AD/ AS Framework Flashcards
Aggregate Demand
Definition
The total level of spending in an economy at each GPL.
Aggregate Demand
Formula
AD = C + I + G + (X-M)
where
- C = consumer expenditure
- I = investment expenditure
- G = government expenditure
- X = export expenditure
- M = import expenditure
- (X-M) = net exports
GPL Determinants
- Wealth Effect
- Interest Rate Effect
- International Substitution Effect
Wealth Effect
With falling GPL & no change in households’ nominal income,
- G&S sold in economy become cheaper
- more G&S can be purchased
- consumers feel wealthier & are encouraged to purchase more
- quantity of G&S demanded increases
Interest Rate Effect
With falling GPL and ceteris paribus,
- less money required for purchases
- demand for money decreases
- interest rates reduced
- households find it cheaper to borrow money
- big ticket purchases become more affordable
- consumers encouraged to take loans & invest in new factory plants
- quantity of G&S demanded increases
International Substitution Effect
With falling domestic GPL, unchanged foreign prices & ceteris paribus,
- domestically-produced goods are cheaper
- demand for foreign goods decreases
- M falls
- demand for domestically-produced goods increases
- X falls
- (X-M) likely increases
- quantity of domestically-produced G&S demanded increases
Non-GPL Determinants
Consumer Expenditure
- Changes in consumer expectations & confidence
- Changes in personal income taxes
- Changes in income distribution
- Changes in interest rates & availability of credit
Changes in consumer expectations & confidence
With the expectations that inflation rate is rising and outlook of economy is optimistic,
- G&S are cheaper now
- more willing & able to spend on G&S
- current demand for G&S increases
- C increases
Changes in personal income taxes
With decreased personal income tax,
- disposable income increases
- purchasing power increases
- C increases
Changes in income distribution
Between different social-economic standing groups,
- those of higher SES spend a smaller proportion of it and instead save/ invest it
- those of lower SES spend a larger proportion of it on necessities
- redistribution of income enables those of lower SES to afford more
- C likely increases
Changes in interest rates & availability of credit
Big ticket items are often financed by loans & influenced by the ease of taking out loans & level of interest rates
- cost of a loan & servicing debt decreases
- more willing & able to purchase interest rate sensitive items
- returns of savings reduced (opportunity cost of spending)
- households rather spend than save
- C increases
Non-GPL Determinants
Investment Expenditure
- Changes in interest rates & access to credit
- Changes in firms’ expectations & business confidence
- Changes in corporate income tax rates
- Changes in technology
Changes in interest rates & access to credit
Businesses typically take out loans to purchase capital goods & expand business operations
With increasing interest rates and no change in the expected revenue from investments,
- loans & finance investments become more expensive
- profitability decreases & fewer investments are profitable
- firms are less incentivised to invest
- number of projects undertaken are fewer
- I decreases
WHILE when access to credit ie. ability to obtain G&S before payment increases, I increases
Changes in firms’ expectations & business confidence
With more optimistic views about future sales & economic activity,
- expectation that returns on investments will rise
- more profitable opportunities arise
- more willing to invest
- I increases
Changes in corporate income tax rates
With reduced corporate tax rates,
- profits increase
- more financial capital for reinvestment in fixed capitals eg. expansion of factory plants
- more willing & able to invest
- I increases
Changes in technology
With new technology, new capital formation is needed
- expectation of technology brings about
