3.2 AD Flashcards
AD (def+formula)
Planned spending on domestic goods and services at different average price levels, per period of time. Consists of consumption, investment and government expenditures plus net exports.
Aggregate demand = C + I + G + (X − M)
reasons for -ve AD curve slope
1. The wealth effect : As the average price level falls, the wealth of participants in the economy increases in real terms as their ability to purchase goods and services improves. The real value of assets, like property or stock, is now higher.
2. The interest rate effect: At lower price levels, interest rates are lower too, giving people more disposable income to spend and with which to demand higher volumes of output. The incentive to save is also lower.
3. The net balance effect: A lower price level makes goods and services relatively cheaper for foreign countries to buy. Therefore, the demand for exports rises and the demand for imports from abroad falls, increasing the net trade balance and leaving it in an overall better position.
the wealth effect
The impact of citizen wealth on their aggregate propensity to demand in the economy.
propensity-inclination or natural tendency to behave a certain way
The wealth effect is a behavioral economic theory suggesting that people spend more as the value of their assets rise. The idea is that consumers feel more financially secure and confident about their wealth when their homes or investment portfolios increase in value. They are made to feel richer, even if their income and fixed costs are the same as before.
interest rate effect
The interest rate effect refers to the effect of an increase or decrease in aggregate demand in an economy due to changes in interest rates set by the central bank of a country. increased interest = decreased demand
The impact of interest rates on the spending and savings habits of citizens, affecting their propensity to demand in the economy.
net balance effect
The effect of the relative price level of imports and exports on people’s propensity to demand in the economy
A lower price level makes goods and services relatively cheaper for foreign countries to buy. Therefore, the demand for exports rises and the demand for imports from abroad falls, increasing the net trade balance and leaving it in an overall better position.
propensity = inclination or natural tendency to behave a certain way
axes of AD curve
x — total output/real GDP
y — price level
non price factors that shift AD/determinants of AD (derive from formula)(4)
consumption
investments
government
net exports
consumption
Spending by households on durable and non-durable goods and on services over a period of
time.
how does consumption expenditure result in shift of AD curve? (3 factors effecting consumption exp and how AD)
1. changes in business confidence
- optimistic in future sales and future of econ. -> high business confidence -> investments ^ -> AD^ -> right shift
- pessimistic in future sales and future of econ. -> low business confidence -> investments v-> AD v -> left shift
2. changes in interest rates
- usually via monetary policy to influence AD
- interest rates ^ -> cost of borrowing to invest financially, servicing existing loans, and investment returns from savings ^^^ -> investments v -> AD v (left)
- interest rates v -> cost of borrowing to invest financially, servicing existing loans, and investment returns from savings v -> likely to vvv investment -> AD ^(right)
3. changes in business taxes
- usually via fiscal policy to influence AD
- ↑ corporate taxes (direct taxes)→ ↓after-tax profit → likely to ↓I → ↓AD (left shifts)
- ↓ corporate taxes → ↑ after-tax profit → likely to ↑I → ↑ AD (right shifts)
from kognity:
1. Confidence: When consumers start feeling anxious about the economy or their own economic prospects, they may choose to reduce their consumption, causing a leftward shift of the AD curve and reduced national output. If consumers feel confident about their future income and employment, they will tend to spend more and the AD curve will shift rightward.
2. Unemployment: The threat of becoming unemployed is a big factor of concern for people, but also for annual real incomes. This in turn influences the ability to consume goods and services. Unemployment is an indicator that is closely monitored by governments, especially in relation to seasonal changes.
3. Real interest rates: Most people also tend to buy property or other large purchases by taking out a mortgage or loan with the bank and paying back a monthly sum that includes interest. When interest rates fall, this makes it easier for people to borrow money and spend, as the repayment on that borrowing becomes lower. On the other hand, interest rates also encourage or discourage people to save. As interest rates increase, the incentive to save rises: a leakage to the economy. If interest rates decrease, the incentive to save falls, which encourages consumer spending. Like unemployment, real interest rates are a closely monitored indicator. Lower savings and increased borrowing can both result in a rightward shift of the AD. Accordingly, higher interest rates will encourage saving and discourage borrowing and will shift the AD leftward.
4. Wealth: Wealth must not be confused with income. Income is earned when the factors of production are exchanged for their respective payments. Wealth refers to assets and includes ownership of property, bonds, shares of a company, and so on. When asset prices rise in a country, it can provide aggregate demand with an enormous boost as people feel wealthier and more able to spend. This was particularly true in the run-up to the financial crisis in 2008, when the housing market in many countries experienced speculative bubbles as property prices rose. AD in the economy will shift rightward when people feel wealthy, leftward when they feel less so due to falling prices of property or falling value of shares owned.
