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IB Diploma Economics:
Individual demand is the total number of goods and service that an individual is willing and able to buy at a range of prices.
Market demand is the sum of all total number of goods or services that all consumers in a market for a particular good or service is willing and able to buy at a range of prices.
Aggregate demand is best defined as being the total quantity of all output (real GDP) that all buyers in a given economy are willing and able to buy at all possible price levels.
A price level is the current weighted average price of a representative selected group of goods and services (such as that found in the consumer price index or CPI) produced in an economy in a specified period of time (typically one year).
We can think of aggregate demand as the total demand for all goods and services in all the different markets for goods and services within an economy; i.e., it is the sum of all demand within a country. However, aggregate demand is not just all consumer demand, it is the demand from all buyers in an economy; namely:
Components of AD
Aggregate demand explained
The aggregate demand curve
The aggregate demand curve (shown below) is a model of the relationship between the total demand from all four components (C + I + G + X-M) of aggregate demand and the price level of an economy (e.g., the CPI) with a given time period (e.g., one year). There is a negative relationship between aggregate output and the price level and this is why the AD curve slopes downward and to the right.
AD = C + I + G + X - M
negative slope of the AD Curve
The AD curve slopes downwards and to the right, indicating a negative relationship between the price level (e.g., CPI) and national output and income (i.e., real GDP). The reasons behind this negative relationship are very different to that of demand in microeconomics.
Reasons why the AD curve slopes downwards:
1. The wealth effect.
The first reason for the downward slope of the aggregate demand curve is the wealth effect. Recall that the nominal value of money is fixed, but the real value is dependent upon the price level. This is because for a given amount of money, a lower price level provides more purchasing power per unit of currency. When the price level falls, consumers are wealthier, a condition which induces more consumer spending. Thus, a drop in the price level induces consumers to spend more, thereby increasing the aggregate demand.
2. The interest rate effect.
The second reason for the downward slope of the aggregate demand curve is the interest-rate effect. Recall that the quantity of money demanded is dependent upon the price level. That is, a high price level means that it takes a relatively large amount of currency to make purchases. Thus, consumers demand large quantities of currency when the price level is high. When the price level is low, consumers demand a relatively small amount of currency because it takes a relatively small amount of currency to make purchases. Thus, consumers keep larger amounts of currency in the bank. As the amount of currency in banks increases, the supply of loans increases. As the supply of loans increases, the cost of loans – that is, the interest rate – decreases. Thus, a low price level induces consumers to save, which in turn drives down the interest rate. A low interest rate increases the demand for investment as the cost of investment falls with the interest rate. Thus, a drop in the price level decreases the interest rate, which increases the demand for investment and thereby increases aggregate demand.
3. The international trade effect.
The third reason for the downward slope of the aggregate demand curve is the exchange-rate effect. Recall that as the price level falls the interest rate also tends to fall. When the domestic interest rate is low relative to interest rates available in foreign countries, domestic investors tend to invest in foreign countries where return on investments is higher. As domestic currency flows to foreign countries, the real exchange rate decreases because the international supply of dollars increases. A decrease in the real exchange rate has the effect of increasing net exports because domestic goods and services are relatively cheaper. Finally, an increase in net exports increases aggregate demand, as net exports is a component of aggregate demand. Thus, as the price level drops, interest rates fall, domestic investment in foreign countries increases, the real exchange rate depreciates, net exports increases, and aggregate demand increases.
The determinants of AD
The aggregate demand curve may shift to the right (an increase in AD) or to the left (a decrease in AD). It is important to distinguish between movements along the AD curve (e.g., due to the wealth effect) and shifts of the AD curve. Only changes in the determinants of aggregate demand (C + I + G + X – M) will shift the AD curve.
Shifts of the AD curve
Investment. Investment, second of the four components of aggregate demand, is spending by firms on capital, not households. Investment is the most volatile component of AD. An increase in investment shifts AD to the right in the short run and helps improve the quality and quantity of factors of production in the long run.
Factors that affect investment:
1. Interest rates
Firms borrow from banks to make large capital intensive purchases, and if the interest rate decreases, it becomes cheaper for firms to invest and provides incentive for firms to take risk.
2. Business confidence
If firms are confident about the economy and its future growth, they are more likely to invest in capital, new projects and buildings/machinery.
3. Investment policy
If governments provide incentives such as tax breaks, subsidies, loans at lower interest rates then investment can increase. However, corruption and bureaucracy deters investment.
Technological improvements lead to greater investment spending as firms adopt new technologies to make them more productive and/or more competitive in their markets.
4. Business taxes
Governments may choose to tax the profits of businesses (business income taxes or corporate taxes), and they can increase or decrease these taxes on businesses. Any increase in business taxes will lead to a lower level of investment spending by firms, because, all things being equal, an extra dollar spent on taxes is a dollar that could have been spent on investment. Vice versa for decreases in the corporate tax rate.
5. Level of corporate indebtedness
Similar to consumer indebtedness, if firms have borrowed a lot in general to finance their investments then they are less likely to engage in additional borrowing to finance further expansion. Thus increase in the debt accumulated by firms in the economy will lead to a decrease in AD, and decrease in the debt of firms will cause AD to increase and shift right.
Government spending forms a large total of aggregate demand, and an increase in government spending shifts aggregate demand to the right. Different governments may have different priorities, both political and economic. Government spending is categorised into transfer payments and capital spending. Transfer payments include pensions and unemployment benefits and capital spending is on things like roads, schools and hospitals. Governments spend to increase the consumption of health services, education and to re-distribute income. They may also spend to increase aggregate demand.
