Aggregate demand
From WikiTextbook
The theory of supply and demand describes how prices vary as a result of the balance between product availability at each price (supply) and the desires of those with purchasing power at each price (demand). Demand can increase due to certain variables, i.e Lower taxes, and this causes the aggregate demand curve to shift.
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The Circular Flow of Income
The circular flow of income is the movement that money takes through the economy beginning with the household and ending at the household.
Money Flow – Households get money in return for a good or service they provide, and use this money to buy consumer goods
Leakages or Withdrawals
This is the money that leaves the circular flow of income: For Example:
- Net savings(money put aside by the household in banks to save for the future)
- Net Taxes– Paid to the government
- Import expenditure – (the money is spent on goods or services from other countries, so the money is leaving the country)
Injections
The money put back into the circular flow of income. For Example:
- Firms (investments)
- The Government (Government spending and national services)
- Exports (selling goods to other countries)
In the end the injections will flow back around to the household, which is the beginning of the flow, and the household will receive money from the firms as factor payments.
The Aggegrate Demand curve will typically rise as the price level falls due to three main reasons. These are the Real Money Balances Effect, Prices/Interest Rates and International Competiveness.
http://www.revisionguru.co.uk/graphics/diagrams/economics/unit3/aggdemand1.gif
http://www.revisionguru.co.uk/graphics/diagrams/economics/unit3/aggdemand2.gif
Aggregate Demand (AD) can be worked out using the formula: Consumer's Expenditure (C) + Investment (I) + General Government financial consumption (G) + Exports (X) - Imports (M)
Consumer's Expenditure
Consumption is spending on goods and services. It can be divided in a number of different ways, for example spending on durable and non-durable goods.
Government Spending
What do governments spend their money on?
Governments usually spend their money on public goods and merit goods. Public goods are goods that are provided for everyones use and that everyone can appreciate for example street lights, roads etc. Merit goods are goods which are under supplied and under demanded as they are not as appreciated as public goods because they do not directly affect the buyer. Environmentally friendly energy for example.
The main aims of government spending:
- To provide the public with goods and services.
- To promote the consumption of merit goods by the public
- To help the poor and reduce levels of poverty
- To influence the level of total demand.
What is government spending affected by?
Government spending is said to be not affected by economic variables such as inflation etc. Government spending is expenditure by the government but does not include transfer payments for example welfare, student grants and social security. This is simply because nothing is being purchased; it is only money being moved around the economy.
A method of controlling the economy that the government use is called the fiscal policy. Fiscal policy is the name given to the actions of the government in setting the level of public expenditure and how the spending is funded.
Investment (gross domestic fixed capital formation)
An example of investment is spending by companies on capital goods. It also includes spending on working capital such as stocks of finished goods and work in progress.
Investment is often modeled as a function of income and interest rates, given by the relation I = (Y, i). An increase in income will encourage higher investment, whereas a higher interest rate may discourage investment as it becomes costlier to borrow money. Even if a firm chooses to use its own funds in an investment, the interest rate represents an opportunity cost of investing those funds rather than loaning them out for interest.
Imports and Exports
Imports
Imports are a leakage from the circular flow of money in the economy, as the money leaves the UK economy for another country’s system – in return for foreign goods and services. Therefore, spending on imports is subtracted from the aggregate demand equation.
Exports minus imports, (X-M), is the current account of the balance of payments.
Exports
Exports sold overseas are an inflow of demand into the circular flow of income in the economy and add to the demand for the UK produced output. When export sales from the UK are healthy, production in exporting industries will increase adding both to national output and the incomes of these people who work in these industries.
Factors that result in a decrease in Aggregate Demand
- People spending less money results in a decrease. For example if people expect there to be a recession then they will save their money ‘for a rainy day’ and this will result in a decrease in aggregate demand.
- The formula for calculating aggregate demand is:
Consumer's Expenditure (C) + Investment (I) + General Government financial consumption (G) + Exports (X) - Imports (M)
Therefore a decrease in any one of these terms will have resulted in a decrease in aggregate demand unless the amount of imports decrease...in this case, aggregate demand will rise. The terms involve government spending, business investments and consumer spending. E.g. businesses may reduce the capital planned investment spending.
- An increase in taxes would mean that people have less disposable income and so therefore less consumer spending would result in a decrease.
Factors That Increase Aggregate Demand
An increase in aggregate demand can cause a shift to happen where at the price level for a product there could be a low national output when it shifts at the same price there will be a higher national output. Factors that can determine this are:
- Interest rates fall - this would cause people to be able to get more money off mortgages and loans as it would be cheaper to pay back. Therefore they will have a lot of money that they can spend on anything they would like. Also other countries would buy more from our country and there would be a higher export therefore more national output.
- Lower tax - this would give people more money to spend on goods therefore they will have a higher demand on goods that they wanted but couldn't buy before.
- Higher Exports - if a county has become richer recently they might decide on buying more goods from another country. Therefore if this happens more goods will be bought shifting the demand curve up to a higher demand for the same price. An example would be China, where many things are made. Thanks to their high number of exports, their economy is booming.
