Aggregate demand is the total spending on goods and services in a given year at a given price level
The x axis of an aggregate demand curve is ‘real output’/ national income. “y” axis is average price level of all goods and services. It shows the inverse relationship between prie level and read output. Law of demand at an aggregate level.
aggregate means total
4 components of aggregate demand
- Consumption: Total spending by consumers on domestic goods and services. Two type of good: Durable(used over a long time) and non durable(used up immediately).
- Investment: Addition of capital stock in the economy by firms. Induced inventment: when firms spend to increase output in response to an increase in AD. Replacement investment.
- Government spending: Government spends(fiscal) on education, healthcare, law and order, transport , etc. Amount depends on the policies and objectives.
- Net Exports: Exports lead to an inflow of income/export revenue and imports lead to an outflow of import expenditure/income. Net exports is export revenue - import expenditure. (X-M)
Equation: AD = C+I+G+X-M
Aggregate demand is the GDP of a country
The aggregate demand curve behaves like a normal demand curve and shifts in a similar manner however the reason for shifting is very different. Change in any of the four components will cause either is leftward or a rightward shift in AD.
What causes changes in consumption:
- Changes in income taxes, if taxes increase, disposable income decreases and therefore spending decreases and vice versa. Government manipulation of taxes: fiscal policy
- Changes in interest rates: Consumers pay for some durable goods like houses using money borrowed from a bank and pay back with interest. if borrowing is cheaper ⇒more people will borrow ⇒ increasing spending ⇒more consumption. High interest rate ⇒ borrowing is expensive ⇒ will save more to earn money ⇒ less spending. Mortgage payent also fall, increasing disposable income.
- A change in wealth: Weath is made up of the assets people own. this means a change in the price of assets the economy holds (happens mainly when house prices increase or when value of stocks and shares change). For example if the price of gold increases, people will feel more wealthy and might spend more. Increase in wealth increases the security
- Changes in consumer expectations: If people are optimistic about the future, they might spend more. If consumers expect economics conditions to improve due to a boom, they might feel more confident to spend more.However if they expect them to worsen in fear of losing their jobs they may put off spending and save. Price level: if they expect inflation, they increase consumption (especially on durables). Deflation may put off purachases in belief that price level will fall.
What causes changes in Investment:
- Changes in interest rates: Increase in interest rates will increase the cost of borrowing, leading to a fall in investment. and as interest rates are high firms may prefer to keep their retained profits in the bank as savings rather than using them to invest. Overall investment falls as interest rates increase vice versa.
- Changes in business taxes: If corporate taxes increases, then businesses will have less post tax-profit and would be unlikely to invest it further and vice versa. Manipulation of corporate taxes: fiscal policy
- If technology changes: firms will need to invest for more efficient production to keep up with the advancements and increase productivity to remain competitive. therefore investment will increase
- Changes in business expectations: id the businesses are confident about the fuuture of the economy and expect the demand for a product to increase, businesses will likely to increase investment to increase output to meet the demand. vice versa. If an industry is declining businesses are less likely to invest in that certain commodity.
- Current level of business debt, if the current debt is high businesses will have higher load payment in the long term and therefore might not further invest into capital since they will have less money . vice versa
What causes changes in government spending:
- depends on the political and economic priorities and objectives. Policies like education might require an increase in government spending cause increase in AG. vice versa
- Economic policies ⇒ infrastructure, capital might require an increase in government spending cause increase in AD
- Demographics ⇒ education status, sex ratio, save the girl child
What causes changes in net exports
- The economic growth of trading partners
- If the GDP of India increases and the national income rises. The indian consumers will be willing to spend more on imported goods and services, thus exports of other countries will rise and the imports of India will increase.
- Change sin exchange rate:
- If a country exchange rate becomes stronger, it will make the country’s exports more expensive to foreigners. This will cause the quantity of exports to fall. Export revenue will fall (the extent depends on the elasticity of of demand for exports). Imports will become cheaper for the country and consumers will spend more on imported goods and services increasing the import expenditure. Vice versa.
- Change in countries’ trade policies
- If a a trading partner adopts a more liberalized free trade policy, it may reduce the tariffs on imports causing the exports of a country to become cheaper thereby increasing the exports of the country. The trading partner will see a rise in imports since domestic consumers will be attracted by lower prices. Vice versa
- Inflation rate of trading partners
- Eg: if a country has a high inflation rate relative to other countries, its exports will become less competitive and thus its export revenue will fall. Its imports will rise since in comparison to domestically produced goods, imported ones will be cheaper, increasing the import expenditure. Vice versa.