Sunday, January 18, 2015

Aggregate Demand

Aggregate Demand
Aggregate D&S is heavily tested on the AP. Know it all.

Aggregate Demand - refers to the total spending on domestic goods and services over a period of time.
Definition: total planned spending on domestic goods/services at various possible average price levels per period of time.

Spending come from:
  • Private sector: (households and firms)
  • Public sector: (government)
  • Foreign sector: (net exports) = (exports minus imports)
Private sector: includes:
  • (C) consumption from households & (I) investment from firms
Public sector includes:
  • (G) government expenditure
Foreign sector includes:
  • (Xn) foreign sales of domestically produced goods and services minus imports
So this looks like the GDP formula, yes?
GDP = C + I + G + Xn
I like to think of the AD/AS curve as showing all the things that are happening during the year and GDP is more of a snapshot at the end of the year (a point in time). The AD/AS curve is a representation of what has gotten us to the final place (GDP). 

Yet, AD (aggregate demand) is like the microeconomic demand curve in that it shows an inverse relationship between how much is demanded and prices. There are things that affect the price level and thus, shift AD, just like the demand curve in micro.

First, lets look at the AD/AS curve in Equilibrium

The AD/AS curve is in equilibrium.
The PL (price level is stable)
There is full employment or at the NRU (Natural Rate of Unemployment)
***Comparisons between the AD/AS curve and the PPC, at AD/AS Equilibrium,, society is producing on its PPC Curve - The economy is utilizing all of its resources efficiently. We are producing at point B on the PPC when the AD/AS curve is in Equilibrium.

I find that students learn quicker when they always start problems by drawing the equilibrium graph and then change the graph according to what happens in the economy.
(My advice) always start from equilibrium and then show the change.

(C) Consumption/Changes in Consumer Spending
           (shifting of the AD curve)
           (focus on what happens to the price level, unemployment & output)

Notice that AD has shifted to the left, there has been a decrease in the PL (Price Level), Output has fallen & we can assume that the economy is in Recession and unemployment has increased.

What are the Consumption/ Changes in Consumer Spending triggers that have caused the decrease in AD?

  • Consumer Income decreases - (Consumer Income decreases, then spending decreases)
  • Wealth decreases - (value of assets decrease (house values) then spending decreases)
  • Taxes increase - (Taxes increase - disposable income decreases - spending decreases)
  • Interest Rates increase - (Interests rates increase - investment decreases)
  • Expectations about the future economy could be pessimistic. - (if expectations about the economy worsen then citizens will want to have more cash on hand for emergencies and will therefore spend less)

If spending decreases for any of the above reasons, then the Price Level (PL) will decrease and output will decrease, unemployment will increase.

PL - decreases
Output - decreases
Unemployment - increases

Or, there could be a shift right of the AD curve due to the opposite action:

(I) Investment - Spending by firms on capital equipment/technology and by households                                           on housing.

(Xn) Net Exports - net exports equals exports (X) - imports (n)

(G) Government Spending (fiscal policy)

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