Aggregate Demand IB Economics Chapter 14

Learning Objectives At the end of this chapter you will be able to  Understand the meaning of aggregate demand  Understand that aggregate demand can change if any of the components of C + I + G + (X – M) change  Understand what causes shifts in aggregate demand  Understand how to use aggregate demand diagrams

The meaning of aggregate demand  When we first learned about supply and demand we were talking about supply and demand within the industry or market  We now use the supply and demand curves to show supply and demand in the entire economy  Note that the axis are labelled slightly differently - we have price level (instead of price) and real output (instead of quantity)  We use P still for price and Y for output  As with the demand curve the AD curve slopes from left to right

The meaning of aggregate demand  The AD curve slopes down from left to right due to the following factors:  When prices fall consumers experience a wealth effect – they feel better off and want to buy more goods or services. More will be consumed at lower prices  A fall in the price of UK goods lowers the price of UK exports so more will sell abroad. Imports will become more expensive so demand for domestic goods will increase  Expectations – if consumers expect prices to rise in the future they will increase their consumption now but if they expect prices to fall they will buy later.  Remember that movements along the curve are only caused by changes in price levels (just as before where movements along the demand curve were caused only by changes in price

Shifts of the aggregate demand curve  Any factor that changes aggregate demand will cause the AD curve to shift – the same as before right is more and left is less  Aggregate demand is made up of  Consumption plus investment plus government expenditure plus net exports (exports minus imports)  This is abbreviated to  AD = C + I + G + (X – M) Make sure you use the correct annotation when drawing macro diagrams or you will lose marks

Factors that affect Aggregate Demand (determinants of Aggregate demand) – Consumption (C)  Consumption is the total spending by consumers on domestic goods and services (durable and non durable goods)  Consumption (C) is probably the most important part of AD because it is often the largest part (around 60%)  It is also the most volatile and least sustainable  The decision to consume is affected by a number of factors  Changes in income  As incomes rise people have more to spend and therefore C will increase  Changes in interest rates  If interest rates increase there is more incentive to save and C will fall  If interest rates increase the cost of borrowing increases leading to a fall in C  If countries where the majority of people own their houses rather than rent an increase in interest rates means an increase in mortgage payments which leads to less disposable income and therefore less spending (less C)

Factors that affect Aggregate Demand (determinants of Aggregate demand) – Consumption  Changes in wealth  If house prices or the value of stocks/shares increase people will feel wealthier and therefore have a tendency to spend more (increase in C)  Changes in expectations  This is probably one of the most important  If people feel that the economic future is bright they are more likely to spend or save if they think there is a chance of losing their job  If people have more disposable income it may not lead to more spending if expectations are low

Factors that affect Aggregate Demand (determinants of Aggregate demand) – Investment (I)  Investment is defined as firms investing into capital equipment machinery and premises.  The decision to invest is affected by a number of factors  The rate of interest (the amount firms pay to borrow money)  If there is a fall in the rate loans will be cheaper and firms will want to invest to improve their competitive position – shift to right  If there is a rise in the rate loans will be more expensive and firms will be less inclined to invest. – shift to left  Business Expectations - if interest rates are falling consumers will have more disposable income and therefore firms will expect sales to increase  Positive expectations (more sales in the future) will increase the likelihood of investment – shift to right  Negative expectations (less sales in the future) will decrease the likelihood of investment – shift to left  The rate of technical progress – if firms don ’ t have state of the art (the best) equipment and there is new equipment/technology available they will want to have it so that they don ’ t lose sales to those that have it – they will invest – shift to the right

Factors that affect Aggregate Demand (determinants of Aggregate demand) – Investment (continued)  The rate of change of income – as income increases demand for goods/services will increase. If firms are working at capacity they will need to invest to cater for the increased consumption  Because the price of the equipment is likely to be much larger than the individual goods it produces investment expenditure will be quite a large injection into the circular flow  Causes shift of AD curve to the right and a multiplier effect  The reaction of investment to the rate of change of income is called the accelerator effect  Coupled with the multiplier effect this could lead to sizeable fluctuations in demand  A slowdown or fall in consumer expenditure is likely to lead to a large fall in investment that will slow the growth of the macroeconomy Examiner tip: Investment is a demand side factor that will initially shift aggregate demand but in the long term is should also increase aggregate supply

Monetary Policy  Both consumption and investment are important parts of the AD identity  If there is a decrease in either AD will fall (growth will fall)  If there is an increase in either AD will increase (growth will increase)  This is why Monetary Policy is such an important macroeconomic tool  When interest rates increase both C and I should decrease  When interest rates decrease both C and I should increase  Note that the amount of change in AD is dependent on confidence in the economy and the size of the multiplier (we will learn more about this later)  Government (via the central bank) can use interest rates to control inflation and influence growth

Factors that affect Aggregate Demand (determinants of Aggregate demand) – Government Spending (G)  Government spending is spending on public and merit goods and local government services  Over the last 50 years UK government spending has reduced as firms have been privatised.  Governments have also reduced their spending to reduce taxation and their levels of borrowing  An increase in government spending will shift the AD curve to the right  A decrease will shift the curve to the left  Over the last 5 years government spending has began to increase (in the UK).  Government spending can have a large multiplier effect (explained later)  However government spending might mean more borrowing if there is not enough tax revenue

Factors that affect Aggregate Demand (determinants of Aggregate demand) – Net Exports (X – M)  UK exports depend on demand from other countries  If other trading countries are growing there will be an AD shift to the right  If other trading countries are in recession there will be an AD shift to the left  Exports and Imports are affected by the value of the pound sterling  If sterling falls in value against the Euro UK exports will be cheaper in Europe, sales should increase and the AD will shift to the right  If sterling increases in value UK exports will become more expensive, sales should decrease and the AD will shift to the right  If the UK economy is growing and incomes are rising consumers may spend more on imports shifting the AD curve to the left (because there is less demand for domestic goods)  If the value of sterling rises imports will appear cheaper and consumers will purchase more cheap imports – AD curve shift to the left.