Aggregate Demand PDF

What is Aggregate Demand? Aggregate demand refers to the total demand for finished goods and services in an economy. Finished products are goods and services that have been fully manufactured – not including intermediate goods that are used as inputs in the production process. Aggregate demand als...

What is Aggregate Demand? Aggregate demand refers to the total demand for finished goods and services in an economy. Finished products are goods and services that have been fully manufactured – not including intermediate goods that are used as inputs in the production process. Aggregate demand also refers to the demand for the country’s gross domestic product (GDP) and the measure of demand for goods and services at all price levels. A price level is the hypothetical overall price of goods and services in the economy. It is determined using the Consumer Price Index, which is a measure of the weighted price of a basket of typically purchased goods and services in the economy. Aggregate Demand – Components An economy’s aggregate demand is the sum of all individual demand curves from different sectors of the economy. It is typically the sum of four components: 1. Government Spending (G) Government spending (G) is the total amount of expenditure by the government on infrastructure, investments, defense and military equipment, public sector facilities, healthcare services, and government employees. It excludes the spending on transfer payments, such as pension plans, subsidies, and aid transfers to other countries that are in need. 2. Consumption Spending (C) Consumption spending (C) is the largest component of an economy’s aggregate demand, and it refers to the total spending of individuals and households on goods and services in the economy. Consumption spending depends on several factors, such as disposable income, per capita income, debt, consumer expectations of future economic conditions, and interest rates. An important point to note is that consumption spending does not include spending on residential structures, which is accounted for in the investment spending component. 3. Investment Spending (I) Investment spending (I) is the total expenditure on new capital goods and services such as machinery, equipment, changes in inventories, investments in nonresidential structures, and residential structures. Investment spending depends on factors such as interest rates (since they determine the cost of borrowing), future expectations regarding the economy, and government incentives (such as tax benefits or subsidies for investing in renewable energy). 4. Net Exports (X–M) Exports are products that are produced by domestic producers and sold abroad, while imports are products that are manufactured abroad and imported for domestic purchase. Compiled by: Arven C. Calago It is important to remember that aggregate demand is the total demand for domestically produced goods and services; therefore, exports are added to the aggregate demand, whereas imports are subtracted. The measure of exports minus imports is called Net Exports, an important determinant of aggregate demand. Shifts in Aggregate Demand The aggregate demand curve plots the demand for domestically produced goods and services at all price levels. Real GDP measures the value of gross domestic product adjusted for inflation and provides a more accurate picture of changes in domestic demand than nominal GDP. The AD curve is downward sloping since higher price levels correspond to lower demand for goods and services, which is in accordance with the Law of Demand. Here are some of the reasons behind the downward slope of the AD curve: 1. Pigou’s Wealth Effect Pigou’s Wealth Effect states that consumers are wealthier at lower price levels (assuming that wages are constant). Disposable income is higher at lower price levels and allows consumers to spend more on goods and services, increasing the demand for output. 2. Exchange Rate Effect When the value of a country’s currency drops against other currencies, domestic goods become relatively cheaper to foreigners, and imports become more expensive. Therefore, at lower price levels, when domestic goods are cheaper compared to imported goods, the demand for exports is higher, and it leads to an increase in aggregate demand. Factors that Cause Shifts in Aggregate Demand Compiled by: Arven C. Calago An increase in any of the components of aggregate demand – consumption spending, investment spending, government spending, and net exports (X-M) – shifts the aggregate demand curve to the right, and a fall in any of these components shifts it to the left. A shift from AD to AD1 reflects an increase in aggregate demand. A shift from AD to AD2 reflects a decrease. This can be the result of a change in any factors that influence the components of aggregate demand, including consumer confidence, investor confidence, tax policies, government spending on infrastructure, interest rates, and more. Why is the aggregate demand curve downward-sloping? 1. Income effect As the price level increases, purchasing power decreases, leading to real income reducing and so consumption falls, leading to a decrease in aggregate demand. As the price level decreases, purchasing power increases, leading to real income increasing and so consumption increases, leading to an increase in aggregate demand. 2. Interest rate effect As price level increases, interest rate increases, and so the cost of borrowing increases, leading to a fall in consumption and therefore a decrease in aggregate demand. As price level decreases, interest rate decreases, and so the cost of borrowing decreases, leading to an increase in consumption and therefore an increase in aggregate demand. 