Aggregate Demand

HOW THE ECONOMY WORKS:

AGGREGATE DEMAND

ECO 2021_August 2014

CURIOUS QUESTIONS
(for today)
 What is
 What is between and the

“aggregate demand”? the relationship aggregate demand economy? Macroeconomics studies the performance of the economy. national global

totals

aggregates

aggregate demand total demand in a country

WAYS TO MEASURE THE
PERFORMANCE OF AN ECONOMY

output method expenditure method income method The Expenditure Method

- Measures output of the economy in terms of spending by various sectors of the economy.

The Expenditure Method total output =
=
+
+
+

total expenditure consumption investment government spending net exports

LEARNING OBJECTIVES
•
•

•

To understand the definition and nature of aggregate demand.
To derive/sketch an aggregate demand curve intuitively.
To understand the determinants of an aggregate demand curve.

Aggregate demand (AD) is the total level of expenditure on goods and services in an economy by households, firms, government and the foreign sector.

AD = C + I + G + X - M consumption investment government spending exports imports

DERIVATION OF
THE AGGREGATE
DEMAND CURVE

Suppose the general price level falls, ceteris paribus.
THREE things will happen…
“all other things remain the same”

If the general price level falls…
• Lower prices give households greater liquidity
(consumers will have more cash to spend).
• Less money will need to be borrowed.
• Interest rates will fall, thus stimulating greater consumption and investment.
• Also, with lower prices, the domestic country’s international competitiveness will increase
(cheaper exports). Demand for exports will rise.

AD = C + I + G + X - M consumption investment government spending exports imports

General price level (P)
AD is downward-sloping.
Negative relationship between general price level & national output.

?1
?2

AD
0

?1 ?2

National output (Y)

If the general price level falls…
• Lower prices give households greater liquidity
(consumers will have more cash to spend).

WEALTH EFFECT

If the general price level falls…

• Less money will need to be borrowed.
• Interest rates will fall, thus stimulating greater consumption and investment.

INTEREST RATE EFFECT

If the general price level falls…

TRADE BALANCE EFFECT
• Also, with lower prices, the domestic country’s international competitiveness will increase
(cheaper exports). Demand for exports will rise.

What are the determinants of the aggregate demand curve?

CONSUMPTION
• Consumption is the expenditure of households on final goods and services. It is the largest component of aggregate demand.
• There are several factors that will affect consumption, and hence affect national output
(expenditure method) and aggregate demand.

(1) The level of national income
• Recall that national income is also known as national output or gross domestic product.
• As national income rises, it is an indication that the economy’s performance is improving.
• Households may feel more confident about future prospects. Therefore, consumption will rise.
• Ceteris paribus, aggregate demand will rise.
The AD curve will shift parallel to the right.

General price level (P)
??0 ??1

When Y increases, ceteris paribus, consumption will increase, hence the AD curve shifts parallel to the right from ??0 to ??1 .

?

0

?0

?1

National output (Y)

(2) Age structure of population
• The younger the population, the higher the levels of consumption, though not guaranteed.
• An aging population tends to have lower consumption levels since people are saving for retirement and future medical needs.
• Elderly people are more careful about their spending since they have retired (no income).

(3) Tastes, preferences, lifestyles
• Some societies consume more & save less if they exist is a more secure economic environment.
• For example in Australia, consumption levels are relatively high and savings low because of a well-established and good welfare system.
• However, for people who live in countries that do not have a proper welfare system, they tend to be more careful: save more, spend less.

(4) Ease of obtaining credit
• If it is easier to obtain credit, people are more likely to spend more by buying more.
• For example, if there are many credit card companies with attractive deals and low interest rates, more people will be attracted to buy more things now and pay later.
• There is no need to save first before they can afford to buy the item later on.

INVESTMENT
• Investment is the action or process of investing money to gain profit.
• It is the most volatile (liable to change rapidly and unpredictably, especially for the worse) component of aggregate demand.
• Like consumption, there are also several factors that can affect investment, and hence affecting aggregate demand.

(1) Interest rates
• Interest rates are the cost of borrowing.
• If investment is financed through borrowing
(from banks), this interest cost must be weighed against potential future profits to see if the investment project is feasible.
• The higher the interest rates, the less profitable any given investment project since they would have to repay the loan with a huge interest. Less investment will be undertaken.

