IB Economics

What is Aggregate Demand (AD) and how do we influence it?

Understanding Aggregate Demand (AD)

• Aggregate Demand (AD) =

– Total level of planned real expenditure on UK produced goods and services

• The components of aggregate demand

• Household Spending (C)

• Gross Fixed Capital Spending (I)

• Government Consumption (G)

• Exports of Goods and Services (X)

• (minus) Imports of Goods and Services (M)

• AD sums to GDP (expenditure based)

The Aggregate Demand Curve

Real National Output

Price Level

AD1

P1

Y1

P2

Y2

P3

Y3

An AD curve is drawn assuming all factors affecting aggregate demand are being held constant except the general price level. A change in factors affecting any one or more components of aggregate demand, household (C), firm (I), government (G) or foreigners (X) changes planned aggregate demand and results shift in the AD curve

An Outward Shift in Aggregate Demand

RNO

Price Level

AD1

P1

Y1 Y2

AD2

Recent Government Actions - AD

Back spending plan, urges Obama

US President-elect Barack Obama has called for "drastic action" to prevent the US economic situation worsening. Speaking two weeks before taking office, Mr Obama urged Congress to act quickly to pass an $800bn (£526bn) stimulus plan.

His proposals include tax cuts and creating new jobs through increased government spending on public works projects. He called on political leaders from all sides to come together behind a bill. Mr Obama is facing his first big battle to persuade Congress to approve a colossal effort to restart America's economy, reports the BBC's Adam Brookes, in Washington. His warnings were more dire than anything before, our correspondent adds, and he is piling on the pressure for action.

Source: Modified from http://news.bbc.co.uk/2/hi/business/7819290.stm | 9th January 2009

How does increased government spending affect AD?

RNO

Price Level

An Inward Shift in Aggregate Demand

Real National Output

Price Level

AD4

P1

Y4 Y3

AD3

Recent Government Actions - AD

Source: http://news.bbc.co.uk/2/hi/business/7522741.stm | 24th July 2008

How does increasing the rate of interest affect AD?

RNO

Price Level

Causes of Changes in AD

• Changes to Government Fiscal Policy

– An increase/decrease in level of taxation

– Changes in real government spending on health, education, transport

– An increase in the size of the budget deficit (where government spending > tax revenue)

• Changes to Monetary Policy

– Changes in official base interest rates by the Bank of England

– Fluctuations in the exchange rate for sterling (e.g. a fall in the value of sterling against the Euro or the US dollar)

• Changes in Business & Consumer Confidence

• Fluctuations in the growth of national income and expenditure in other countries (the global economic cycle)

– E.g. the effects of a recession in the United States

– A cyclical recovery within the Euro Zone

How do changes in the rate of interest affect the level of business investment?

Level of Investment

R (%)

The UK and Global Economic Fluctuations

– Demand-side economic shocks

• Growth of income & demand in OECD economies

– E.g. an economic recession in the United States

– Asian economic downturn / financial turbulence

• Interest rates decisions in Europe and in the USA

• Performance of global stock markets - particularly in the USA

• Foreign Investment decisions of global multinationals

– Supply-side economic shocks

• Fluctuations in international commodity prices

How will the global economic downturn affect Dubai?

How will the global economic downturn affect Dubai?

RNO

Price Level

Fiscal Policy and Aggregate Demand

AD = C + I + G + (X-M)

Where;– C = Consumption– I = Investment– G = Government Spending– X = Exports– M = Imports

Fiscal Policy and Aggregate Demand

• Fiscal Policy can affect AD through several channels

• Direct changes in government spending (current and capital)

• Changes in direct taxes

– Income tax / National Insurance

– Corporation tax

– Taxation of saving

• Tax incentives for R&D

• Changes in indirect tax

– Changes in excise duties e.g. cigarettes and alcohol

– Changes in VAT, the UK recently reduced VAT to 15% to stimulate demand (it will return to 17.5% in 2010)

• Changes in the budget deficit or surplus, in an attempt to stimulate the US economy it has been forecasted that the government will borrow $1.8 tn in this financial year

Taxes and Aggregate Demand – what happens when the economy is growing too SLOW?

Cut in personal income tax

Boost to disposable income

Adds to consumer demand

Cut in indirect taxes

Lower prices – higher real incomes

Adds to consumer demand

Adds to business capital spending

Cut in corporation tax

Higher “post tax” profits for businesses

Cut in tax on interest from saving

Boost to disposable income of people with net savings

Adds to consumer demand

Expansionary Fiscal Policy

Taxes and Aggregate Demand – what happens when the economy is growing too QUICK?

Contractionary Fiscal Policy

Monetary Policy and Aggregate Demand

Expansionary Monetary Policy

Lower Nominal Interest Rates

Stimulates Capital Investment Spending

Increase in Economic Activity

Expansionary Monetary Policy

Increase in Bank Loans

Stimulates Household Spending

Increase in Economic Activity

Expansionary Monetary Policy

Exchange Rate Depreciation

Stimulates Net Exports

Increase in Economic Activity

Expansionary Monetary Policy

Rise in Equity Prices

Rise in House Prices

Rise in Value of Household Wealth

Increase in Economic Activity

Interest Rate Channel

Bank Lending Channel

Exchange Rate Channel

Wealth Effect Channel

Tasks

Today’s Classwork

• Complete student workpoint 16.6 (page 177)

• Complete SRQ # 3 (page 177)

• Complete DRQ (page 178)