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Aggregate Demand and Aggregate Supply, components, consequences, graphs
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Unit 9 - Aggregate Demand and Aggregate SupplyAggregate demand (AD)
In microeconomics, demand → willingness and ability of consumers to pay for a particular
product at each price level.
In macroeconomics, aggregate demand (AD) → value of
total demand for all g/s in the economy, per time period. It
is calculated as the total amount of spending in the
economy, usually per year. The AD curve shows the real
national output that is purchased at each price level, per
time period. It has a negative slope (downward sloping)
because when the general level of prices is high, the level
of aggregate demand tends to be low.
The determinants of aggregate demand
Factors that cause a change in any component of aggregate demand (AD = C + I + G + X
– M) will cause a shift in the AD curve, ceteris paribus.
The components of aggregate demand are:
1. Consumption (C)
2. Investment (I)
3. Government spending (G)
4. Net exports (X-M)
1. Consumption (C)
Factors that cause a change in consumption include:
I. consumer confidence
II. interest rates
III. wealth
IV. income taxes
V. level of household indebtedness
VI. expectations of the future price level
I. Consumer confidence
The more confident consumers are, the greater the level of consumption. Is low during a
recession (when unemployment increases) and high during a boom (when there is economic
growth). An increase in consumer confidence shifts the aggregate demand curve rightwards,
raising national output (real GDP) at all price levels, ceteris paribus.
II. Interest rates
The price of money, cost of borrowing money or return for saving money. An increase in
interest rates tends to reduce the level of consumption because households will find it less
affordable to borrow money to finance their expenditure. Households with loans and mortgages
have higher loan repayments when interest rates increase, so less income to spend. If interest
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, rates rise, it could give an incentive for some people to save more money. Higher interest rates
tend to reduce level of consumption by a leftwards shift of the AD curve, and vice versa.
III. Wealth
Changes in household wealth have a direct impact on the level of consumption in the
economy. Positive correlation between household wealth and the value of real GDP, the
wealthier households are, the more they consume. Increase in the wealth of the average
household in the economy will shift the aggregate demand curve to the right.
IV. Income taxes
If the level of disposable income falls due to higher income taxes, the level of consumption will
also fall, ceteris paribus. Disposable income are the earnings after taxes have been accounted
for, the actual take-home income that workers are able to spend. A reduction in income tax
rates will stimulate consumption expenditure and shift the AD outwards.
V. Level of household indebtedness
Condition of owing money. Lower level of household indebtedness can be brought about by
reduced interest rates (reduces the amount of debt interest owed by households) or by higher
household incomes (due to better employment opportunities in the economy). Hence, a lower
level of household indebtedness will shift the AD curve to the right, ceteris paribus.
VI. Expectations of the future price level
Future expected price movements of g/s. Household expectations about the future price will
also affect domestic consumption levels. If households expect the price level to increase in the
future, will tend to increase consumption today. Tend to shift the AD curve outwards to the
right.
2. Investment (I)
Factors that cause a change in investment expenditure in the economy include:
I. interest rates
II. business confidence
III. technology
IV. business taxes
V. level of corporate indebtedness
I. Interest rates
Higher interest rates make it more expensive for firms to borrow money to finance their growth,
investment expenditure will fall. Firms with existing loans will face larger debt repayments when
interest rates increase due to higher debt interest. Higher interest rates will reduce investment
expenditure, shifting the AD curve to the left. By contrast, if interest rates fall, the AD curve will
shift rightwards.
II. Business confidence
In general, the greater the level of business confidence in the economy, the higher the level of
investment will be. Business confidence is high when the economy is growing, as national
income and employment are both rising. Hence, this would shift the AD outwards to the right.
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