Aggregate Demand/Supply Notes

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AGGREGATE DEMAND

- the total spending on goods and services in a period of time at a given price level

C + I + G + (X – M)

C = Consumption

o The total spending by consumers on domestic goods and services ▪ Durable goods: used by consumers over a period of time (i.e. cars, computers, mobile phones) ▪ Non – durable goods: used up immediately or over a short time span (i.e. rice, toilet paper, newspapers) o Causes of change in consumption

▪ Changes in income – Income rises, people have more money to spend on goods and services, therefore consumption rises • Increase in consumption leads to increase in aggregate demand. In countries with a growing economy, consumption and therefore aggregate demand will rise. ▪ Changes in interest rates – Spending on durable goods usually comes from money borrowed from the bank. Increase in interest rate leads to decrease in borrowing of money, as it is more expensive to borrow. • Increase in interest rates leads to decrease in consumption and therefore decrease in aggregate demand • High interest rates encourage consumers to save money rather than spend it, therefore consumption decreases. ▪ Changes in wealth – The amount of consumption depends on amount of wealth that consumers have (income ≠ wealth) o Income = money that people earn

o Wealth = assets that people own
• Change in house prices – House prices increase, consumers feel wealthy/confident and therefore increase consumption by saving less and borrowing more • Change in the value of stocks and shares – Many consumers hold shares in companies. If value of shares increases, people feel wealthy and therefore spend more. Or they sell shares and use money to increase consumption ▪ Changes in expectations/consumer confidence – If people are optimistic, they will spend more. High consumer confidence will lead to increased consumption. ▪ Household indebtedness – The extent to which households are willing/able to borrow money. • If easy to borrow money and interest rates are low, households will take on more debt by increased spending with credit cards and getting loans. Therefore consumption will increase. • If interest rates then rise, households will have a harder time paying off the debts due to having to spend more on paying back debt rather than spending on goods and services. Thus, consumption will decrease.

I = Investment

o The addition of capital stock to the economy, carried out by firms ▪ Replacement investment: firms spend on capital in order to maintain productivity of existing capital ▪ Induced investment: firms spend on capital to increase output to respond to a higher demand in the economy ▪ Capital stock: includes all goods that are made by people and are used to produce other goods and services o Causes of change in investment

▪ Interest rates – Firms can borrow money in order to have money to invest or use their “retained profit”. Both methods affected by interest rate. • If money is borrowed, increase in interest rate leads to a fall in investment • Firms are likely to put retained profit in bank rather than invest when interest rates are high and therefore investment falls ▪ Changes in the level of national income – If national income rises, there will be an increase in consumption. • Pressure on capacity of firms therefore firms will invest in new plants/equipment to satisfy increase in demand ( induced investment. Investment accelerates when national income rises. ▪ Technological change

▪ Expectations/business confidence – Expectations for the future and confidence in economic climate affects firms’ investments. • If consumer demand is likely to fall in future, firms will not invest in order to increase output. • If economic climate promises a good future, firms are likely to invest in order to increase output to meet the increase in demand. - G =...
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