Aggregate Demand

Topics: Economics, Macroeconomics, Gross domestic product Pages: 48 (1652 words) Published: November 1, 2014
HOW THE ECONOMY WORKS:

AGGREGATE DEMAND

ECO 2021_August 2014

CURIOUS QUESTIONS
(for today)
 What is
 What is
between
and the

“aggregate demand”?
the relationship
aggregate demand
economy?

Macroeconomics studies the
performance of the economy.
national global

totals

aggregates

aggregate demand
total demand in a country

WAYS TO MEASURE THE
PERFORMANCE OF AN ECONOMY

output
method

expenditure
method

income
method

The Expenditure Method

- Measures output of the
economy in terms of
spending by various
sectors of the economy.

The Expenditure Method
total output =
=
+
+
+

total expenditure
consumption
investment
government spending
net exports

LEARNING OBJECTIVES





To understand the definition
and nature of aggregate demand.
To derive/sketch an aggregate
demand curve intuitively.
To understand the determinants
of an aggregate demand curve.

Aggregate demand (AD) is the
total level of expenditure on
goods and services in an economy
by households, firms, government
and the foreign sector.

AD = C + I + G + X - M
consumption
investment
government spending
exports
imports

DERIVATION OF
THE AGGREGATE
DEMAND CURVE

Suppose the general price
level falls, ceteris paribus.
THREE things will happen…
“all other things remain the same”

If the general price level falls…
• Lower prices give households greater liquidity
(consumers will have more cash to spend).
• Less money will need to be borrowed.
• Interest rates will fall, thus stimulating
greater consumption and investment.
• Also, with lower prices, the domestic country’s
international competitiveness will increase
(cheaper exports). Demand for exports will rise.

AD = C + I + G + X - M
consumption
investment
government spending
exports
imports

General price level (P)
AD is downward-sloping.
Negative relationship
between general price
level & national output.

𝑃1
𝑃2

AD
0

𝑌1 𝑌2

National output (Y)

If the general price level falls…
• Lower prices give households greater liquidity
(consumers will have more cash to spend).

WEALTH EFFECT

If the general price level falls…

• Less money will need to be borrowed.
• Interest rates will fall, thus stimulating
greater consumption and investment.

INTEREST RATE EFFECT

If the general price level falls…

TRADE BALANCE EFFECT
• Also, with lower prices, the domestic country’s
international competitiveness will increase
(cheaper exports). Demand for exports will rise.

What are the
determinants of
the aggregate
demand curve?

CONSUMPTION
• Consumption is the expenditure of households
on final goods and services. It is the
largest component of aggregate demand.
• There are several factors that will affect
consumption, and hence affect national output
(expenditure method) and aggregate demand.

(1) The level of national income
• Recall that national income is also known as
national output or gross domestic product.
• As national income rises, it is an indication
that the economy’s performance is improving.
• Households may feel more confident about future
prospects. Therefore, consumption will rise.
• Ceteris paribus, aggregate demand will rise.
The AD curve will shift parallel to the right.

General price level (P)
𝐴𝐷0 𝐴𝐷1

When Y increases, ceteris
paribus, consumption will
increase, hence the AD
curve shifts parallel to
the right from 𝐴𝐷0 to 𝐴𝐷1 .

𝑃

0

𝑌0

𝑌1

National output (Y)

(2) Age structure of population
• The younger the population, the higher the
levels of consumption, though not guaranteed.
• An aging population tends to have lower
consumption levels since people are saving for
retirement and future medical needs.
• Elderly people are more careful about their
spending since they have retired (no income).

(3) Tastes, preferences, lifestyles
• Some societies consume more & save less if...
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