Theme 2.7: Aggregate Demand Analysis Flashcards
Aggregate Demand Curve
The aggregate demand curve uses different axis to the normal demand curve.
- Along the x-axis is national output
- Up the y-axis is price level
The price level represents the average level of prices in an economy - in the UK this price is likely to be the CPI
The aggregate demand (AD) curve slopes downwards - the lower the price level, the more output is demanded . Lower prices mean consumers can buy more goods/services with their money.
Movement along a Aggregate Demand curve
A change in the price level will cause a movement along the AD curve - for example, if the price level rose from P to P1, the total aggregate demand would fall from Y to Y1 .
A rise in the price level will cause output to fall because:
- Domestic consumpion will be reduced - things become more expensive, so people can be purchase fewer goods and services.
- The demand for exports will be reduced - domestically produced products become less productive
- The demand for imports will increase - if prices haven’t risen abroad, imports will become cheaper in comparison.
Aggregate demand curve shift to the right
The AD curve will shift to the right if there’s a rise in consumption, investment, government spending or net exports that hasn’t been caused by a change in the price level. For example:
A reduction in income tax will cause an increase in consumers’ disposable income. This tends to lead to an increase in consumption, so there will be an increase in aggregate demand and a shift of the AD curve to the right from AD to AD1.
If a government changes its fiscal policy and decides to increase its spending above any increase in its revenue, then this is an injection into the circular flow of income. It will cause an increase in aggregate demand and a shift of the AD curve to the right, e.g. from AD to AD1.
A weak currency will make exports cheaper and imports more expensive. This will lead to a rise in net exports, so there will be an increase in aggregate demand and a shift of the AD curve to the right, e.g. from AD to AD1.
Effects of an right-ward shift of the aggregate demand curve
The outward shift of the curve means that at a given price level, more output can be produced - but also, a given amount of output will have a higher price level. For example, if there’s an increase in aggregate demand from AD to AD1. - at price level P, there’s an increase in output from Y to Y1, and at output Y, the price level increases P to P1.
Labour is derived demand - an increase in AD means output increases, so the demand for labour increases. More jobs are created so that the extra output can be produced, and there will be an increase in employment levels.
Aggregate demand curve shift to the left
The AD curve will shift to the left if there’s a fall in consumption, investment, government spending or net exports that hasn’t been caused by a a change in the price level. For example:
A rise in interest rates will lead to a reduction in consumer spending because people will choose to save more. Higher interest rates also lead to a reduction in investment because borrowing money becomes more expensive. Both of these factors lead to a reduction in aggregate demand, and a shift of the AD curve to the left, e.g. AD to AD2.
A strong currency will make exports more expensive and imports cheaper, so there will be a fall in net exports. This will lead to a reduction in aggregate demand and a shift of the AD curve to the left, e.g. from AD to AD2.
Effects of an left-ward shit of the aggregate demand curve
The inward shift of the curve means that at a given price level (P), less output (Y2) can be produced - but also, a given amount of output (Y) will have a lower price level (P2). There will also be a decrease in employment levels.
Multiplier effect’s effect on aggregate demand
When there’s an injection into the economy (e.g. as a result of increased government spending), the AD curve will shift slightly to the right.
However, when money is injected into the circular flow of income, the value of the initial injection is multiplied - this is the multiplier effect. One person’s expenditure becomes someone else’s income, so the money goes round the circular flow multiple times until it’s all leaked out.
The effect is that the AD curve shifts even further to the right - and the bigger the multiplier, the greater the shift.
For example:
if a government injects money into healthcare, the money might be used for wages. Some of this money would then be spent by consumers - increasing consumption. This would create a second increase in AD, and the cycle will continue until all the money from the initial injection has leaked out.
Calculating and controlling the multiplier effect
The overall size of the multiplier will depend on the size of the leakages from the circular flow of income, but it is very difficult to measure in practice. This is partly because there are time lags and the multiplier effect of government spending can take years to fully show up in the economy - e.g. the full benefits to the economy of government spending on improving transport links may only appear years later.
Measuring the size of the multiplier effect is also made difficult because like everything else in the economy, it is changing all the time.
This makes it very difficult for any government to accurately control AD.