IMports, exports and exchange rates
Aggregate demand: Practice
Consumption. This is made by households, and sometimes consumption accounts for the larger portion of aggregate demand. An increase in consumption shifts the AD curve to the right.
Factors that affect consumption:
1. Consumer confidence
If consumers are confident about their future income, job stability, and the economy is growing and stable, spending is likely to increase. However, any job insecurity and uncertainty over income is likely to delay spending. An increase in consumer confidence shifts AD to the right.
2. Interest rates
Lower interest rates tend to increase consumption because larger goods are usually purchased on credit and if interest rates are low, then it’s cheaper to borrow. Consumers mostly borrow to buy houses, which is one of the biggest purchases and lower interest rates means lower mortgage payments, so households can spend more on other goods. Some Economists argue that lower interest rates also make saving less attractive, but there is no real evidence. So, lower interest rates increase Aggregate Demand.
3. Consumer debt
If a consumer has a lot of debt, he is unlikely to buy more since he would have to pay his debt off first. Low consumer debt increases consumption and aggregate demand.
Wealth are assets held by a household, such as property or stocks. An increase in property is likely increase to consumption.
5. Changes in personal income taxes
Personal income taxes are taxes paid by households on the incomes they earn. Any increase in personal income tax will decrease the disposable income of consumers (i.e., their after tax income) and thus, spending decreases. The opposite occurs if governments reduce personal income taxes – disposable income increases and consumer spending increases.
1. Net exports. Imports are foreign goods bought by consumers domestically, and exports are domestic goods bought abroad. Net exports is the difference between exports and imports, and this component can be net imports too, if imports are greater than exports. An increase in net exports shifts aggregate demand to the right. Changes in national income abroad, the exchange rate and trade policy affects net exports.
2. Changes in the national income of trading partners
Most countries will have major export markets. These are overseas markets which purchase a relatively large proportion of a country’s exports. For example, China is the largest destination for New Zealand exports, and Germany exports more to France than to any other country. As national incomes in key export destinations increase, all things being equal, demand for all products in these markets increases, including exports. Economic recessions in major export markets will see a decrease in demand for a nation’s exports and aggregate demand will decrease as export receipts fall.
3. Trade protection
In economics, protectionism is the economic policy of restraining trade between countries through methods such as tariffs on imported goods, restrictive quotas, and a variety of other government regulations.
Increases and decreases in trade protectionism affect aggregate demand. Take for example, if country A imposes a trade tariff on country B’s goods (which they import) in a bid to “protect” its domestic produce and make it more competitive (assuming that they are in competitive demand), the imports coming from country B will become more expensive. Consumers will switch away from buying those imports to buying the locally produced good (for country A this is good because consumption of domestic good increase causing their aggregate demand to increase). Country B’s export revenue falls and this results in a fall in country B’s aggregate demand.
4. Exchange rates
An exchange rate is the price of one currency in terms of another, the rate at which one currency can be exchanged for another. For example, the exchange rate between U.S. dollars and British pounds is the price of buying one British pound in terms of the amount of U.S dollars paid.
Exchange rates surface as an aggregate demand determinant because they effect the relative prices of imports and exports, and thus the net exports component of aggregate expenditures. When exchange rates change, the relative prices of exports and imports also change, which causes exports, imports, net exports, and thus aggregate demand to change.
An appreciation (increase) of the exchange rate, that is, the price of buying foreign currency in terms of domestic currency increases, causes a decrease in net exports and an decrease in aggregate demand.
A depreciation (decrease) of the exchange rate, that is, the price of buying foreign currency in terms of domestic currency decreases, causes an increase in net exports and an increase in aggregate demand.
In terms of an appreciating exchange rate, if for example the UK pound and the US dollar previously traded at US$2.00 to the UK pound, and it now trades at US$2.50 per pound. This higher exchange rate means that US consumers pay more for any goods purchased from British producers (that is, imports). A British-made car selling for 10,000 British pounds in Britain costs U.S. consumers $20,000 at the original exchange rate and $25,000 at the new exchange rate. At this higher price, US consumers are bound to buy fewer British-made products, causing UK exports to decline.
On the other side of the net export equation, British consumers pay less for goods purchased from US producers (that is, imports). An American publisher selling books into the UK market for US$20 costs British consumers £10 at the original exchange rate and £8 at the new exchange rate. At this lower price, British consumers are bound to buy more American-made products, causing US imports to the UK to increase.
With imports falling and exports rising, net exports unquestionably increase. And with this increase in net exports goes an increase in aggregate demand. The higher exchange rates cause an increase in aggregate demand, which is a rightward shift of the aggregate demand curve.
The opposite occurs with a depreciating exchange rate.
PROGRESS CHECK - TEST YOUR UNDERSTANDING BY COMPLETING THE ACTIVITIES BELOW
You have below, a range of practice activities, flash cards, exam practice questions and an online interactive self test to ensure you have complete mastery of the IB Economics requirements for the Macroeconomics: 2.5 Aggregate Demand topic.
IB Economics interactive QUIZZES
Test how well you know the IB Economics Macroeconomics – AD/AS: 2.5 Aggregate Demand HL and SL topic with the interactive self-assessment quizzes below. Aim for a score of at least 80 per cent.