(2) Expectations of future agg. dd.
• Regardless of the current level of aggregate demand – the economy could be in recession; it does not matter – but if future aggregate demand is expected to be high, investment spending may increase right now.
• This is to prepare for the need for greater productive capacity in the future when aggregate demand really increases.

(3) Technological change
• When there is a significant change in production technology, a firm may have to involuntarily upgrade its machinery in order to remain competitive with other firms.
• For example, the Internet revolution forced many firms to develop their own webpages.
• If they refuse to do so, customers may turn away to other firms who have internet services that are more convenient for them.

(4) Level of current profits
• Retained profits are the most popular method of financing investment since there is no need to repay any loan with interest.
• If a firm is doing very well with its operations– very profitable – then it will have more profits for reinvestment.

GOVERNMENT EXPENDITURE
• Government expenditure is any form of spending carried out by the government.
• Like consumption and investment, there are several factors that can affect government spending and hence aggregate demand.

(1) Phases of the business cycle
• Government spending tends to move counter to the business cycle. This is because one function of the government is to dampen the fluctuations which may have an undesirable economic impact.
• During recessions, the government may increase their spending in order to create new jobs.
• During inflation, the government may cut back on non-essential expenditure to ease the pressure on the general price level.

(2) Natural disasters, war
• When there are natural disasters such as a tsunami or hurricane that destroys large communities, the government will spend more to help to the communities to rebuild.
• Also, when a country is facing a war with another country, the government will have to spend more on weapons and war casualties.

(3) Government goals and policies
• Some governments believe it is their role to correct certain imbalances in the economy.
• Therefore, they will spend a large amount on providing pensions and welfare to citizens, especially the poorer ones with low income.
• However, some governments believe that the economy should be left to self-regulate. Hence, they do not spend a lot on welfare payments.

NET EXPORTS (EXPORT minus IMPORT)
• Exports are goods and services that a country sell to the rest of the world, and income will flow into the domestic economy.
• Imports are goods and services that a country buy from the rest of the world, and income will flow out of the domestic economy.
• There are several factors that can affect net exports and hence aggregate demand.

(1) Income at home and abroad
• If domestic national income grows faster than national income for the rest of the world, imports tend to increase faster than exports.
• As a result, aggregate demand will fall.
• If domestic national income grows slower than national income for the rest of the world, exports tend to increase faster than imports.
• As a result, aggregate demand will rise.

(2) Relative price levels
• If domestic price levels are relatively high compared to prices in the rest of the world, exports will fall and imports will rise.
• This is because domestic goods and services are relatively more expensive/less desirable.
Other countries may not want to buy them.
• Also, since overseas goods and services are relatively cheap, domestic imports will rise.

(3) Exchange rate movements
• If the domestic currency is stronger in value, exports will fall and imports will rise.
• For example, initially you need RM 3.50 to exchange for 1 USD. Now suppose you need
RM2.50 to exchange for 1 USD.
• This means the ringgit has become stronger.
Foreigners buying Malaysian goods have to pay more. They may be less inclined to do so.

Change in aggregate demand (AD)
Involves a shift General price level (P) in the entire
Parallel shift!
AD curve.
A rise in
??1
aggregate demand
??0
National is shown as a
0
income (Y) shift to the right
General price level of the AD curve. remains constant!

Change in aggregate demand (AD)
Involves a shift General price level (P) in the entire
Parallel shift!
AD curve.

A fall in aggregate demand is shown as a
0
shift to the left of the AD curve.

??0
??1
National income (Y)
General price level remains constant!

Change in aggregate demand (AD)
General price level (P)
Parallel shift!

General price level remains constant!
??1 ??0 ??2

0

National income (Y)

Determinants of aggregate demand
•
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Consumption level of national income age structure of population tastes, preferences, lifestyles ease of obtaining credit

Determinants of aggregate demand
•


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Investment interest rates expectations of future aggregate demand technological change level of current profits

Determinants of aggregate demand
•

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Government expenditure phases of the business cycle natural disasters, war government goals and policies

Determinants of aggregate demand
•
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Net exports income at home and abroad relative price levels exchange rate movements

LEARNING OUTCOMES
•
•

•

Be able to provide the definition of aggregate demand.
Be able to sketch the AD curve and explain it intuitively.
Be able to understand and explain the determinants of the AD curve.

THE END
(for today)