II. Aggregate Demand

• The quantity of real GDP demanded is the sum of consumption expenditure (C), investment (I), government expenditure (G), and net exports (X - M), or Y = C + I + G + (X - M).
• Buying plans depend on many factors including:

· The price level

· Expectations

· Fiscal policy and monetary policy

· The world economy

The Aggregate Demand Curve

• Other things remaining the same, the higher the price level, the smaller is the quantity of real GDP demanded. The relationship between the quantity of real GDP demanded and the price level is called aggregate demand. As the figure shows, the AD curve is downward sloping.

· The negative relationship between the price level and the quantity of real GDP demanded reflects the wealth effect (when the price level rises, real wealth decreases and so people decrease consumption) and substitution effects (first, the intertemporal substitution effect: when the price level rises, real money decreases and the interest rates rises so that consumption expenditure and investment decrease; and, second, the international price substitution effect: when the price level rises, domestic goods become more expensive relative to foreign goods so people decrease the quantity of domestic goods demanded).

Changes in Aggregate Demand

• Any factor that influences buying plans other than the price level brings a change in aggregate demand and a shift in the aggregate demand curve. Factors that change aggregate demand are:

· Expectations: Expectations of higher future income, expectations of higher future inflation, and expectations of higher future profits increase aggregate demand and shift the AD curve rightward.

· Fiscal policy and monetary policy: The government’s attempt to influence the economy by setting and changing taxes, making transfer payments, and purchasing goods and services is called fiscal policy. Tax cuts or increased transfer payments increase disposable income (aggregate income minus tax payments plus transfers) and thereby increase consumption expenditure and aggregate demand. Increased government expenditures increase aggregate demand. Monetary policy consists of changes in interest rates and in the quantity of money in the economy. An increase in the quantity of money and lower interest rates increase aggregate demand.

· The world economy: Exchange rates and foreign income affect net exports (X - M) and, therefore, aggregate demand. A decrease in the exchange rate or an increase in foreign income increases aggregate demand.

Date: 2015-12-11; view: 761