Transcript 14 Aggregate Demand

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.