3. Exchange rate effect As price level increases, exchange rate also increases, leading to an appreciation of currency, due to which: o Price of exports increase, leading to a decrease in demand of exports and therefore a fall in the X component (exports). Compiled by: Arven C. Calago  o Price of imports decrease, leading to an increase in the demand for imports, and so the M (imports) component of AD increases. Both of these lead to a decrease in AD. Aggregate Demand (AD) Curve In macroeconomics, the focus is on the demand and supply of all goods and services produced by an economy. Accordingly, the demand for all individual goods and services is also combined and referred to as aggregate demand. The supply of all individual goods and services is also combined and referred to as aggregate supply. Like the demand and supply for individual goods and services, the aggregate demand and aggregate supply for an economy can be represented by a schedule, a curve, or by an algebraic equation The aggregate demand curve represents the total quantity of all goods (and services) demanded by the economy at different price levels. An example of an aggregate demand curve is given in Figure. The vertical axis represents the price level of all final goods and services. The aggregate price level is measured by either the GDP deflator or the CPI. The horizontal axis represents the real quantity of all goods and services purchased as measured by the level of real GDP. Notice that the aggregate demand curve, AD, like the demand curves for individual goods, is downward sloping, implying that there is an inverse relationship between the price level and the quantity demanded of real GDP. The reasons for the downward‐sloping aggregate demand curve are different from the reasons given for the downward‐sloping demand curves for individual goods and services. The demand curve for an individual good is drawn under the assumption that the prices of other goods remain constant and the assumption that buyers' incomes remain constant. As the price of good X rises, the demand for good X falls because the relative price of other goods is lower and because buyers' real incomes will be reduced if they purchase good X at the higher price. The aggregate demand curve, however, is defined in terms of Compiled by: Arven C. Calago the price level. A change in the price level implies that many prices are changing, including the wages paid to workers. As wages change, so do incomes. Consequently, it is not possible to assume that prices and incomes remain constant in the construction of the aggregate demand curve. Hence, one cannot explain the downward slope of the aggregate demand curve using the same reasoning given for the downward‐ sloping individual product demand curves. Reasons for a downward‐sloping aggregate demand curve. Three reasons cause the aggregate demand curve to be downward sloping. The first is the wealth effect. The aggregate demand curve is drawn under the assumption that the government holds the supply of money constant. One can think of the supply of money as representing the economy's wealth at any moment in time. As the price level rises, the wealth of the economy, as measured by the supply of money, declines in value because the purchasing power of money falls. As buyers become poorer, they reduce their purchases of all goods and services. On the other hand, as the price level falls, the purchasing power of money rises. Buyers become wealthier and are able to purchase more goods and services than before. The wealth effect, therefore, provides one reason for the inverse relationship between the price level and real GDP that is reflected in the downward‐sloping demand curve. A second reason is the interest rate effect. As the price level rises, households and firms require more money to handle their transactions. However, the supply of money is fixed. The increased demand for a fixed supply of money causes the price of money, the interest rate, to rise. As the interest rate rises, spending that is sensitive to rate of interest will decline. Hence, the interest rate effect provides another reason for the inverse relationship between the price level and the demand for real GDP. The third and final reason is the net exports effect. As the domestic price level rises, foreign‐made goods become relatively cheaper so that the demand for imports increases. However, the rise in the domestic price level also means that domestic‐made goods are relatively more expensive to foreign buyers so that the demand for exports decreases. When exports decrease and imports increase, net exports (exports ‐ imports) decrease. Because net exports are a component of real GDP, the demand for real GDP declines as net exports decline. Changes in aggregate demand. Changes in aggregate demand are represented by shifts of the aggregate demand curve. An illustration of the two ways in which the aggregate demand curve can shift is provided in Figure. Compiled by: Arven C. Calago A shift to the right of the aggregate demand curve. from AD 1 to AD 2, means that at the same price levels the quantity demanded of real GDP has increased. A shift to the left of the aggregate demand curve, from AD 1 to AD 3, means that at the same price levels the quantity demanded of real GDP has decreased. Changes in aggregate demand are not caused by changes in the price level. Instead, they are caused by changes in the demand for any of the components of real GDP, changes in the demand for consumption goods and services, changes in investment spending, changes in the government's demand for goods and services, or changes in the demand for net exports. Consider several examples. Suppose consumers were to decrease their spending on all goods and services, perhaps as a result of a recession. Then, the aggregate demand curve would shift to the left. Suppose interest rates were to fall so that investors increased their investment spending; the aggregate demand curve would shift to the right. If government were to cut spending to reduce a budget deficit, the aggregate demand curve would shift to the left. If the incomes of foreigners were to rise, enabling them to demand more domestic‐made goods, net exports would increase, and aggregate demand would shift to the right. These are just a few of the many possible ways the aggregate demand curve may shift. None of these explanations, however, has anything to do with changes in the price level. References. Aggregate Demand and Aggregate Supply. (n.d.). https://www.blitznotes.org/ib/economics/agg_demand_supply.html Team, C. (2023, November 22). Aggregate Demand. Corporate Finance Institute. https://corporatefinanceinstitute.com/resources/economics/aggregate-demand/ Compiled by: Arven C. Calago