AGGREGATE DEMAND
PART 1 OF 3
BY: PUNI AND MUSTAFA
CONTENTS
• What is Aggregate Demand?
• Components of AD and their Determinants
• The aggregate demand curve
• Shifts in the AD curve
• Thank you
What is Aggregate Demand?
It is the total demand for an economy’s goods and services at a given price level
in a given time period.
Formula for AD
Aggregate Demand (AD) = Consumer Expenditure (C) + Investment (I) +
Government Spending (G) + Net Exports (X-M)
Components of AD and their Determinants
1. Consumer Expenditure
This is total spending by households on goods and services.
a. Disposable Income - Disposable income is a key determinant of
consumption. As disposable income increases, consumers are likely to spend
more on goods and services. In cases where households are poor, most or all
income will be spent, it may also mean that some spend more than their
income and hence will used past savings or may borrow, this situation is
called dissaving. When income rises, people will save money.
b. b. Distribution of income - When income distribution is more equal, there
will be more spending. Increased direct tax and state benefits will mean that
those who have higher incomes are likely to not stop spending if income
drops while those who have lower incomes will spend more hence, overall
spending will rise.
c. Interest rates - There will be more spending when interest rates are low,
this is because low interest rates will encourage people to borrow and buy on
credit more as it will be cheaper to pay it back hence, to spend more. Low
interest rates will also mean that return on savings will be less.
d. Expectations - If people are optimistic about the security of their future jobs
and believe that their income will rise, they will spend more, however if people
are pessimistic, they will reduce spending and borrowing.
e. Wealth - An increase in wealth like an increase in the value of a house or
share will lead to more spending
f. Population - If there are more people, total demand will be more.
2.Investment
This is the spending on capital goods. (Referring to private sector firms only)
a. Consumer demand - If demand rises, firms will invest more to increase
capacity.
b. Interest rates - If interest rates fall, it will encourage firms to borrow more.
Firms will find it cheaper to borrow and get loans to invest than to use retained
earnings. Firms will also expect higher sales as low interest will mean more
consumer spending.
c. Technology - Advances in technology will mean productivity of capital goods
are raise which will lead to more investment.
d. Cost - A fall in cost or price of capital equipment is likely to result in higher
investment.
e. Expectations - If firms are optimistic about the economy and believe that
they will receive higher sales, it will encourage them to invest more.
f. Government policy - The government may help increase investment by
private sector firms by cutting on corporation taxes and reducing interest rates,
or by providing subsidies.
3. Government spending
The total of local and national government spending on goods and services,
mostly merit goods and public goods.
a. Government policy - If the government wants to raise economic activity,
they will spend more.
b. Tax - Higher tax rates will mean that government can spend more without
having to borrow.
c. Demographic changes (changes in population) - Changes in population
can influence government spending, for example an increase in the number of
children or elderly people in a country can put pressure on the government to
spend on education or healthcare respectively
4. Net exports
This is exports minus imports.
a. GDP of the country - When a country’s GPD rises, demand for imports will
rise. Also, goods and services produced in a country can be diverted from
exports to the domestic market.
b. GPD of other countries - When GDP of another country rises, demand for
exports will rise.
c. Competitiveness of the product - Exports can rise if domestic products are
produced for efficiently or are of better quality.
d. Exchange rate - If a country’s exchange rate drops, exports will become
cheaper and imports will become expensive, if also demand for exports and
imports are elastic, then export revenue will rise and import expenditure will
drop leading the net exports rising.
The aggregate demand curve
An AD curve works just like a normal demand curve but it
represents the total demand for all products in an economy. A rise
in price will lead to a contraction in demand and a fall in price will
lead to an extension in demand.
There is a significant
difference. In a
demand curve for an
individual product, it
shows how price
changes can affect
demand however, this
done on the
assumption that all
other variables where
constant (Ceteris
paribus). In a AD
curve, the prices of
REASONS WHY AD FALLS WHEN PRICES RISE AND AD
RISES WHEN PRICES FALL:
1. The wealth effect: A rise in price level will reduce the purchasing power
from people’s wealth in the form of savings and financial assets.
2. The international effect: A rise in price will lead to demand for exports
reducing and demand for imports will increase hence, making net exports
fall.
3. The interest rate effect: A rise in price will lead to greater demand for
money to pay the higher prices, this will make the interest rates to rise.
Higher interest rates will result in less expenditure.
SHIFTS IN THE AD CURVE
Just like with a normal demand curve, shifts for the AD curve only happen
due to non-price factors.
The non-price factors are the components of AD that we discussed earlier.
A shift to the left will show a fall in AD and a shift to the right will show a rise
in AD.
The figure shows an increase in AD caused by:
1. Consumer expenditure - A rise in confidence,
cut on taxes, increase in wealth and an
increase in population.
2. Investment - A rise in firm’s confidence, cut
on tax, advances in technology.
3. Government spending - A desire to stimulate
economic activity, a desire to win political
support.
4. Net exports - A fall in the exchange rate, rise
in the quality of domestic goods, increases in
GDP in other countries.
THANK YOU
• We thank you for you patience.
• We are yet to present Part 2 Aggregate Supply
