Aggregate DemandBY AARON, SEB AND ELENA

Definition of Aggregate Demand

Aggregate Demand is the total demand for goods and services produced in an economy at a given price level in a given time period.

Formula for Aggregate Demand

AD stands for Aggregate demand

C stands for consumption

I stands for investment

G stands for government spending

X stands for exports

M stands for imports

AD= C + I + G + (X-M)

The difference between demand and aggregate demand

Aggregate demand is the total spent in the economy by an individual business or government at any price at a given time so it encompasses many different items and services. This is different to the demand for one single good or service.

Why the AD curve is Downward Sloping?

There are three factors that explain the shape of the AD curve.

1. Interest rates

2. Changes in real wealth

3. The foreign sector

Interest Rates

As interest rates increase, people will have to pay more for their mortgages meaning they have less money to spend on expensive goods such as cars etc as they would have to get a loan and pay back a lot of interest.

The higher the interest rate the less likely businesses are going to get loans for investment this means that the overall aggregate demand will fall as less is being demanded due to high rates of costs.

Higher interest rates mean more consumers will be saving rather than spending as they will get more on their money in the back and have to spend more for mortgages meaning they have less disposable income. This has the effect that people have to save for a year before buying a big 'ticket product'.

Changes in Real Wealth

If price levels rise, for a given level of nominal wealth, then peoples' real wealth will fall.

The wealth effect - When their is a rise in the price level this will make people who have money feel poorer, this intern means they will buy less causing aggregate demand to fall however the opposite is true if the price level were to fall people would buy more as they feel like they have more money and are richer. If people feel poorer then consumption will decrease meaning that aggregate demand will decrease. If people feel that they are more well off then they are likely to increase consumption causing aggregate demand to increase.

The Foreign Sector

If the UK price levels rise then households products in different countries will also increase in prices. This means that the exports for the UK will decrease. If our main exports such a machinery, pharmaceuticals and jewelry rise in price in other countries then the demand for them will decrease, meaning that the UK will be exporting less.

Factors That Affect Aggregate Demand

Exchange rates

Distribution of income

Expectations

Monetary and Fiscal Policies

These factors will cause either an outward or inward shift in the AD curve.

Exchange Rates

A decrease in exchange rates causes an increase (rightward shift) of the aggregate demand curve. This is because the countries exports will become cheaper so other countries over time will want to buy more products form that country. In turn this means that the cost of importing goods into the country will increase.

An Increase in exchange rates causes a decrease(leftward shift) to occur. This is because the goods being produced by the country will go up in price. However the need for imports from other countries is fairly inelastic in the short run. However in the long run the country will lose the demand on its exports as the price will have increased to much. On the other hand though prices of imports for that country will have gone down.

Distribution of Income

Income distribution is the smoothness or equality in which income is dealt out to members of a society. If everyone earns the same amount the distribution of income is perfectly equal.

When a workers real wage increases, then people will have more money on their hands because their overall income has increased this means that people will be more inclined to consume causing the consumption expenditures to increase.

Real wage - is your nominal wage that has ben adjusted for inflation showing your purchasing power.

Consumer expenditure - The measure of price changes of consumer goods and services.

Expectations

Consumers tend to have a certain expectation about the future of the economy this can effect the aggregate demand in many different ways.

If the consumer expects the economy not to do so well in the future then savings will increase meaning overall expenditures will decrease causing a leftward shift.

Rising price levels will cause aggregate demand to increase, this is because if the consumer can foresee the price level to rise in the near future then they might go out and buy the good now rather than later, increasing the consumption expenditures.

Expectations have the ability to increase and decrease aggregate demand and it is not always clear to what is going to happen.

Monetary and Fiscal Policies.

The government has some ability to impact aggregate demand. They are able to spend money or increase taxes to influence how consumers spend or save. An expansionary fiscal policy causes aggregate demand to increase whereas a contractionary monetary policy causes aggregate demand to decrease.

Expansionary fiscal policy - Designed to stimulate the economy during or in anticipation of a business cycle contraction. This is achieved by increasing aggregate expenditures and aggregate demand through government spending or a decrease in tax.

Contractionary monetary policy - The decrease in the quantity of money in circulation, with corresponding increases in interest rates for the purpose of putting the brakes on an over heated business cycle expansion and to address the problem of inflation.

Video!

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