5. Personal Taxes: The amount that we have to pay in tax to the government varies from country to country but, generally, most countries pay for public services using the revenue earned from taxes. There are many different types of taxes that have to be paid, including income taxes, indirect taxes and import duties.
When income taxes decrease, our disposable income, or the amount of income left to spend on other things, increases, causing consumption to increase. As mentioned in subtopic 3.1.8, the 2017 Tax Cuts and Jobs Act aimed at precisely this outcome. As tax rates went down, aggregate demand shifted rightward, contributing to economic growth.
**6. Level of household indebtedness: **
Most people have to borrow money not only to buy their home but also for other large purchases like university education, cars and home renovations. In some countries, private sector net debt exceeds annual national output several times over. To see how worldwide debt compares, see here.
Borrowing money and spending is good for GDP in the short term, as it allows people to increase consumption. However, in the long term, individuals deprive themselves of future consumption to pay back the debt with interest. This will mean a short-run shift of AD rightward that might result in a later leftward shift as debt is repaid.
7. Expectations of future price level:
Consumers may decide to spend more and save less if they expect prices to rise in the future. This price rise is called inflation . On the other hand, consumers may decide to spend less and save more if they expect prices to fall in the future. This price fall is called deflation. You will learn about inflation and deflation in the next subtopic. When consumers expect future inflation, they tend to spend more in the present, shifting AD rightward.
how does investment expenditure result in shift of AD curve? (3 factors affecting IE and how they cause shifts)
1. Changes in business confidence
- Optimistic → future sales & future of the economy → high business confidence → likely to ↑I → ↑AD (right shifts)
- Pessimistic → future sales & future of the economy → low business confidence → likely to ↓I → ↓AD (left shifts)
2. Changes in interest rates
- Usually via. Monetary Policy to influence AD
- ↓ interest rates → ↓ cost of borrowing to finance investment, ↓cost of servicing of existing loans & ↓ interest returns from saving→ likely to ↑I (as ROI ^^) → ↑AD (right shifts)
- ↑ interest rates → ↑ cost of borrowing to finance investment, ↑ cost of servicing of existing loans & ↑ interest returns from saving→ likely to ↓I → ↓AD (left shifts)
3. Changes in business taxes
- Usually via. Fiscal Policy to influence AD
- ↑ corporate taxes (direct taxes)→ ↓after-tax profit → likely to ↓I → ↓AD (left shifts)
- ↓ corporate taxes → ↑ after-tax profit → likely to ↑I → ↑ AD (right shifts)
from kognity:
1. Interest rates: As with consumers, interest rates play a big role in determining a firm’s decision to borrow. Sometimes, firms borrow to finance large-scale investment. This is because it is easier to manage repayments with smaller amounts rather than to save the money and spend it all at once.
Higher interest rates make borrowing less attractive and can cause investment to fall (AD shifts leftward). In contrast, lower interest rates may encourage borrowing and investment (AD shifts rightward) as long as the perceived reward of that investment through increased consumption is higher than the interest rate.
2. Business confidence: The health of the economy is important for all businesses as they need to be able to plan for the future. For example, if prices are rapidly rising in an economy, or a recession appears to be looming, firms are unlikely to spend or plan for expansion. They will cut their costs (causing AD to shift leftward). Like consumer confidence, business confidence is closely monitored as a warning sign of an economic slowdown.
3. Technology: Investing in the innovation of technology can ultimately lead to market growth, reduced costs and time saved, allowing countries to make the best use of their resources. For example, consider this video segment on hydroponics, a new way of growing plants without soil. Improvements in technology reduce the need for using more resources than are necessary and decrease production costs, causing AD to shift rightward. However, technological innovation itself takes time and costs money to develop. It also costs a lot of money to implement the new technology into a business, and training for staff is often required before this technology can be used.
4. Business taxes:
Like consumers, firms also pay taxes to the government. Raising business taxes reduces the amount left for investment and causes leftward shift of AD. Therefore, it is important that taxes are set to an appropriate level. This means that governments are not discouraging firms from setting up businesses in their country or from making investments.
