changes in export spending minus import spending
Changes in National Income abroad:
Changes in exchange rates:
Changes in the level of trade protection:
Find an article about one of the situations above and paste the link here.