5. Level of corporate indebtedness: Like consumers, firms also borrow money to finance their expansion. This is especially true for entrepreneurs starting new businesses. They will often approach banks to lend them the start-up capital necessary to launch their brand. These debts have to be paid with future earnings and so can slow future investment, causing a leftward shift of AD.
how does govt expenditure result in shift of AD curve? (2 kinds of spending)
1. Political spending
- Increasing spending before election to win votes → ↑G → ↑AD (right shifts)
2. Economic spending to influence AD
- A form of Fiscal Policy to influence AD
- Deliberate spending in targeted public & merit goods to stimulate economic activities → ↑G → ↑AD (right shifts)
- Reduction in public and merit goods spending to slow down economic activities→ ↓G → ↓AD (left shifts)
how does net exports expenditure result in shift of AD curve? (3 factors affecting net exports)
1. Changes in income level abroad
- ↑income abroad → ↑purchasing power → ↑imports (M) → ↑exports (X) of domestic country → ↑AD (right shifts)
- ↓income abroad →↓purchasing power → ↓imports (M) → ↓exports (X) of domestic country → ↓AD (left shifts)
2. Changes in exchange rates (price of one’s currency against another’s)
- When domestic country’s currency appreciates → domestic currency becomes more costly to be purchased by foreign currencies to buy domestic exports (X ) → domestic exports (X) ↓ while imports (M) ↑ as it is now cheaper for domestic currency to purchase foreign currencies to buy imports (M) → ↓ (X-M) → ↓AD (left shifts)
- When domestic country’s currency depreciates → domestic currency becomes cheaper to be purchased by foreign currencies to buy domestic exports (X ) → domestic exports (X) ↑ while imports (M) ↓ as it is now more costly for domestic currency to purchase foreign currencies to buy imports (M) → ↑ (X-M) → ↑AD (right shifts)
3. Changes in trade policies or the level of trade protection
- Trade protection refers to trade restrictions to free international trade often imposed by the government to protect its own industries.
- When domestic country imposes trade protection to limit its imports (M) to protect its import-substitute industries → ↓M → ↑(X-M) →↑ AD (right shifts)
- Trading partners will experience a ↓X → ↓(X-M) → ↓AD (left shifts) → trading partners are likely to retaliate with similar trade restrictions
from kognity:
1. Income of trading partners: Economic growth abroad is necessary to sustain demand for exports and, as we saw during the financial crisis of 2008, it is not always guaranteed. The growth of large emerging consumer markets like China, India and Indonesia has provided large boosts in the exports for developed markets like German, Japan and the USA. As incomes have risen in the emerging markets, a greater demand for the exports of the developed markets has resulted in a shift of AD, increasing growth for Germany, Japan and the USA. However, this relationship also means that these economies are linked. A slowdown in consumption in one economy can result in a leftward shift of AD in another, as consumers become less willing or able to purchase the exports. In early 2020, Japan and Germany ‘ s growth was impacted when the economy of one of their largest trading partners slowed down and consumption of their goods and services slumped.
2. Exchange rates : The values of currencies determine the relative prices of goods and services traded. When exchange rates appreciate, more of one currency is required to purchase another, and therefore more money is needed to acquire the same good. This makes exports less competitive abroad, but also makes it cheaper to import goods and services, which will cause a leftward shift of AD. Depreciation causes the opposite to happen. Changes in the exchange rate may affect the aggregate demand, but to what extent depends on the size of the trade balance and relative price elasticity of demand (PED) of imports and exports. More on this will be discussed in topic 4: The global economy.
3. Changes in trade policies: Countries might change their trade policies, which will affect the way that they interact with other economies. They might impose restrictions on the way goods or services are imported from another country, or change the way they support their own industries when competing with foreign firms. Countries can also:
impose taxes on imports, known as tariffs
impose restrictions on volumes of goods imported, known as quotas or voluntary export restrictions (VER)
support their own industries with subsidies.
4. Less traditional methods also include exchange rate manipulation and health and safety requirements. When countries increase the level of protectionism , other countries struggle to sell the same volume of goods and services. The aggregate demand then increases for the importing country and falls for the exporting country. For example, in 2019, US president Donald Trump said he would place tariffs on steel and aluminium coming into the US from Brazil and Argentina. This was an effort to protect domestic producers and decrease imports.
3 factors affecting NET EXPORT EXPENDITURE
- abroad income level
- exchange rates
- trade policies
2 factors affectin ggovt spending(2 areas of spending)
- political spending
- economical spending to influence AD
3 factors affecting consumer expenditure
- business confidence
- interest rates
- business tax
